SRM BUSINESS SCHOOL (666)

COMPILED NOTES KMBNFM04

FOREIGN EXCHANGE & FOREX RISK MANAGEMENT

PREPARED BY – PRAKASHINI DIXIT

ASST. PROFESSOR
MBA DEPARTMENT
7678000059

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 FOREIGN EXCHANGE & FOREX RISK MANAGEMENT

KMBN FM04

UNIT I (7 Hrs.)
Foreign Exchange and Foreign Trade, Exchange Rate, Foreign Exchange as stock, Balance of
Payments, Balance of Payments accounting, Components of Balance of Payments; Current
Account, Capital Account, Official Reserve Accounts, Debit and Credits Entries, International
Exchange Systems; Fixed and Floating Exchange rate system. Exchange Rate System prior to
IMF; Gold currency standard, Gold bullion standard, Gold exchange standard, Exchange Rate
System under IMF: Bretton woods system, The Smithsonian Agreement, The Flexible Exchange
Rate Regime.

UNIT II (8 Hrs.)
Convertibility of rupee; Current account convertibility, Capital Account Convertibility; Theories
of Foreign exchange rate: Purchasing power parity (PPP), International Fisher Effect (IFE),
Interest Rate Parity (IRP); Administration of Foreign Exchange; Authorized persons, Authorized
dealers, Authorized Money Changers; Foreign Currency Accounts: Nostro Account, Vostro
Account and Loro Account in foreign transactions.

UNIT III (8 Hrs.)

Foreign Exchange Transactions; Purchase and sale transactions; Exchange quotations: Direct and
Indirect Quotations, Two way Quotation; Spot and Forward Transactions: Forward margin,
Factors Determining forward margin; Merchant Rates: Basis of Merchant Rates, Types of buying
and Selling rates, Ready rates based on cross rates; Forward exchange contract: Fixed and option
forward contracts, Calculation of fixed and option forward rates; Inter Bank Deals; Execution of
forward Contracts.

UNIT IV (5 Hrs.)
Exchange Dealings: Dealing position- Exchange position, Cash Position; Accounting and
Reporting: Mirror account, Value date, Exchange profit and loss, R returns; Forex Risk
Management: Risk in Forex Dealing, Measure of Value at Risk; Foreign Exchange markets;
Settlement of Transactions: Swift, Chips, Chaps, Fed wire.

Unit V (8 Hrs.)
Exchange Risk: Exchange exposure and exchange risk; Transaction Exposure, Managing
Transaction exposure: External Hedge-Forward contract hedge, Money market hedge, hedging
with futures and options, Internal Hedge; Translation exposure, Methods of translation, managing
translation exposure; Economic exposure, managing economic exposure; Interest rate risk.

UNIT-1
What Is Foreign Exchange?
Foreign exchange, or forex, is the conversion of one country's currency into another. In a free
economy, a country's currency is valued according to the laws of supply and demand. Inother
words, a currency's value can be pegged to another country's currency, such as the U.S. dollar,
or even to a basket of currencies. A country's currency value may also be set by the country's
government.
However, many countries float their currencies freely against those of other countries, which
keeps them in constant fluctuation.
Factors Affecting Currency Value
The value of any particular currency is determined by market forces based on trade,
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investment, tourism, and geo-political risk. Every time a tourist visits a country, for
example, they must pay for goods and services using the currency of the host country.
Therefore, a tourist must exchange the currency of his or her home country for the local
currency. Currency exchange of this kind is one of the demand factors for a particular
currency.
Foreign exchange, also known as forex, is the conversion of one country's currency
into another.
The value of any particular currency is determined by market forces related to trade,
investment, tourism, and geo-political risk.
Foreign exchange is handled globally between banks and all transactions fall under
the auspice of the Bank for International Settlements (BIS).1
How Inflation Affects Foreign Exchange Rates
Inflation can have a major effect on the value of a country's currency and its foreign
exchange rates with other currencies. While it is just one factor among many, inflation is
more likely to have a significant negative effect on a currency's value and foreign exchange
rate. A very low rate of inflation does not guarantee a favorable exchange rate, but an
extremely high inflation rate is very likely to have a negative impact.
Inflation is also closely related to interest rates, which can influence exchange rates. The
interrelationship between interest rates and inflation is complex and often difficult for
currency-issuing countries to manage. Low interest rates spur consumer
spending and economic growth, and generally positive influences on currency value. If
consumer spending increases and demand grows to exceed supply, inflation may ensue,
which is not necessarily a bad outcome. However, low interest rates don't usually attract
foreign investment the way higher interest rates can. Higher interest rates attract foreign
investment, which is likely to increase demand for a country's currency.
Exchange Rates
In finance, an exchange rate between two currencies is the rate at which one currency will be
exchanged for another.
 Exchange rates are determined in the foreign exchange market, which is
open to a wide range of buyers and sellers where currency trading is
continuous.
 In the retail currency exchange market, a different buying rate and selling
rate will be quoted by money dealers.
 The foreign exchange rate is also regarded as the value of one country’s
currency in terms of another currency.
exchange rate: The amount of one currency that a person or institution defines as
equivalent to another when either buying or selling it at any particular moment.In
finance, an exchange rate (also known as a foreign-exchange rate, forex rate, or rate) between
two currencies is the rate at which one currency will be exchanged for another. It isalso
regarded as the value of one country’s currency in terms of another currency.
Exchange rates are determined in the foreign exchange market, which is open to a wide range
of buyers and sellers where currency trading is continuous. The spot exchange rate refers to
the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted
and traded today, but for delivery and payment on a specific future date.
Foreign Trade: Definition, Types of Foreign Trade
Foreign trade is the exchange of capital, goods, and services across international borders or
territories.
Foreign trade is the exchange of goods across national boundaries. Prof. J.L. Hanson said,
“An exchange of various specialized commodities and services rendered among the
corresponding countries is known as foreign trade.”
Foreign trade is, in principle, not different from domestic trade as the motivation and the
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behavior of parties involved in a trade does not change fundamentally depending on whether
a trade is across a border or not.
Foreign trade is all about imports and exports. The backbone of any foreign trade between
nations is those products and services which are being traded to some other location outside a
particular country’s borders.
Types of Foreign Trade
1. Import
Importing is the purchasing of goods or services made in another country. For example,
importing edible oil from Chinese producers to sell in Africa.
2. Export
Exporting is selling domestic-made goods in another country. For example, Hameem
Garments exports Readymade Garments (RMG) products to Western Countries.
3. Re-export
When goods are imported from a foreign country and are re-exported to buyers in some other
foreign countries, it is called re-export.
For example, Firm/ Readymade Garments located at EPZs imports raw materials (cotton)
from Korea and produces Readymade Garments products by Thai cotton and then those
products to Canada.
Reasons / Need / Importance / Advantages of Foreign Trade
The following points explain the need and importance of foreign trade to a nation.
1. Division of Labor and Specialization
Foreign trade leads to the division of labor and specialization at the world level. Some
countries have abundant natural resources.
They should export raw materials and import finished goods from countries which are
advanced in skilled manpower. This gives benefits to all the countries and thereby leading to
the division of labor and specialization.
2. Optimum Allocation and Utilization of Resources
Due to specialization, unproductive lines can be eliminated, and wastage of resources
avoided. In other words, resources are canalized for the production of only those goods,
which would give the highest returns.
Thus there is rational allocation and utilization of resources at the international level due to
foreign trade.
3. Equality of Prices
Prices can be stabilized by foreign trade. It helps to keep the demand and supply position
stable, which in turn stabilizes the prices, making allowances for transport and other
marketing expenses.
4. Availability of Multiple Choices
Foreign trade helps in providing a better choice to the consumers. It helps in making available
new varieties to consumers all over the world.
5. Ensures Quality and Standard Goods
Foreign trade is highly competitive. To maintain and increase the demand for goods, the
exporting countries have to keep up the quality of goods.
Thus quality and standardized goods are produced.
6. Raises Standard of Living of the People
Imports can facilitate the standard of living of the people. This is because people can have a
choice of new and better varieties of goods and services.
By consuming new and better varieties of goods, people can improve their standard of living.
7. Generate Employment Opportunities
Foreign trade helps in generating employment opportunities by increasing the mobility of
labor and resources. It generates direct employment in the import sector and indirect
employment in other sectors of the economy.
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Such as Industry, Service Sector (insurance, banking, transport, communication), etc.
8. Facilitate Economic Development
Imports facilitate the economic development of a nation. This is because, with the import of
capital goods and technology, a country can generate growth in all sectors of the economy,
agriculture, industry, and service sector.
9. Assistance During Natural Calamities
During natural calamities such as earthquakes, floods, famines, etc., the affected countries
face the problem of shortage of essential goods.
Foreign trade enables a country to import food grains and medicines from other countries to
help the affected people.
10. Maintains Balance of Payment Position
Every country has to maintain its balance of payment position.
Since every country has to import, which results in an outflow of foreign exchange, it also
deals in export for the inflow of foreign exchange.
11. Brings Reputation and Helps Earning Goodwill
A country which is involved in exports earns goodwill in the international market.
For example, Japan has earned a lot of goodwill in foreign markets due to its exports of
quality electronic goods.
12. Promotes World Peace
Foreign trade brings countries closer. It facilitates the transfer of technology and other
assistance from developed countries to developing countries. It brings different countries
closer due to economic relations arising out of trade agreements.
Thus, foreign trade creates a friendly atmosphere for avoiding wars and conflicts. It promotes
world peace as such countries try to maintain friendly relations among themselves.
Features of Foreign Trade (Export/ Import)
1. Import dependency (our country foreign trade depend on import because of high
demand and low supply),
2. Import capital goods and industrial goods,
3. Export of readymade garments (RMG), RMG and Knitwear 74% export,
4. Export of agricultural raw materials and products,
5. Unfavorable balance of payment ( More import but less export),
6. Operate most business by sea/ocean,
7. More import from Asia (China, Singapore, India ) and export in Western countries
(USA, England),
8. Government initiation and control (By TCB and EPB govt control foreign trade and
operate helpful initiative),
9. Export of jute and jute goods,
10. Export of manpower,
11. Private initiative,
12. Diversity of import goods (necessary goods and unnecessary luxurious goods ).
13. Effect of free trade economy (for open market economy unnecessary luxurious goods
are imported in our country, and our country’s money went to another country)
14. Business with all countries.
Foreign Exchange as stock
The International Stock Exchange (TISE) is a stock exchange headquartered in St. Peter Port,
Guernsey. The TISE provides a responsive and innovative listing facility for international
companies to raise capital from investors based around the globe. It offers a regulated
marketplace, with globally recognizable clients and a growing product range, from a location
within the European time zone but outside the EU.
TISE is the trading name of The International Stock Exchange Group Limited. It wholly owns
The Channel Islands Securities Exchange Authority Limited which trades as The International
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Stock Exchange Authority (TISEA) which is licensed to operate an investment exchange under
The Protection of Investors (Bailiwick of Guernsey) Law, 1987, as amended, by the Guernsey
Financial Services Commission.
The exchange lists a wide range of securities:
Primary and secondary listings of securities issued by Guernsey, Jersey and overseas
trading companies.
Investment vehicles, including open and closed ended funds and Real Estate Investment
Trusts (REITs).
Specialist debt securities for sophisticated investors, including the use of Special
Purpose Vehicles (SPVs) and the Quoted Eurobond Exemption for convertible bonds,
intra-group financing, structured products and warrants.
There are specific rules for equities and corporate debt securities issued by extractive
industries.
Special Purpose Acquisition Companies (SPACs) were introduced in November 2015.
The New York Stock Exchange
The New York Stock Exchange (NYSE) is part of NYSE EURONEXT, which now has
exchanges in the U.S. and Europe. It estimates that its exchanges represent a third of all equities
traded in the world. The NYSE continues to be one of the primary exchanges in the world and
the largest in terms of the nearly $10 trillion in stock market capitalization it represents.
The NYSE has been around since 1792 and it is believed that Bank of New York, which is now
part of Bank of New York Mellon, was the first stock traded. The ringing of the NYSE bell at
the start and end of the day is a common occurrence in today’s media.
The business has grown incredibly competitive in recent years. In a recent filing with the
Securities and Exchange Commission (SEC), the company notes that it must compete for the
listings of cash equities, exchange traded funds, structure products, futures, options and other
derivatives.
The Tokyo Stock Exchange
The Tokyo Stock Exchange (TSE) is the largest exchange in Japan and also number two behind
the NYSE in terms of the more than $3 trillion in market capitalization the companies on its
exchange represent. A stronger national currency is part of the reason behind the increasing
size of the TSE. Around 2,000 firms are listed on the TSE.
The exchange was estimated to have first opened in 1878 and partners with other exchanges
around the world, such as the London Stock Exchange below. The Nikkei 225 index is one of
the primary and most popular indexes that represent some of the largest and most successful
firms in Japan.
The London Stock Exchange
The London Stock Exchange (LSE) qualifies as a top-five stock market, with an estimated $2.2
trillion in stock market capitalization from the companies listed on its exchange. Its estimated
founding was 1801, or nearly a decade following the opening of the NYSE.
The LSE considers itself the most international of global exchanges, based on the fact that
around 3,000 companies from around the world trade on the LSE and its affiliated exchanges.
The Hong Kong Stock Exchange
The Hong Kong Stock Exchange is one of the top 10 largest stock exchanges. The firms that
are listed on the Hong Kong Stock Exchange represent close to $2 trillion in total market
capitalization. Roughly 1,500 companies are listed on the exchange, which dates back to just
prior to 1900, when it first started operating. Most importantly, the exchange represents one of
the primary avenues for global investors to invest in China.
The Shanghai Stock Exchange
The Shanghai Stock Exchange is one of the newest in the world. It opened in late 1990, and
1,500 companies trade on its exchange. Trading volume continues to increase but has fallen
dramatically since 2008, which marked a peak in terms of investment interest in China.
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Balance of Payments
The balance of payments (henceforth BOP) is a consolidated account of the receipts and
payments from and to other countries arising out of all economic transactions during the course
of a year.
In the words of C. P. Kindleberger : “The balance of payments of a country is a systematic
record of all economic transactions between the residents of the reporting and the
residents of the foreign countries during a given period of time.” Here by ‘residents’ we
mean individuals, firms and government.
By all economic transactions we mean individuals, firms and government. By all economic
transactions we mean transactions of both visible goods (merchandise) and invisible goods
(services), assets, gifts, etc. In other words, the BOP shows how money is spent abroad (i.e.,
payments) and how money is received domestically (i.e., receipts).
Thus, a BOP account records all payments and receipts arising out of all economic transactions.
All payments are regarded as debits (i.e., outflow of money) and are recorded in the accounts
with a negative sign and all receipts are regarded as credits (i.e., inflow or money) and are
recorded-in the accounts with a positive sign. The International Monetary Fund defines BOP
as a “statistical statement that subsequently summarises, for a specific time period, the
economic transactions of an economy with the rest of the world.”
Components of BOP Accounts
(A) The Current Account
The current account of BOP includes all transaction arising from trade in currently produced
goods and services, from income accruing to capital by one country and invested in another
and from unilateral transfers— both private and official. The current account is usually divided
in three sub-divisions.
The first of these is called visible account or merchandise account or trade in goods account.
This account records imports and exports of physical goods. The balance of visible exports and
visible imports is called balance of visible trade or balance of merchandise .
The second part of the account is called the invisibles account since it records all exports and
imports of services. The balance of these transactions is called the balance of invisible trade.
As these transactions are not recorded—in the customs office—unlike merchandise trade we
call them invisible items.
(B) The Capital Account
The capital account shows transactions relating to the international movement of ownership of
financial assets. It refers to cross-border movements in foreign assets like shares, property or
direct acquisitions of companies’ bank loans, government securities, etc. In other words, capital
account records export and import of capital from and to foreign countries.
The capital account is divided into two main subdivisions: short term and the long term move-
ments of capital. A short term capital is one which matures in one year or less, such as bank
accounts.
Long term capital is one whose maturity period is longer than a year, such as long term bonds
or physical capital. Long term capital account is, again, of two categories: direct investment
and portfolio investment. Direct investment refers to expenditure on fixed capital formation,
while portfolio investment refers to the acquisition of financial assets like bonds, shares, etc.
India’s investment (e.g., if an Indian acquires a new Coca- Cola plant in the USA) abroad
represents an outflow of money. Similarly, if a foreigner acquires a new factory in India it will
represent an inflow of funds.
(C) Statistical Discrepancy Errors and Omissions
The sum of A and B (Table 6.1) is called the basic balance. Since BOP always balances in
theory, all debits must be offset by all credits, and vice versa. In practice, it rarely happens—
particularly because statistics are incomplete as well as imperfect. That is why errors and
omissions are considered so that the BOP accounts are kept in balance (Item C).
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(D) The Official Reserve Account
The total of A, B, C, and D comprise the overall balance. The category of official reserve
account covers the net amount of transactions by governments. This account covers purchases
and sales of reserve assets (such as gold, convertible foreign exchange and special drawing
rights) by the central monetary authority.
Now, we can summarise the BOP data
Current account balance + Capital account balance + Reserve balance = Balance of Payments
(X – M) + (CI – CO) + FOREX = BOP
X is exports,
M is imports,
CI is capital inflows,
CO is capital outflows,
FOREX is foreign exchange reserve balance.
BOP Always Balances
A nation’s BOP is a summary statement of all economic transactions between the residents of
a country and the rest of the world during a given period of time. A BOP account is divided
into current account and capital account. Former is made up of trade in goods (i.e., visible) and
trade in services (i.e., invisibles) and unrequited transfers. Latter account is made up of
transactions in financial assets. These two accounts comprise BOP
A BOP account is prepared according to the principle of double-entry book keeping. This
accounting procedure gives rise to two entries— a debit and a corresponding credit. Any
transaction giving rise to a receipt from the rest of the world is a credit item in the BOP account.
Any transaction giving rise to a payment to the rest of the world is a debit item.
The left hand side of the BOP account shows the receipts of the country. Such receipts of
external purchasing power arise from the commodity export, from the sale of invisible services,
from the receipts of gift and grants from foreign governments, international lending institutions
and foreign individuals, from the borrowing of money from the foreigners or from repayment
of loan by the foreigners.
The right hand side shows the payments made by the country on different items to the
foreigners. It shows how the total of external purchasing power is used for acquiring imports
of foreign goods and services as well as the purchase of foreign assets. This is the accounting
procedure.
Implications of an Unbalance in the BOP
Although a nation’s BOP always balances in the accounting sense, it need not balance in an
economic sense.
An unbalance in the BOP account has the following implications:
In the case of a deficit
(i) Foreign exchange or foreign currency reserves decline,
(ii) Volume of international debt and its servicing mount up, and
(iii) The exchange rate experiences a downward pressure. It is, therefore, necessary to correct
these imbalances.
BOP Adjustment Measures:
BOP adjustment measures are grouped into four:
(i) Protectionist measures by imposing customs duties and other restrictions, quotas on imports,
etc., aim at restricting the flow of imports,
(ii) Demand management policies—these include restrictionary monetary and fiscal policies to
control aggregate demand [C + I + G + (X – M)],
(iii) Supply-side policies—these policies aim at increasing the nation’s output through greater
productivity and other efficiency measures, and, finally,
(iv) exchange rate management policies— these policies may involve a fixed exchange rate, or
a flexible exchange rate or a managed exchange rate system.
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As a method of connecting disequilibrium in a nation’s BOP account, we attach importance
here to exchange rate management policy only.
Balance of Payments: Understanding, Analysis & Interpretation
The balance of payments (BOP) is the place where countries record their monetary transactions
with the rest of the world. Transactions are either marked as a credit or a debit. Within the BOP
there are three separate categories under which different transactions are categorized:
the current account, the capital account, and the financial account. In the current account,
goods, services, income and current transfers are recorded. In the capital account, physical
assets such as a building or a factory are recorded. And in the financial account, assets
pertaining to international monetary flows of, for example, business or portfolio investments,
are noted. In this article, we will focus on analyzing the current account and how it reflects an
economy’s overall position.
The Current Account
The balance of the current account tells us if a country has a deficit or a surplus. If there is a
deficit, does that mean the economy is weak? Does a surplus automatically mean that the
economy is strong?
Not necessarily. But to understand the significance of this part of the BOP, we should start by
looking at the components of the current account: goods, services, income and current transfers.
1. Goods– These are movable and physical in nature, and for a transaction to be recorded
under “goods,” a change of ownership from/to a resident (of the local country) to/from
a non-resident (in a foreign country) has to take place. Movable goods include general
merchandise, goods used for processing other goods, and non-monetary gold. An export
is marked as a credit (money coming in), and an import is noted as a debit (money going
out).
2. Services– These transactions result from an intangible action such as transportation,
business services, tourism, royalties or licensing. If money is being paid for a service,
it is recorded like an import (a debit), and if money is received, it is recorded like an
export (credit).
3. Income– Income is money going in (credit) or out (debit) of a country from salaries,
portfolio investments (in the form of dividends, for example), direct investments or any
other type of investment. Together, goods, services, and income provide an economy
with fuel to function. This means that items under these categories are actual resources
that are transferred to and from a country for economic production.
4. Current Transfers– Current transfers are unilateral transfers with nothing received in
return. These include workers’ remittances, donations, aids and grants, official
assistance and pensions. Due to their nature, current transfers are not considered real
resources that affect economic production.
Now that we have covered the four basic components, we need to look at the mathematical
equation that allows us to determine whether the current account is in deficit or surplus
(whether it has more credit or debit). This will help us understand where any discrepancies may
stem from, and how resources may be restructured in order to allow for a better functioning
economy.
The following variables go into the calculation of the current account balance (CAB):
X = Exports of goods and services

M = Imports of goods and services

NY = Net income abroad
NCT = Net current transfers
The formula is:
CAB = X – M + NY + NCT
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 What Does It Tell Us?
Theoretically, the balance should be zero, but in the real world this is improbable, so if the
current account has a surplus or a deficit, this tells us something about the government and
state of the economy in question, both on its own and in comparison to other world markets.
A surplus is indicative of an economy that is a net creditor to the rest of the world. It shows
how much a country is saving as opposed to investing. What this means is that the country is
providing an abundance of resources to other economies, and is owed money in return. By
providing these resources abroad, a country with a CAB surplus gives other economies the
chance to increase their productivity while running a deficit. This is referred to as financing a
deficit.
A deficit reflects government and an economy that is a net debtor to the rest of the world. It is
investing more than it is saving and is using resources from other economies to meet its
domestic consumption and investment requirements. For example, let us say an economy
decides that it needs to invest for the future (to receive investment income in the long run), so
instead of saving, it sends the money abroad into an investment project. This would be marked
as a debit in the financial account of the balance of payments at that period, but when future
returns are made, they would be entered as investment income (a credit) in the current account
under the income section.
A current account deficit is usually accompanied by depletion in foreign-exchange assets
because those reserves would be used for investment abroad. The deficit could also signify
increased foreign investment in the local market, in which case the local economy is liable to
pay the foreign economy investment income in the future.
It is important to understand from where a deficit or a surplus is stemming because sometimes
looking at the current account as a whole could be misleading.
Analyzing the Current Account
Exports imply demand for a local product while imports point to a need for supplies to meet
local production requirements. An export is a credit to a local economy while an import is
adebit; an import means that the local economy is liable to pay a foreign economy. Therefore
a deficit between exports and imports (goods and services combined) – otherwise known
as a balance of trade (BOT) deficit (more imports than exports) – could mean that the country
is importing more to increase its productivity and to eventually churn out more exports. This,
in turn, could ultimately finance and alleviate the deficit.
The Bottom Line
The volume of a country’s current account is a good sign of economic activity. By scrutinizing
the four components of it, we can get a clear picture of the extent of activity of a country’s
industries, capital market, services and the money entering the country from other governments
or through remittances. However, depending on the nation’s stage of economic growth, its
goals, and of course the implementation of its economic program, the state of the current
account is relative to the characteristics of the country in question. But when analyzing a current
account deficit or surplus, it is vital to know what is fueling the extra credit or debit and what
is being done to counter the effects (a surplus financed by a donation may not be the most
prudent way to run an economy). On a separate note, the current account also highlights what
is traded with other countries, and it is a good reflection of each nation’s comparative
advantage in the global economy.
Forex Earnings
Foreign exchange earnings refer to the monetary gain made by selling goods and services OR
by exchanging currencies in global markets. Such markets are known as Foreign Exchange
markets/ Forex markets. Foreign exchange earnings are denominated in convertible currencies,
which means that even though the earnings come in the respective currencies of the countries
where the products or services are sold, they have to be exchanged with the home currency in
order to be calculated.
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Foreign exchange earnings can have two components:
(a) Profits from the export of goods and services
(b) Profits from the conversion of currencies due to the difference in exchange rates
The exchange rates of the currencies are a function of the demand and supply of money in a
given country and fluctuate with time.
As explained by the money market equilibrium equation (LM curve), if the money supply
increases in a country, the price of the currency generally decreases, and the converse holds
true. The interest rate, set by the government, also affects the demand for money, and thus the
amount of foreign exchange earnings that can be made from it.
Money Market Equilibrium (LM curve) –>L= kY -hi
 L= Money demand
 h= Sensitivity of money demand w.r.t interest
 k=Sensitivity of money demand w.r.t. Y
 Y= Aggregate demand
 i= Interest rate
Fixed and Floating Exchange rate system
Functions of Foreign Exchange Market
Transfer Function: Foreign exchange market transfers purchasing power between the
countries involved in the transaction.
This function is performed through credit instruments like bills of foreign exchange, bank
drafts and telephonic transfers.
Credit Function: Foreign exchange market provides credit for foreign trade.
Bills of exchange, with maturity period of three months, are generally used for international
payments.
Thus, credit is required for this period to enable the importer to take possession of goods, sell
them and obtain money to pay off the bill.
Hedging Functions: Hedging in an important function of foreign exchange market.
When exporter and importers enter into an agreement to sell and buy gods on some future date
at the current prices and exchange rate, it is called hedging.
Fixed exchange rate system:
The system in which the foreign exchange rate is officially fixed by the government/monetary
authority and not determined by markets forces.
Under fixed exchange rate system: Each country keeps the value of its currency fixed in terms
of some external standard.
This external standard can be gold, silver, other precious metal, another country’s currency, or
even some internationally agreed unit of account.
In earlier times, exchange rates of all major countries were fixed according to the Gold
Standard.
A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate
regime in which a currency’s value is fixed or pegged by a monetary authority against the value
of another currency, a basket of other currencies, or another measure of value, such as gold.
There are benefits and risks to using a fixed exchange rate system.
Merits:
(i) It ensures stability in exchange rate which encourages foreign trade.
(ii) It contributes to the coordination of macro policies of countries in an interdependent world
economy.
(iii) Fixed exchange rates prevent capital outflow.
(iv) It prevents speculation in foreign exchange market.
(v) Fixed exchange rates are more conductive to expansion of world trade because it prevents
risk and uncertainty in transactions.
Demerits:
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(i) There is a fear of devaluation in situation of excess demand.
Central Bank uses its reserves to maintain fixed exchange rate.
But when reserves are exhausted and excess demand still persists, government is compelled to
devalue domestic currency.
If speculators believe the exchange rate cannot be held for log, they buy foreign exchange in
massive amount causing deficit in BOP. This may lead to larger devaluation.
This is the main flaw of fixed exchange rate system.
(ii) Benefits of free markets are deprived.
(iii) There is always possibility of undervaluation or overvaluation.
Disadvantages of Fixed Exchange Rate
Developing economies commonly use a fixed rate structure to curb inflation and provide a
stable system. A secure environment enables importers, exporters, and investors to plan without
having to worry about currency movements.
A fixed-rate structure, however, limits the ability of a central bank to change interest rates as
required for boosting economic growth. Often, a fixed rate system prevents market fluctuations
when a currency is over or undervalued. Effective management of a fixed-rate system also
needs a large pool of reserves, when it is under pressure, to support the currency.
An unsustainable official exchange rate can also trigger a parallel, unofficial, or dual exchange
rate to grow. A large gap between official and unofficial rates will draw hard currency away
from the central bank, which can result in shortages of forex and periodic devaluations. These
can be more detrimental for an economy than the daily adjustment of a floating currency
regime.
Flexible (fixating) Exchange Rate:
Flexible exchange rate is the rate which is determined by forces of supply and demand in the
foreign exchange market. There is no official (govt.) Intervention. Here the value of a currency
is left completely free to be determined by market forces of demand and supply of foreign
exchange.
In macroeconomics and economic policy, a floating exchange rate (also known as a fluctuating
or flexible exchange rate) is a type of exchange rate regime in which a currency’s value is
allowed to fluctuate in response to foreign exchange market events. A currency that uses a
floating exchange rate is known as a floating currency, in contrast to a fixed currency, the value
of which is instead specified in terms of material goods, another currency, or a set of currencies
(the idea of the last being to reduce currency fluctuations).

Merits:
(i) Deficit or surplus in BOP is automatically corrected.
(ii) There is no need for government to hold any foreign reserve.
(iii) It helps in optimum resource allocation.
(iv) It frees the government from problem of balance of payment.
(v) Flexible exchange rate increases the efficiency in the economy by achieving best allocation
of resources.
Demerits:
(i) It encourages speculation leading to fluctuation in exchange rate.
(ii) Wide fluctuations in exchange rate can hamper foreign trade and capital movement between
countries.
(iii) It generates inflationary pressure when prices of imports go up due to depreciation of the
currency caused by deficit in BOP.
(iv) It discourages investment and international trade.
Determination of Exchange Rate (Flexible Exchange Rate System)
Rate of exchange is determined by the interaction of then force of demand and supply.
Demand for Foreign Exchange Demand (outflow) for foreign exchange arises due to the
12 KMBNFM04
following reasons
 Import of Goods and Services: foreign exchange is demanded to make the payment
for imports of goods and services.
 Tourism: When Indian tourists go abroad, they need to have foreign currency with
them to meet their expenditure abroad. So, foreign exchange is needed to undertake
foreign tour.
 Unilateral Transfers sent abroad: Foreign exchange is required for making unilateral
transfers like sending gifts to other countries.
 Purchase of Assets in Foreign Countries: Foreign exchange in needed to make
payment for the purchase of assets (like land, building, share, bonds etc.) in foreign
countries.
 Speculation: Demand for foreign exchange arises when people want to make gains
from appreciation of the currency.
Exchange Rate System prior to IMF
Gold currency Standard, Gold Bullion standard
The gold standard is a monetary system where a country’s currency or paper money has a value
directly linked to gold. With the gold standard, countries agreed to convert paper money into a
fixed amount of gold. A country that uses the gold standard sets a fixed price for gold and buys
and sells gold at that price. That fixed price is used to determine the value of the currency. For
example, if the U.S. sets the price of gold at $500 an ounce, the value of the dollar would be
1/500th of an ounce of gold.
The gold standard is not currently used by any government. Britain stopped using the gold
standard in 1931 and the U.S. followed suit in 1933 and abandoned the remnants of the system
in 1973.1 2 The gold standard was completely replaced by fiat money, a term to describe
currency that is used because of a government’s order, or fiat, that the currency must be
accepted as a means of payment. In the U.S., for instance, the dollar is fiat money, and for
Nigeria, it is the naira.
A major defect in such a system was its inherent lack of liquidity; the world’s supply of money
would necessarily be limited by the world’s supply of gold. Moreover, any unusual increase in
the supply of gold, such as the discovery of a rich lode, would cause prices to rise abruptly. For
these reasons and others, the international gold standard broke down in 1914.
During the 1920s the gold standard was replaced by the gold bullion standard, under which
nations no longer minted gold coins but backed their currencies with gold bullion and agreed
to buy and sell the bullion at a fixed price. This system, too, was abandoned in the 1930s.
Gold exchange standard
gold-exchange standard, monetary system under which a nation’s currency may be converted
into bills of exchange drawn on a country whose currency is convertible into gold at a stable
rate of exchange. A nation on the gold-exchange standard is thus able to keep its currency at
parity with gold without having to maintain as large a gold reserve as is required under the gold
standard.
The gold-exchange standard came into prominence after World War I because of an inadequate
supply of gold for reserve purposes. British sterling and the U.S. dollar have been the most
widely recognized reserve currencies. The requirement of a fixed rate of exchange for the
reserve currency has the effect of limiting the freedom of the reserve-currency country’s
monetary policy to solve domestic economic problems. The use of gold reserves is now limited
almost exclusively to the settlement of international transactions, on rare occasions.
The objective of the gold standard is to prevent inflation and to provide certainty in the market.
Basically, the populace can feel confident in the value of a countries currency if the currency
represents and can be readily exchanged for a certain amount of gold. In 1933, the US moved
away from the Gold Standard.
Exchange Rate System under IMF: Bretton woods system, The Smithsonian
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Agreement, The Flexible Exchange Rate Regime
The original scheme of the IMF therefore, provided that:
1. Each member-country would peg their own currency for exchanging with other
currency of the globe, in terms of gold. In addition to the gold, most of the countries of
the globe, have declared values of their currencies in terms of US dollar. The pegging
of the currency value with gold and/or US Dollar is named as ‘par value’ of the
currency.
2. At the time of finalization of valuation of currency with gold, to make the easement the
value of fine and pure gold per ounce was fixed at US dollar 35.
3. The Cold and US Dollars were agreed upon as the official monetary reserves of
member-countries.
4. The market value of member country currency accepted within a margin of 1% of the
par value. If the market value of currencies deviates to the extent of more than the
permitted level, the country should take steps to devalue or up value the currency to
correct the position.
5. The member countries of IMF were allowed to devalue their currencies on their own.
If the member country would like to devalue their currency more than 1 % then the
approval of the IMF should be obtained. The IMF had no power to reject the proposal
of member country, only they can advise the member country for course of action they
feel correct.
6. To come out from the temporary imbalance in the balance of payment situations, the
IMF can grant short-term financial assistance to its member-countries. But if the
problem of Balance of Payment is chronic, and seems to be permanent nature, then IMF
suggest the member country to use permanent solutions like devaluation.
Working of the System:
For the smooth running of the system, the major industrialised countries other than the USA
endeavoured to keep exchange rate changes to the minimum and maintain a common price
level for tradable goods. As other countries were supposed to maintain the exchange rate, USA
had to remain passive in foreign exchange markets.
On the other hand, USA had to follow a monetary policy that could provide a stable price level
for tradable goods. Europe and Japan found it convenient to rely upon the USA to supply a
stable price environment, and support US dollar as unit of account and means of settlement of
international transactions.
It was strength because dollar became a reserve asset in addition to gold providing additional
base for creation of money supply to keep pace with increase in international trade. It was a
weakness in the sense the system depended excessively on a single currency. This dependence
ultimately brought the fall of the system.
Collapse of the System:
For about two decades the system worked smoothly. Slowly during the late sixties, the
deficiencies of the system began to surface. One of the major difficulties was that the growth
of means of settlement of international debts (international liquidity) did not keep pace with
the increase in the volume of international trade.
Many countries began to experience balance of payments problems. The reason can be
attributed to the fact that increase in international liquidity depended upon the availability of
gold. The supply of gold did not increase because its official price was fixed at US dollar 35
per ounce. With inflation and increased cost of mining, many countries found it uneconomical
to mine gold.
Bretton woods system
The Bretton Woods system of monetary management established the rules for commercial and
financial relations among the United States, Canada, Western European countries, Australia,
and Japan after the 1944 Bretton Woods Agreement. The Bretton Woods system was the first
14 KMBNFM04
example of a fully negotiated monetary order intended to govern monetary relations among
independent states. The chief features of the Bretton Woods system were an obligation for each
country to adopt a monetary policy that maintained its external exchange rates within 1 percent
by tying its currency to gold and the ability of the International Monetary Fund (IMF) to bridge
temporary imbalances of payments. Also, there was a need to address the lack of cooperation
among other countries and to prevent competitive devaluation of the currencies as well.
Preparing to rebuild the international economic system while World War II was still being
fought, 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in
Bretton Woods, New Hampshire, United States, for the United Nations Monetary and Financial
Conference, also known as the Bretton Woods Conference. According to Barry Eichengreen,
the Bretton Woods system operated successfully due to three factors: “low international capital
mobility, tight financial regulation, and the dominant economic and financial position of the
United States and the dollar.”
Smithsonian Agreement:
The state of instability and confusion led the other countries to devote immediate attention to
the issue. Ten major industrialised countries of the world (the USA, Canada, Britain, West
Germany, France, Italy, Holland, Belgium, Sweden and Japan) which came to be known as the
‘Croup of Ten’ met at the Smithsonian building in Washington during December 1971 to solve
the dollar crisis and to decide about the realignment of the currencies. The agreement entered
into known as the ‘Smithsonian Agreement’, and came into effect from December 20, 1971.
The following actions where decided and taken:
1. The US dollar was devalued by 7.87% and the new dollar-gold parity was fixed at US
dollar 38 per ounce of gold.
2. The other major countries decided to revalue their currencies. Japan revalued its
currency in relation to dollar by 7.66% and West Germany by 4.61 %. This meant that
in relation to gold, the Japanese yen was revalued by 16.88% and the Deutsche Mark
by 12.6%.
3. It was provided for a wider band of fluctuation in exchange rates. The exchange rates
were allowed to fluctuate within 2.25% on either side instead of 1% existing previously.
This step was taken with a view to affording greater flexibility to exchange rates in the
market.
4. The USA removed the 10% surcharge on its imports, but the non-convertibility of dollar
into gold continued.
The USA faced unprecedented balance of payments deficit for the year 1971 characterised by
increased imports due to domestic boom. Dollar continued to fall in the exchange market. A
number of countries tried to save the situation by purchasing dollar in large quantities. The
situation was beyond repair by these methods and hence the USA devalued dollar for the
second time on February 13, 1973.
The extent of devaluation this time was 10% with the gold value increasing from US dollar 38
to US dollar 42.22 per ounce. Following the second devaluation of US dollar, many countries,
including Japan, West Germany and UK, started floating their currencies. Thus, the
Smithsonian Agreement came to an end.
Abolition of Gold and Emergence of Special Drawing Rights (SDR):
The turmoil in the exchange market continued. The dollar continued to fall and Japanese Yen
and Deutsche Mark emerged strong. Major currencies of the world continued to float.
The Committee which had 20 principal members both from developed and developing
countries made a number of far-reaching recommendations on reforming the IMF system. The
major recommendations relate to the place of gold in the IMF system and the use of Special
Drawing Rights (SDR).
SDR is an artificial international reserve created by IMF in 1970. The SDR, which is a basket
of currency comprising major individual currencies, was allotted to the members of the IMF.
15 KMBNFM04
The members of IMF could use it for transactions among themselves or with the IMF. In
addition to gold and foreign exchange, countries could use the SDR to make international
payments.
The official price of gold was abolished in November 1975f putting an end to the gold era. The
countries were free to purchase or sell for monetary reserve gold at the prevailing market price.
SDR emerged as the international currency. No agreement could, however, be reached on a
new system of exchange rates. The USA advocated floating rates, while France was for fixed
rates and return to par values.
Fixed exchange rates
The rules of Bretton Woods, set forth in the articles of agreement of the International Monetary
Fund (IMF) and the International Bank for Reconstruction and Development (IBRD), provided
for a system of fixed exchange rates. The rules further sought to encourage an open system by
committing members to the convertibility of their respective currencies into other currencies
and to free trade.
What emerged was the “pegged rate” currency regime. Members were required to establish a
parity of their national currencies in terms of the reserve currency (a “peg”) and to maintain
exchange rates within plus or minus 1% of parity (a “band”) by intervening in their foreign
exchange markets (that is, buying or selling foreign money).
In theory, the reserve currency would be the bancor (a World Currency Unit that was never
implemented), proposed by John Maynard Keynes; however, the United States objected and
their request was granted, making the “reserve currency” the U.S. dollar. This meant that other
countries would peg their currencies to the U.S. dollar, and—once convertibility was
restored—would buy and sell U.S. dollars to keep market exchange rates within plus or minus
1% of parity. Thus, the U.S. dollar took over the role that gold had played under the gold
standard in the international financial system.
Member countries could only change their par value by more than 10% with IMF approval,
which was contingent on IMF determination that its balance of payments was in a “fundamental
disequilibrium”. The formal definition of fundamental disequilibrium was never determined,
leading to uncertainty of approvals and attempts to repeatedly devalue by less than 10% instead.
Any country that changed without approval or after being denied approval was denied access
to the IMF.
The Flexible Exchange Rate Regime
A floating (or flexible) exchange rate regime is one in which a country’s exchange rate
fluctuates in a wider range and the country’s monetary authority makes no attempt to fix it
against any base currency. A movement in the exchange is either an appreciation or
depreciation.
Free float (Floating exchange rate)
A floating exchange rate is a regime where the currency price of a nation is set by the forex
market based on supply and demand relative to other currencies. This is in contrast to a fixed
exchange rate, in which the government entirely or predominantly determines the rate.
Under a free float, also known as clean float, a currency’s value is allowed to fluctuate in
response to foreign-exchange market mechanisms without government intervention.
Managed float (or dirty float)
Under a managed float, also known as dirty float, a government may intervene in the market
exchange rate in a variety of ways and degrees, in an attempt to make the exchange rate move
in a direction conducive to the economic development of the country, especially during an
extreme appreciation or depreciation.
A monetary authority may, for example, allow the exchange rate to float freely between an
upper and lower bound, a price “ceiling” and “floor”.

16 KMBNFM04
 UNIT-2
Convertibility of rupee
In general, the convertibility of rupee means that those who have a foreign exchange
(e.g. US dollars, Pound Sterlings, etc.) can get them converted into rupees and vice-
versa at the market-determined rate of exchange. The rupee is both convertibles on
capital account and current account.
In 1991-92 the GOI adopted a dual exchange rate system under which the official rate of ex-
change was controlled and the market rate (or the black-market rate) of exchange was free to
move or fluctuate according to forces of supply and demand.
Current account convertibility
All current transactions of India with other countries in respect of trade (merchandise), services
such as education, travel, medical expenses, etc. and ‘invisibles’ such as remittances are fully
met through full convertibility of the Rupee into other currencies. The Rupee can be used to
buy other currencies and other countries can buy Indian rupee without limit.
Capital Account Convertibility
Capital account convertibility is a feature of a nation's financial regime that centers on the ability to
conduct transactions of local financial assets into foreign financial assets freely or at market
determined exchange rates. It is sometimes referred to as capital asset liberation or CAC.
Benefits of CAC:
The potential benefits from the scheme are:
1. Availability of large funds to supplement domestic resources and thereby promote
faster economic growth.
2. Improved access to international financial markets and reduction of the cost of capital.
3. Incentive for Indians to acquire and hold international securities and assets.
4. Improvement (strengthening) of the financial system in the context of global
competition.
Main Provisions Under the System of CAC:
(a) Indian companies would be allowed to issue foreign currency denominated bonds to local
investors, to invest in such bonds and deposits to issue Global Depository Receipts (GDRs)
without RBI or GOI approval and to go for external commercial borrowings subject to certain
limits.
(b) Indian residents would be permitted to have foreign currency denominated deposits with
banks in India, to make transfers of financial capital to other countries within certain limits,
and to take loans from non-relatives and others up to a ceiling of $1 million.
(c) Indian banks would be permitted to borrow from overseas markets for short-term and long-
term up to certain limits, to invest in overseas money markets, to accept deposits and extend
loans denominated in foreign currency. Such facilities would also be available to non- bank
financial institutions and financial intermediaries like insurance companies, investment
companies and mutual funds.
(d) All India financial institutions which fulfill certain regulatory and prudential requirements
would be allowed to participate in foreign exchange market along with banks which are the
only Authorised Dealers (ADs) now. At a later stage, certain select Non-Bank Financial
Companies (NBFCs) would also be permitted to act as Ads in foreign exchange markets.
(e) Banks and financial institutions would be permitted to operate in domestic and international
markets. They would be allowed to buy and sell gold freely and offer gold denominated
deposits and loans.
Preconditions for CAC:
According to the Tarapore Committee four preconditions have to be fulfilled to ensure full
currency convertibility:
(i) Reducing Fiscal Deficit:
Fiscal deficit should be reduced to 3.5% of GDP.
17 KMBNFM04
 (ii) Reducing Public Debt:
The GOI should also set up a Consolidated Sinking Fund (CSF) to reduce its debt.
(iii) Fixing Inflation Target:
The GOI should fix the annual inflation target between 3% to 5%. This is called mandated
inflation target. The GOI should also give full freedom to the RBI to use monetary weapons to
achieve the inflation target.
(iv) Strengthening the Indian Financial Sector:
For this, four conditions are to be satisfied:
(a) Full deregulation of interest rates,
(b) Reduction of gross Non-Performing Assets (NPAs) to 5%,
(c) Reduction of average effective CRR to 3% and
(d) Liquidation of weak banks or their merger with other strong banks.
Apart from these, the Tarapore Committee also recommended that:
(a) The RBI should fix an exchange rate band of 5% around real effective exchange rate and
should intervene only when the Real Effective Exchange Rate (REER) is outside the band.
(b) The size of the current account deficit should be within manageable limits and the debt
service ratio should be gradually reduced from the present 25% to 20% of the export earnings.
(c) To meet import bill and to service external debt, forex reserves should be adequate and
range between $22 billion and $32 billion.
(d) The GOI should remove all restrictions on the movement of gold.
Disadvantages of CAC:
(i) Contagion Effect:
The Asian financial crisis of 1997 makes it abundantly clear that financial crisis from one
country may be easily transmitted to other countries having convertible currencies. Any
adverse development in overseas market will affect India’s economy equally adversely as was
amply shown in the recent world recession of 2008-09.
(ii) Speculation:
A convertible currency shows greater fluctuation than an inconvertible one and thus gives
greater scope for destabilising speculation. This creates uncertainty and reduces the volume of
trade.
(iii) Outflow of Funds:
Indians will have a tendency to buy more assets abroad and India may become a debtor nation
like the USA since it may develop a tendency to spend beyond its means.
(iv) No Ceiling on External Debt:
Finally, there will be no ceiling on India’s external debt since the GOI knowing well that rupee
can now be used for debt serving will borrow without limits.

THEORIES OF FOREIGN EXCHANGE RATE

Purchasing power parity (PPP)
ne popular macroeconomic analysis metric to compare economic productivity and standards of
living between countries is purchasing power parity (PPP). PPP is an economic theory that
compares different countries' currencies through a "basket of goods" approach, not to be
confused with the Paycheck Protection Program created by the CARES Act.
This theory states that the equilibrium rate of exchange is determined by the equality of the
purchasing power of two inconvertible paper currencies. It implies that the rate of exchange
between two inconvertible paper currencies is determined by the internal price levels in two
countries.

Calculating Purchasing Power Parity

The relative version of PPP is calculated with the following formula:

18 KMBNFM04
 S=P2P1where:S= Exchange rate of currency 1 to currency 2P1
= Cost of good X in currency 1P2= Cost of good X in currency 2

There are two versions of the purchasing power parity theory:

(i) The Absolute Version and
(ii) The Relative Version.
(i) The Absolute Version:
According to this version of the purchasing power parity theory, the rate of exchange should
normally reflect the relation between the internal purchasing power of the different national
currency units. In other words, the rate of exchange equals the ratio of outlay required to buy a
particular set of goods at home as compared with what it would buy in a foreign country.
The absolute version of the purchasing power parity theory is, no doubt, quite simple and
elegant, yet it has certain shortcomings. Firstly, this version of determining exchange rate is of
little use as it attempts to measure the value of money (or purchasing power) in absolute terms.
In fact, the purchasing power is measured in relative terms. Secondly, there are differences in
the kinds and qualities of products in the two countries.
These diversities create serious problem in the equalisation of product prices in different
countries. Thirdly, apart from the differences in quality and kind of goods there are also
differences in the pattern of demand, technology, transport costs, tariff structures, tax policies,
extent of state intervention and control and several other factors. These differences prohibit the
measurement of exchange rate in two or more currencies in strict absolute terms.
(ii) The Relative Version:
The relative version of Cassel’s purchasing power parity theory attempts to explain the changes
in the equilibrium rate of exchange between two currencies. It relates the changes in the
equilibrium rate of exchange to changes in the purchasing power parities of currencies. In other
words, the relative changes in the price levels in two countries between some base period and
current period have vital bearing upon the exchange rates of currencies in the two periods.
the purchasing power parity curve is of a fluctuating character. It signifies a moving parity.
Along with it, the curves indicating commodity export and commodity import points also
fluctuate. The market rate of exchange is determined by the intersection of demand curve DD
and supply curve SS of foreign exchange.
The market rate of exchange is OR and the quantity of foreign exchange demanded and
supplied is OQ. When the demand for and supply of foreign exchange change, the demand and
supply curves can undergo shifts as shown by D1 and S1 curves.
Accordingly, there will be variations in the market rate of exchange around the normal rate of
exchange determined by the purchasing power parity. The market rate of exchange, however,
will invariably lie between the limits specified by the commodity export and commodity import
points.

Drawbacks of Purchasing Power Parity

Since 1986, The Economist has playfully tracked the price of McDonald's Corp.’s (MCD) Big Mac
hamburger across many countries. Their study results in the famed "Big Mac Index". In
"Burgernomics"—a prominent 2003 paper that explores the Big Mac Index and PPP—authors Michael
R. Pakko and Patricia S. Pollard cited the following factors to explain why the purchasing power parity
theory is not a good reflection of reality

International Fisher Effect (IFE)

The International Fisher Effect (IFE) is an economic theory stating that the expected disparity between
the exchange rate of two currencies is approximately equal to the difference between their countries'
nominal interest rates.
19 KMBNFM04
  The International Fisher Effect (IFE) states that differences in nominal interest rates between
countries can be used to predict changes in exchange rates.
 According to the IFE, countries with higher nominal interest rates experience higher rates of
inflation, which will result in currency depreciation against other currencies.
 In practice, evidence for the IFE is mixed and in recent years direct estimation of currency
exchange movements from expected inflation is more common.

The international Fisher effect (sometimes referred to as Fisher’s open hypothesis) is a

hypothesis in international finance that suggests differences in nominal interest rates reflect
expected changes in the spot exchange rate between countries. The hypothesis specifically
states that a spot exchange rate is expected to change equally in the opposite direction of the
interest rate differential; thus, the currency of the country with the higher nominal interest rate
is expected to depreciate against the currency of the country with the lower nominal interest
rate, as higher nominal interest rates reflect an expectation of inflation.
The International Fisher Effect theory was recognized on the basis that interest rates are
independent of other monetary variables and that they provide a strong indication of how the
currency of a specific country is performing. According to Fisher, changes in inflation do not
impact real interest rates, since the real interest rate is simply the nominal rate minus inflation.
The theory assumes that a country with lower interest rates will see lower levels of inflation,
which will translate to an increase in the real value of the country’s currency in comparison to
another country’s currency. When interest rates are high, there will be higher levels of inflation,
which will result in the depreciation of the country’s currency.
Derivation of the International Fisher effect
The International Fisher effect is an extension of the Fisher effect hypothesized by American
economist Irving Fisher. The Fisher effect states that a change in a country’s expected inflation
rate will result in a proportionate change in the country’s interest rate
(1+i) =(1+r) *(1+E[pi])
were
i is the nominal interest rate
r is the real interest rate
E[pi] is the expected inflation rate
How to Calculate the Fisher Effect
The formula for calculating the IFE is as follows:
E = [(i1-i2) / (1+ i2)] = (i1-i2)
Where:
E = Percentage change in the exchange rate of the country’s currency
i1 = Country’s A’s Interest rate
i2 = Country’s B’s Interest rate
In the short term, the International Fisher Effect is seen as an unreliable variable of estimating
the price movements of a currency due to the existence of other factors that affect exchange
rates. The factors also exert an effect on the prediction of nominal interest rates and inflation.
However, in the long run, the IFE is viewed as a more reliable variable to determine the effect
of changes in nominal interest rates on shifts in exchange rates.

Interest Rate Parity (IRP)

Interest rate parity (IRP) is a theory according to which the interest rate differential between
two countries is equal to the differential between the forward exchange rate and the spot
exchange rate.
 Interest rate parity is the fundamental equation that governs the relationship between
interest rates and currency exchange rates.
 The basic premise of interest rate parity is that hedged returns from investing in
20 KMBNFM04
 different currencies should be the same, regardless of their interest rates.
 Parity is used by forex traders to find arbitrage opportunities.

Interest rate parity (IRP) is a theory according to which the interest rate differential between
two countries is equal to the differential between the forward exchange rate and the spot
exchange rate.
The formula for IRP is:
F0 = S0 * {{1+ ic) / (1+ 1b)}
where:
F0 =Forward Rate
S0 =Spot Rate
ic =Interest rate in country c
ib = Interest rate in country b
Covered vs. Uncovered interest rate parity
When the no-arbitrage condition mentioned above is satisfied using forward contracts, the IRP
is ‘covered.’ If the no-arbitrage condition can still be met without using forward contracts to
hedge against risk, this is called uncovered interest rate parity.
Uncovered and covered interest rate parity look similar, the only difference being the use of
forward contracts. For example, imagine that a British investor is converting AUD into GBP.
The investor agrees to invest the foreign currency (AUD in this case) locally at a risk-free
foreign rate. He enters a forward rate agreement, which states he will convert any proceeds at
the end of the investing period into GBP at the forward exchange rate. This would be a covered
interest rate parity example concept.
By contrast, he could also choose to convert the AUD into GBP using the spot exchange rate,
then investing this GBP for the same period at the local risk-free rate. This technique would be
using uncovered interest rate parity, and both should end up with equal cash flows.

Administration of Foreign Exchange; Authorized persons, Authorized dealer

The Foreign Exchange Regulation Act (FERA) was legislation passed in India in 1973 that
imposed strict regulations on certain kinds of payments, the dealings in foreign exchange
(forex) and securities and the transactions which had an indirect impact on the foreign exchange
and the import and export of currency. The bill was formulated with the aim of regulating
payments and foreign exchange.
FERA came into force with effect from January 1, 1974.
FERA was introduced at a time when foreign exchange (Forex) reserves of the country were
low, Forex being a scarce commodity. FERA therefore proceeded on the presumption that all
foreign exchange earned by Indian residents rightfully belonged to the Government of India
and had to be collected and surrendered to the Reserve Bank of India (RBI). FERA primarily
prohibited all transactions not permitted by RBI.
Coca-Cola was India’s leading soft drink until 1977 when it left India after a new government
ordered the company to dilute its stake in its Indian unit as required by the Foreign Exchange
Regulation Act (FERA). In 1993, the company (along with PepsiCo) returned after the
introduction of India’s Liberalization policy.
Features
 Activities such as payments made to any person outside India or receipts from them,
along with the deals in foreign exchange and foreign security is restricted. It is FEMA
that gives the central government the power to impose the restrictions.
 Free transactions on current account subject to reasonable restrictions that may be
imposed.
 Without general or specific permission of FEMA, MA restricts the transactions
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 involving foreign exchange or foreign security and payments from outside the country
to India – the transactions should be made only through an authorized person.
 Deals in foreign exchange under the current account by an authorized person can be
restricted by the Central Government, based on public interest generally.
 Although selling or drawing of foreign exchange is done through an authorized person,
the RBI is empowered by this Act to subject the capital account transactions to a number
of restrictions.
 Residents of India will be permitted to carry out transactions in foreign exchange,
foreign security or to own or hold immovable property abroad if the currency, security
or property was owned or acquired when he/she was living outside India, or when it
was inherited by him/her from someone living outside India.
Authorized Persons
The term authorized dealer refers to any type of financial institutions who has received
authorization from the RBI as a dealer to involve in trading of foreign currencies. The
transaction of the authorized dealer should have been conducted in pursuance of a legal mode
and under the framework established by law. Authorized dealers are nothing else but the market
pronounced name of AMC i.e., Authorized Money Changer.
As per master circular no. 10/2013-14 of RBI dated 01st July 2013 it describes that the
AMC/ADs are entities, authorized by the Reserve Bank under section 10of the Foreign
exchange Management Act 1999. In addition to Authorized Dealers category-I Banks (AD
Category –I Banks) and Authorized Dealer Category–II (Ads category-II), Full Fledged
Money Changers (FFMCs) are authorized by Reserve Bank to deal in Foreign exchange for
specified purposes, to widen the access of foreign exchange facilities to residents and tourists
while ensuring efficient customer service through competition.
Category of
Qualifying Entities Activities/Functions
ADs
All Commercial Banks And
Authorized
Scheduled banks registered Under It deals in all type of current ant capital
Dealers
RBI Act. account transaction according to the norms
Category – I
Urban Co-operative Banks (To and procedure laid down by RBI.
(ADs- I )
some prescribed extent).
Upgraded Full Fledged Money
Authorized
Changer and another new inclusion
Dealers It deals in transaction of foreign exchange
like Department of Post and various
Category – II which is non-trade in characteristics.
type of NBFCs who are operated in
(ADs- II )
open market
Authorized Financial Institutions, EXIM Bank, It deals with the activities which are
Dealers SIDBI, IFCI, Clearing corporation incidental to financing of international trade
Category – III of India and Various Factoring related activities undertaken by these
(ADs- II) Agents. institutions.
FFMCs are authorized to purchase foreign
Full Fledged It can any entities who are related
exchange from resident and non-resident
money Changer with the finance sector including
visiting India and to sell Foreign Exchange
(FFMCs) NBFCs, Department of Post etc.,
for certain approved purposes.

Authorized Dealer
Authorized Dealers Category–I (ADs–I)
As per the latest circular Issued by the RBI, there are around 110 entities who are qualified
under the segment of Authorized Dealers category–I. It includes all type of Commercial Banks
irrespective of Nationalized Banks, Scheduled Banks, Private Banks and Foreign Commercial
22 KMBNFM04
Banks operating in India. These segments of banks allowed to deals in all type of foreign
exchange transaction related to current and capital account transaction according to the norms
and procedure laid down by RBI.
Authorized Dealers Category – II (ADs–II)
The second category of authorized dealer operates under the restrictive environment for the
implementation of some specified purposes prescribed by RBI. It includes the Upgraded Full
Fledged Money Changer and another new inclusion like Department Of Post and various types
of NBFCs who are operated in open markets. As per RBI the detailed of dealers classified
under this category are considered as per region basis. At present, there are 11 regions in India
which under this category.
Authorized Dealers Category -III (ADs–II)
The third category of authorized dealer operates with the purpose to boost the international
trade by proving them adequate availability foreign currency for promotion of international
trade as per the norms lay down in section 10 of the FEMA Act 1999. It includes the major
player of financial institutions like IFCI, SIDBI EXIM Bank and various Factor Agencies.
Full-Fledged money Change (FFMCs)
It is the new aspect of regulation of Indian Foreign Exchange markets. It may be any financial
entity other than Commercial Banks who qualified the norms and criteria laid down by RBI.
FFMCs are authorized to purchase foreign exchange from resident and non-resident visiting
India and to sell Foreign Exchange for certain approved purposes. The main objective of the
enactment of FFMCs is to provide easy access to foreign exchange transaction to common
masses.

Authorized Money Changers

Authorised Money Changers (AMCs) are companies that have been approved by the Reserve
Bank of India (RBI) as per Section 10 of the Foreign Exchange Management Act of 1999.
Under which, an AMC may either register as a Restricted Money Changer (RMC) or a Full
Fledged Money Changer (FFMC).The companies that after obtaining a licence from the
Reserve Bank of India (RBI) intents to carry out functions of forex currency or money
changer activity is termed as ‘Full Fledged Money Changers’ (FFMCs). Every full fledged
money changer is required to follow circular on Memorandum of Instruction on Money
Changing Activities published by RBI and also provisions of Foreign Exchange Management
Act, 1999 is to be followed by every FFMC licence holder.
No person shall carry on or advertise that he carries on money changing business unless he is
in possession of a valid money changer’s licence issued by the Reserve Bank. Any person
found undertaking money changing business without a valid licence is liable to be penalised.

Full Fledged Money Changer (FFMC)

Full Fledged Money Changer is a company that carries out trading activities like forex
currency after prior approval from the Reserve Bank of India (RBI).
A Full Fledged Money Changer (FFMC) is an authorized entity who may purchase foreign
exchange from non-residents and residents of India and sell the same for private and business
travel purposes only to the people visiting abroad. As Section 10 of the Foreign Exchange
Management Act, 1999 prescribes, authorized money changers are the only entities in the
country that can deal in money changing activities and offer necessary foreign exchange
services. For the purpose of removing the obstacles faced by foreign visitors and tourists,
particular firms and hotels have also been offered the registration to deal in foreign currency
notes, coins and traveller’s cheques under the directions issued by the RBI frequently.
No individual is permitted to carry on or advertise that they carry on money changing business
23 KMBNFM04
unless they own a valid money changer’s license issued by the RBI. Any individual found
undertaking any sort of money changing business without a valid license is liable to be
penalised under the Act.
Activities of FFMCs
The following are the activities that are undertaken by Full Fledged Money Changer (FFMC).
An FFMC may enter into a franchise agreement at their convenience for the purpose of carrying
on the Restricted Money Changing business which basically involves the conversion of foreign
currency notes, coins or travellers’ cheques into Indian Rupees (INR).
An FFMC or its franchisees may freely purchase any foreign currency notes, coins or traveller’s
cheques from the residents as well as the non-residents of India.
An FFMC may sell Indian Rupees (INR) to foreign tourists or visitors against International
Debit Cards/ International Credit Cards and take prompt actions in order to obtain
reimbursements through normal banking channels.
FFMCs may choose to sell foreign exchange for the following purposes.
 Business Visits
 Private Visits
 Forex Pre-Paid Cards
Eligibility to obtain FFMC License
The following are the eligibility criteria that are required in order to operate as a Full Fledged
Money Changer (FFMC).
 The Entity that wishes to apply for a Full Fledged Money Changer License must be
registered under the Companies Act of 2013.
 The Entity must have a minimum net-owned fund of INR 25 Lakhs in order to apply
for a single-branch license and INR 50 Lakhs for a multiple-branch license.
 The object clause of the Memorandum must reflect the activity of money changing that
is to be undertaken by the Entity.
 There must not be civil or criminal cases pending against the Entity with the
enforcement of the Department of Revenue Intelligence.
 After obtaining the FFMC License, the Entity must carry out its business activity within
6 months from the date of issuance of the Forex License and should, without fail,
intimate the RBI.

Foreign Currency Accounts: Nostro Account, Vostro Account and Loro Account in
foreign transactions

Foreign Currency Account (FCA) is a transactional account denominated in a currency other

than the home currency and can be maintained by a bank in the home country (onshore) or a
bank in another country (offshore).
Exchange Earner’s Foreign Currency (EEFC) account is in the form of a non-interest-bearing
current account. Special Economic Zones (SEZ) developers can open, maintain and hold EEFC
accounts and credit their foreign exchange earnings to this account. The claims which are
settled in rupees by the Insurance companies or the Export Credit Guarantee Corporation of
India is not construed as the export realisation in foreign exchange, and thus, the claim amount
cannot be credited to this account.
The sum total of the accruals during the current month in the account should be converted into
Indian Rupees before the last day of the next month after adjusting for utilisation of the balances
for forward commitments or approved purposes. Credit facilities, both non-fund and fund-
based, are not granted against the balances held in this account.
A ‘Foreign Currency Account’ means an account held or maintained in a currency that is not
the currency of India or Bhutan, or Nepal. Any person who is residing in India can open, hold
and maintain a foreign account. ‘Person Resident in India’ is defined under Section 2(v) of the
24 KMBNFM04
 Foreign Exchange Management Act, 1999 (FEMA).
Nostro Account
A nostro account refers to an account that a bank holds in a foreign currency in another bank.
Nostros, a term derived from the Latin word for "ours," are frequently used to
facilitate foreign exchange and trade transactions. The opposite term "vostro accounts,"
derived from the Latin word for "yours," is how a bank refers to the accounts that other banks
have on its books in its home currency. Normally, such account is a current account in the
books of the overseas Bank. For example, an Indian bank authorized to deal in foreign
exchange maintain an account with overseas bank in USA in US Dollar such account
maintained in the foreign currency at foreign center by Indian bank is said as ‘Nostro
Account’. Nostro is an Italian word which literally means ‘Our’. So, the ‘Nostro Account’ of
the Indian bank with its branch/correspondents in USA is said as ‘Our Accounts with You’.

How a Nostro Account Works

A nostro account and a vostro account actually refer to the same entity but from a different perspective.
For example, Bank X has an account with Bank Y in Bank Y's home currency. To Bank X, that is a
nostro, meaning "our account on your books," while to Bank Y, it is a vostro, meaning "your account
on our books." These accounts are used to facilitate international transactions and to settle transactions
that hedge exchange rate risk.

Vostro Account
A vostro account is an account a correspondent bank holds on behalf of another bank. These accounts
are an essential aspect of correspondent banking in which the bank holding the funds acts as custodian
for or manages the account of a foreign counterpart. For example, if a Spanish life insurance company
approaches a U.S. bank to manage funds on the Spanish life insurer's behalf, the account is deemed by
the holding bank as a vostro account of the insurance company.
Uses of Vostro Accounts
There are several situations where vostro accounts are typically used. The most common situations
include but are not limited to:

 International Trade. Vostro accounts make transactions in international trade possible. Vostro
accounts can be used by importers and exporters to settle payments, manage currency
conversions, and guarantee effective trade finance operations.
 Payment Remittance. Vostro accounts can be used for sending money to other people.
Respondent banks may maintain Vostro accounts with correspondent banks in nations where
their clients often remit or receive funds, facilitating quicker and easier cross-border remittance
transactions.
 Foreign Currency Transactions. Vostro accounts allow responding banks to hold money in
foreign currencies for foreign currency transactions. This is especially advantageous for banks
that frequently carry out foreign currency transactions, including currency hedging or foreign
exchange trading.
 Cost Mitigation. Vostro accounts can assist in lowering transaction costs related to
international transfers and currency conversions. Respondent banks can streamline their
operations and potentially reduce foreign exchange fees by storing funds in the correspondent
bank's native currency.
 Regulatory Compliance: Vostro accounts make it possible for responding banks to abide by
regional laws in international marketplaces. The respondent bank can guarantee compliance
with regulatory requirements such as know-your-customer duties by using a correspondent
bank's services through a Vostro account.

25 KMBNFM04
 Loro Account
Loro account is derived from the Italian word “Loro,” which means ‘Their,’ which means this account is
a ‘Third Party Account.’ In bilateral correspondence between any two given banks, the words Vostro
(Your) and Nostro (Our) are used, that is, the bank whose book the account is maintained and the one
who is maintaining the account. In such conditions, a third bank’s account, which is talked about, is
called a Loro account.

Working of a Loro account

A Loro account is a combination of an ordinary and a Nostro account. Let us take an example
of a student seeking admission to a university abroad. That particular student has a bank
account with Bank of Baroda and the university has an account with Wells Fargo. For instance,
Bank of Baroda does not have an account with Wells Fargo so now when that student wants to
deposit his/her tuition fees, Bank of Baroda will instruct State Bank of India (assuming SBI
has an account with Wells Fargo) to deposit fee in the University’s account on their behalf.

UNIT-3
Foreign Exchange Market: Nature, Structure, Types of Transactions

The foreign exchange market (also known as forex, FX, or the currencies market) is an over-the-
counter (OTC) global marketplace that determines the exchange rate for currencies around the world.
Participants in these markets can buy, sell, exchange, and speculate on the relative exchange rates of
various currency pairs.

Foreign exchange markets are made up of banks, forex dealers, commercial companies, central banks,
investment management firms, hedge funds, retail forex dealers, and investors.

 The foreign exchange market is an over-the-counter (OTC) marketplace that determines the
exchange rate for global currencies.
 It is, by far, the largest financial market in the world and is comprised of a global network of
financial centers that transact 24 hours a day, closing only on the weekends.
 Currencies are always traded in pairs, so the "value" of one of the currencies in that pair is relative
to the value of the other.

The Foreign Exchange Market is a market where the buyers and sellers are involved in the
sale and purchase of foreign currencies. In other words, a market where the currencies of
different countries are bought and sold is called a foreign exchange market.

26 KMBNFM04
 The structure of the foreign exchange market constitutes central banks, commercial banks,
brokers, exporters and importers, immigrants, investors, tourists. These are the main players of
the foreign market, their position and place are shown in the figure below.
At the bottom of a pyramid are the actual buyers and sellers of the foreign currencies- exporters,
importers, tourist, investors, and immigrants. They are actual users of the currencies and
approach commercial banks to buy it.
The commercial banks are the second most important organ of the foreign exchange market.
The banks dealing in foreign exchange play a role of “market makers”, in the sense that they
quote on a daily basis the foreign exchange rates for buying and selling of the foreign
currencies. Also, they function as clearing houses, thereby helping in wiping out the difference
between the demand for and the supply of currencies. These banks buy the currencies from
the brokers and sell it to the buyers.
The third layer of a pyramid constitutes the foreign exchange brokers. These brokers function
as a link between the central bank and the commercial banks and also between the actual buyers
and commercial banks. They are the major source of market information. These are the persons
who do not themselves buy the foreign currency, but rather strike a deal between the buyer and
the seller on a commission basis.
The central bank of any country is the apex body in the organization of the exchange market.
They work as the lender of the last resort and the custodian of foreign exchange of the
country. The central bank has the power to regulate and control the foreign exchange market
so as to assure that it works in the orderly fashion. One of the major functions of the central
bank is to prevent the aggressive fluctuations in the foreign exchange market, if necessary, by
direct intervention. Intervention in the form of selling the currency when it is overvalued and
buying it when it tends to be undervalued.

Functions of Foreign Exchange Market

Functions of Foreign Exchange Market

Now that we know what foreign exchange market is, listed below are some of the functions of foreign exchange market:

1. Facilitate Currency Conversion

27 KMBNFM04
 It is the primary function of the foreign exchange market. Transferring money or currencies from one nation to
another in order to settle accounts is the fundamental and most obvious functions of foreign exchange market. In
essence, the foreign exchange market transforms one currency to another.

2. Provide Instruments to Manage Foreign Exchange Risk

An investor would need to completely refrain from investing in foreign assets in order to minimise FX risk. But,
using currency forwards or futures, foreign exchange rate risk can be reduced. Providing instruments to manage
foreign exchange risk is thus one of the functions of foreign exchange market.

3. Allow Investors to Speculate in the Market for Profit

Because exchange values between currencies are constantly fluctuating, both on an intraday and long-term basis,
the foreign currency exchange or forex market is well-liked by speculators. Because there are so many distinct
currency pairs that may be traded, the foreign exchange market also offers regular trading possibilities, which
makes up the one of the other functions of foreign exchange market.

Types of Foreign Exchange Transactions

The Foreign Exchange Transactions refers to the sale and purchase of foreign currencies.
Simply, the foreign exchange transaction is an agreement of exchange of currencies of one
country for another at an agreed exchange rate on a definite date.

1. Spot Transaction: The spot transaction is when the buyer and seller of different
currencies settle their payments within the two days of the deal. It is the fastest way to
exchange the currencies. Here, the currencies are exchanged over a two-day period,
which means no contractis signed between the countries. The exchange rate at which
the currencies are exchanged is called the Spot Exchange Rate. This rate is often the
prevailing exchange rate. The market in which the spot sale and purchase of currencies
is facilitated is called as a Spot Market.
2. Forward Transaction: A forward transaction is a future transaction where the buyer
and seller enter into an agreement of sale and purchase of currency after 90 days of the
dealat a fixed exchange rate on a definite date in the future. The rate at which the
currency is exchanged is called a Forward Exchange Rate. The market in which the
deals for the sale and purchase of currency at some future date is made is called
a Forward Market.
3. Future Transaction: The future transactions are also the forward transactionsand
deals with the contracts in the same manner as that of normal forward transactions. But
however, the transactions made in a future contract differs from the transaction made
in the forward contract on the following grounds:

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 The forward contracts can be customizedon the client’s request, while the future

contracts are standardized such as the features, date, and the size of the contracts is
standardized.
 The future contracts can only be traded on the organized exchanges,while the
forward contracts can be traded anywhere depending on the client’s convenience.
 No marginis required in case of the forward contracts, while the margins are
required of all the participants and an initial margin is kept as collateral so as to
establish the future position.
4. Swap Transactions: The Swap Transactions involve a simultaneous borrowing and
lending of two different currencies between two investors. Here one investor borrows
the currency and lends another currency to the second investor. The obligation to repay
the currencies is used as collateral, and the amount is repaid at a forward rate. The
swap contracts allow the investors to utilize the funds in the currency held by him/her
to pay off the obligations denominated in a different currency without suffering a
foreign exchange risk.
5. Option Transactions: The foreign exchange option gives an investor theright, but not
the obligation to exchange the currency in one denomination to another at an agreed
exchange rate on a pre-defined date. An option to buy the currency is called as a Call
Option, while the option to sell the currency is called as a Put Option.
Thus, the Foreign exchange transaction involves the conversion of a currency of one country
into the currency of another country for the settlement of payments.

Exchange quotations: Direct and Indirect Quotations, Two way Quotation

Forex quotations can be quite complex for the average person. It takes some training and knowledge to understand that these quotations can be
provided in more than one way! Also, it takes a little getting used to before a person can quickly comprehend these quotes and take quick
decisions based on the same. In this article, we will explain the two types of Forex quotations as well as the abbreviations which are used in them.
Direct Quote

 Meaning: Under this method, the quote is expressed in terms of domestic currency. This means that the rate expresses how one unit of
domestic currency relates to the foreign currency. Therefore, if unit of the domestic currency were to be exchanged, how many units of the
foreign currency would it beget? This method is also alternatively referred to as the price quotation method.

Therefore, if the value of the domestic currency increases, a smaller amount of it would have to be exchanged. Conversely a d ecline in value
would create a situation where a large amount of the domestic currency would have to be exchanged. Hence, it can be said that the quotation
rate has an inverse relationship with the value of the domestic currency.

The value of the domestic currency is assumed to be 1 in case of a direct quotation. The price being qu oted explains the number of units of
foreign currency that can be exchanged for a single unit of domestic currency.

 Example: An example of direct quotation would be

USD/JPY: 143.15/18

This quote suggests that roughly 143 units of Japanese Yen can be exchanged for 1 unit of United States Dollar. The two rates provided are bid
and ask rates i.e. the different rates at which the market maker is willing to buy and sell the currency.

 Usage: The direct quote method is one of the most widely used quotation methods across the world. This is the norm for quoting Forex prices
and is assumed de facto until another method has been explicitly mentioned.

Indirect Quote:

 Meaning: This method is the opposite of the direct quotation method. Under this method, the quote is expressed in terms of foreign currency.
Therefore this rate assumes one unit of foreign currency. It then expresses how many units of domestic currency are required to obtain a single
unit of a foreign currency. Sometimes this quote is also expressed in terms of 100 units of foreign currency. This method is often referred to as
the quantity quotation method.

29 KMBNFM04
 Since this method is quoted in terms of foreign currency, the quoted rate has a direct correlation with the domestic rate. If the quote goes up, so
does the value of the domestic currency and vice versa.

 Example: An example of indirect quotation would be:

EUR/USD: 0.875/79

In this case, the first currency i.e. EUR is the domestic currency. Therefore, the indirect quote refers to approximately 0.875 EUR being
exchanged for 1 unit of USD. Once again the two rates provided are the bid ask rate i.e. the two different rates at which market makers are
willing to buy and sell the currency.

 Usage: The usage of indirect currency quotation is extremely rare. It is only in the Commonwealth countries like United Kingdom and
Australia that the indirect quotation method is used as a result of convention.

Two way Quotation

A two-way (or two-sided) quote indicates both the current bid price and the current ask price
of a security during a trading day on an exchange. To a trader, a two-way quote is more
informative than the usual last-trade quote, which indicates only the price at which the security
last traded.
A two-way quote involves a bid-ask spread, or the difference between the highest price that a
buyer is willing to pay for an asset and the lowest price that a seller is willing to accept. An
individual looking to sell will receive the bid price while one looking to buy will pay the ask
price.
Two-way quotes can be contrasted with one-way quotes, which provide only the bid side or
the ask side.
A quote is the price at which an asset can be traded; it may also refer to the most recent price
that a buyer and seller agreed upon and at which some amount of the asset was transacted. A
two-way quote tells traders the current price at which they can buy or sell a security. Moreover,
the difference between the two indicates the spread or the difference between the bid and the
ask, giving traders an idea of the current liquidity in the security.
A smaller spread indicates greater liquidity. There are enough shares available at that moment
to meet demand, causing a narrowing of the gap between the bid and ask.
Two-way price quotations are often conveyed as $X/$Y when written, or “$X bid at $Y” when
spoken.

Forward margin, Factors Determining forward margin

The forward margin, or forward spread, reflects the difference between the spot rate and the
forward rate for a certain commodity or currency. The difference between the two rates can
either be a premium or a discount, depending on if the forward rate is above or below the spot
rate, respectively.
The forward margin is the difference between the forward rate less the spot rate, or, in the event
of a discount rate, the spot rate minus the forward rate. The forward margin can be large, small,
negative, or positive, and represent the costs associated with locking in the price for a future
date.
The forward margin will be different based on how far out the delivery date of the forward is
as a one year forward will be priced differently than a 30-day forward. The forward margin is
often measured in basis points, known as forward points, and if you add or subtract the forward
margin to the spot rate, you would get the forward rate.

 The forward margin is the difference between the forward rate less the spot rate, or, in the event of
a discount rate, the spot rate minus the forward rate.

30 KMBNFM04
  The forward margin can be large, small, negative, or positive, and represent the costs associated
with locking in the price for a future date.
 The forward margin will be different based on how far out the delivery date of the forward is as a
one year forward will be priced differently than a 30-day forward.
 The forward margin is often measured in basis points, known as forward points, and if you add or
subtract the forward margin to the spot rate, you would get the forward rate.

Factors Determining Forward Margin

. Inflation Rates
Changes in market inflation cause changes in currency exchange rates. A country with a lower inflation rate than another's
will see an appreciation in the value of its currency. The prices of goods and services increase at a slower rate where the
inflation is low. A country with a consistently lower inflation rate exhibits a rising currency value while a country with
higher inflation typically sees depreciation in its currency and is usually accompanied by higher interest rates.

2. Interest Rates
How do interest rates affect money exchange rates? Changes in interest rate affect currency value and dollar exchange rate.
Forex rates, interest rates, and inflation are all correlated. Increases in interest rates cause a country's currency to appreciate
because higher interest rates provide higher rates to lenders, thereby attracting more foreign capital, which causes a rise in
exchange rates.

3. Country's Current Account/Balance of Payments

A country's current account reflects balance of trade and earnings on foreign investment. It consists of total number of
transactions including its exports, imports, debt, etc. A deficit in current account due to spending more of its currency on
importing products than it is earning through sale of exports causes depreciation. Balance of payments fluctuates exchange
rate of its domestic currency.

4. Government Debt
Government debt is public debt or national debt owned by the central government. A country with government debt is less
likely to acquire foreign capital, leading to inflation. Foreign investors will sell their bonds in the open market if the market
predicts government debt within a certain country. As a result, a decrease in the value of its exchange rate will follow.

5. Terms of Trade
A trade deficit also can cause exchange rates to change. Related to current accounts and balance of payments, the terms of
trade is the ratio of export prices to import prices. A country's terms of trade improves if its exports prices rise at a greater
rate than its imports prices. This results in higher revenue, which causes a higher demand for the country's currency and an
increase in its currency's value. This results in an appreciation of exchange rate.

6. Political Stability & Performance

A country's political state and economic performance can affect its currency strength. A country with less risk for political
turmoil is more attractive to foreign investors, as a result, drawing investment away from other countries with more political
and economic stability. Increase in foreign capital, in turn, leads to an appreciation in the value of its domestic currency. A
country with sound financial and trade policy does not give any room for uncertainty in value of its currency. But, a country
prone to political confusions may see a depreciation in exchange rates.

7. Recession
When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to acquire foreign capital.
As a result, its currency weakens in comparison to that of other countries, therefore lowering the exchange rate.

31 KMBNFM04
 8. Speculation
If a country's currency value is expected to rise, investors will demand more of that currency in order to make a profit in the
near future. As a result, the value of the currency will rise due to the increase in demand. With this increase in currency
value comes a rise in the exchange rate as well.

Merchant Rates: Basis of Merchant Rates, Types of buying and Selling

rates, Ready rates based on cross rates
The merchant discount rate can also be defined as a bank fee charged to a merchant for taking
payment from their customers through credit and debit cards for goods or services. The bank
can lower the rate as sales of merchants increase. Merchants generally pay a 1% to 3% fee for
the processing of payments for each transaction. Alternatively, the merchant discount rate is
also referred to as the transaction discount rate (TDR).
The foreign exchange dealing of a bank with its customers is known as merchant business and the exchange rate at which the
transaction takes place is the ‘merchant rate’. The merchant business in which the contract with the customer to buy or sell foreign
exchange is agreed to and executed on the same day is known as ‘ready transaction’ or ‘cash transaction’. As in the case of
interbank transactions, ‘a value next day’ contract is deliverable on the next business day and ‘spot contract’ is deliverable on the
second succeeding business day following the date of the contract. In this section we focus on principle types of buying as well as
selling rates.

Principal Types of Buying Rates

In a purchase transaction the bank acquires foreign exchange from the customer and pays him in Indian rupees. Some of the
purchase transactions result in the bank acquiring foreign exchange immediately, while some involve delay in the acquisition of
foreign exchange. Depending upon the time of realization of foreign exchange by the bank, tow types of buying rates are quoted in
India. They are:
1. TT Buying Rate, and
2. Bill Buying Rate.
TT Buying Rate (TT Stands for Telegraphic Transfer)
This is the rate applied when the transactions does not involve any delay in realization of the foreign exchange by the bank. In
other words, the nostro account of the bank would already have been credited. The rate is calculated by deducting from the
interbank buying rate the exchange margin as determined by the bank.
Though the name implies telegraphic transfer, it is not necessary that the proceeds of the transaction are received by telegram. Any
transaction where no delay is involved in the bank acquiring the foreign exchange will be done at the TT rate. Transactions where
TT rate is applied are:
1. Payment of demand drafts, mail transfers, telegraphic transfers, etc. drawn on the bank where bank’s nostro account is
already credited;
2. Foreign bills collected. When a foreign bill is taken for collection, the bank pays the exporter only when the importer
pays for the bill and the bank’s nostro account abroad is credited;
3. Cancellation of foreign exchange sold earlier.
Bill Buying Rate
This is the rate to be applied when a foreign bill is purchased. When a bill is purchased, the rupee equivalent of the bill value is
paid to the exporter immediately. However, the proceeds will be realized by the bank after the bill is presented to the drawee at the
overseas centre. In the case of a usance bill, the proceeds will be realized on the due date of the bill which includes the transit
period and the usance period of the bill.

32 KMBNFM04
 Principal Types of Selling Rates
When bank sells foreign exchange it receives Indian rupees from the customer and parts with foreign currency. The sale is effected
by issuing a payment instrument on the correspondent bank with which it maintains the nostro account. Immediately on sale, the
bank buys the requisite foreign exchange from the market and gets its nostro account credited with the amount so that when the
payment instrument issued by it is presented to the correspondent bank and it can be honoured by debit to the nostro account.
Therefore, for all sales on ready/spot basis to the customer, the bank resorts to the interbank market immediately and the base rate
is the interbank spot selling rate. However, depending upon the work involved, viz., whether the safe involves handling of
documents by the bank or not, two types of selling rates are quoted in India. They are:
1. TT selling rate; and
2. Bills selling rate.
TT Selling Rate
This is the rate to be used for all transactions that do not involve handling of documents by the bank. Transactions for which this
rate is quoted are:
1. Issue of demand drafts, mail transfers, telegraphic transfers, etc., other than for retirement of an import bill; and
2. Cancellation of foreign exchange purchased earlier.
The TT selling rate is calculated on the basis of Interbank selling rate. The rate to the customer is calculated by adding exchange
margin to the interbank rate.

Bills Selling Rate

This rate is to be used for all transactions which involve handling of documents by the bank: for example, payment against import
bills. The bills selling rate is calculated by adding exchange margin to the TT selling rate. That means the exchange margin enters
into the bills selling rate twice, once on the interbank rate and again on the TT selling rate.

Ready rates based on cross rates

A cross rate is a foreign currency exchange transaction between two currencies that are both
valued against a third currency. In the foreign currency exchange markets, the U.S. dollar is
the currency that is usually used to establish the values of the pair being exchanged. As the
base currency, the U.S. dollar always has a value of one.
When a cross-currency pair is traded, two transactions are actually involved.3 The trader first
trades one currency for its equivalent in U.S. dollars. The U.S. dollars are then exchanged for
another currency.

Forward exchange contract: Fixed and option forward contracts,

Calculation of fixed and option forward rates; Inter Bank Deals

A forward exchange contract (FEC) is a special type of over-the-counter (OTC) foreign currency (forex)
transaction entered into in order to exchange currencies that are not often traded in forex markets. These
may include minor currencies as well as blocked or otherwise inconvertible currencies. An FEC involving
such a blocked currency is known as a non-deliverable forward, or NDF.

Broadly speaking, forward contracts are contractual agreements between two parties to exchange a pair of
currencies at a specific time in the future. These transactions typically take place on a date after the date
that the spot contract settles and are used to protect the buyer from fluctuations in currency prices.

Forward Price Formula

The forward price formula (which assumes zero dividends) is seen below:
33 KMBNFM04
F = S0 x erT
Where:
F = The contract’s forward price
S0 = The underlying asset’s current spot price
e = The mathematical irrational constant approximated by 2.7183
r = The risk-free rate that applies to the life of the forward contract
T = The delivery date in years
Inter Bank Deals
The interbank market is a global network utilized by financial institutions to trade currencies
and other currency derivatives directly between themselves. While some interbank trading is
done by banks on behalf of large customers, most interbank trading is proprietary, meaning
that it takes place on behalf of the banks’ own accounts. Banks use the interbank market to
manage their own exchange rate and interest rate risk as well as to take speculative positions
based on research.
Execution of forward Contracts
A customer under forward exchange contract knows in advance the time and amount of foreign
exchange to be delivered and the customer is bound by this agreement. There should not be
any variation and on the due date of the forward contract the customer will either deliver or
take delivery of the fixed sum of foreign exchange agreed upon. But, in practice, quite often
the delivery under a forward contract may take place before or after the due date, or delivery
of foreign exchange may not take place at all. The bank generally agrees to these variations
provided the customer agrees to bear the loss, if any, that the bank may have to sustain on
account of the variation.
Though the delivery or take delivery of a fixed sum of foreign exchange under a forward
contract has to take place at the agreed time, quite often this does not happen and it may either
take place before or after the due date agreed upon. However, the bank generally agrees to
these variations provided the customer bears the loss if any on account of this variation.
Based on the circumstances, the customer may end up in any of the following ways:
 Delivery on the due date.
 Early delivery.
 Late delivery.
 Cancellation on the due date.
 Early cancellation.
 Late cancellation.
 Extension on the due date.
 Early extension.
 Late extension.
As per the Rule 8 of FEDAI, a request for delivery or cancellation or extension of the forward
contract should be made by the customer on or before its maturity date. Otherwise a forward
contract which remains unutilized after the due date becomes an overdue contract. Rule 8 of
FEDAI stipulates that banks shall levy a minimum charge of Rs. 100 for every request from a
merchant for early delivery, extension or cancellation of a forward contract. This is in addition
to recovery of actual loss incurred by the bank caused by these changes.

UNIT-4

Dealing position: Exchange position, Cash Position

Dealing Position or Exchange Position
This is the overall position of the bank in a particular currency. All purchases and sales
whether spot or forward are included here. In the case of forward contracts, they will enter
into the exchange position on the date the contract with the customer is concluded. The actual
34 KMBNFM04
 date of delivery is not considered here. All purchases add to the balance and sales reduce the
balance. The exchange position is worked out every day so as to ascertain the position of the
bank in that particular currency and wherever remedial measures are needed they may be
taken. For example, if the bank finds that it is over-sold to the extent of US $ 25,000 it may
arrange to buy this amount from the inter-bank market.
Examples of sources for the bank for purchase of foreign currency are:
Payment of DD, MT, TT, Traveler cheques, etc.
2. Purchase of bills. 3. Forward purchase contract with export customers. (Entered in the
position on the date of purchase.)
4. Realization of bills sent for collection.
Examples of avenues of sales are:
1. Issue of DD, MT, TT, Traveler cheques, etc.
2. Payment of bills drawn on customers.
3. Forward sale contract with importer-customers. (Entered in the position on the date of
contract.)
Cash Position

The stock of foreign currency is held by the bank in the form of balances with correspondent
bank in the foreign center concerned. For example, an Indian bank will have an account with
Bank of America in New York. All the transactions of the bank in US.dollars will be routed
through this account. If the bank is required to issue a demand draft in US dollars it will issue
it on Bank of America, New York.
On presentation at New York the bank’s account with Bank of America will be debited.
Likewise, when the bank purchases bills in US dollars they will be sent to another bank in the
USA with instructions to remit proceeds to the credit of bank’s account with Bank of
America. Thus, purchase of foreign exchange by the bank in India increases the balance and
sale of foreign exchange reduces the balance in the bank’s account with its correspondent
bank abroad. Cash position is the balance outstanding in the bank’s overseas account. If the
balance is in debit it indicates oversold position; if it is in credit it indicates overbought
position.
Accounting and Reporting: Mirror account, Value date, Exchange profit
and loss, R returns
A business uses their accounting records to compile financial reports called Accounting
Reports. Reports can be as brief or comprehensive as needed for custom-made reports intended
for specific purposes such as profitability of a product line or sales by region. Accounting
reports are equivalent financial statements.
Accounting and reporting are critical functions in finance that involve recording financial transactions,
generating financial statements, and analyzing financial performance. Here are some key terms related
to accounting and reporting:
Mirror account: A mirror account is a separate account used to reconcile differences between a
company’s cash account and its bank statement. Transactions are recorded in both the cash account and
the mirror account, which allows for the identification and correction of any discrepancies.
Value date: The value date is the date on which a financial transaction is considered to be completed
and the funds are available for use. This is important for recording transactions accurately and
determining interest charges, among other things.
Exchange profit and loss: Exchange profit and loss refers to the gain or loss resulting from changes in
exchange rates when converting one currency to another. This is particularly relevant for companies
that conduct business across international borders and must convert currencies to complete
transactions.

35 KMBNFM04
R returns: R returns refer to the returns generated by a particular investment in excess of the risk-free
rate. This is a measure of the excess return generated by the investment and is commonly used to
evaluate the performance of investment managers and mutual funds. The risk-free rate is typically
determined by the return on a government bond, which is considered to be a relatively safe investment
with minimal risk.

Forex Risk Management: Risk in Forex Dealing, Measure of Value at Risk

Trading is the exchange of goods or services between two or more parties. So if you need gasoline for
your car, then you would trade your dollars for gasoline. In the old days, and still, in some societies,
trading was done by barter, where one commodity was swapped for another.

A trade may have gone like this: Person A will fix Person B's broken window in exchange for
a basket of apples from Person B's tree. This is a practical, easy to manage, day-to-day example of
making a trade, with relatively easy management of risk. In order to lessen the risk, Person A might ask
Person B to show his apples, to make sure they are good to eat, before fixing the window. This is how
trading has been for millennia: a practical, thoughtful human process .

Risk in Forex Dealing

Foreign exchange risk, also known as exchange rate risk, is the risk of financial impact due to
exchange rate fluctuations. In simpler terms, foreign exchange risk is the risk that a business’
financial performance or financial position will be impacted by changes in the exchange rates
between currencies.

Types of Foreign Exchange Risk

The three types of foreign exchange risk include:
Economic risk
Economic risk, also known as forecast risk, is the risk that a company’s market value is
impacted by unavoidable exposure to exchange rate fluctuations. Such a type of risk is usually
created by macroeconomic conditions such as geopolitical instability and/or government
regulations.
For example, a Canadian furniture company that sells locally will face economic risk from
furniture importers, especially if the Canadian currency unexpectedly strengthens.
Transaction risk
Transaction risk is the risk faced by a company when making financial transactions between
jurisdictions. The risk is the change in the exchange rate before transaction settlement.
Essentially, the time delay between transaction and settlement is the source of transaction risk.
Transaction risk can be mitigated using forward contracts and options.
Translation risk
Translation risk, also known as translation exposure, refers to the risk faced by a company
headquartered domestically but conducting business in a foreign jurisdiction, and of which the
company’s financial performance is denoted in its domestic currency. Translation risk is higher
when a company holds a greater portion of its assets, liabilities, or equities in a foreign
currency.
For example, a parent company that reports in Canadian dollars but oversees a subsidiary based
in China faces translation risk, as the subsidiary’s financial performance which is in Chinese
yuan is translated into Canadian dollar for reporting purposes.
Margin Risk
Using leverage in forex trading isn’t all that different from using it with stocks and options.
When you trade on margin, you borrow money from your broker to finance trades that require
funds in excess of your actual cash balance. If your trade goes south, you might face a margin
36 KMBNFM04
 call, requiring cash in excess of your original investment to come back into compliance.
While leverage can exponentially increase profits, it can do the same with losses. Currency
markets can be volatile even small price shifts can trigger margin calls. If you’re heavily
leveraged, you might face substantial losses. If you’re a novice trader, consider the major risks
of trading on margin before borrowing from your broker.
Measure of Value at Risk
What is the value at risk?
Value at risk is an important financial measure for every business and investment decision whether big
or small. In simple terms, the concept of value or risk is the calculation of the maximum financial loss
that can occur over a period of time. This is a financial metric and is more popularly known as VaR.
It is better understood as the quantitative measure of the worst-case scenario translate into maximum
potential losses. This information can help the investors and managers make strategic decisions or
choose between multiple available investment options.
In terms of the stock market, Value at risk is the measurement of the expected loss from any particular
stock or the entire portfolio based on the confidence level of the investor and the market sentiment.
Key elements of value at risk (VaR)
Value at Risk involves measurement of three key factors:
1. The amount of potential losses
2. The time frame of loss
3. The chance or probability of loss
What is the importance of the concept of value at risk?
Stock markets are extremely volatile and the probability of making losses is quite high if there is not a
thorough understanding of the markets and the price movements. Investors and traders, therefore, give
high importance to quantifying the risk through the measurement of volatility. However, the key
shortcoming of such measurement is the indifference in the direction of fluctuations.
A stock with an increasing price trend is volatile too but such volatility does not scare the investors.
However, it is exactly the opposite in the reverse case. When the markets in general or a particular
stock are on a decreasing trend, the volatility often makes investors and traders take rash decisions to
limit their losses. At such time, the calculation of the maximum potential loss can caution the investors
and traders and help them make rational decisions that will benefit their portfolio.
How is the value at risk calculated?
The concept of value at risk has wide application and can be used to measure the maximum loss that
can be incurred through any project or investment. There are several methods that can be used to
calculate the VaR. Some of the key methods are discussed below.
a. Historical Method
The historical method is the easiest and the simplest method of calculating the VaR. It uses the market
data for a long period of time like the past 250 days to calculate the percentage of change in every risk
factor and arrange them in the order of worst to best. This method helps in calculating the probability
of the worst outcome that helps in decision-making as the premise of this method is that history repeats
itself.
b. Parametric Method
The parametric method is also known as the variance-covariance method and is based on the
assumption that the returns are in a normal distribution. This method is used to measure risk when the
distributions are known and are estimated based on fair certainty. The parametric method uses two
factors to calculate the VaR the expected returns and the standard deviation. However, the main
disadvantage of this method is that it does not work for a small sample size.
c. Montecarlo Method
This is a dynamic method of calculating VaR. In this method, the value at risk is calculated by creating
a number of random scenarios for future rates. It uses non-linear price models for estimating any
changes in the value for each such scenario and calculating the VaR based on the worst losses. This
method is ideal to use in complex situations and is also the most flexible.
37 KMBNFM04
 What is the value at risk formula?
The specific formula for Value at Risk (VaR) calculation depends on the methodology used, as there
are different approaches to estimating VaR. Here are three commonly used formulas for VaR
calculation:
1. Historical VaR: VaR = -1 x (percentile loss) x (portfolio value)
2. Parametric VaR: VaR = -1 x (Z-score) x (standard deviation of returns) x (portfolio value)
3. Monte Carlo VaR: VaR = -1 x (percentile loss) x (portfolio value)
In all of these formulas, VaR is expressed in currency units and represents the maximum loss that can
be expected with a certain level of probability over a specific time horizon. The percentile loss
represents the loss expected at the chosen confidence level, the Z-score represents the number of
standard deviations from the mean return, and the standard deviation of returns measures the volatility
of the portfolio or investment.
What are the benefits of the value at risk?
Value at risk is widely used to measure potential loss as it is easy to understand and apply. It gives the
users (investors or managers) a thorough analysis of the potential losses and the probability of the
same. Value at risk is a better version of measurement of risk in comparison to mere volatility of the
market as it shows the direction of the fluctuations and helps in the decision-making process.
What are the shortcomings of value at risk?
The calculation of value at risk is primarily based on a few assumptions which make the results
subjective. If the users make an error in the basic assumptions, the results will not show an accurate
analysis of the evaluation of maximum potential losses. Also, there is no standard process to collect the
data relevant for analysis.
Hence, the result from different methods of calculating VaR can be different and lead to confusion.
This implies that VaR is not a foolproof tool to calculate the maximum loss or a one-stop-shop for
making strategic decisions. There, it is important to note that VaR should be considered to be a small
part of the overall analysis of a project or investment to be used as an effective risk management
strategy.

Settlement of Transactions: Swift, Chips, Chaps, Fed wire

Transaction settlement is the process of moving funds from the cardholder’s account to the
merchant’s account following a credit or debit card purchase.
The issuer will route funds to the acquirer via the card network. For debit card payments, the
funds will be withdrawn directly from the cardholder’s bank account. For credit card payments,
the issuer will forward funds to the acquirer and the cardholder will reimburse the issuer at a
later date. When the acquirer receives the funds, the amount of the transaction minus fees will
be deposited into the merchant’s account.
Swift
The Society for Worldwide Interbank Financial Telecommunication (SWIFT), legally
S.W.I.F.T. SCRL, is a Belgian cooperative society that serves as an intermediary and executor
of financial transactions between banks worldwide. It also sells software and services to
financial institutions, mostly for use on its proprietary “SWIFTNet”, and ISO 9362 Business
Identifier Codes (BICs), popularly known as “SWIFT codes”.
SWIFT does not facilitate funds transfer: rather, it sends payment orders, which must be settled
by correspondent accounts that the institutions have with each other. To exchange banking
transactions, each financial institution must have a banking relationship by either being legally
organized as a bank or through its affiliation with at least one bank. While SWIFT transports
financial messages in a secure manner, it does not hold accounts for its members nor performs
any form of clearing or settlement.
As of 2018, around half of all high-value cross-border payments worldwide used the SWIFT
network, and in 2015, SWIFT linked more than 11,000 financial institutions in over 200
countries and territories, who were exchanging an average of over 32 million messages per day
38 KMBNFM04
(compared to an average of 2.4 million daily messages in 1995).
Though widely utilized, SWIFT has been criticized for its inefficiency. In 2018, the London-
based Financial Times noted that transfers frequently “pass through multiple banks before
reaching their final destination, making them time-consuming, costly and lacking transparency
on how much money will arrive at the other end”. SWIFT has since introduced an improved
service called “Global Payments Innovation” (GPI), claiming it was adopted by 165 banks and
was completing half its payments within 30 minutes. SWIFT has also attracted controversy for
enabling the United States government to monitor, and in some cases interfere with, intra-
European transactions.
As a cooperative society under Belgian law, SWIFT is owned by its member financial
institutions. It is headquartered in La Hulpe, Belgium, near Brussels; its main building was
designed by Ricardo Bofill Taller de Arquitectura and completed in 1989. The chairman of
SWIFT is Yawar Shah of Pakistan, and its CEO is Javier Pérez-Tasso of Spain. SWIFT hosts
an annual conference, called Sibos, specifically aimed at the financial services industry.
SWIFT has become the industry standard for syntax in financial messages. Messages formatted
to SWIFT standards can be read and processed by many well-known financial processing
systems, whether or not the message traveled over the SWIFT network. SWIFT cooperates
with international organizations for defining standards for message format and content. SWIFT
is also Registration authority (RA) for the following ISO standards:
 ISO 9362: 1994 Banking: Banking telecommunication messages; Bank identifier codes
 ISO 10383: 2003 Securities and related financial instruments; Codes for exchanges and
market identification (MIC)
 ISO 13616: 2003 IBAN Registry
 ISO 15022: 1999 Securities; Scheme for messages (Data Field Dictionary) (replaces
ISO 7775)
 ISO 20022-1: 2004 and ISO 20022-2:2007 Financial services; Universal Financial
Industry message scheme
Chips
The Clearing House Interbank Payments System (CHIPS) is a United States private clearing
house for large-value transactions. By 2015, it was settling well over US$1.5 trillion a day in
around 250,000 interbank payments in cross border and domestic transactions. Together with
the Fedwire Funds Service (which is operated by the Federal Reserve Banks), CHIPS forms
the primary U.S. network for large-value domestic and international USD payments where it
has a market share of around 96%. CHIPS transfers are governed by Article 4A of Uniform
Commercial Code.
Unlike the Fedwire system which is part of a regulatory body, CHIPS is owned by the financial
institutions that use it. For payments that are less time-sensitive in nature, banks typically prefer
to use CHIPS instead of Fedwire, as CHIPS is less expensive (both by charges and by funds
required). One of the reasons is that Fedwire is a real-time gross settlement system, while
CHIPS allows payments to be netted.
There are two steps to processing funds transfers: clearing and settlement. Clearing is the
transfer and confirmation of information between the payer (sending financial institution) and
payee (receiving financial institution). Settlement is the actual transfer of funds between the
payer’s financial institution and the payee’s financial institution. Settlement discharges the
obligation of the payer financial institution to the payee financial institution with respect to the
payment order. Final settlement is irrevocable and unconditional. The finality of the payment
is determined by that system’s rules and applicable law.
\The legal framework for institutions offering payment services is complex. There are rules for
large-value payments that are distinct from retail payments. Large-value funds transfer systems
differ from retail electronic funds transfer (EFT) systems, which generally handle a large
volume of low-value payments including automated clearing house (ACH) and debit and credit
39 KMBNFM04
card transactions at the point of sale.
Chaps
The Clearing House Automated Payments System (CHAPS) is a company that facilitates large
money transfers denominated in British pounds (GBP). CHAPS is administered by the Bank
of England (BoE) and is used by 30 participating financial institutions. Approximately 5,500
additional institutions also engage with the system by way of partnership agreements with the
30 primary members.
CHAPS is used by large financial institutions that need to transfer billions of dollars’ worth of
currency each day. To assist in these transfers, CHAPS enables real-time fund transfers and
can accommodate frequent large transfers with virtually no delay. The speed of CHAPS also
substantially eliminates the risk that senders will cancel their transfers before they are accepted
by the recipient.
Fedwire
Fedwire (formerly known as the Federal Reserve Wire Network) is a real-time gross settlement
funds transfer system operated by the United States Federal Reserve Banks that allows financial
institutions to electronically transfer funds between its more than 9,289 participants (as of
March 19, 2009). Transfers can only be initiated by the sending bank once they receive the
proper wiring instructions for the receiving bank. These instructions include: the receiving
bank’s routing number, account number, name and dollar amount being transferred. This
information is submitted to the Federal Reserve via the Fedwire system. Once the instructions
are received and processed, the Fed will debit the funds from the sending bank’s reserve
account and credit the receiving bank’s account. Wire transfers sent via Fedwire are completed
the same business day, with many being completed instantly.

UNIT-5
Foreign Exchange Risk Exposure, Types of Risk
Exchange rate fluctuations affect not only multinationals and large corporations, but also small
and medium-sized enterprises. Therefore, understanding and managing exchange rate risk is
an important subject for business owners and investors.
There are various kinds of exposure and related techniques for measuring the exposure. Of all
the exposures, economic exposure is the most important one and it can be calculated
statistically.
Companies resort to various strategies to contain economic exposure.
Types of Exposure
Companies are exposed to three types of risk caused by currency volatility −
 Transaction exposure − Exchange rate fluctuations have an effect on a company’s
obligations to make or receive payments denominated in foreign currency in future.
Transaction exposure arises from this effect and it is short-term to medium-term in
nature.
 Translation exposure − Currency fluctuations have an effect on a company’s
consolidated financial statements, particularly when it has foreign subsidiaries.
Translation exposure arises due to this effect. It is medium-term to long-term in nature.
 Economic (or operating) exposure − Economic exposure arises due to the effect of
unpredicted currency rate fluctuations on the company’s future cash flows and market
value. Unanticipated exchange rate fluctuations can have a huge effect on a company’s
competitive position.
Note that economic exposure is impossible to predict, while transaction and translation
exposure can be estimated.
Economic Exposure – An Example
Consider a big U.S. multinational with operations in numerous countries around the world. The
40 KMBNFM04
company’s biggest export markets are Europe and Japan, which together offer 40% of the
company’s annual revenues.
The U.S. company is now facing not just transaction exposure (as its large export sales) and
translation exposure (as it has subsidiaries worldwide), but also economic exposure. The Dollar
was expected to decline about 3% annually against the Euro and the Yen, but it has already
gained 5% versus these currencies, which is a variance of 8 percentage points at hand. This
will have a negative effect on sales and cash flows. The investors have already taken into
account the currency fluctuations and the stock of the company fell 7%.
Calculating Economic Exposure
Foreign asset or overseas cash flow value fluctuates with the exchange rate changes. We know
from statistics that a regression analysis of the asset value (P) versus the spot exchange rate (S)
will offer the following regression equation −
P = a + (b x S) + e
Where, a is the regression constant, b is the regression coefficient, and e is a random error term
with a mean of zero. Here, b is a measure of economic exposure, and it measures the sensitivity
of an asset’s dollar value to the exchange rate.
The regression coefficient is the ratio of the covariance between the asset value and the
exchange rate, to the variance of the spot rate. It is expressed as −
b=
Cov (P,S)Var (S)
Economic Exposure – Numerical Example
A U.S. company (let us call it USX) has a 10% stake in a European company –
say EuroStar. USX is concerned about a decline in the Euro, and as it wants to maximize the
Dollar value of EuroStar. It would like to estimate its economic exposure.
USX thinks the probabilities of a stronger and/or weaker Euro is equal, i.e., 50–50. In the
strong-Euro scenario, the Euro will be at 1.50 against the Dollar, which would have a
negative impact on EuroStar (due to export loss). Then, EuroStar will have a market value of
EUR 800 million, valuing USX’s 10% stake at EUR 80 million (or $120 million).
In the weak-Euro scenario, currency will be at 1.25; EuroStar would have a market value of
EUR 1.2 billion, valuing USX’s 10% stake will be equal to $150 million.
If P represents the value of USX’s 10% stake in EuroStar in Dollar terms, and S represents
the Euro spot rate, then the covariance of P and S is −
Cov (P,S) = –1.875
Var (S) = 0.015625
Therefore, b = –1.875 ÷ (0.015625) = – EUR 120 million
USX’s economic exposure is a negative EUR 120 million, which is equivalent to saying that
the value of its stake in EuroStar decreases as the Euro gets stronger, and increases as the
Euro weakens.
Determining Economic Exposure
The economic exposure is usually determined by two factors −
 Whether the markets where the company inputs and sells its products are competitive
or monopolistic? Economic exposure is more when either a firm’s input costs or goods’
prices are related to currency fluctuations. If both costs and prices are relative or

41 KMBNFM04
 secluded to currency fluctuations, the effects are cancelled by each other and it reduces
the economic exposure.
 Whether a firm can adjust to markets, its product mix, and the source of inputs in a
reply to currency fluctuations? Flexibility would mean lesser operating exposure, while
sternness would mean a greater operating exposure.
Managing Economic Exposure
The economic exposure risks can be removed through operational strategies or currency risk
mitigation strategies.
Operational strategies
 Diversifying production facilities and markets for products − Diversification
mitigates the risk related with production facilities or sales being concentrated in one
or two markets. However, the drawback is the company may lose economies of scale.
 Sourcing flexibility − Having sourcing flexibilities for key inputs makes strategic
sense, as exchange rate moves may make inputs too expensive from one region.
 Diversifying financing − Having different capital markets gives a company the
flexibility to raise capital in the market with the cheapest cost.
Currency risk mitigation strategies
The most common strategies are −
 Matching currency flows − Here, foreign currency inflows and outflows are matched.
For example, if a U.S. company having inflows in Euros is looking to raise debt, it must
borrow in Euros.
 Currency risk-sharing agreements − It is a sales or purchase contract of two parties
where they agree to share the currency fluctuation risk. Price adjustment is made in this,
so that the base price of the transaction is adjusted.
 Back-to-back loans − Also called as credit swap, in this arrangement, two companies
of two nations borrow each other’s currency for a defined period. The back-to-back
loan stays as both an asset and a liability on their balance sheets.
 Currency swaps − It is similar to a back-to-back loan, but it does not appear on the
balance sheet. Here, two firms borrow in the markets and currencies so that each can
have the best rates, and then they swap the proceeds.
1. Transaction Exposure
Financial Techniques to Manage Transaction Exposure
The main feature of a transaction exposure is the ease of identifying its size. Additionally, it
has a well-defined time interval associated with it that makes it extremely suitable for hedging
with financial instruments.
The most common methods for hedging transaction exposures are −
 Forward Contracts− If a firm has to pay (receive) some fixed amount of foreign
currency in the future (a date), it can obtain a contract now that denotes a price by which
it can buy (sell) the foreign currency in the future (the date). This removes the
uncertainty of future home currency value of the liability (asset) into a certain value.
 Futures Contracts− These are similar to forward contracts in function. Futures
contracts are usually exchange traded and they have standardized and limited contract
sizes, maturity dates, initial collateral, and several other features. In general, it is not
possible to exactly offset the position to fully eliminate the exposure.
 Money Market Hedge− Also called as synthetic forward contract, this method uses
the fact that the forward price must be equal to the current spot exchange rate multiplied
by the ratio of the given currencies’ riskless returns. It is also a form of financing the
foreign currency transaction. It converts the obligation to a domestic-currency payable
and removes all exchange risks.

42 KMBNFM04
  Options− A foreign currency option is a contract that has an upfront fee, and offers the
owner the right, but not an obligation, to trade currencies in a specified quantity, price,
and time period.
Uncertainty about existence of exposure
Uncertainty about existence of exposure arises when there is an uncertainty in submitting bids
with prices fixed in foreign currency for future contracts. The firm will pay or receive foreign
currency when a bid is accepted, which will have denominated cash flows. It is a kind of
contingent transaction exposure. In these cases, an option is ideally suited.
Under this kind of uncertainty, there are four possible outcomes. The following table provides
a summary of the effective proceeds to the firm per unit of option contract which is equal to
the net cash flows of the assignment.
State Bid Accepted Bid Rejected
Spot price better than exercise price : let
Spot Price 0
option expire
Spot price worse than exercise price:
Exercise Price Exercise Price – Spot Price
exercise option
Operational Techniques for Managing Transaction Exposure
Operational strategies having the virtue of offsetting existing foreign currency exposure can
also mitigate transaction exposure. These strategies include −
 Risk Shifting− The most obvious way is to not have any exposure. By invoicing all
parts of the transactions in the home currency, the firm can avoid transaction exposure
completely. However, it is not possible in all cases.
 Currency risk sharing− The two parties can share the transaction risk. As the short-
term transaction exposure is nearly a zero sum game, one party loses and the other party
gains%
 Leading and Lagging− It involves playing with the time of the foreign currency cash
flows. When the foreign currency (in which the nominal contract is denominated) is
appreciating, pay off the liabilities early and collect the receivables later. The first is
known as leading and the latter is called lagging.
 Reinvoicing Centers− A reinvoicing center is a third-party corporate subsidiary that
uses to manage one location for all transaction exposure from intra-company trade. In
a reinvoicing center, the transactions are carried out in the domestic currency, and
hence, the reinvoicing center suffers from all the transaction exposure.
Reinvoicing centers have three main advantages −
 The centralized management gains of transaction exposures remain within company
sales.
 Foreign currency prices can be adjusted in advance to assist foreign affiliates budgeting
processes and improve intra affiliate cash flows, as intra-company accounts use
domestic currency.
 Reinvoicing centers (offshore, third country) qualify for local non-resident status and
gain from the offered tax and currency market benefits.
2. Translation Exposure
Translation exposure, also known accounting exposure, refers to a kind of effect occurring
for an unanticipated change in exchange rates. It can affect the consolidated financial reports
of an MNC.
From a firm’s point of view, when exchange rates change, the probable value of a foreign
subsidiary’s assets and liabilities expressed in a foreign currency will also change.
There are mechanical means for managing the consolidation process for firms that have to deal
with exchange rate changes. These are the management techniques for translation exposure.

43 KMBNFM04
We have discussed transaction exposure and the ways to manage it. It is interesting to note that
some items that create transaction exposure are also responsible for creating translation
exposure.
Translation Exposure – An Exhibit
The following exhibit shows the transaction exposure report for Cornellia Corporation and its
two affiliates. Items that produce transaction exposure are the receivables or payables. These
items are expressed in a foreign currency.
Affiliate Amount Account Translation Exposure
Parent CD 200,000 Cash Yes
Parent Ps 3,000,000 Accounts receivable No
Spanish SF 375,000 Notes payable Yes
From the exhibit, it can be easily understood that the parent firm has mainly two sources of a
probable transaction exposure. One is the Canadian Dollar (CD) 200,000 deposit that the firm
has in a Canadian bank. Obviously, when the Canadian dollar depreciates, the deposit’s value
will go down for Cornellia Corporation when changed to US dollars.
It can be noted that this deposit is also a translation exposure. It is a translation exposure for
the same reason for which it is a transaction exposure. The given (Peso) Ps 3,000,000 accounts
receivable is not a translation exposure due to the netting of intra-company payables and
receivables. The (Swiss Franc) SF 375,000 notes for the Spanish affiliate is both a transaction
and a translation exposure.
Cornellia Corporation and its affiliates can follow the steps given below to reduce its
transaction exposure and translation exposure.
 Firstly, the parent company can convert its Canadian dollars into U.S. dollar deposits.
 Secondly, the parent organization can also request for payment of the Ps 3,000,000 the
Mexican affiliate owes to it.
 Thirdly, the Spanish affiliate can pay off, with cash, the SF 375,000 loan to the Swiss
bank.
These three steps can eliminate all transaction exposure. Moreover, translation exposure will
be diminished as well.
Translation Exposure Report for Cornellia Corporation and its Mexican and Spanish Affiliates
(in 000 Currency Units) −
Canadian Dollar Mexican Peso Euro Swiss Frank
Assets
Cash CD0 Ps 3,000 Eu 550 SF0
A/c receivable 0 9,000 1,045 0
Inventory 0 15,000 1,650 0
Net Fixed Assets 0 46,000 4,400 0
Exposed Assets CD0 Ps 73,000 Eu 7,645 SF0
Liabilities
A/c payable CD0 Ps 7,000 Eu 1,364 SF0
Notes payable 0 17,000 935 0
Long term debt 0 27,000 3,520 3,520
Exposed liabilities CD0 Ps51,000 Eu 5,819 SF0
Net exposure CD0 Ps22,000 Eu 1,826 SF0

44 KMBNFM04
The report shows that no translation exposure is associated with the Canadian dollar or the
Swiss franc.
Hedging Translation Exposure
The above exhibit indicates that there is still enough translation exposure with changes in the
exchange rate of the Mexican Peso and the Euro against the U.S. dollar. There are two major
methods for controlling this remaining exposure. These methods are: balance sheet
hedge and derivatives hedge.
Balance Sheet Hedge
Translation exposure is not purely entity specific; rather, it is only currency specific. A
mismatch of net assets and net liabilities creates it. A balance sheet hedge will eliminate this
mismatch.
Using the currency Euro as an example, the above exhibit presents the fact that there are
€1,826,000 more net exposed assets than liabilities. Now, if the Spanish affiliate, or more
probably, the parent firm or the Mexican affiliate, pays €1,826,000 as more liabilities, or
reduced assets, in Euros, there would be no translation exposure with respect to the Euro.
A perfect balance sheet hedge will occur in such a case. After this, a change in the Euro / Dollar
(€/$) exchange rate would not have any effect on the consolidated balance sheet, as the change
in value of the assets would completely offset the change in value of the liabilities.
Derivatives Hedge
According to the corrected translation exposure report shown above, depreciation from
€1.1000/$1.00 to €1.1786/$1.00 in the Euro will result in an equity loss of $110,704, which
was more when the transaction exposure was not taken into account.
A derivative product, such as a forward contract, can now be used to attempt to hedge this loss.
The word “attempt” is used because using a derivatives hedge, in fact, involves speculation
about the forex rate changes.
3. Economic Exposure
Economic exposure is the toughest to manage because it requires ascertaining future exchange
rates. However, economists and investors can take the help of statistical regression equations
to hedge against economic exposure. There are various techniques that companies can use to
hedge against economic exposure. Five such techniques have been discussed in this chapter.
It is difficult to measure economic exposure. The company must accurately estimate cash flows
and the exchange rates, as transaction exposure has the power to alter future cash flows while
fluctuation of the currency exchange rates occur. When a foreign subsidiary gets positive cash
flows after it corrects for the currency exchange rates, the subsidiary’s net transaction exposure
is low.
Note − It is easier to estimate economic exposure when currency exchange rates display a
trend, and the future cash flows are known.
Regression Equation
Analysts can measure economic exposure by using a simple regression equation, shown in
Equation 1.
P = α + β.S + ε (1)
Suppose, the United States is the home country and Europe is the foreign country. In the
equation, the price, P, is the price of the foreign asset in dollars while S is spot exchange rate,
expressed as Dollars per Euro.
The Regression equation estimates the connection between price and the exchange rate. The
random error term (ε) equals zero when there is a constant variance while (α) and (β) are the
estimated parameters. Now, we can say that this equation will give a straight line between P
and S with an intercept of (α) and a slope of (β). The parameter (β) is expressed as the Forex
Beta or Exposure Coefficient. β indicates the level of exposure.

45 KMBNFM04
We calculate (β) by using Equation 2. Covariance estimates the fluctuation of the asset’s price
to the exchange rate, while the variance measures the variation of the exchange rate. We see
that two factors influence (β): one is the fluctuations in the exchange rate and the second is the
sensitivity of the asset’s price to changes in the exchange rate.
β = Covariance (P,S)Variance (S)
(2) Economic Exposure – A Practical Example
Suppose you own and rent out a condominium in Europe. A property manager recruited by you
can vary the rent, making sure that someone always rents and occupies the property.
Now, assume you receive € 1,800, € 2,000, or € 2,200 per month in cash for rent, as shown in
Table 1. Let’s say each rent is a state, and as is obvious, any of the rents have a 1/3 probability.
The forecasted exchange rate for each state, which is S has also been estimated. We can now
calculate the asset’s price, P, in U.S. dollars by multiplying that state’s rent by the exchange
rate.
Table 1 – Renting out your Condo for Case 1
State Probability Rent (Euro) Exchange Rate (S) Rent (P)
1 1/3 €1,800 $1/1.00 E $1,800
2 1/3 €2,000 $1.25/1.00 E $1.25/1.00 E
3 1/3 €2,200 $1.50/1.00 E $3,300
In this case, we calculate 800 for (β). Positive (β) shows that your cash rent varies with the
fluctuating exchange rate, and there is a potential economic exposure.
A special factor to notice is that as the Euro appreciated, the rent in Dollars also increased. A
forward contract for € 800 at a contract price of $1.25 per €1 can be bought to hedge against
the exchange rate risk.
In Table 2, (β) is the correct hedge for Case 1. The Forward Price is the exchange rate in the
forward contract and it is the spot exchange rate for a state.
Suppose we bought a forward contract with a price of $1.25 per euro.
 If State 1 occurs, the Euro depreciates against the U.S. dollar. By exchanging € 800 into
Dollars, we gain $200, and we compute it in the Yield column in Table 2.
 If State 2 occurs, the forward rate equals the spot rate, so we neither gain nor lose
anything.
 State 3 shows that the Euro appreciated against the U.S. dollar, so we lose $200 on the
forward contract. We know that each state is equally likely to occur, so we, on average,
break even by purchasing the forward contract.
Table 2 – The Beta is the Correct Hedge for Case 1
State Forward Price Exchange rate Yield
1 $1.25/1 $1.00/1E (1.25 – 1.00) × 800 = 200$
2 $1.25/1E $1.25/1E (1.25 – 1.25) × 800 = 0
3 $1.25/1E $1.50/1E (1.25 – 1.50) × 800 = –200 $
Total $0
The rents have changed in Table 3. In Case 2, you could now get € 1,667.67, € 2,000, or €
2,500 per month in cash, and all rents are equally likely. Although your rent fluctuates greatly,
the exchange moves in the opposite direction of the rent.
Table 3 – Renting out your Condo for Case 2
State Probability Rent (E) Exch. Rate Rent (P)
1 1/3 2,500 $1/1E $2,500
2 1/3 2,000 $1.25/1E $2,500

46 KMBNFM04
 3 1/3 1,666.67 $1.50/1E $2,500
Now, do you notice that when you calculate the rent in dollars, the rent amounts become $2,500
in all cases, and (β) equals –1,666.66? A negative (β) indicates that the exchange rate
fluctuations cancel the fluctuations in rent. Moreover, you do not need a forward contract
because you do not have any economic exposure.
We finally examine the last case in Table 4. The same rent, € 2000, is charged for Case 3
without considering the exchange rate changes. As the rent is calculated in U.S. dollars, the
exchange rate and the rent amount move in the same direction.
Table 4 – Renting out your Condo for Case 3
State Probability Rent (E) Exch. Rate Rent (P)
1 1/3 2,000 $1/1E $2,000
2 1/3 2,000 $1.25/1E $2,500
3 1/3 2,000 $1.50/1E $3,000
However, the (β) equals 0 in this case, as rents in Euros do not vary. So, now, it can be hedged
against the exchange rate risk by buying a forward for €2000 and not the amount for the (β).
By deciding to charge the same rent, you can use a forward to protect this amount.
Techniques to Reduce Economic Exposure
International firms can use five techniques to reduce their economic exposure −
 Technique 1− A company can reduce its manufacturing costs by taking its production
facilities to low-cost countries. For example, the Honda Motor Company produces
automobiles in factories located in many countries. If the Japanese Yen appreciates and
raises Honda’s production costs, Honda can shift its production to its other facilities,
scattered across the world.
 Technique 2− A company can outsource its production or apply low-cost labor.
Foxconn, a Taiwanese company, is the largest electronics company in the world, and it
produces electronic devices for some of the world’s largest corporations.
 Technique 3− A company can diversify its products and services and sell them to
clients from around the world. For example, many U.S. corporations produce and
market fast food, snack food, and sodas in many countries. The depreciating U.S. dollar
reduces profits inside the United States, but their foreign operations offset this.
 Technique 4− A company can continually invest in research and development.
Subsequently, it can offer innovative products at a higher price. For instance, Apple
Inc. set the standard for high-quality smartphones. When dollar depreciates, it increases
the price.
 Technique 5− A company can use derivatives and hedge against exchange rate
changes. For example, Porsche completely manufactures its cars within the European
Union and exports between 40% to 45% of its cars to the United States. Porsche
financial managers hedged or shorted against the U.S. dollar when the U.S. dollar
depreciated. Some analysts estimated that about 50% of Porsche’s profits arose from
hedging activities.
Hedging with Forwards
The Forward Contract is an agreement between two parties wherein they agree to buy or sell
the underlying asset at a predetermined future date and a price specified today. The Forward
contracts are the most common way of hedging the foreign currency risk.
The foreign exchange refers to the conversion of one currency into another, and while dealing
in the currencies, there exist two markets: Spot Market and Forward Market. The Spot
market means where the delivery is made right away, while in the forward market the payment
is made at the predetermined date in the future.

47 KMBNFM04
In the spot market, the rate is the current rate, which is prevailing at the time the currencies are
being exchanged. Whereas, the rate in the forward market is the rate which has been fixed
today or at the time the transaction is agreed to but the actual delivery takes place at a specified
date in the future. Thus, forward currency contracts enable the parties to the contract to lock
the exchange rate today, to buy or sell the currency on the predefined future date.
The party who agrees to buy the underlying asset at a specified future date assumes the long
position, whereas the seller who promises to deliver the asset at a rate locked today assumes
the short position. In a forward currency contract, the buyer hopes the currency to appreciate,
while the seller expects the currency to depreciate in the future. Thus, the gain and loss of the
buyer can be calculated as follows:
Gain = Spot Rate– Contract Rate
Loss = Contract Rate – Spot Rate
Where, the spot rate is the actual rate prevailing at the future date while the contract rate is the
rate which was locked at the time transaction was agreed upon.
The forward contracts are similar to the options in hedging risk, but there is a significant
difference between these two. The parties to the forward contracts are obliged to buy or sell
the underlying securities at a specified date in the future, whereas in the case of the options,
the buyer has the right to whether exercise the option or not. The other difference is that the
forward contracts do not require any upfront payment in the form of premium which is very
much required when buying the options contracts.
Pricing of Futures Contract, Currency Futures, Hedging In Currency Futures
Pricing Of Futures Contract
The value of a futures contract is derived from the cash value of the underlying asset. While a
futures contract may have a very high value, a trader can buy or sell the contract with a much
smaller amount, which is known as the initial margin.
The initial margin is essentially a down payment on the value of the futures contract and the
obligations associated with the contract. Trading futures contracts is different than trading
stocks due to the high degree of leverage involved. This leverage can amplify profits and losses.
Initial Margin
The initial margin is the initial amount of money a trader must place in an account to open a
futures position. The amount is established by the exchange and is a percentage of the value of
the futures contract.
For example, a crude oil contract futures contract is 1,000 barrels of oil. At $75 per barrel, the
notional value of the contract is $75,000. A trader is not required to place this amount into an
account. Rather, the initial margin for a crude oil contract could be around $5,000 per contract
as determined by the exchange. This is the initial amount the trader must place in the account
to open a position.
Maintenance Margin
The maintenance margin amount is less than the initial margin. This is the amount the trader
must keep in the account due to changes in the price of the contract.
In the oil example, assume the maintenance margin is $4,000. If a trader buys an oil contract
and then the price drops $2, the value of the contract has fallen $2,000. If the balance in the
account is less than the maintenance margin, the trader must place additional funds to meet the
maintenance margin. If the trader does not meet the margin call, the broker or exchange could
unilaterally liquidate the position.
Currency Futures
The global forex market is the largest market in the world with over $4 trillion traded daily,
according to Bank for International Settlements (BIS) data. The forex market, however, is not
the only way for investors and traders to participate in foreign exchange. While not nearly as

48 KMBNFM04
large as the forex market, the currency futures market has a respectable daily average closer to
$100 billion.
Currency futures – futures contracts where the underlying commodity is a currency exchange
rate – provide access to the foreign exchange market in an environment that is similar to other
futures contracts.
Currency futures, also called forex futures or foreign exchange futures, are exchange-traded
futures contracts to buy or sell a specified amount of a particular currency at a set price and
date in the future. Currency futures were introduced at the Chicago Mercantile Exchange (now
the CME Group) in 1972 soon after the fixed exchange rate system and gold standard were
discarded. Similar to other futures products, they are traded in terms of contract months with
standard maturity dates typically falling on the third Wednesday of March, June, September
and December.
Hedging In Currency Futures
Currency Hedging is an act of entering into a financial contract in order to protect against
anticipated or unexpected changes in currency exchange rates. Currency hedging is used by
businesses to eliminate risks they encounter when conducting business internationally.
The concept of Currency hedging is the use of various financial instruments, like Forward
Contract and other Derivative contracts, to manage financial risk. It involves the designation
of one or more financial instruments (usually a Bank or an Exchange) as a buffer for potential
loss.
So any business that has dealing in overseas market is open to such Currency or more popularly
known as Forex exposure. There may be other kinds of exposure including commodity risk,
Interest rate risk, wage inflation etc. Un-hedged exposure of FX can affect the balance sheet or
profitability, which can create cash flow and operational issues. Hedging reduces a firm’s
exposure to unwanted risk. This helps in sustaining profits, reducing volatility and ensuring
smoother operations.
Different type of Exposure
Revenue Exposure (in Foreign
Expense Exposure (in Foreign Currency)
Currency)
Value of Imports, Purchase of products and
Value of Exports (FOB value)
services
Revenue from Services and other
Salaries and other administrative overheads
consultancy
Other Income (Interest/ Dividend) Business establishment expenses
Purchase of Fixed Assets
Foreign Exchange Risk Exposure, Types of Risk
Exchange rate fluctuations affect not only multinationals and large corporations, but also small
and medium-sized enterprises. Therefore, understanding and managing exchange rate risk is
an important subject for business owners and investors.
There are various kinds of exposure and related techniques for measuring the exposure. Of all
the exposures, economic exposure is the most important one and it can be calculated
statistically.
Companies resort to various strategies to contain economic exposure.
Types of Exposure
Companies are exposed to three types of risk caused by currency volatility −
 Transaction exposure − Exchange rate fluctuations have an effect on a company’s
obligations to make or receive payments denominated in foreign currency in future.

49 KMBNFM04
 Transaction exposure arises from this effect and it is short-term to medium-term in
nature.
 Translation exposure − Currency fluctuations have an effect on a company’s
consolidated financial statements, particularly when it has foreign subsidiaries.
Translation exposure arises due to this effect. It is medium-term to long-term in nature.
 Economic (or operating) exposure − Economic exposure arises due to the effect of
unpredicted currency rate fluctuations on the company’s future cash flows and market
value. Unanticipated exchange rate fluctuations can have a huge effect on a company’s
competitive position.
Note that economic exposure is impossible to predict, while transaction and translation
exposure can be estimated.
Economic Exposure – An Example
Consider a big U.S. multinational with operations in numerous countries around the world. The
company’s biggest export markets are Europe and Japan, which together offer 40% of the
company’s annual revenues.
The company’s management had factored in an average slump of 3% for the dollar against the
Euro and Japanese Yen for the running and the next two years. The management expected that
the Dollar will be bearish due to the recurring U.S. budget deadlock, and growing fiscal and
current account deficits, which they expected would affect the exchange rate.
Calculating Economic Exposure
Foreign asset or overseas cash flow value fluctuates with the exchange rate changes. We know
from statistics that a regression analysis of the asset value (P) versus the spot exchange rate (S)
will offer the following regression equation −
P = a + (b x S) + e
Where, a is the regression constant, b is the regression coefficient, and e is a random error term
with a mean of zero. Here, b is a measure of economic exposure, and it measures the sensitivity
of an asset’s dollar value to the exchange rate.
The regression coefficient is the ratio of the covariance between the asset value and the
exchange rate, to the variance of the spot rate. It is expressed as −
b=
Cov (P,S)Var (S)
Economic Exposure – Numerical Example
A U.S. company (let us call it USX) has a 10% stake in a European company –
say EuroStar. USX is concerned about a decline in the Euro, and as it wants to maximize the
Dollar value of EuroStar. It would like to estimate its economic exposure.
USX thinks the probabilities of a stronger and/or weaker Euro is equal, i.e., 50–50. In the
strong-Euro scenario, the Euro will be at 1.50 against the Dollar, which would have a
negative impact on EuroStar (due to export loss). Then, EuroStar will have a market value of
EUR 800 million, valuing USX’s 10% stake at EUR 80 million (or $120 million).
In the weak-Euro scenario, currency will be at 1.25; EuroStar would have a market value of
EUR 1.2 billion, valuing USX’s 10% stake will be equal to $150 million.
If P represents the value of USX’s 10% stake in EuroStar in Dollar terms, and S represents
the Euro spot rate, then the covariance of P and S is −
Cov (P,S) = –1.875
Var (S) = 0.015625
Therefore, b = –1.875 ÷ (0.015625) = – EUR 120 million
USX’s economic exposure is a negative EUR 120 million, which is equivalent to saying that
the value of its stake in EuroStar decreases as the Euro gets stronger, and increases as the
Euro weakens.

50 KMBNFM04
Determining Economic Exposure
The economic exposure is usually determined by two factors −
 Whether the markets where the company inputs and sells its products are competitive
or monopolistic? Economic exposure is more when either a firm’s input costs or goods’
prices are related to currency fluctuations. If both costs and prices are relative or
secluded to currency fluctuations, the effects are cancelled by each other and it reduces
the economic exposure.
 Whether a firm can adjust to markets, its product mix, and the source of inputs in a
reply to currency fluctuations? Flexibility would mean lesser operating exposure, while
sternness would mean a greater operating exposure.
Managing Economic Exposure
The economic exposure risks can be removed through operational strategies or currency risk
mitigation strategies.
Operational strategies
 Diversifying production facilities and markets for products − Diversification
mitigates the risk related with production facilities or sales being concentrated in one
or two markets. However, the drawback is the company may lose economies of scale.
 Sourcing flexibility − Having sourcing flexibilities for key inputs makes strategic
sense, as exchange rate moves may make inputs too expensive from one region.
 Diversifying financing − Having different capital markets gives a company the
flexibility to raise capital in the market with the cheapest cost.
Currency risk mitigation strategies
The most common strategies are −
 Matching currency flows − Here, foreign currency inflows and outflows are matched.
For example, if a U.S. company having inflows in Euros is looking to raise debt, it must
borrow in Euros.
 Currency risk-sharing agreements − It is a sales or purchase contract of two parties
where they agree to share the currency fluctuation risk. Price adjustment is made in this,
so that the base price of the transaction is adjusted.
 Back-to-back loans − Also called as credit swap, in this arrangement, two companies
of two nations borrow each other’s currency for a defined period. The back-to-back
loan stays as both an asset and a liability on their balance sheets.
 Currency swaps − It is similar to a back-to-back loan, but it does not appear on the
balance sheet. Here, two firms borrow in the markets and currencies so that each can
have the best rates, and then they swap the proceeds.
1. Transaction Exposure
Financial Techniques to Manage Transaction Exposure
The main feature of a transaction exposure is the ease of identifying its size. Additionally, it
has a well-defined time interval associated with it that makes it extremely suitable for hedging
with financial instruments.
The most common methods for hedging transaction exposures are −
 Forward Contracts− If a firm has to pay (receive) some fixed amount of foreign
currency in the future (a date), it can obtain a contract now that denotes a price by which
it can buy (sell) the foreign currency in the future (the date). This removes the
uncertainty of future home currency value of the liability (asset) into a certain value.
 Futures Contracts− These are similar to forward contracts in function. Futures
contracts are usually exchange traded and they have standardized and limited contract
sizes, maturity dates, initial collateral, and several other features. In general, it is not
possible to exactly offset the position to fully eliminate the exposure.

51 KMBNFM04
  Money Market Hedge− Also called as synthetic forward contract, this method uses
the fact that the forward price must be equal to the current spot exchange rate multiplied
by the ratio of the given currencies’ riskless returns. It is also a form of financing the
foreign currency transaction. It converts the obligation to a domestic-currency payable
and removes all exchange risks.
 Options− A foreign currency option is a contract that has an upfront fee, and offers the
owner the right, but not an obligation, to trade currencies in a specified quantity, price,
and time period.
Note − The major difference between an option and the hedging techniques mentioned above
is that an option usually has a nonlinear payoff profile. They permit the removal of downside
risk without having to cut off the profit from upside risk.
The decision of choosing one among these different financial techniques should be based on
the costs and the penultimate domestic currency cash flows (which is appropriately adjusted
for the time value) based upon the prices available to the firm.
Transaction Hedging Under Uncertainty
Uncertainty about either the timing or the existence of an exposure does not provide a valid
argument against hedging.
Uncertainty about transaction date
Lots of corporate treasurers promise to engage themselves to an early protection of the foreign-
currency cash flow. The key reason is that, even if they are sure that a foreign currency
transaction will occur, they are not quite sure what the exact date of the transaction will be.
There may be a possible mismatch of maturities of transaction and hedge. Using the mechanism
of rolling or early unwinding, financial contracts create the probability of adjusting the
maturity on a future date, when appropriate information becomes available.
Uncertainty about existence of exposure
Uncertainty about existence of exposure arises when there is an uncertainty in submitting bids
with prices fixed in foreign currency for future contracts. The firm will pay or receive foreign
currency when a bid is accepted, which will have denominated cash flows. It is a kind of
contingent transaction exposure. In these cases, an option is ideally suited.
Under this kind of uncertainty, there are four possible outcomes. The following table provides
a summary of the effective proceeds to the firm per unit of option contract which is equal to
the net cash flows of the assignment.
State Bid Accepted Bid Rejected
Spot price better than exercise price : let
Spot Price 0
option expire
Spot price worse than exercise price:
Exercise Price Exercise Price – Spot Price
exercise option
Operational Techniques for Managing Transaction Exposure
Operational strategies having the virtue of offsetting existing foreign currency exposure can
also mitigate transaction exposure. These strategies include −
 Risk Shifting− The most obvious way is to not have any exposure. By invoicing all
parts of the transactions in the home currency, the firm can avoid transaction exposure
completely. However, it is not possible in all cases.
 Currency risk sharing− The two parties can share the transaction risk. As the short-
term transaction exposure is nearly a zero sum game, one party loses and the other party
gains%
 Leading and Lagging− It involves playing with the time of the foreign currency cash
flows. When the foreign currency (in which the nominal contract is denominated) is

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 appreciating, pay off the liabilities early and collect the receivables later. The first is
known as leading and the latter is called lagging.
 Reinvoicing Centers− A reinvoicing center is a third-party corporate subsidiary that
uses to manage one location for all transaction exposure from intra-company trade. In
a reinvoicing center, the transactions are carried out in the domestic currency, and
hence, the reinvoicing center suffers from all the transaction exposure.
Reinvoicing centers have three main advantages −
 The centralized management gains of transaction exposures remain within company
sales.
 Foreign currency prices can be adjusted in advance to assist foreign affiliates budgeting
processes and improve intra affiliate cash flows, as intra-company accounts use
domestic currency.
 Reinvoicing centers (offshore, third country) qualify for local non-resident status and
gain from the offered tax and currency market benefits.
2. Translation Exposure
Translation exposure, also known accounting exposure, refers to a kind of effect occurring
for an unanticipated change in exchange rates. It can affect the consolidated financial reports
of an MNC.
From a firm’s point of view, when exchange rates change, the probable value of a foreign
subsidiary’s assets and liabilities expressed in a foreign currency will also change.
There are mechanical means for managing the consolidation process for firms that have to deal
with exchange rate changes. These are the management techniques for translation exposure.
We have discussed transaction exposure and the ways to manage it. It is interesting to note that
some items that create transaction exposure are also responsible for creating translation
exposure.
Translation Exposure – An Exhibit
The following exhibit shows the transaction exposure report for Cornellia Corporation and its
two affiliates. Items that produce transaction exposure are the receivables or payables. These
items are expressed in a foreign currency.
Affiliate Amount Account Translation Exposure
Parent CD 200,000 Cash Yes
Parent Ps 3,000,000 Accounts receivable No
Spanish SF 375,000 Notes payable Yes
From the exhibit, it can be easily understood that the parent firm has mainly two sources of a
probable transaction exposure. One is the Canadian Dollar (CD) 200,000 deposit that the firm
has in a Canadian bank. Obviously, when the Canadian dollar depreciates, the deposit’s value
will go down for Cornellia Corporation when changed to US dollars.
It can be noted that this deposit is also a translation exposure. It is a translation exposure for
the same reason for which it is a transaction exposure. The given (Peso) Ps 3,000,000 accounts
receivable is not a translation exposure due to the netting of intra-company payables and
receivables. The (Swiss Franc) SF 375,000 notes for the Spanish affiliate is both a transaction
and a translation exposure.
Cornellia Corporation and its affiliates can follow the steps given below to reduce its
transaction exposure and translation exposure.
 Firstly, the parent company can convert its Canadian dollars into U.S. dollar deposits.
 Secondly, the parent organization can also request for payment of the Ps 3,000,000 the
Mexican affiliate owes to it.
 Thirdly, the Spanish affiliate can pay off, with cash, the SF 375,000 loan to the Swiss
bank.

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These three steps can eliminate all transaction exposure. Moreover, translation exposure will
be diminished as well.
Translation Exposure Report for Cornellia Corporation and its Mexican and Spanish Affiliates
(in 000 Currency Units) −
Canadian Dollar Mexican Peso Euro Swiss Frank
Assets
Cash CD0 Ps 3,000 Eu 550 SF0
A/c receivable 0 9,000 1,045 0
Inventory 0 15,000 1,650 0
Net Fixed Assets 0 46,000 4,400 0
Exposed Assets CD0 Ps 73,000 Eu 7,645 SF0
Liabilities
A/c payable CD0 Ps 7,000 Eu 1,364 SF0
Notes payable 0 17,000 935 0
Long term debt 0 27,000 3,520 3,520
Exposed liabilities CD0 Ps51,000 Eu 5,819 SF0
Net exposure CD0 Ps22,000 Eu 1,826 SF0
The report shows that no translation exposure is associated with the Canadian dollar or the
Swiss franc.
Hedging Translation Exposure
The above exhibit indicates that there is still enough translation exposure with changes in the
exchange rate of the Mexican Peso and the Euro against the U.S. dollar. There are two major
methods for controlling this remaining exposure. These methods are: balance sheet
hedge and derivatives hedge.
Balance Sheet Hedge
Translation exposure is not purely entity specific; rather, it is only currency specific. A
mismatch of net assets and net liabilities creates it. A balance sheet hedge will eliminate this
mismatch.
Using the currency Euro as an example, the above exhibit presents the fact that there are
€1,826,000 more net exposed assets than liabilities. Now, if the Spanish affiliate, or more
probably, the parent firm or the Mexican affiliate, pays €1,826,000 as more liabilities, or
reduced assets, in Euros, there would be no translation exposure with respect to the Euro.
A perfect balance sheet hedge will occur in such a case. After this, a change in the Euro / Dollar
(€/$) exchange rate would not have any effect on the consolidated balance sheet, as the change
in value of the assets would completely offset the change in value of the liabilities.
Derivatives Hedge
According to the corrected translation exposure report shown above, depreciation from
€1.1000/$1.00 to €1.1786/$1.00 in the Euro will result in an equity loss of $110,704, which
was more when the transaction exposure was not taken into account.
A derivative product, such as a forward contract, can now be used to attempt to hedge this loss.
The word “attempt” is used because using a derivatives hedge, in fact, involves speculation
about the forex rate changes.
3. Economic Exposure
Economic exposure is the toughest to manage because it requires ascertaining future exchange
rates. However, economists and investors can take the help of statistical regression equations

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to hedge against economic exposure. There are various techniques that companies can use to
hedge against economic exposure. Five such techniques have been discussed in this chapter.
It is difficult to measure economic exposure. The company must accurately estimate cash flows
and the exchange rates, as transaction exposure has the power to alter future cash flows while
fluctuation of the currency exchange rates occur. When a foreign subsidiary gets positive cash
flows after it corrects for the currency exchange rates, the subsidiary’s net transaction exposure
is low.
Note − It is easier to estimate economic exposure when currency exchange rates display a
trend, and the future cash flows are known.
Regression Equation
Analysts can measure economic exposure by using a simple regression equation, shown in
Equation 1.
P = α + β.S + ε (1)
Suppose, the United States is the home country and Europe is the foreign country. In the
equation, the price, P, is the price of the foreign asset in dollars while S is spot exchange rate,
expressed as Dollars per Euro.
The Regression equation estimates the connection between price and the exchange rate. The
random error term (ε) equals zero when there is a constant variance while (α) and (β) are the
estimated parameters. Now, we can say that this equation will give a straight line between P
and S with an intercept of (α) and a slope of (β). The parameter (β) is expressed as the Forex
Beta or Exposure Coefficient. β indicates the level of exposure.
We calculate (β) by using Equation 2. Covariance estimates the fluctuation of the asset’s price
to the exchange rate, while the variance measures the variation of the exchange rate. We see
that two factors influence (β): one is the fluctuations in the exchange rate and the second is the
sensitivity of the asset’s price to changes in the exchange rate.
β = Covariance (P,S)Variance (S)
(2) Economic Exposure – A Practical Example
Suppose you own and rent out a condominium in Europe. A property manager recruited by you
can vary the rent, making sure that someone always rents and occupies the property.
Now, assume you receive € 1,800, € 2,000, or € 2,200 per month in cash for rent, as shown in
Table 1. Let’s say each rent is a state, and as is obvious, any of the rents have a 1/3 probability.
The forecasted exchange rate for each state, which is S has also been estimated. We can now
calculate the asset’s price, P, in U.S. dollars by multiplying that state’s rent by the exchange
rate.
Table 1 – Renting out your Condo for Case 1
State Probability Rent (Euro) Exchange Rate (S) Rent (P)
1 1/3 €1,800 $1/1.00 E $1,800
2 1/3 €2,000 $1.25/1.00 E $1.25/1.00 E
3 1/3 €2,200 $1.50/1.00 E $3,300
In this case, we calculate 800 for (β). Positive (β) shows that your cash rent varies with the
fluctuating exchange rate, and there is a potential economic exposure.
A special factor to notice is that as the Euro appreciated, the rent in Dollars also increased. A
forward contract for € 800 at a contract price of $1.25 per €1 can be bought to hedge against
the exchange rate risk.
In Table 2, (β) is the correct hedge for Case 1. The Forward Price is the exchange rate in the
forward contract and it is the spot exchange rate for a state.
Suppose we bought a forward contract with a price of $1.25 per euro.
 If State 1 occurs, the Euro depreciates against the U.S. dollar. By exchanging € 800 into
Dollars, we gain $200, and we compute it in the Yield column in Table 2.

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  If State 2 occurs, the forward rate equals the spot rate, so we neither gain nor lose
anything.
 State 3 shows that the Euro appreciated against the U.S. dollar, so we lose $200 on the
forward contract. We know that each state is equally likely to occur, so we, on average,
break even by purchasing the forward contract.
Table 2 – The Beta is the Correct Hedge for Case 1
State Forward Price Exchange rate Yield
1 $1.25/1 $1.00/1E (1.25 – 1.00) × 800 = 200$
2 $1.25/1E $1.25/1E (1.25 – 1.25) × 800 = 0
3 $1.25/1E $1.50/1E (1.25 – 1.50) × 800 = –200 $
Total $0
The rents have changed in Table 3. In Case 2, you could now get € 1,667.67, € 2,000, or €
2,500 per month in cash, and all rents are equally likely. Although your rent fluctuates greatly,
the exchange moves in the opposite direction of the rent.
Table 3 – Renting out your Condo for Case 2
State Probability Rent (E) Exch. Rate Rent (P)
1 1/3 2,500 $1/1E $2,500
2 1/3 2,000 $1.25/1E $2,500
3 1/3 1,666.67 $1.50/1E $2,500
Now, do you notice that when you calculate the rent in dollars, the rent amounts become $2,500
in all cases, and (β) equals –1,666.66? A negative (β) indicates that the exchange rate
fluctuations cancel the fluctuations in rent. Moreover, you do not need a forward contract
because you do not have any economic exposure.
We finally examine the last case in Table 4. The same rent, € 2000, is charged for Case 3
without considering the exchange rate changes. As the rent is calculated in U.S. dollars, the
exchange rate and the rent amount move in the same direction.
Table 4 – Renting out your Condo for Case 3
State Probability Rent (E) Exch. Rate Rent (P)
1 1/3 2,000 $1/1E $2,000
2 1/3 2,000 $1.25/1E $2,500
3 1/3 2,000 $1.50/1E $3,000
However, the (β) equals 0 in this case, as rents in Euros do not vary. So, now, it can be hedged
against the exchange rate risk by buying a forward for €2000 and not the amount for the (β).
By deciding to charge the same rent, you can use a forward to protect this amount.
Techniques to Reduce Economic Exposure
International firms can use five techniques to reduce their economic exposure −
 Technique 1− A company can reduce its manufacturing costs by taking its production
facilities to low-cost countries. For example, the Honda Motor Company produces
automobiles in factories located in many countries. If the Japanese Yen appreciates and
raises Honda’s production costs, Honda can shift its production to its other facilities,
scattered across the world.
 Technique 2− A company can outsource its production or apply low-cost labor.
Foxconn, a Taiwanese company, is the largest electronics company in the world, and it
produces electronic devices for some of the world’s largest corporations.

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  Technique 3− A company can diversify its products and services and sell them to
clients from around the world. For example, many U.S. corporations produce and
market fast food, snack food, and sodas in many countries. The depreciating U.S. dollar
reduces profits inside the United States, but their foreign operations offset this.
 Technique 4− A company can continually invest in research and development.
Subsequently, it can offer innovative products at a higher price. For instance, Apple
Inc. set the standard for high-quality smartphones. When dollar depreciates, it increases
the price.
 Technique 5− A company can use derivatives and hedge against exchange rate
changes. For example, Porsche completely manufactures its cars within the European
Union and exports between 40% to 45% of its cars to the United States. Porsche
financial managers hedged or shorted against the U.S. dollar when the U.S. dollar
depreciated. Some analysts estimated that about 50% of Porsche’s profits arose from
hedging activities.
Translation exposure, Methods of translation, Managing translation exposure
Translation exposure (also known as translation risk) is the risk that a company’s equities,
assets, liabilities, or income will change in value as a result of exchange rate changes. This
occurs when a firm denominates a portion of its equities, assets, liabilities, or income in a
foreign currency. It is also known as “Accounting exposure.”
Accountants use various methods to insulate firms from these types of risks, such as
consolidation techniques for the firm’s financial statements and using the most effective cost
accounting evaluation procedures. In many cases, translation exposure is recorded in financial
statements as an exchange rate gain (or loss).
The assets, liabilities, equities, and earnings of a subsidiary of a multinational company are
usually denominated in the currency of the country it is situated in. If the parent company is
situated in a country with a different currency, the values of the holdings of each subsidiary
need to be converted into the currency of the home country.
Such conversion can lead to certain inconsistencies in calculating the consolidated earnings of
the company if the exchange rate changes in the interim period. It is translation exposure.
Methods of translation
Current/Non-current Method
The values of current assets and liabilities are converted at the exchange rate that prevails on
the date of the balance sheet. On the other hand, non-current assets and liabilities are converted
at a historical rate.
Items on a balance sheet that are written off or converted into cash within a year are called
current items, such as short-term loans, bills payable/receivable, and sundry creditors/debtors.
Any item that remains on the balance sheet for more than a year is a non-current item, such as
machinery, building, long-term loans, and investments.
Current Rate Method
The current rate method is the easiest method, wherein the value of every item in the balance
sheet, except capital, is converted using the current rate of exchange. The stock of capital is
evaluated at the prevailing rate when the capital was issued.
Monetary/Non-monetary Method
All monetary accounts are converted at the current rate of exchange, whereas non-monetary
accounts are converted at a historical rate.
Monetary accounts are those items that represent a fixed amount of money, either to be received
or paid, such as cash, debtors, creditors, and loans. Machinery, buildings, and capital are
examples of non-monetary items because their market values can be different from the values
mentioned on the balance sheet.
Temporal Method

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The temporal method is similar to the monetary/non-monetary method, except in its treatment
of inventory. The value of inventory is generally converted using the historical rate, but if the
balance sheet records inventory at market value, it is converted using the current rate of
exchange.
Managing translation exposure
Currency Swaps
Currency swaps are a settlement between two entities to exchange cash flows denominated for
a particular currency for a fixed time frame. Currency amounts are swapped for a
predetermined period and interest is paid during that time span.
Forward Contracts
Under the forward contracts, two entities fix a specific exchange rate for the interchange of two
currencies for a future date. The settlement for the agreed amount of currencies is conducted
on the particular future date which is pre-decided.
Currency Options
The Currency option gives the right to the party to exchange the amount of a particular currency
at an agreed exchange rate. However, the party is not obligated to do so. Nevertheless, the
transactions must be conducted on or before a set date in the future.
Managing Interest Rate Exposure
Interest rate risk is the risk where changes in market interest rates might adversely affect a
bank’s financial condition. The management of Interest Rate Risk should be one of the critical
components of market risk management in banks. The regulatory restrictions in the past had
greatly reduced many of the risks in the banking system. Deregulation of interest rates has,
however, exposed them to the adverse impacts of interest rate risk.
What is the Impact of IRR:
Board and senior management oversight of interest rate risk
Principle 1: In order to carry out its responsibilities, the board of directors in a bank should
approve strategies and policies with respect to interest rate risk management and ensure that
senior management takes the steps necessary to monitor and control these risks. The board of
directors should be informed regularly of the interest rate risk exposure of the bank in order to
assess the monitoring and controlling of such risk.
Principle 2: Senior management must ensure that the structure of the bank’s business and the
level of interest rate risk it assumes are effectively managed, that appropriate policies and
procedures are established to control and limit these risks, and that resources are available for
evaluating and controlling interest rate risk.
Principle 3: Banks should clearly define the individuals and/or committees responsible for
managing interest rate risk and should ensure that there is adequate separation of duties in key
elements of the risk management process to avoid potential conflicts of interest. Banks should
have risk measurement, monitoring and control functions with clearly defined duties that are
sufficiently independent from position-taking functions of the bank and which report risk
exposures directly to senior management and the board of directors. Larger or more complex
banks should have a designated independent unit responsible for the design and administration
of the bank’s interest rate risk measurement, monitoring and control functions.
Adequate Risk Management Policies and Procedures
Principle 4: It is essential that banks’ interest rate risk policies and procedures are clearly
defined and consistent with the nature and complexity of their activities. These policies should
be applied on a consolidated basis and, as appropriate, at the level of individual affiliates,
especially when recognising legal distinctions and possible obstacles to cash movements
among affiliates.
Principle 5: It is important that banks identify the risks inherent in new products and activities
and ensure these are subject to adequate procedures and controls before being introduced or

58 KMBNFM04
undertaken. Major hedging or risk management initiatives should be approved in advance by
the board or its appropriate delegated committee.
Risk Measurement, Monitoring and Control Functions
Principle 6: It is essential that banks have interest rate risk measurement systems that capture
all material sources of interest rate risk and that assess the effect of interest rate changes in
ways that are consistent with the scope of their activities. The assumptions underlying the
system should be clearly understood by risk managers and bank management.
Principle 7: Banks must establish and enforce operating limits and other practices that
maintain exposures within levels consistent with their internal policies.
Principle 8: Banks should measure their vulnerability to loss under stressful market conditions
– including the breakdown of key assumptions – and consider those results when establishing
and reviewing their policies and limits for interest rate risk.
Principle 9: Banks must have adequate information systems for measuring, monitoring,
controlling and reporting interest rate exposures. Reports must be provided on a timely basis
to the bank’s board of directors, senior management and, where appropriate, individual
business line managers.
Internal controls
Principle 10: Banks must have an adequate system of internal controls over their interest rate
risk management process. A fundamental component of the internal control system involves
regular independent reviews and evaluations of the effectiveness of the system and, where
necessary, ensuring that appropriate revisions or enhancements to internal controls are made.
The results of such reviews should be available to the relevant supervisory authorities.
Information for supervisory authorities
Principle 11: Supervisory authorities should obtain from banks sufficient and timely
information with which to evaluate their level of interest rate risk. This information should take
appropriate account of the range of maturities and currencies in each bank’s portfolio, including
off-balance sheet items, as well as other relevant factors, such as the distinction between trading
and non-trading activities.
Capital adequacy
Principle 12: Banks must hold capital commensurate with the level of interest rate risk they
undertake.
Disclosure of interest rate risk
Principle 13: Banks should release to the public information on the level of interest rate risk
and their policies for its management.
Sources, effects and measurement of interest rate risk
Interest rate risk is the exposure of a bank’s financial condition to adverse movements in
interest rates. Accepting this risk is a normal part of banking and can be an important source
of profitability and shareholder value. However, excessive interest rate risk can pose a
significant threat to a bank’s earnings and capital base. Changes in interest rates affect a bank’s
earnings by changing its net interest income and the level of other interest-sensitive income
and operating expenses. Changes in interest rates also affect the underlying value of the bank’s
assets, liabilities and off-balance sheet instruments because the present value of future cash
flows (and in some cases, the cash flows themselves) change when interest rates change.
Sources of Interest Rate Risk
Repricing risk: As financial intermediaries, banks encounter interest rate risk in several ways.
The primary and most often discussed form of interest rate risk arises from timing differences
in the maturity (for fixed rate) and repricing (for floating rate) of bank assets, liabilities and
off-balance-sheet (OBS) positions. While such repricing mismatches are fundamental to the
business of banking, they can expose a bank’s income and underlying economic value to
unanticipated fluctuations as interest rates vary. For instance, a bank that funded a long-term

59 KMBNFM04
fixed rate loan with a short-term deposit could face a decline in both the future income arising
from the position and its underlying value if interest rates increase. These declines arise because
the cash flows on the loan are fixed over its lifetime, while the interest paid on the funding is
variable, and increases after the short-term deposit matures.
Yield curve risk: Repricing mismatches can also expose a bank to changes in the slope and
shape of the yield curve. Yield curve risk arises when unanticipated shifts of the yield curve
have adverse effects on a bank’s income or underlying economic value. For instance, the
underlying economic value of a long position in 10-year government bonds hedged by a short
position in 5-year government notes could decline sharply if the yield curve steepens, even if
the position is hedged against parallel movements in the yield curve.
Basis risk: Another important source of interest rate risk (commonly referred to as basis risk)
arises from imperfect correlation in the adjustment of the rates earned and paid on different
instruments with otherwise similar repricing characteristics. When interest rates change, these
differences can give rise to unexpected changes in the cash flows and earnings spread between
assets, liabilities and OBS instruments of similar maturities or repricing frequencies.
Optionality: An additional and increasingly important source of interest rate risk arises from
the options embedded in many bank assets, liabilities and OBS portfolios. Formally, an option
provides the holder the right, but not the obligation, to buy, sell, or in some manner alter the
cash flow of an instrument or financial contract. Options may be stand alone instruments such
as exchange-traded options and over-the-counter (OTC) contracts, or they may be embedded
within otherwise standard instruments. While banks use exchange-traded and OTC-options in
both trading and non-trading accounts, instruments with embedded options are generally most
important in non-trading activities.
Effects of Interest Rate Risk
As the discussion above suggests, changes in interest rates can have adverse effects both on a
bank’s earnings and its economic value. This has given rise to two separate, but
complementary, perspectives for assessing a bank’s interest rate risk exposure.
Earnings perspective: In the earnings perspective, the focus of analysis is the impact of
changes in interest rates on accrual or reported earnings. This is the traditional approach to
interest rate risk assessment taken by many banks. Variation in earnings is an important focal
point for interest rate risk analysis because reduced earnings or outright losses can threaten the
financial stability of an institution by undermining its capital adequacy and by reducing market
confidence. In this regard, the component of earnings that has traditionally received the most
attention is net interest income (i.e. the difference between total interest income and total
interest expense).
Economic value perspective: Variation in market interest rates can also affect the economic
value of a bank’s assets, liabilities and OBS positions. Thus, the sensitivity of a bank’s
economic value to fluctuations in interest rates is a particularly important consideration of
shareholders, management and supervisors alike. The economic value of an instrument
represents an assessment of the present value of its expected net cash flows, discounted to
reflect market rates. By extension, the economic value of a bank can be viewed as the present
value of bank’s expected net cash flows, defined as the expected cash flows on assets minus
the expected cash flows on liabilities plus the expected net cash flows on OBS positions. In
this sense, the economic value perspective reflects one view of the sensitivity of the net worth
of the bank to fluctuations in interest rates. Since the economic value perspective considers the
potential impact of interest rate changes on the present value of all future cash flows, it provides
a more comprehensive view of the potential long-term effects of changes in interest rates than
is offered by the earnings perspective. This comprehensive view is important since changes in
near-term earnings – the typical focus of the earnings perspective – may not provide an accurate
indication of the impact of interest rate movements on the bank’s overall positions.

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Embedded losses: The earnings and economic value perspectives discussed thus far focus on
how future changes in interest rates may affect a bank’s financial performance. When
evaluating the level of interest rate risk it is willing and able to assume, a bank should also
consider the impact that past interest rates may have on future performance. In particular,
instruments that are not marked to market may already contain embedded gains or losses due
to past rate movements. These gains or losses may be reflected over time in the bank’s earnings.
For example, a long term fixed rate loan entered into when interest rates were low and refunded
more recently with liabilities bearing a higher rate of interest will, over its remaining life,
represent a drain on the bank’s resources.
Measuring Interest Rate Risk
The techniques available for measuring interest rate risk range from calculations that rely on
simple maturity and repricing tables, to static simulations based on current on- and off-balance
sheet positions, to highly sophisticated dynamic modelling techniques that incorporate
assumptions about the behaviour of the bank and its customers in response to changes in the
interest rate environment. Some of these general approaches can be used to measure interest
rate risk exposure from both an earnings and an economic value perspective, while others are
more typically associated with only one of these two perspectives. In addition, the methods
vary in their ability to capture the different forms of interest rate exposure: the simplest methods
are intended primarily to capture the risks arising from maturity and repricing mismatches,
while the more sophisticated methods can more easily capture the full range of risk exposures.

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