Foreign Exchange Risk

Management (Unit-1)
 Foreign Exchange Market

► Foreign exchange market is a market where participants buy and sell foreign currency.
In this market, one currency is exchanged for other currency.
► Foreign exchange market has no physical place. In fact it is an electronically linked
network of banks, foreign exchange brokers and dealers. The entire functioning of this
market takes place through telephone and telex.
► The market comprises of all foreign exchange traders who are connected to each other
through out the world. They deal with each other through telephones, telexes and
electronic systems.
► With the help of Reuters Money 2000-2, it is possible to access any trader in any corner
of the world within a few seconds.
► The foreign exchange market operates twenty four hours a day during the business
week; the only time it is silent is after the New York market closes on Friday afternoon
and before the Sydney market opens on Monday morning (which would be Sunday
evening New York time).
 Foreign Exchange Market
► Since the market is not perfect, they may be difference in the value of a currency in
different market.
► Then the arbitrageurs take advantage of this. Whenever there is a difference between
exchange rates in different markets related to two currencies, the process of arbitrage
take place to eliminate this profit and to establish equilibrium in the market.
► Speculative activities also take place in foreign exchange market. The speculators also
make profit out of uncertainty in the market. The hedgers also take help of various
instruments like futures, options etc. to hedge their risk.
► Large commercial banks, central banks, brokers and different corporations participate in
this foreign exchange market.
► The currencies with high level of convertibility play major role in this market.
► Exchange is dependent on so many factor like interest rates, Balance of payment, rate of
inflation etc. In foreign exchange market two foreign exchange rates are quoted spot
rate (for immediate delivery) and forward rate (for future transactions).
 EXCHANGE MARKET PARTICIPANTS
► Arbitragers: they enter into foreign exchange transactions in order to cover the risk of
loss from foreign-currency proceeds in taking advantages of differences of interest
rates among countries.
► Traders: The customers who are engaged in foreign trade participate in foreign
exchange markets by availing of the services of banks. Exporters require converting
the dollars in to rupee and importers require converting rupee in to the dollars as they
have to pay in dollars for the goods/services they have imported. They want to
eliminate their risk of loss from export or import orders denominated in foreign
currencies.
 EXCHANGE MARKET PARTICIPANTS
► Commercial Banks: They are most active players in the forex market. Commercial
banAks dealing with international transactions offer services for conversion of one
currency in to another. They have wide network of branches. Typically banks buy
foreign exchange from exporters and sells foreign exchange to the importers of the
goods. As every time the foreign exchange bought and sold may not be equal banks are
left with the overbought or oversold position. The balance amount is sold or bought
from the market. In India Reserve Bank of India has given license to the commercial
banks to deal in foreign exchange under section 6 Foreign Exchange Regulation
Act, 1973, which are called the Authorized Dealer (ADs).
► CENTRAL BANK : Central bank of the country is mainly concerned with the investment
of countries foreign exchange reserve in a stable proportion in range of currencies and
in a range of assets in each currency. For this bank has to involve certain amount of
switching between currencies. Central banks usually intervene in exchange market in
order to prevent fluctuations in exchange rates and try to maintain it at a level or in
a band so fixed.
 EXCHANGE MARKET PARTICIPANTS

► EXCHANGE BROKERS :In India as per FEDAI guidelines the authorized dealers (Ads) are
free to deal directly among themselves without going through brokers. The forex brokers
are not allowed to deal on their own account all over the world and also in India. Banks
seeking to trade display their bid and offer rates on their respective pages of Reuters
screen, but these prices are indicative only. On inquiry from brokers they quote firm
prices on telephone. In this way, the brokers can locate the most competitive buying and
selling prices, and these prices are immediately broadcast to a large number of banks by
means of hotlines / loudspeakers in the banks dealing room / contacts many dealing
banks through calling assistants employed by the broking firm. If any bank wants to
respond to these prices thus made available, this is done by counterparty bank by
clinching the deal. Brokers do not disclose counterparty bank's name until the buying
and selling banks have concluded the deal. Once the deal is struck the broker exchange
the names of the bank who has bought and who has sold. The brokers charge commission
for the services rendered. In India broker's commission bas been fixed by FEDAI.
 EXCHANGE MARKET PARTICIPANTS

► Hedgers: They wish to protect the home-currency value of foreign-currency

denominated balance-sheet items. Speculators: They indulge in speculation
activities and expose themselves to currency risks.
► Foreign Participants: Countries like Britain, USA and Singapore have reaped
considerable benefit from foreign participation in their future markets. At
present, foreign participation is not allowed in the Indian futures market; this is
likely fallout of the exchange controls under the erstwhile Foreign Exchange
Regulation Act. Looking into the future, a sober reassessment of this question is
called for, considering the potential economic benefits to the country. It goes
without saying that foreign participation –permitting foreign nationals and
entities to trade in Indian futures markets – must only be permitted if the
benefits it brings outweighs the drawbacks.
 FACTORS INFLUENCING THE EXCHANGE
RATE
► 1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate exhibits a rising currency
value, as its purchasing power increases relative to other currencies. During the last half of
the twentieth century, the countries with low inflation included Japan, Germany and
Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries
with higher inflation typically see depreciation in their currency in relation to the currencies
of their trading partners. This is also usually accompanied by higher interest rates.
2. Differentials in Interest Rates
Interest rates, inflation and exchange rates are all highly correlated. By manipulating
interest rates, central banks exert influence over both inflation and exchange rates, and
changing interest rates impact inflation and currency values. Higher interest rates offer
lenders in an economy a higher return relative to other countries. Therefore, higher interest
rates attract foreign capital and cause the exchange rate to rise. The impact of higher
interest rates is mitigated, however, if inflation in the country is much higher than in others,
or if additional factors serve to drive the currency down. The opposite relationship exists for
decreasing interest rates - that is, lower interest rates tend to decrease exchange rates.
 FACTORS INFLUENCING THE EXCHANGE
RATE
► 3. Current-Account Deficits
The current account is the balance of trade between a country and its trading partners,
reflecting all payments between countries for goods, services, interest and dividends.
A deficitin the current account shows the country is spending more on foreign trade than it
is earning, and that it is borrowing capital from foreign sources to make up the deficit. In
other words, the country requires more foreign currency than it receives through sales of
exports, and it supplies more of its own currency than foreigners demand for its products.
The excess demand for foreign currency lowers the country's exchange rate until domestic
goods and services are cheap enough for foreigners, and foreign assets are too expensive to
generate sales for domestic interests.
4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector projects and
governmental funding. While such activity stimulates the domestic economy, nations with
large public deficits and debts are less attractive to foreign investors. The reason? A large
debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately
paid off with cheaper real dollars in the future.
 FACTORS INFLUENCING THE EXCHANGE
RATE
► 5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to current
accounts and the balance of payments. If the price of a country's exports rises by a greater
rate than that of its imports, its terms of trade have favorably improved. Increasing terms of
trade shows greater demand for the country's exports. This, in turn, results in rising revenues
from exports, which provides increased demand for the country's currency (and an increase in
the currency's value). If the price of exports rises by a smaller rate than that of its imports,
the currency's value will decrease in relation to its trading partners.

6. Political Stability and Economic Performance

Foreign investors inevitably seek out stable countries with strong economic performance in
which to invest their capital. A country with such positive attributes will draw investment
funds away from other countries perceived to have more political and economic risk. Political
turmoil, for example, can cause a loss of confidence in a currency and a movement of capital
to the currencies of more stable countries.
FACTORS INFLUENCING THE EXCHANGE
RATE

7. POLITICAL FACTORS:
The exchange rate is effected by many of the political factors such the monetary policy
of government , government action or inaction plans on the various items like money
supply, inflation, taxes, and deficit financing. When any government actively intervenes
in the foreign currency markets with the help of central bank, the exchange rate is
effected up to a great extent. Political stability and its relative economic exposure also
affects exchange rate. International Monetary Fund also plays an important role in
deciding exchange rate in any member country.
FACTORS INFLUENCING THE EXCHANGE
RATE
8. ECONOMIC FACTORS:
Economic factors such as hedging activities, interest rates, inflationary pressures,
trade imbalances, and Euro market activities have a great impact on exchange rate.
Four way equivalence model explains the relationship of exchange rate with different
economic variables such as interest rate and inflation rate. According to Dornbush,
the long-run determinants of exchange rates are the nominal quantities of monies,
the real money demands and the relative price structure. Among the factors that
exert an influence on real money demand are interest rates, expected inflation, and
real income growth. In the short run, Dombush theorizes, exchange rates are
determined by interest arbitrage together with speculation about future spot rates.
9. PSYCHOLOGICAL FACTORS:
Psychological factors like; market anticipation, speculative pressures, and future
expectations also influence exchange rates. Any event, from a declaration of war to
a fainting political leader, can take its toll on a currency's value.
 THE SPOT RATE
►
Spot rate is a foreign exchange rate paid for immediate deliver of a currency. It
applies to interbank transactions that require delivery of the purchased currency
within two business days in the exchange for immediate cash payments of that
particular currency.
► SPOT EXCHANGE QUOTATIONS
► 1. Direct quote and indirect quote:
► a Direct quote is a home currency price per unit of a foreign currency, such as
Rs. 50 =US $ 1.
► b Indirect quote is a foreign currency price per unit of a home currency, such
as Rs. 1 = US$ 0.02.
► 2. Cross rate is an exchange rate between two non-home currencies, such as
Mex$6.40 per £ for a US resident.
 THE SPOT RATE

►
3. Bid-Ask Rates: These rates are always quoted as a two way price- bid price and
ask price. Bid price is the price at which bank is willing to buy foreign currency and
ask price is the price at which bank is willing to sell foreign currency. The difference
between these two rates is termed as spread. This spread represents return to the
dealer.
► Spread in direct quote = (ask price - bid price)/ask price.
► 4. Speculating in the spot market: Speculators buy a foreign currency at today's
spot rate, will hold it for some time, and will resell it at a higher spot rate.
 THE FORWARD RATE

The forward rate is a contractual rate between a foreign exchange trader and
the trader's client for delivery of foreign currency sometime in the future
usually after atleast one month.
FORWARD EXCHANGE QUOTATION
1. Forward premium or discount
Quote in points:
One point is equal to 0.01 percent or $0.0001.
Forward quote in point = forward rate - spot rate.
 THE FORWARD RATE

2. Forward exchange transactions are used to eliminate possible exchange

losses on foreign-currency denominated obligations.
3.Speculating in the forward market:
Speculators buy a foreign currency forward today, will hold it for some time,
and will resell it at a higher spot rate.
 Direct Quote

► Direct Quote: A quote that expresses a currency price in terms of one

unit of the foreign currency and x units of the home currency. If we
live in Australia we can convert the indirect quote AUD/USD 0.8168,
into a direct quote of approx USD/AUD 1.2243. This is achieved by
dividing one by the indirect quote and adding one. Another important
thing you need to know is about exchange rates is the base currency
or the commodity currency. The base or commodity currency is the
currency whose price is given in the exchange rate. The base currency
is always the first currency quoted and is always one.
 Indirect Quote

► A quote that expresses a currency price in terms of one unit of the home
currency and x units of the foreign currency. In short it just means that
the home currency is the base currency or first currency expressed in
terms of the foreign currency. If we live in Australia an example of an
indirect quote would be AUD/USD 0.8168. Generally the banking system of
England and countries formally of England quote on an indirect basis.
 Spread in Foreign Exchange Market

► The bid–offer spread (also known as bid–ask or buy–sell spread, and their
equivalents using slashes in place of the dashes) for securities (such as stocks,
futures contracts, options, or currency pairs) is the difference between the
prices quoted (either by a single market maker or in a limit order book) for an
immediate sale (ask) and an immediate purchase (bid).
► The size of the bid-offer spread in a security is one measure of the liquidity of
the market and of the size of the transaction cost.
► If the spread is 0 then it is a frictionless asset.
 Spread in Foreign Exchange Market

► The bid–ask spread is an accepted measure of liquidity costs in exchange traded

securities and commodities.
► On any standardized exchange two elements comprise almost all of the transaction
cost – brokerage fees and bid-ask spreads.
► Under competitive conditions the bid-ask spread measures the cost of making
transactions without delay.
► The difference in price paid by an urgent buyer and received by an urgent seller is
the liquidity cost.
► Since brokerage commissions do not vary with the time taken to complete a
transaction, differences in bid-ask spread indicate differences in the liquidity cost.
 Spread in Foreign Exchange Market

► The bid price is the price the bank is willing to buy the currency for. If you wanted
to sell one Australian dollar to the bank they would buy it to from you for $USD
0.8158. This is known as the bid price. The ask price is the price the bank is willing
to sell the currency for. If you wanted to buy one Australian dollars from the bank
you would need to give them $USD 0.8168. This is known as the ask price.
► Ask price > Bid price
► The difference between the ask price and the bid price is known as the bid ask
spread. This is very simple when you think about it the bank will always sell the
currency for a higher price than it pays for it. In the above example the bank would
make $USD 0.0010 for every buy/sell transaction they undertake.
 Exchange Arbitrage

► Exchange arbitrage involes the simultaneous purchase and sale of a currency in

different foreign exchange markets. Thus, arbitragers take a closed position. (No
risk).
► Arbitrage becomes profitable whenever the price of a currency in one market
differs from that in another market.
► It will wipe out the spread in exchange rates between FE markets.
 Exchange Arbitrage

► Suppose the pound quoted in NY is $1.75, but pound quoted in London

is $1.78. Then an arbitrager in NY and his partner in London can take
the following steps:
► (a) buy 10 M pounds in NY: cost = $17.5 M
► (b) sell 10 M pounds in London: revenue = $17.8 M
► (c) profit = $300,000 less the cost of telephone, cable transfer. The
supply of pound shrinks in NY, increases in London.
 Official and market Exchange Rate

► Official exchange rate refers to the exchange rate determined by

national authorities or to the rate determined in the legally sanctioned
exchange market. It is calculated as an annual average based on monthly
averages.
► Market exchange rate
► A market-based exchange rate will change whenever the values of either of
the two component currencies change. A currency will tend to become more
valuable whenever demand for it is greater than the available supply. It will
become less valuable whenever demand is less than available supply (this
does not mean people no longer want money, it just means they prefer
holding their wealth in some other form, possibly another currency).
 Nominal exchange rate

► Nominal exchange rate is the price of one currency in terms of number of units of some
other currency. This is determined by fiat in a fixed rate regime and by demand and
supply for the two currencies in the foreign exchange rate market in a floating rate
► It is 'nominal' because it measures only the numerical exchange value, and does not say
anything about other aspects such as the purchasing power of that currency. In a floating
rate regime, an increase in the value of the domestic currency against other currencies
is called an appreciation, while a decrease in value is called depreciation. In contrast,
an increase in the exchange rate in a fixed rate regime is called a revaluation (for an
increase) and a decrease in the exchange value of the domestic currency is referred to
as a devaluation.
 Real exchange rate

► To incorporate the purchasing power and competitiveness aspect and,

therefore, make the measure more meaningful, real exchange rates
are used. The real exchange rates are nothing but the nominal
exchange rates multiplied by the price indices of the two countries.
This means the market price level of goods and services, given by
indices of inflation. So if the price level in the US is higher than the
price level in India, then the real exchange rate of the rupee versus
the dollar will be greater than the nominal exchange rate.
 Effective Exchange Rate

► Effective Exchange Rate is an index that describes the relative

strength of a currency relative to a basket of other currencies.
Although typically that basket is trade-weighted, the trade-weighted
effective exchange rate index is not the only way to derive a
meaningful effective exchange rate index.
 NEER

► Unlike nominal and real exchange rates, NEER and REER are not determined for
each foreign currency separately. With effect from 1st March 1993. Modified
Liberalized Exchange Rate Management System (Modified – LERMS) was
implemented in India. NET EFFECTIVE EXCHANGE RATE (NEER) is a good
indicator of the exchange rate of the country.
► It is a multi-lateral measurement of the exchange rate of the Rupee depends on
the trade based weights of five countries. To calculate NEER we weight the
nominal exchange rate of the rupee against the currencies of these trading
partners by their share in India's trade. Then, by summing the weighted
exchange rates, we get the NEER. By setting the NEER for some year at 100, we
can track changes in the rupee's value as percentage changes over the base
year.
 NEER and REER

► A real effective exchange rate (REER) adjusts NEER by appropriate foreign price level
and deflates by the home country price level.
► Similar to the NEER, the REER is the weighted average of real exchange rates,
weighted by the relative importance of each country in trade with the domestic
economy. In other words, like the NEER, the REER is an index of a country's real
exchange rate, a single number which gives some reference or benchmark about how
the currency is performing in relation to the rest of the world as a whole, rather than
just individual countries. Both these measures are useful as benchmarks that give an
idea of the general movement of the domestic currency against the rest of the
world. Theory tells us that if the domestic currency becomes more expensive in
terms of other currencies, then exports will become less valuable in terms of the
domestic currency and imports will become cheaper. The converse is true if the
domestic currency weakens (in nominal and real terms).
 Exchange Rate Systems worldwide

► An exchange-rate regime is the way an authority manages its currency in

relation to other currencies and the foreign exchange market. It is closely
related to monetary policy and the two are generally dependent on many of
the same factors. The basic types are a floating exchange rate, where the
market dictates movements in the exchange rate; a pegged float, where a
central bank keeps the rate from deviating too far from a target band or
value; and a fixed exchange rate, which ties the currency to another
currency, mostly more widespread currencies such as the U.S. dollar or
the euro or a basket of currencies.
 FLEXIBLE ORIENTED REGIMES

► 1. Free Float
► This extreme kind of regime has been rarely seen in the world economy. In this regime,
government has no direct effect on the currency markets. The market agents determine the
rate. This regime provides elasticity. Monetary policy is very efficient. There is no need to
keep large amount of reserve. The change in rate absorbs all of the internal and external
shocks. On the other hand, high volatility of exchange rate effects the allocation of resources
negatively. In addition, free-floating exchange rate regime may cause the inflation in
unstable economies.
► 2. Managed Float
► Mainly the free market determines the rate, but central bank is ready to intervene to the
market without anchor. In other words, there is no determined rate but policy-makers may
intervene according to the economic conditions. Interventions are generally indirect.
Relative to free float, volatility of exchange rates is less than that of free float.
 FLEXIBLE ORIENTED REGIMES
► 3. Floating Within a Band
► Nominal exchange rate may change within a determined central parity. Monetary
authority intervenes to the market if the rate goes out of the band. Width of the band
may differ. This system causes credibility and flexibility. Volatility of rate within the band
absorbs the shocks. On the contrary, this regime may cause speculative attacks in
instable economies. The narrower the band the credibility of system is the less. The
success of this system depends on reputation of government policies.
► 4. Sliding Band
► Monetary authority declares central parity and engages itself to that parity. This regime
may be assessed as a kind of “floating within a band” in countries in which inflation
exists. This regime avoids the overvaluation of currency in which high inflation rate
exists. Width of the band is very important. It causes uncertainty in the markets and
volatility in interest rates.
 FIXED ORIENTED REGIMES

► 1. Crawling Band
► Central parity is adapted to the economic situation. Parity is determined according to
mainly balance of payments. The difference between past inflation rates may be used
to determine the parity. There is no need for large adjustments in exchange rates. If
the parity is determined in a wrong way, it may cause inflation expectations to
increase or overvaluation of the currency. This system must be supported by interest
rate policies. As a result, government has no more interest rate policy.
► 2 Crawling Peg
► Nominal exchange rate is adjusted periodically according to some economic indicators.
The band is very narrow. Market expectations are corrected according to this system.
Credibility of policies is higher.
 FIXED ORIENTED REGIMES
► 3. Fixed-but-adjustable Exchange Rate
► Nominal exchange rate is fixed but central bank is not restricted by strict rules. Sometimes it
may intervene to the market. This regime provides macroeconomic discipline, because
expectation of risk decreases -especially exchange rate risk in foreign trade-. Devaluation
chance causes elasticity in the economy. On the other hand, if the devaluation rate is too
high, that will cause uncertainty. Uncertainty increases the inflation expectations.
► 4. Currency Board
► This is a fixed exchange rate regime with strict regulations. Monetary authority can issue the
currency if only it has more foreign currency. That is, the more foreign currency a country has
the more national currency it can issue. That means central bank is no more the last land of
resort. Credibility of system (monetary and fiscal policies) is at maximum level because all the
economic agents can foresee exchange rates in the future. However, system is not elastic. If
the country has a relatively small economy, external shocks can only be absorbed by
unemployment and recession.
 FIXED ORIENTED REGIMES

► 5. Full ‘dollarization
► Country uses another country’s currency. That means its monetary
policy is dependent on the other county. The credibility level is at
maximum. Some of the Latin American countries implemented this
regime. On the contrary, system does not have elasticity. External
shocks can only be absorbed by unemployment and recession.
Thank You