Global Finance with Electronic Banking
(FIMA 40073)
MODULE 3: FOREIGN EXCHANGE MARKET
Foreign Exchange
Foreign exchange (Forex or FX) is the conversion of one currency into another at a
specific rate known as the foreign exchange rate. The conversion rates for almost all
currencies are constantly floating as they are driven by the market forces of supply and
demand.
The most traded currencies in the world are the United States dollar, Euro, Japanese
yen, British pound, and Australian dollar. The US dollar remains the key currency, accounting
for more than 87% of total daily value traded.
Factors that Affect Foreign Exchange Rates
Many factors can potentially influence the market forces behind foreign exchange
rates. The factors include various economic, political, and even psychological conditions.The
economic factors include a government’s economic policies, trade balances, inflation, and
economic growth outlook.
Political conditions also exert a significant impact on the forex rate, as events such as
political instability and political conflicts may negatively affect the strength of a currency. The
psychology of forex market participants can also influence exchange rates.
The Foreign Exchange Market
The foreign exchange market is a decentralized and over-the-counter market where all
currency exchange trades occur. It is the largest (in terms of trading volume) and themost
liquid market in the world. On average, the daily volume of transactions on the forex market
totals $5.1 trillion, according to the Bank of International Settlements’ Triennial Central Bank
Survey (2016).
The forex market major trading centers are located in major financial hubs around the
world, including New York, London, Frankfurt, Tokyo, Hong Kong, and Sydney. Due to this
reason, foreign exchange transactions are executed 24 hours, five days a week (except
weekends). Despite the decentralized nature of forex markets, the exchange rates offered in
the market are the same among its participants, as arbitrage opportunities can arise otherwise.
The foreign exchange market is probably one of the most accessible financial markets.
Market participants range from tourists and amateur traders to large financial institutions
(including central banks) and multinational corporations.
Also, the forex market does not only involve a simple conversion of one currency into another.
Many large transactions in the market involve the application of a wide variety of financial
instruments, including forwards, swaps, options, etc.
Interest Rate Parity
The interest rate parity (IRP) is a theory regarding the relationship between the spot
exchange rate and the expected spot rate or forward exchange rate of two currencies, based
on interest rates. The theory holds that the forward exchange rate should be equal to the spot
currency exchange rate times the interest rate of the home country, divided by the interest rate
of the foreign country.
As with many other theories, the equation can be rearranged to solve for any single
component of the equation to draw different inferences. If IRP holds true, then you should not
be able to create a profit simply by borrowing money, exchanging it into a foreign currency,
and exchanging it back to your home currency at a later date.
Uncovered Interest Rate Parity vs Covered Interest Rate Parity
The uncovered and covered interest rate parities are very similar. The difference is that
the uncovered IRP refers to the state in which no-arbitrage is satisfied without the use of a
forward contract. In the uncovered IRP, the expected exchange rate adjusts so that IRP holds.
This concept is a part of the expected spot exchange rate determination.
The covered interest rate parity refers to the state in which no-arbitrage is satisfied with
the use of a forward contract. In the covered IRP, investors would be indifferent as to whether
to invest in their home country interest rate or the foreign country interest rate since the forward
exchange rate is holding the currencies in equilibrium. This concept is part of the forward
exchange rate determination.
Purchasing Power Parity
When the law of one price is applied internationally to a standard commodity basket,
we obtain the theory of purchasing power parity (PPP). This theory states that the exchange
rate between currencies of two countries should be equal to the ratio of the countries' price
levels.
The concept of Purchasing Power Parity (PPP) is a tool used to make multilateral
comparisons between the national incomes and living standards of different countries.
Purchasing power is measured by the price of a specified basket of goods and services. Thus,
parity between two countries implies that a unit of currency in one country will buy the same
basket of goods and services in the other, taking into consideration price levels in both
countries.
A PPP ratio measures deviation from the condition of parity between two countries and
represents the total number of the baskets of goods and services that a single unit of a
country’s currency can buy.
Constructing Purchasing Power Parity
The general method of constructing a PPP ratio is to take a comparable basket of
goods and services consumed by the average citizen in both countries and take a weighted
average of the prices in both countries (the weights representing the share of expenditure on
each item in total expenditure). The ratio of the prices will be the PPP rate of exchange.
Indexes such as the Big Mac Index and KFC Index use the prices of a Big Mac burger
and a bucket of 12-15 pieces of chicken, respectively, to compare living standards between
countries. These are moderately standardized products that include input costs from a
wide range of sectors in the local economy, which makes them suitable for comparison.
Transaction Exposure Management
Transaction exposure is the risk incurred due to the fluctuations in exchange rates
before the contract is settled. The foreign exchange rate that changes in cross-currency
transactions can adversely affect the involved parties. Once a cross-currency contract has
been framed, and a specific amount of money and quantity of goods is fixed, exchange rate
fluctuations can change the value of the contract. However, a company that has agreed to a
contract but not yet settled it, faces the transaction exposure risk. The greater the time
between agreement and settlement of contracts, the higher is the risk involved with exchange
rate fluctuations.
When transaction exposure exists, the firm faces three major tasks:
1. Identify its degree of transaction exposure.
2. Decide whether to hedge this exposure.
3. Choose a hedging technique if it decides to hedge part or all of the exposure.
Financial Techniques for Managing Transaction Exposure
• Forward Contracts
If a firm is required to pay a specific amount of foreign currency in the future, it can
enter into a contract that fixes the price for the foreign currency for a future date. This
eliminates the chances of suffering due to currency fluctuations.
• Futures Contracts
Futures contracts are similar to ‘forward contracts. However, futures contracts have
standardized and limited maturity dates, initial collateral and contract sizes.
• Money Market Hedge
In a money market hedge, the forward price is equal to current spot price multiplied
by the ratio of the currency’s riskless returns. This also creates the finance for the
foreign currency transaction.
• Options
The options contracts involve an upfront fee and do not oblige the owner to trade
currencies at a specified price, time period and quantity.
Operational Techniques for Managing Transaction Exposure
• Risk Shifting
The firm can completely avoid transaction exposure by not involving itself in foreign
exchange at all. All the transactions can be conducted in the home currency.
However, thisis not possible for all types of businesses.
• Currency Risk Sharing
The two parties involved in the deal can have the understanding to share the
transaction risk.
• Leading and Lagging
Leading and lagging involve manipulating currency cash flows in accordance with the
fluctuations. Paying off liabilities when the currency is appreciating is known as leading.
While collecting receivables when the currency is at a low value in called lagging.
• Reinvoicing Centers
A reinvoicing center is a single third-party subsidiary used to conduct all intra-company
trades. The reinvoicing centers carry out transactions in domestic currency, thereby
bearing the losses from the transaction exposures.
Economic Exposure Management
Economic exposure, also known as operating exposure refers to an effect caused on
a company’s cash flows due to unexpected currency rate fluctuations. Economic exposures
are long-term in nature and have a substantial impact on a company’s market value.
Economic exposure can prove to be difficult to hedge as it deals with unexpected
fluctuations in foreign exchange rates. As the foreign exchange volatility rises, the economic
exposure increases and vice versa. Multinational companies having numerous subsidiaries
overseas and transactions in foreign currencies face a greater risk of economic exposure.
Determining Economic Exposure
The following are the two factors that help in determining economic exposure:
• Economic exposure is higher for firms having both, product prices and input costs
sensitive to currency fluctuations. It is lower when costs and prices are not sensitive
to currency fluctuations.
• Economic exposure is higher for firms which do not adjust its markets, product mix,
and source of inputs in accordance with currency fluctuations. Flexibility in adapting
to currency rate fluctuations indicates lesser economic exposure.
Managing Economic Exposure
The risk of economic exposure can be hedged either by operational strategies or
currency risk mitigation strategies.
Operational Strategies
The following are the operational strategies which can be used to alleviate the risk of
economic exposure:
• Diversifying Production Facilities and Markets for Products
Diversifying the production facilities and sales to a number of markets rather than
concentrating on one or two markets would mitigate the risk inherent. However, in such
cases, the companies have to forgo the advantage earned by economies of scale.
• Sourcing Flexibility
Companies may have alternative sources for acquiring key inputs. The substitute
sources can be utilized in case the exchange rate fluctuations make the inputs
expensive from one region.
• Diversifying Financing
A company can have access to capital markets in a number of major regions. This
enables the company to gain flexibility in raising capital in the market with the cheapest
cost of funds.
Currency Risk Mitigation Strategies
The following are the currency risk mitigation strategies which can be used to alleviate
the risk of economic exposure:
• Matching Currency Flows
This is the simplest form of mitigating economic exposure by matching foreign currency
inflows and outflows. For example, if a European company has significant inflows in
US dollars and is looking to raise debt, it should consider borrowing in US dollars.
• Currency Risk-Sharing Agreements
An agreement is framed between the two parties involved in the purchase and sales
contract. The agreement states that the parties must share the risk arising from the
exchange rate fluctuations. The agreement consists of a price adjustment clause which
states that the base price of the transaction will be adjusted in case of currency rate
fluctuations.
• Back-to-Back Loans
This method, also known as credit swap involves two companies located in different
countries entering into an arrangement to borrow each other’s currency for a fixed
period of time. Once the defined period is over, the currencies are repaid.
• Currency Swaps
The currency swap method is similar to the back-to-back loan’s method, however, does
not reflect on the balance sheet. This method involves two firms who borrow currencies
in the world market where each can benefit from the best rates and then swap the
proceeds.
