1. It is part of management science
-Organization and control of Forex
- Budgeting for Forex
- Utilization of Forex
2. It refers to generation of Forex
- From international trade transactions
3. It pertains to use of Forex
- Identification of suppliers of goods and services
- Negotiation of terms and conditions of the transaction
4. It covers storage of Forex
- Deposits in foreign currency bank accounts
- Forex reserves-gold, special drawing rights of IMF and foreign currencies.
- Foreign exchange reserves
- Awareness of historical development of world trade
- Ability to forecast future trends
- Comparative analysis skills
- In-depth knowledge of forex market
- Knowledge of interest rates
- Willingness to undertake risks
- Hedging strategies
Foreign Exchange Market
- Is the market where the currency of one country is exchanged for the currency of another country
- The market is an over the counter market
- There is no single market place or an organized exchange (like a stock exchange) where traders meet and exchange currencies.
- The dealers sit in their dealing room of major commercial banks around the world and communicate with each other through telephones, computer terminals and swift mechanism.
Foreign Exchange Rates:
- Is the price of one country’s money in terms of other country’s money
- When Indian rupee depreciates against the US dollar, it indicates that demand for latter is more than it’s supply.
- When the supply of US dollar is more than it’s demand, it declaims in value against the Indian rupee.
Factors Affecting Foreign:
1. Fundamental factors:
- All such events that affect the basic economic and fiscal policies of the concerned government.
- These are basic economic policies followed by the government in relation to inflation, balance of payment position, unemployment, capacity utilization, trends in import and export, etc.
2. Political and psychological factors
3. Technical factors
- Capital movement
- Relative inflation rates
- Exchange rate policy and intervention
- Interest rates
- The anticipation of the market participants many times is the prime reason for exchange rate movements.
- Those speculators anticipate the events even before the actual data is out and position themselves accordingly to take advantage when the actual data confirms the anticipations.
Determination of Foreign Exchange Rates:
1. Balance of Payments
a. If payments by a country for its imports of goods and services, two possibilities arises
b. Foreign currency payments exceed receipts and there is a deficit. This puts the home currency of the country under downward pressure against foreign currencies.
2. Demand and Supply
3. Purchasing power parity
4. Interest rate-again relating to foreign trade
5. Relative income levels
6. Market expectations – developments regarding political and economic matters. Of a count
INTER-RELATIONSHIP OF VARIABLES AFFECTING EXCHANGE RATES:
- Interest rates, inflation rates, forward margins, exchange rates and expectations across nations are inter- related.
Exchange rates quotes:
There are two major ways of offering exchange rate quotes.
- Direct quote
- Indirect quote
Spot Exchange Rates:
- Is a rate at which currencies are being traded for delivery on the same day.
- Is for a currency is the current rate at which one currency can be immediately converted into another currency.
- These rates are set by the demand and supply forces in the foreign exchange market.
- The direct quote indicates the number of units of the domestic currency required to buy one unit of foreign currency.
- An indirect quote indicates the number of units of foreign currency that can be exchange for one unit of the domestic currency.
- An indirect quote is the inverse of a direct quote.
- Indirect quote = 1
Types of Spot Rates:
1. Ask price:
- Is the rate at which the foreign exchange dealer asks it’s customer to pay in local currency exchange of the foreign currency.
- Is the rate at which the foreign currency can be purchased from the dealer.
2. Bid rate:
- Is the rate at which the dealer is ready to buy the foreign currency in exchange for the domestic currency.
- Is the rate at which the dealer is ready to pay in domestic currency in exchange for the foreign currency and they are ready to pay for buying it.
- Normally, the direct ask price is greater than the direct bid price and the difference between the two is known as the ask-bid spread.
- The bid spread is usually stated as a percentage cost of transacting in the foreign exchange market and may be computed as follows:
- % Spread = Ask price-Bid price
-The exchange rate between two currencies calculated on the basis of the rate of these two currencies in terms of a third currency.
-Forward rate is a price quotation to deliver the currency in future.
- The exchange rate is determined at the time of concluding the contract, but payment and delivery are not required till maturity.
- Forward rate may be higher than the spot rate if the market participants expect the currency to appreciate v-s-v the other currency, say US dollar. The currency, in such case is called trading at a forward premium.
- If the forward rate is lower than the spot rate, the participants expect the currency to depreciate v-s-v the US dollar. The currency in such case is said to be ‘trading at forward discount’.
- Forward premium/discount is generally calculated as percentage per annum.
- = (Forward rate-Spot rate) 12/n. *100
Where ‘n’ indicates the number of months till maturity of the forward contract
Risks in Foreign Exchange Market:
- Control of foreign exchange risk can be effective if a firm is able to manage the fundamental relationship among inflation, foreign exchange rates and interest rate.
- The objective in exposure management is two fold the minimization of exchange losses as a result of currency movements and the minimization of protection costs.
2. General Protection Measures:
a) Invoicing policies:
- Invoices to third parties abroad should be denominated in the relatively stronger currency. On the other hand, while importing goods. Etc. from third parties a firm should try to negotiate payments in the weaker currency.
- Respective bargaining strengths and the need for good customer relations have a bearing on the invoicing decision.
b) Transfer pricing:
- It is a mechanism by which profits are transferred through an adjustment of prices on intra-firm transactions
- It can be applied to transactions between the parent firm and its subsidiaries or between strong currency and weak currency subsidiaries.
c) Leading and lagging and extension of trade credit:
Leading: it implies speeding up collections on receivables if the foreign currency in which they are invoiced is expected to appreciate.
Lagging: it implies delaying payments of payables invoiced in a foreign currency that is expected to depreciate.
There are three elements in this calculation:
- Cash cost/benefits represented by the interest rate differential between the lead and log countries
- An expected cash gain/loss to be realized on the altered transactional exposure in the said countries, and
- An expected translation gain/loss on the altered translation exposure.
- All transactions-gross receipts and payments among the parent firm and subsidiaries should be adjusted and only net amounts should be transferred.
- This reduces costs of remittance of funds, and increases control of intra-firm settlement.
- It also produces savings in the form of lower float and lower exchange costs.
- It is a process whereby cash inflows in a foreign currency are matched with cash outflows in the same currency with regard, to as far as possible, amount and maturation.
- When there are cash inflows in one foreign currency and cash outflows in another foreign currency, the two could still be matched, provided they are positively correlated.
3.SPECIFIC PROTECTION MEASURES:
1. Transaction Exposure (TE):
- It occurs when a value of a future transaction, through known with certainty, is denominated in some currency other than the domestic currency.
- In such cases, the monetary value is fixed in terms of foreign currency at the time of agreement, which is complete at a later date.
- EX: an Indian exporter is to receive payment in euros in 90 days time for an export made today. His receipt in euros is fixed and certain but as far as the re. Value is concerned; it is uncertain and will depend upon the exchange rate prevailing at the time of receipt.
- All fixed money value transactions such as receivables; payables, fixed price sale and purchase contracts etc. are subject to transaction exposure.
- TE refers to the potential change in the value of a foreign currency denominated transaction due to changes in the exchange rate.
- It covers rate risk, credit risk and liquidity risk.
- This is also called the accounting exposure
- It refers to and deals with the probability that the firm may suffer a decrease in assets value due to devaluation of a foreign currency even if no foreign exchange transaction has occurred during the year.
- This exposure needs to be measured so that the financial statement i.e. the balance sheet and the income statement reflect the change in value of assets and liabilities.
- This occurs when the firm’s foreign balances are expressed in terms of the domestic currency.
- Two related decisions involved in translation exposure management:
(a) Managing balance sheet items to minimize the net exposure
(b) Deciding how to hedge against this exposure
- It results in exchange rate losses and gains that are reflected in the firm’s accounting record and are not realized and hence have no impact on the taxable income.
3. Economic Exposure:
- It refers to the probability that the change in foreign exchange rate will affect the value of the firm.
- The risk contained in economic exposure requires a determination of the effect of changes in exchange rates on each of the expected future cash flows.
- The translation and the transaction losses are one-time events, whereas the economic loss is a continuous one.
Managing Foreign Exchange Rate Risk:
- Firms that import and export often need to make commitments to buy or sell the goods for delivery at the time, with the payment to be made in foreign currency.
- As soon as, a firm enters into a transaction that exposes it to the cash flows in a foreign currency, it is exposed to exchange rate risk.
- The options available to a firm for hedging against exchange risk are subject to the following:
(a) Shareholders composition
(b) Diversification across countries-different business in different countries
(c) Cost of hedging risk
Exchange Rat Forecasting:
- The exchange rates among countries are affected by a large number of factors like rate of inflation, growth prospectus, political stability and economic policies.
- The % change between the current and the forecasted exchange rates may be calculated to find out appreciation or depreciation in the currency.
- A positive % change represents currency appreciation whereas a negative % change shows depreciation.
- The exchange rate may be fixed or floating.
- The market forces of demand and supply determine the floating exchange rates. These are not influenced by the government intervention.
- Fixed exchange rates, on the other hand, are decided by the regulating agencies.
The Floating Exchange Rates may be forecast with the help of various methods.
- Fundamental Analysis: this studies the relationship between macro economic variables (such as inflation rates, national income growth and changes in money supply)
- Technical Analysis: this uses past prices and volume movements to project future currency exchange rates.
- The reliability of the forecasts may be found out on the basis of forecasting error, which is calculated by root square error.
- The root square error is computed with the help of the following formula:
Where ‘FV’ is the forecasted value and ‘RV’ is the realized value.
Mechanics of Forex Trading:
- It is basically concerned with various forex operations including purchase and sale of currencies of different countries in order to meet payments and receipts requirements as a result of foreign trade.
- Forex trading is done either in
Retail market – the traveler and tourists exchange one currency for another in the form of currency notes or traveler Cheques. Here the total turnover and average transaction size are very small.
Wholesale Market or Inter Bank Market- is a market with huge turnover. The major participants of this market include commercial banks, corporation and central banks.
CAPITAL ACCOUNT CONVERTIBILITY:
- IT REFERS TO AN ECONOMIC TOOL EXPECTED TO ENGENDER MORE EFFICIENT CAPITAL FLOWS AND CATALYSE GROWTH IMPULSES AND ENABLE THE SOCIETY TO ACHIEVE A STABLE BALANCE BETWEEN Its INTERNAL AND EXTERNAL PRICES.
- The basic objective of capital account convertibility is to:
- Deepen and integrate financial markets
- Raise the access to global savings
- Discipline domestic policy markers and
- Allow greater freedom to individual decision-making
- A more open capital account will facilitate higher availability of larger capital stock, supplemental domestic resources thereby leading to higher growth and reducing the cost of capital and also facilitating access to the international financial market.
FOREIGN EXCHANGE MARKETS IN INDIA:
- The forex market in India is regulated by reserve bank of India.
- Participants in this market are the authorised moneychangers and authorised dealers.
- In order to provide facilities for encashment of foreign currency to visitors from abroad, especially foreign tourists, reserve bank has granted licenses to certain established firms, hotels and other organisations permitting them to deal in foreign currency notes, coins and travelers Cheques subject to directions issued to them from time to time.
- These firms and organisations are fall into two categories:
i. Full-fledged money changers- who are authorised to undertake both purchase and sale transactions with the public and
ii. Restricted money changers- who are authorised only to purchase foreign currency notes, coins and travelers Cheques, subject to the condition that all such collections are surrendered by them in turn to an authorised dealer in foreign exchange/full fledged money changer.
- Authorizations in the form of licenses to deal in foreign exchange are granted to banks, which are well equipped to undertake foreign exchange transactions in India.
- Authorizations have also been granted to certain financial institutions to undertake specific types of foreign exchange transactions incidental to their main business.