Final

Forex & Risk Management
INTRODUCTION
Exchange Rate Arrangements
Broadly speaking, the exchange rate of any currency can be settled in two ways: either administered by the central bank, or by demand and supply in the exchange market. Various combinations of the two extremes are not only possible but also are more the rule. The IM classifies the exchange arrangements of member countries under three broad heads: !egged, to a single currency "the #.$. dollar and the euro are most common%, or a currency composite like the $&'. lexibility limited against a single currency or group of currencies "the &anish (rone against the euro for example% More flexible arrangements like )managed floating*, and )independent floating*. The di+iding line between )independently floating* "the dollar, the euro and the yen for example% and )managed floating* often gets blurred in practice. To the extent the group of se+en ", - of IM %, or indi+idual central banks, inter+ene in the exchange market in pursuance of international economic co.operation or domestic macro.economic ob/ecti+es, the exchange rate if the independently floating currencies is also managed. 0s per the IM 1s 2xchange 0rrangements and 2xchange 'estrictions 0nnual 'eport 344-, the number of pegged currencies was 54, of currencies with limited flexibility was 35, and the remaining 44 currencies had more flexible arrangements. 6ith the introduction of the euro with effect from 3.3.3444, the number of currencies with limited flexibility has come down from the numbers 7uoted here.

There is yet another kind of exchange arrangement, not separately recogni8ed by the IM in the abo+e classification. This is known as the 9urrency Board 0rrangement, presently in force in :ong (ong and 0rgentina. This is a special form of pegged exchange rate in that the central bank has no control o+er domestic money supply ; the 9urrency Board undertakes to con+ert domestic currency for foreign currency "which is #.$. dollars in the case of both :ong (ong and 0rgentina% at a fixed rate, and the domestic money supply and interest rate depend on the currency reser+es a+ailable with 9urrency Board. In an ideal 9urrency Board 0rrangement, the reser+es would be e7ual to the broad money supply measure. In :ong (ong, for example, specified commercial banks ha+e the right to issue the :ong (ong dollar currency notes << but they can do only to the extent of #.$. dollars they deposit with the :ong (ong Monetary 0uthority. 9urrency Board 0rrangements suffer from two ma/or weaknesses: &omestic money supply and interest rates became a function of the reser+es of foreign exchange, comparable to the old gold standard. There is no ender of last resort for the banking system. In late 344=>early 3444, the 0rgentinean authorities examined the feasibility of adopting the #.$. dollar as the domestic currency, in preference to the 9urrency Board. ?ne other country, !anama, has been using #$& as its currency for a long time now.
A Forex Trading Strategy: Your
ey to the !ar"et
6hen trading in the foreign currency exchange, you undoubtedly need a orex trading strategy. :a+ing a orex trading strategy is crucial to the success of your in+estments in this +olatile and ceaseless market. 6ith the right knowledge you can take your money and trade it right.

0 orex Trading $trategy is like the yeast for your dough. 6ithout it, there will be no rise and expansion. The efforts of your currency trading will be all for not if you do not ha+e the ingredients to na+igate the tricky world of foreign exchange trading.
Need o# Foreign Exchange

Aet us consider a case where a Bapanese company exports electronic goods to #$0 and in+oices the goods in #$ &ollars. The 0mercian importer will pay the amount in #$ &ollars, as the same as his home currency. :owe+er the Bapanese exporter re7uires Cen means his home currency for procuring raw materials and for payment to the labour charges, etc. this he would need exchanging #$ dollars for Cen. If the Bapanese exporters in+oice his goods in Cen, then importer in #$0 will get his dollars con+erted in Cen and pay the exporter. rom the abo+e example we can infer that in case goods are bought or sold outside the country, exchange of currency in necessary. $ometimes it also happens that transaction between two countries will be settled in the currency of the third country. That case both the countries, which are transacting will re7uire con+erting their perspecti+e currencies in the currency of the third country. or that also the foreign exchange is re7uired. or example, an Indian exporter, exporting goods to $ingapore may rise an in+oice for the goods sold in #$ dollars and as the importer in $ingapore has to make payment in #$ &ollars, he will ha+e to exchange his $ingapore dollars into #$ dollars. The Indian exporter on receipt of #$ dollars will exchange them into Indian rupees. Thus, the transaction will gi+e rise to exchange of currencies in the exporters country as well as importer s country. $uch transaction may gi+e rise to con+ersation of currencies at two stages.
O$$ortunities #rom Around the %or&d

?+er the last three decades the foreign exchange market has become the worldEs largest financial market, with o+er F3.G trillion #$& traded daily. orex is part of the bank.to. bank currency market known as the @H.hour Interbank market. The Interbank market literally follows the sun around the world, mo+ing from ma/or banking centers of the #nited $tates to 0ustralia, Iew Jealand to the ar 2ast, to 2urope then back to the #nited $tates. #ntil recently, the forex market wasnEt for the a+erage trader or indi+idual speculator. 6ith the large minimum transaction si8es and often.stringent financial re7uirements, banks, hedge funds, ma/or currency dealers and the occasional high net.worth indi+idual speculator were the principal participants. These large traders were able to take ad+antage of the many benefits offered by the forex market +s. other markets, including fantastic li7uidity and the strong trending nature of the worldEs primary currency exchange rates.
Ad'antages o# The Forex !ar"et orex is open @H hours a day. orex is the most li7uid market in the world. large amounts of capital.
3KK.to.3 le+erage reduces the need for
9ommission.free trading on more than 5K currencies. Io restrictions on shorting which allows during any market condition you to en/oy profit opportunities
%hy Trade Foreign Exchange(

oreign 2xchange is the prime market in the world. Take a look at any market trading through the ci+ili8ed world and you will see that e+erything is +alued in terms of money. ast becoming recogni8ed as the worldEs premier trading +enue

by all styles of traders, foreign exchange "forex% is the worldEs largest financial market with more than F3.G trillion #$& traded daily. orex is a great market for the trader and itEs where Lbig boysL trade for large profit potential as well as commensurate risk for speculators. orex used to be the exclusi+e domain of the worldEs largest banks and corporate establishments. or the first time in history, itEs barrier.free offering an e7ual playing. field for the emerging number of traders eager to trade the worldEs largest, most li7uid and accessible market, @H hours a day. Trading forex can be done with many different methods and there are many types of traders . from fundamental traders speculating on mid.to.long term positions to the technical trader watching for breakout patterns in consolidating markets. The methods for trading foreign exchange are many.
Forex ')s Other !ar"ets

Other !ar"ets Forex !ar"ets
Aimited floor trading hours dictated by the The orex market is open @H hours a day, time 8one of the trading location, G.G days a week. Because of the significantly restricting the number of decentrali8ed clearing of trades and hours a market is open and when it can be o+erlap of ma/or markets in 0sia, accessed. Aondon and the #nited $tates, the market remains open and li7uid throughout the day and o+ernight. Threat of li7uidity drying up after market hours or because many market participants decide to stay on the sidelines or mo+e to more popular markets. Most li7uid market in the world eclipsing all others in must comparison. continue, is a Most since re7uired transactions currency commerce.
exchange
mechanism needed to facilitate world

Traders are gouged with fees, such as commissions, clearing fees, exchange fees and go+ernment fees. Aarge capital re7uirements, high margin ?ne consistent margin rate @H hours a rates, restrictions on shorting, +ery little day allows orex traders to le+erage their autonomy. capital more efficiently with as high as 3KK.to.3 le+erage. $hort selling and stop order restrictions. Ione. 9ommission. ree
!attern daytraders sub/ect to restrictions Io restrictions. Very low account balances. re7uiring account balances in excess of FGK,KKK.
Forex !ar"et In India

The Rupees Exchange Rate: A Brief History 0s already stated in chapter 3, India was a founder member of the IM . &uring the existence of the fixed exchange rate system, the inter+ention currency of the 'eser+e Bank was the British poundM the 'BI ensured maintenance of the exchange rate by selling and buying pounds against rupees at fixed rates. The interbank rate therefore ruled within the 'BI band. &uring the fixed exchange rate era, there was only one ma/or change in the parity of the rupee. de+aluation in Bune3445. 0fter the collapse of the fixed exchange rate system in 34-3 also, the 'BI continued to maintain the parity with the pound, with some minor changesM the exchange rates against other currencies were determined through their cross rate against the pound. This link with the pound continued until $eptember 34-G. By then, in recognition of the fact that India1s trade had substantially di+ersified in terms of both currencies and destinations and that, therefore, the link with the pound was no longer +ery logical the rupee1s exchange rate was linked to a basket of currencies. The composition of this basket was kept secret and the pound continued as the inter+ention currency. Its exchange rate against the rupee was so fixed by the 'BI daily, and sometimes changed intra.day, as to ensure that the +alue of the "secret% basket of the currencies remained reasonably steady in the rupee terms.
RBI Study In the early 34=K1s, the 'BI undertook a study of the real effecti+e exchange rate of the rupeeM it was published in the series of ?ccasional !apers, Bune34=H, ")The Iominal and 'eal 2ffecti+e 2xchange 'ate of the Indian 'upee 34-3.=D* by &r Vi/ay Boshi%. The principal conclusions of the study were that the real effecti+e rate "'2'% of the rupee depreciated by 33.GN between 34-3 and 34-G and by a further 3-N between 34-G and 34-4. rom 34-4 to 34=D, howe+er, it showed a sharp 3GN appreciation. It seems that, as a result of the study, the 'BI started to depreciate the rupee in nominal terms beginning late 34=D, so as to correct the earlier appreciation, and to depreciate the rupee modestly in )real*, i.e. inflation ad/usted terms. This policy continued up to Bune3443. In the first week of Buly 3443, a two.step de+aluation of the rupee was engineered "and the cash compensatory support for exports discontinued%, and the inter+ention currency changed to #.$. dollars. The next ma/or change was the introduction of a liberali8ed exchange rate management system "A2'M$% in March 344@. This introduced a dual exchange rate system. ?ne rate was the administered "or official% one at which specified type or proportion of currency exchange had to be transacted. or example, out the receipt of foreign exchange exports, 5KN had to be sold in the market at the market rate and the balance surrendered to the 'eser+e Bank at official rate. The foreign currency purchased by the 'BI through this mechanism was sold to importers of oil "and a few other products% at the official rate. The market rate was determined by the demand and supply in the market and, as can be expected, the rupee was at a discount in the market, as compared to the official rate. In

March 344D, this system was abolished and a single market determined rate is since applicable for all transactions. The market spot and forward rates are determined by demand and supply. The market is primarily for exchange of dollars against the rupeeM other currencies are not acti+ely traded against the rupee in the local market. Mumbai is the biggest centre, followed by &elhi, 9alcutta and other markets. The local exchange market is a two.tier one: non.bank customers ha+e to buy currencies from, or sell currencies to, banks permitted to act as authori8ed dealers. The second tier consists of the interbank market. The reser+e Bank can influence the market rate by inter+ening. $uch inter+ention can take +arious forms: Verbal "i.e. statements through media%M Tightening exchange control to curb speculati+e acti+ityM Tightening money supply or increasing interest rates to make it costlier to short the rupeeM 0ctual sale or purchase of dollars in the market. 'BI has used all these measures, often in combination, to influence the market rate. 6hile some authori8ed dealers restrict their market acti+ities to co+ering customer transactions, others also trade, or speculate, on their own account. The market lot is #$& GKK,KKK.
Foreign Exchange !ar"ets Re'ie* ++,anuary - ,une. /0001 Re'ie* done during Decem2er /0001 rom 0ugust 3444 to March @KKK, 'e traded in a narrow band of around 's. HD.GK per #$F. 0t end.march, 'e at HD.53 to a #$F.
3K

In Ban.Mar, @KKK low forward premium due to return of excess supply conditions in forex market. But excess demand conditions de+eloped in May and continued in Bune. 'e depreciated from HD.5H in 0pril to HH.@= per #$F in May. The reasons for the depreciation can be stated as: &emand pressures :igher Import ?il !ayments "?il !rices doubled since early 3444% 'educed 9apital Inflows 6idening of excess demand in spot and forward markets S3 mn 0pr.KK May.KK Excess DD in s$ot mar"et @K@ =GG Excess DD in s$ot mar"et =HG 34K4
'BI undertook net sales of #$F 34H= mn during May.Bune @KKK to meet temporary &&. $$ mismatches. In order to reduce the uncertainty the 'BI undertook the following steps: Interest rate surcharge of GKN of the lending rate on import finance of all non.essential imports. orex re7uirements for import of crude oil to be met by I?9.
'BI would continue to sell #$F. Banks told not to deal for speculati+e purposes. !enalty of @GN p.a. on o+erdue export bills.
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In response to these, 'e between H.G- to HH.-4 per #$F during Bune @KKK. 2xchange rate depreciates to HG.K@ per #$F on Buly @3, @KKK. The 'BI steps in response were: Bank rate increased by 3N point to =N. 9'' increased by K.GN point to =.GN.
!ain 4artici$ants In Foreign Exchange !ar"et

Customers The customers who are engaged in foreign trade participate in foreign exchange markets by a+ailing of the ser+ices of banks. 2xporters re7uire con+erting the dollars into rupee and importers re7uire con+erting rupee into the dollars as they ha+e to pay in dollars for the goods > ser+ices they ha+e imported. $imilar types of ser+ices may be re7uired for setting any international obligation i.e., payment of technical know.how fees or repayment of foreign debt, etc. Commercia& 5an"s They are most acti+e players in the forex market. 9ommercial banks dealing with international transactions offer ser+ices for con+ersation of one currency into another. These banks are speciali8ed in international trade and other transactions. They ha+e wide network of branches. ,enerally, commercial banks act as intermediary between exporter and importer who are situated in different countries. Typically banks buy foreign exchange from exporters and sells foreign exchange to the importers of the goods. $imilarly, the banks for executing the orders of other customers, who are engaged in international transaction, not necessarily on the account of trade alone, buy and sell foreign exchange. 0s e+ery time the foreign exchange bought and sold may not be e7ual banks are left with
3@

the o+erbought or o+ersold position. If a bank buys more foreign exchange than what it sells, it is said to be in Oo+erbought>plus>long position1. In case bank sells more foreign exchange than what it buys, it is said to be in Oo+ersold>minus>short position1. The bank, with open position, in order to a+oid risk on account of exchange rate mo+ement, co+ers its position in the market. If the bank is ha+ing o+ersold position it will buy from the market and if it has o+erbought position it will sell in the market. This action of bank may trigger a spate of buying and selling of foreign exchange in the market. Iowadays, in international foreign exchange markets, the international trade turno+er accounts for a fraction of huge amount dealt, i.e. bought and sold. The balance amount is accounted for either by financial transaction or speculation. Banks ha+e enough financial accounted for either by financial transactions or speculation. Banks ha+e enough financial strength and wide experience to speculate the market and bank does so. This is popularly known as the trading in the forex market. This speculation is not only limited to banks alone but some of the conglomerates also speculate and thus a gigantic market has come into existence. 9ommercial banks ha+e following ob/ecti+es for being acti+e in the foreign exchange markets. They render better ser+ice by offering competiti+e rates to their customers engaged in international trade They are in a better position to manage risks arising out of exchange rate fluctuations. oreign exchange business is a profitable acti+ity and thus such banks are in a position to generate more profits for themsel+es. They can manage their integrated treasury in a more efficient manner.
3D
In India Reser'e 5an" o# India has gi'en &icense to the commercia& 2an"s to dea& in #oreign exchange under section 6 Foreign Exchange Regu&ation Act. 789:. *hich are ca&&ed Authori;ed dea&ers +A Ds1< A&& the 2an"s that ha'e 2een Authori;ed to dea& in #oreign exchange co&&ecti'e&y constitute *hat is "no*n as =Inter 2an"> mar"et in India< They are re?uired to #o&&o* the Ru&es)guide&ines Framed 2y Foreign Exchange Dea&er>s Association o# India +FEDAI1
Centra& 5an"s In most of the countries central bank ha+e been charged with the responsibility of maintaining the external +alue of the domestic currency. If the country is following a fixed exchange rate system, the central bank has to take necessary steps to maintain the parity, i.e., the rate so fixed. 2+en under floating exchange rate system, the central bank has to ensure orderliness in the mo+ement of exchange rates. ,enerally this is achie+ed by the inter+ention of the bank. $ometimes this becomes a concerted effort of central banks of more than one country. 0part from this central banks deal in the foreign exchange market for the following purposes. Exchange rate management: Though sometimes this is achie+ed through inter+ention, yet where a central bank is re7uired to maintain external rate of domestic currency at a le+el or in a band so fixed, they deal in the market to achie+e the desired ob/ecti+e Reser'e management: 9entral bank of the country is mainly concerned with the in+estment of the countries foreign exchange reser+e in a stable proportions in range of currencies and in a range of assets in each currency. These proportions
3H

are, inter alias, influenced by the structure of official external assets>liabilities. or this bank has in+ol+ed certain amount of switching between currencies. 9entral banks are conser+ati+e in their approach and they do not deal in foreign exchange markets for making profits. :owe+er, there ha+e been some aggressi+e central banks but market has punished them +ery badly for their ad+enturism. In the recent past Malaysian 9entral bank, Bank Iegara lost billions of dollars in foreign exchange transactions. !onetary !easures used 2y R5I to Counter Exchange Rate !o'ements: Indian companies are permitted to make direct in+estment in /oint +entures > wholly owned subsidiaries outside India "i.e. in+estment by way of contribution to the capital or subscription to the Memorandum of 0ssociation of a foreign entity, excluding portfolio in+estment or in+estment through stock exchange or by pri+ate placement% without prior appro+al of the 'BI, upto an amount of #$& 3KK Million, sub/ect to the following: The drawal of foreign exchange from an authori8ed dealer in India does not exceed GK percent of the net worth of the Indian company "net worth paid.up capital and free reser+es% The Indian company is not on the 'BI1s caution > defaulter1s list. The in+estment is made in a foreign entity engaged is a similar core acti+ity "core acti+ity is an acti+ity carried on by Indian entity which constitutes atleast GK percent of its a+erage turno+er in the pre+ious accounting year%. 0s a measure to further liberalise outbound outbound in+estment under the automatic route, the 'BI pro+ided that
3G

!urchase of foreign exchange for in+estment in /oint +enture > wholly owned subsidiaries may now be made upto 3KK percent of the networth of the in+esting company as against pre+ious GK percent ceiling. 0n Indian company with a pro+en track record is allowed to in+est by way of market purchases in a foreign entity engaged in a bonafide business acti+ity that may not necessarily be its core acti+ity. The in+estment is sub/ect to 3. 3KK percent of the net worth of the in+esting company. @. 0n o+erall limit of #$& 3KK million.
Inter'ention 2y Centra& 5an" It is truly said that foreign exchange is as good as any other commodity. If a country is following floating rate system and there are no controls on capital transfers, then the exchange rate will be influenced by the economic law of demand and supply. If supply of foreign exchange is more than demand during a particular period then the foreign exchange will become cheaper. ?n the contrary, if the the supply is less than the demand during the particular period then the foreign exchange will become costlier. The exporters of goods and ser+ices mainly supply foreign exchange to the market. If there are no control o+er foreign in+estors are also suppliers of foreign exchange. &uring a particular period if demand for foreign exchange increases than the supply, it will raise the price of foreign exchange, in terms of domestic currency, to an unrealistic le+el. This will no doubt make the imports costlier and thus protect the domestic industry but this also gi+es boost to the exports. :owe+er, in the short run it can disturb the e7uilibrium and orderliness of the foreign exchange markets. The centra& 2an" *i&& then ste$ #or*ard to su$$&y #oreign exchange to meet the demand #or the same< This will smoothen the market. The central bank achie+es this by selling the foreign exchange and buying or absorbing
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domestic currency. Thus demand for domestic currency which, coupled with supply of foreign exchange, will maintain the price of foreign currency at desired le+el. This is called =inter'ention 2y centra& 2an">< If a country, as a matter of policy, follows fixed exchange rate system, the central bank is re7uired to maintain exchange rate generally within a well.defined narrow band. 6hene+er the +alue of the domestic currency approaches upper or lower limit of such a band, the central bank inter+enes to counteract the forces of demand and supply through inter+ention. In India, the central bank of the country, the 'eser+e Bank of India, has been en/oined upon to maintain the external +alue of rupee. #ntil March 3, 344D, under section HK of the 'eser+e Bank of India act, 34DH, 'eser+e Bank was obliged to buy from and sell to authori8ed persons i.e., 0&1s foreign exchange. :owe+er, since March 3, 344D, under Modified Aiberali8ed 2xchange 'ate Management $ystem "Modified A2'M$%, 'eser+e Bank is not obliged to sell foreign exchange. 0lso, it will purchase foreign exchange at market rates. 0gain, with a +iew to maintain external +alue of rupee, 'eser+e Bank has gi+en the right to inter+ene in the foreign exchange markets.
Exchange 5ro"ers orex brokers play a +ery important role in the foreign exchange markets. :owe+er the extent to which ser+ices of forex brokers are utili8ed depends on the tradition and practice pre+ailing at a particular forex market center. In India dealing is done in interbank market through forex brokers. In India as per 2&0I guidelines the 0&1s are free to deal directly amoung themsel+es without going through brokers. The forex brokers are not allowed to deal on their own account all o+er the world and also in India.
3-
@o* Exchange 5ro"ers %or"( Banks seeking to trade display their bid and offer rates on their respecti+e pages of 'euters screen, but these prices are indicati+e only. ?n in7uiry from brokers they 7uote firm prices on telephone. In this way, the brokers can locate the most competiti+e buying and selling prices, and these prices are immediately broadcast to a large number of banks by means of hotlines>loudspeakers in the banks dealing room>contacts many dealing banks through calling assistants employed by the broking firm. If any bank wants to respond to these prices thus made a+ailable, the counterparty bank does this by clinching the deal. Brokers do not disclose counterparty bank1s name until the buying and selling banks ha+e concluded the deal. ?nce the deal is struck the broker exchange the names of the bank who has bought and who has sold. The brokers charge commission for the ser+ices rendered. In India broker1s commission is fixed by 2&0I. O'erseas Forex !ar"ets Today, the daily global turno+er is estimated to be more than #$ F 3.G trillion a day. The international trade howe+er constitutes hardly G to - N of this turno+er. The rest of trading in world forex markets is constituted of financial transaction and speculation. Aondon has been the biggest market and continues to be so e+en today. :owe+er, many other cities ha+e de+eloped as ma/or trading centers. 0s we know that the forex market is @H ; hour market, the day begins with Tokyo and thereafter $ingapore opens, thereafter India, followed by Bahrain, rankfurt, !aris, Aondon, Iew Cork, $ydney and back to Tokyo. &ealers ha+e access to the dealing not only during their business hours but remain acti+e from their residences also.
3=
S$ecu&ators $peculators play a +ery acti+e role in the foreign exchange markets. In fact ma/or chunk of the foreign exchange dealings in forex markets in on account of speculators and speculati+e acti+ities. The speculators are the ma/or speculator in the forex markets. 3. Banks dealing are the ma/or speculators in the forex markets with a +iew to make profit on account of fa+ourable mo+ement in exchange rate, take position i.e., if they feel the rate of particular currency is likely to go up in short term. They buy that currency and sell it as soon as they are able to make a 7uick profit. @. 9orporations particularly Multinational 9orporations and
Transnational 9orporations ha+ing business operations beyond their national frontiers and on account of their cash flows. Being large and in multi.currencies get into foreign exchange exposures. 6ith a +iew to take ad+antage of foreign rate mo+ement in their fa+our they either delay co+ering exposures or do not co+er until cash flow materiali8e. $ometimes they take position so as to take ad+antage of the exchange rate mo+ement in their fa+our and for undertaking this acti+ity, they ha+e state of the art dealing rooms. In India, some of the big corporate are as the exchange control ha+e been loosened, booking and canceling forward contracts, and a times the same borders on speculati+e acti+ity. D. ,o+ernments narrow or in+est in foreign securities and delay co+erage of the exposure on account of such deals.
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H. Indi+idual like share dealings also undertake the acti+ity of buying and selling of foreign exchange for booking short.term profits. They also buy foreign currency stocks, bonds and other assets without co+ering the foreign exchange exposure risk. This also results in speculations. G. 9orporate entities take positions in commodities whose prices are expressed in foreign currency. This also adds to speculati+e acti+ity. The speculators or traders in the forex market cause significant swings in foreign exchange rates. These swings, particular sudden swings, do not do any good either to the national or international trade and can be detrimental not only to national economy but global business also. :owe+er, to be far to the speculators, they pro+ide the much need li7uidity and depth to foreign exchange markets. This is necessary to keep bid.offer which spreads to the minimum. $imilarly, li7uidity also helps in executing large or uni7ue orders without causing any ripples in the foreign exchange markets. ?ne of the +iews held is that speculati+e acti+ity pro+ides much needed efficiency to foreign exchange markets. Therefore we can say that speculation is necessary e+il in forex markets.
EAC@ANBE RATE SYSTE!

9ountries of the world ha+e been exchanging goods ands ser+ices amongst themsel+es. This has been going on from time, immemorial. The world has come a long way from the days of barter trade. 6ith the in+ention of money the figures and problems of barter trade ha+e disappeared. The barter trade has gi+en way ton exchange of goods and ser+ices. Aike any other commodities, price is one unit of foreign exchange can be started in terms of domestic currency. Therefore, simply stated, an exchange rate is the rate at which two currencies can be exchanged or we can also say that it is the price of one currency in
@K

terms of the other currency. To state it differently, the exchange rate is the rate at which number of one units of one currency can be exchanged for number of another currencies. $imply defined, exchange rate is noting but +alue of one currency in terms of another currency.
For exam$&e. $rice o# US Do&&ar +USD1 or Deutsche !ar" +DE!1 or ,a$anese Yen +Yen1 can 2e ex$ressed in terms o# Indian Ru$ees +INR1< Thus i# *e say. USD 7 C Rs< D6. it means that the exchange rate o# USD and Ru$ee is 7:D6< simi&ar&y. i# *e say. B54 7 C Rs< 68 it means that the exchange ratio o# B54 and Ru$ee is 7:68<
&ifferent countries ha+e adopted different exchange rate system at different time. The following are some of the exchange rate system followed by +arious countries.
The Fixed Rate System

?n foundation, the IM drew up a detail code of conduct for member countries, which included rules about exchange rates. 0rticle IV of the IM pro+ided for fixed exchange rates and member countries agreed not to change these rates except in consultation with the und. Besides, the und would agree to such a change only in of a Ofundamental "i.e. not temporary% dise7uilibrium1 in the external payments positions of a member country. The initiati+e for changing the exchange rate had to be taken by the member country. The code of conduct also aimed at furthering a liberal multilateral system of international payments and con+ertibility of currencies. In pursuance of the fixed exchange rate regime, each country agreed upon a certain par +alue for its currency, measured in terms of gold. The #nited $tates, as the strongest economy at the end of the war, was the only country which undertook to con+ert dollars into gold and +ice +ersa at a fixed price of #$ dollars DG per ounce of gold.
@3

?ne of the first achie+ements of the IM was to get member countries to declare a par +alue for their currencies and to eliminate o+er the first two decades the multiple exchange rate systems some of the member countries had earlier adopted. The fixed exchange rate system brought into being by the IM ga+e considerable stability to the international monetary system and led to an unprecedented growth in world trade. 9urrencies other than the dollar, while ha+ing a notional, or theoretical, gold content, were not )con+ertible* into gold. :owe+er, the gold content established a par +alue for each currency against the #.$. dollar. 0nd, the central bank of each member country was obliged to inter+ene in the foreign exchange market "by buying or selling dollars against the local currency% to ensure that the actual rate stayed with 3N of the parity. Strains in the Fixed Exchange Rate System 0s stated earlier, the initial exchange rate ob/ecti+es of the IM were well on their way to being achie+ed by the middle of the 345K1s ; all members had declared par +alues, the multiple rates had been mostly eliminated, and an increasing number of currencies, in 6est 2urope for example, had become con+ertible for current transactions. 0s a result, world trade was growing at a rapid pace and led to fast reco+ery in the economies of 6estern 2urope and Bapan. By the 345K1s the IM administered fixed exchange rate system started showing signs of strains from different directions. irst and foremost was the fact that world li7uidity, measured in terms of the aggregate reser+es of the member countries, was not keeping pace with the growth in world trade. This led to apprehensions that the growth in trade would be hampered if measures were not taken to impro+e and increase world li7uidity. The second ma/or strain in the system was arising from the sharp increase in dollars held by other countries of the IM as a result of the current account deficits of the #.$.. This was bringing into 7uestion the ability of the #nited $tates go+ernment to meet its undertaking to con+ert dollars into gold at a fixed rate of #$ FDG per ounce of gold. By
@@

345K, the #.$. external liabilities exceeded its reser+es of gold. The outflow of dollars from the #nited $tates got a further fillip in the 345K1s as a result of the Vietnam 6ar. 9entral banks, who were the ma/or holders of dollars, were getting worried that should all of them insist on con+erting their dollar balances into gold, the #nited $tates Treasury1s stock of gold would be insufficient to meet the demand. Cet another strain was the result of the rigidity imposed by the fixed exchange rate system ; ad/ustments in par +alues could not be done 7uickly enough to reflect changes in economic fundamentals. This was all the more so in the case of countries running a persistent surplus on the current account. 0s may be recalled, the initiati+e for a change in the par +alue had to come from the member concerned. Too often, countries whose currencies were under+alued had little incenti+e to initiate an upward +aluation of their currencies. The export success of Bapan and, to an extent, 6est ,ermany, was based on a significant under +aluation of their currencies during a ma/or part of the fixed rate era.
The Bo&d Standard

Many countries ha+e adopted gold standard as their monetary system during the last two decades of the 34th century. This system was in +ogue till the outbreak of 6orld 6ar I. #nder this system the parties of currencies were fixed in terms of gold. These were two main types of gold standard. Bo&d S$ecie Standard ,old was recogni8ed as means of international settlement for receipts and payments amongst countries. ,old coins were an accepted mode of payment and medium, of exchange in domestic market also. 0 country was stated to be on gold standard if the following condition were satisfied. Monetary authority, generally the central bank of the country, guaranteed to buy and sell gold in unrestricted amounts at the fixed price.
@D

Melting gold including gold coins, and putting it to different uses was freely allowed. Import and export of gold was freely allowed. The total money supply in the country was determined by the 7uantum, of gold a+ailable for monetary purpose. Bo&d 5u&&ion Standard #nder this system, the money in circulation was either partly or entirely paper and gold ser+ed as reser+e asset for the money supply. :owe+er, paper money could be exchanged for gold at any time. The currencies of the countries, which were an gold standard, could be exchanged freely. The exchange rate was determined by the gold content of the respecti+e currency i.e., if the gold content in the currency of Britain was three times as much as that of #$0, then automatically fixed at ,B! 3 P #$& D. The exchange rate +aried depending upon the gold content of the currencies. This was also known as O Mint !arity Theory1 of exchange rates. ,old standard helped maintain stability in the exchange rates. This system also helped in correcting the dise7uilibrium in their balance of payments on an automatic basis. 0 country with a balance of payment deficit had to surrender gold to the country, which has surplus balance of payment position. The outflow of gold from the country, which had deficit balance of payments position to the country, which has surplus balance of payment, resulted in reduction in money supply in that country which would lead to deflation. 0s against this, inward mo+ement of gold into the country with surplus B?! would lead to inflation in that country. This would create a differential in the price of goods in the two countries and in the country, which had inflationM the prices will be more as compared to the country, which had deflation.
@H

9onse7uently, the latter would export goods to the former, thus inducing re+erse flow of gold. It was further re.inforced by the changes made in the interest rates by this countries. The country with deficit B?! would raise the interest rates, which would induce capital inflows, which would help in correcting the B?! deficit. $imilarly the country with surplus B?! would lower the interest rates. 6orld 6ar I brought an end to the gold standard.
4urchasing 4o*er 4arity +4441

!rofessor ,usta+ 9assel, a $wedish economist, introduced this system. The theory, to put in simple terms states that currencies are +alued for what they can buy. Thus if 3DG B!C buy a fountain pen and the same fountain pen could be bought for #$& 3, it can be inferred that since #$& 3 or B!C 3DG can buy the same fountain pen, therefore #$& 3 P B!C 3DG.
@G
#nder purchasing power parity "!!!% the sole criterion to determine exchange rate of currency of two countries was their purchasing power. If there were temporary de+iations from the purchasing power parity theory, the market forces would operate to remo+e them. If there were no trade controls, then as per this theory, the balance of payments e7uilibrium would always be maintained.
For exam$&e i# country A had a higher rate o# in#&ation as com$ared to country 5 then goods $roduced in country A *ou&d 2ecome cost&ier as com$ared to goods $roduced in country in country 5< This *ou&d induce im$orts in to country A and a&so the goods $roduced in country A 2eing cost&ier. *ou&d &ose in internationa& com$etition to goods $roduced in country 5< This decrease in ex$orts o# country A as com$ared to ex$orts #rom country 5 *ou&d &ead to demand #or the currency o# country 5 and excess su$$&y o# country A< This in turn. causes currency o# country A to de$reciate in com$arison o# currency o# country 5 that is ha'ing re&ati'e&y more ex$orts<
The 5retton %oods System

The Bretton 6oods conference took place while the war was still going on but the allied powers were by then sure of winning it. 0s a result of the war, most of the 2uropean economies had been de+astated. $o was the case with Bapan. The only ma/or industrial power, whose economy was relati+ely unaffected by the war, was the #nited $tates. It was in this background that the Bretton 6oods institutions, namely the International Monetary und and the 6orld Bank, were formed. #$0 and Britain took the lead in this regard and the 0merican proposal was ultimately accepted at the Bretton 6oods
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9onference held in Buly 34HH and thus International Monetary und, which established in 34H5, had its following ob/ecti+es: To establish an international monetary system with stable exchange rates. To estimate existing exchange controls. To bring about free con+ertibility of all currencies. The B6$ re7uired the member countries to fix the parties of their currencies in terms of #$ dollars or gold. The ob/ecti+e of stable exchange rate was achie+ed, as the countries were obliged to keep fluctuations in their currency within Q3N of their declared party. In order to a+oid unnecessary de+aluation of currency, it was agreed that no change in parity could take place without the und1s appro+al. In the Bretton 6oods conference #$0 agreed to fix the parity of #$ &ollars in terms of gold 0t #$ F 3 P DG ounce and undertook con+ert dollar balances held by monetary authority of other countries freely into gold at the fixed rate and thereby maintain stability of the price of #$ dollars in terms of gold the central banks kept the exchange rate fluctuations within the permissible band by inter+iewing the market. :owe+er, if there was persistent fundamental dise7uilibrium in the B?! of the country the declared parity of the currency could be changes as agreed to by the IM . #nder this system, as the central banks were obliged to inter+ene in the market for keeping the exchange rate within Q3N of the declared parity, this necessitated maintenance of the foreign exchange reser+es by the central banks to inter+ene effecti+ely in the market as and when needed. If the foreign exchange reser+es held by the central banks to inter+ene effecti+ely in the market were not sufficient, member countries could draw from IM though. $pecial &rawing 'ights "$&'% and resort to other facilities extended by the IM , as and when needed. The B6$ of exchange rates collapsed because of persistent and high 0merican B?! deficit. 0nd thereafter came the O$mithsonian 0greement1, which also did not last for long. 0nd now there is loating 'ate system.
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F&oating Rate System

6ith the exit of fixed parities system countries experimented with different exchange rate systems. 0lmost all the industriali8ed countries depend some form of )Managed loat*. Dirty F&oat If the +alue of the floating currency is not determined solely by demand and supply but is managed by the central bank of the country through continuous inter+ention, the same is known as O&irty loat1. #nder this system central bank continually inter+enes the market. Cra*&ing 4eg If a country has an exchange rate arrangement under which it is able to effect de+aluation and re+aluation of its currency, such an exchange rate arrangement is known as crawling peg. Currency 4egging Many countries, particularly de+eloping countries chose to mo+e their exchange rate in lump sum with #$ dollar or pound sterling or to $&' or basket of chosen currencies. If the currency was pegged into the single currency, the +alue of the currency of that country changed in the international markets as the +alue of the currency to which it was pegged, or weighted a+erage of currencies in the basket mo+ed. This is known as Currency $egging. Many countries had adopted floating rate system with the hope that sooner than later some understanding would be reached amongst nations and again there would be an era of fixed exchange rates, but as the oil prices increased, resulting in high inflation followed by recession in subse7uent years causing B?! dise7uilibrium, the return of fixed exchange rates was ruled out.
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The Euro$ean !onetary System

The 2uropean monetary system began operating in 34-4. Its purpose was to foster monetary stability in the 2uropean community "29, or the 9ommon Market%. The main ob/ecti+es of the 2M$ were: To stabili8e the exchange rates between the currencies of member countries. To promote economic con+ergence in 2urope by persuading go+ernments of all member states to adopt to economic policies similar to those member who ha+e been successful in maintaining stability in their currencies by managing the macro.economic factors as well. To de+elop 2uropean economic and monetary union, with a single common currency to be known as 2#'?. 0s part of )The 2uropean Monetary system* the members ha+e established an 2uropean 9urrency #nit "29#%, which plays a pi+otal role in the functioning of 2M$. It is not only used as a reference for the central rates between the central banks, it also ser+es as the basis for working out the Odi+ergence indicator1 for the exchange rates in+ol+ed. The 2M$ exchange rates mechanism pro+ides that the member countries ha+e to take
@4

measures when their currencies rates against the 29# exceed a Odi+ergence threshold1 which is established at -GN of the maximum spread between the inter+ention points and the 29# central rate for each member currency. These measures include currency market inter+ention, changes in central rates, monetary and economic policy decisions aimed at stabili8ing exchange rates as agreed.
Currency 5as"et
Instead of linking their currencies with a single currency, some countries had linked their currencies with a basket of currencies. Iormally, the basket consists of the currencies of the countries who are trading partners and weight age to the respecti+e currencies is gi+en in accordance with trade figures. The ad+antage of such a linkage was that the exchange rates of the currency, linked to the basket or currencies, through and through other currencies do not depend on the fortunes of single currency and thus are more stable and balanced. ?n $eptember @G, 34-G rupee was de.linked from pound sterling and was linked to basket of currencies. The main ad+antage of linking a rupee with the basket of currencies was that it was no longer be dependent on the +agaries of a single currency and India was free to exercise its discretion to alter the currency components in basket without allowing market to speculate on rupee exchange rate. 'eser+e Bank announced the buying and selling rate for pound sterling which would keep the exchange rate stable as the 0.&1s had access to 'eser+e Bank for buying or selling unlimited amounts. Thus if the interbank market was selling pound sterling at more than the 'BI rate, the bank could buy from 'BI, at 'eser+e Bank1s rate which was at lower rate. This will push down the interbank exchange rate. $imilarly, if the interbank market were buying pound sterling at a lower rate than the 'BI rate, then bank would sell to 'BI at 'eser+e Bank1s buying rate which was higher rate. This will push the exchange rate upward. Thus the interbank market always remained within the rates announced by 'BI.
DK
The 'eser+e Bank, with a +iew to support exports, was buying #$&, ,B!, &2M and C2I, spot and forward. To maintain reasonable supply of F#$ spot and for sometime forward also. In +iew of this buying and selling rates of 'BI, which were acting as floor and ceiling rates, the interbank market remained within these rates. :owe+er, the main criticism of this system was that it did not allow market forces of demand and supply to determine the exchange rates. 6ith the liberali8ation wa+e sweeping through the real and financial sectors, it was only natural to allow the forces of demand and supply to determine exchange rates. The li7uidity crunch in 344K and 3443 on forex front only hastened the process. ?n March 3, 344@ the 'BI announced a new system of exchange rates known as Aiberalised 2xchange 'ate Management $ystem "A2'M$%.
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Forex & Risk Management Ei2era&ised Exchange Rate !anagement System +EER!S1
The main ob/ecti+e of introducing Aiberalised 2xchange 'ate Management $ystem "A2'M$% was to make balance of payments sustainable on ongoing basis by allowing market forces to play a greater role in determining exchange rate of rupee. 6hile introducing the new exchange rate system ,o+ernment of India and 'BI were led by the following considerations: 9ontaining current account deficit at sustainable le+el. Introducing an element of e7uilibrium in imports and exports on an automatic basis. Imparting necessary degree of flexibility in the exchange rate system. 2nsuring that the cost of imported goods did not rise too high or abruptly. (eeping capital outflows under control and effecti+ely monitor the same. 0s per A2'M$, the rupee became o+erall con+ertible for all appro+ed transactions. The exporters of goods and ser+ices and those who recei+ed remittances from abroad were allowed to sell bulk of their foreign exchange receipts i.e., 5KN of it at market determined rates. :owe+er, they were re7uired to surrender HKN of such receipts to the 'BI through 0uthorised &ealers at ?fficial rate "?'% announced by the 'BI. $imilarly, those who needed foreign exchange to import and tra+el abroad were to buy foreign exchange and trade control regulations in force. In cases of certain essential items of imports, the 'eser+e Bank made a+ailable foreign exchange at official rate. $ubse7uently, in March 344D, the A2'M$ was replaced by the unified exchange rate system and hence the system of market determined exchange rate was adopted. :owe+er, the 'BI did not relin7uish its right to inter+ene in the market to enable orderly control.
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In addition, the foreign exchange market of India was characteri8ed by the existence of both official and black market rates with median premium. :owe+er, such black market premium steadily declined during the following decades until 344D.
FUNDA!ENTAES IN EAC@ANBE RATE

Typically, rupee "II'% a legal lender in India as exporter needs Indian rupees for payments for procuring +arious things for production like land, labour, raw material and capital goods. But the foreign importer can pay in his home currency like, an importer in Iew Cork, would pay in #$ dollars "#$&%. Thus it becomes necessary to con+ert one
DD

currency into another currency and the rate at which this con+ersation is done, is called O2xchange 'ate1. 2xchange rate is a rate at which one currency can be exchange in to another currency, say #$& 3 P 's. H@. This is the rate of con+ersion of #$ dollar in to Indian rupee and +ice +ersa.
!ethods O# Fuoting Exchange Rates

There are two methods of 7uoting exchange rates. Direct method: or change in exchange rate, if foreign currency is kept constant and home currency is kept +ariable, then the rates are stated be expressed in O&irect Method1 2.g. #$ F3 P 's. H4.DHKK. Indirect method: or change in exchange rate, if home currency is kept constant and foreign currency is kept +ariable, then the rates are stated be expressed in OIndirect Method1. 2.g. 's. 3KK P #$ F @.K@5= In India, with the effect from 0ugust @, 344D, all the exchange rates are 7uoted in direct method, i.e. #$ F3 P 's. H4.DHKK ,B!3 P 's. 54.=-KK
!ethod O# Fuotation
DH

It is customary in foreign exchange market to always 7uote tow rates means one rate for buying and another for selling. This helps in eliminating the risk of being gi+en bad rates i.e. if a party comes to know what the other party intends to do i.e., buy or sell, the former can take the latter for a ride. There are two parties in an exchange deal of currencies. To initiate the deal one party asks for 7uote from another party and the other party 7uotes a rate. The party asking for a 7uote is known as O0sking party1 and the party gi+ing 7uote is known as ORuoting party1 The ad'antage o# t*oG*ay ?uote is as under: The market continuously makes a+ailable price for buyers and sellers. Two.way price limits the profit margin of the 7uoting bank and comparison of one 7uote with another 7uote can be done instantaneously. 0s it is not necessary any player in the market to indicate whether he intends to buy of sell foreign currency, this ensures that the 7uoting bank cannot take ad+antage by manipulating the prices. It automatically ensures alignment of rates with market rates. Two.way 7uotes lend depth and li7uidity to the market, which is so +ery essential for efficient. In two.way 7uotes the first rate is the rate for buying and another rate is for selling. 6e should understand here that, in India, the banks, which are authori8ed dealers, always 7uote rates. $o the rates 7uote ; buying and selling is for banks will buy the dollars from him so while calculation the first rate will be used which is a buying rate, as the bank is buying the dollars from the exporter. The same case will happen in+ersely with the importer, as he will buy the dollars form the banks and bank will sell dollars to importer.
DG
Forex & Risk Management 5ase Currency

0lthough a foreign currency can be bought and sold in the same way as a commodity, but they1re us a slight difference in buying>selling of currency aid commodities. #nlike in case of commodities, in case of foreign currencies two currencies are in+ol+ed. Therefore, it is necessary to know which is the currency to be bought and sold and the same is known as OBase 9urrency1.
5id And O##er Rates

The buying and selling rates are also referred to as the bid and offered rates. In the dollar exchange rates referred to abo+e, namely, F 3.5@4K>4=, the 7uoting bank is offering "selling% dollars at F 3.5@4K per pound while bidding for them "buying% at F 3.5@4=. In this 7uotation, therefore, the bid rate for dollars is F 3.5@4= while the offered rate is F 3.5@4K. The bid rate for one currency is automatically the offered rate for the other. In the abo+e example, the bid rate for dollars, namely F 3.5@4=, is also the offered rate of pounds. The following table gi+es the exchange rates 7uoted for the dollar "against some of the ma/or currencies% on ebruary 3@, 3444 as reported by the inancial Times, Aondon: COUNTRY United ingdom #$& per ,B! Canada 9anadian &ollar per #$& Euro&and #$& per 2#'? ,a$an Cen per #$& DAY>S S4READ 3.5D3K ; 3.5@3CEOSE 3.5@4K ; 3.5@4=
3.H4H@ ; 3.H==5
3.H4D@ ; 3.H4H@
3.3@=5 ; 3.3@3G
3.3@-5 ; 3.3@=K
33G.-G ; 33D.==
33G.@= ; 33D.DD
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The term )bid and offered rates* is also pre+alent in the money market. or example, if a bank 7uotes an interest rate of G.3>@ > G>= for six.month dollar deposits, it con+eys that the bank is willing to accept a six.month dollar deposit at G.3>@ per cent while it is willing to place deposits of the same duration at G.G>= per cent per annum. In the market /argon, it is bidding for deposits at G.3>@ "the bid rate% while offering deposits at G.G>= "the offered rate%. Interest on &oans o##ered in these mar"ets is o#ten &in"ed to the Eondon InterG5an" O##ered Rate +EI5OR1<
S$ot And For*ard Rates: Ha&ue Dates

2+ery forex transaction in+ol+es exchange of two currencies by the counter parties to the transaction. ?ne party, for example, recei+es dollars in Iew Cork and pays out rupees in Mumbai. The counterparty pays out dollars and recei+es rupees in respecti+e centres. The date on which the exchange of currencies is to place is the )+alue date* of the transaction. In theory, the essential principle of +alue compensee "compensated +alue% re7uires the currencies to change hands at the same point of time. In practice, this is not possible because of time differences in the two centres. :ence the use of +alue dates, i.e. currencies must be paid and recei+ed on the same day. 6orldwide, standard nomenclatures and practices are pre+alent to determine the +alue date of exchange contracts, namely the date on which the two currencies in+ol+ed in an exchange transaction changes hands. $ince money in any currency has a time +alue, namely interest, the +alue date of a foreign exchange transaction will ha+e to be a working day in both the centres where the money transfers are to take place, e.g. rupees being paid in Mumbai, and dollars being recei+ed in Iew Cork. If either if the two centres has a holiday on a particular day, its date cannot be a proper +alue date for a dollar rupee transaction. The standard notations for the +alue dates are ;
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'eady or cash ; +alue today Tomorrow ")tomm*% ; +alue tomorrow, or next working day $pot ; +alue two business days after the trading date "one business day for 9an F : #$ F transaction and F : Cen contracts in the east%. Thus, for a spot transaction done Monday, currencies will change hands the following 6ednesday assuming this is a working day in both the centres. $imilarly, for a spot transaction done Thursday, currencies will change hands the following Monday, there being no forex transaction on $aturdays and $undays. 6hile the definition of )spot* maturity seems straight forward, in practice some difficulties crop up because of different holidays at different centres, particularly in case of cross currency "i.e. neither currency is home currency of the centre% trades. 9onsider a dollar: euro trade in Aondon on a riday. In the normal course settlement will be on the following Tuesday if this is a business day in Aondon, Iew Cork rankfurt "The euro will change hands in rankfurt and the dollars in Iew Cork%. If Tuesday happens to be a holiday in nay of the three centres, then settlement will be postponed to 6ednesday. But what if Monday, not Tuesday, is a holiday in AondonS In that case a specific settlement date date is agreed by the counterparties, generally the )spot* day for the bank initiating trade. For*ards - any 'a&ue date 2eyond s$ot< The rules for determining +alue dates of standard maturities of forward transaction are as follows ; 3. In general, the value date of a one !onth for"ard contract "ill #e the date in the next !onth corresponding to the $spot% value date& Aet us consider a transaction done on Monday, the 3= th Banuary 3444. The +alue date for a spot transaction will be 6ednesday the @K th Banuary and the
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+alue date of a one.month forward transaction undertaken on 3=th Banuary will be @Kth ebruary. @. If the value date so calculated happens to #e a holiday in either centre 'as it is in the a#ove case, ()th *e#ruary +,,, #eing a Saturday-, the su#se.uent "or/ing day& In this case, @@nd ebruary 3444 will be the +alue date for a one.month transaction. :owe+er, if this means a change of month, the preceding work would become the +alue date. or example, for a transaction in+ol+ing rupees done on Monday, @G th Banuary 3444, spot date must be @=th Banuary, @5th Banuary being a holiday in India. the one month forward transaction will therefore ha+e, by rule "i%, @= th ebruary as the +alue date. But this happens to be a $unday. The subse7uent working date is 3st March , but this means a change of month. Therefore, the preceding working date, namely @5th become the +alue date for one.month forward contract. D. The rule of $no change in the !onth% also applies in cases "here the !onth in .uestion does not have a date corresponding to the spot date& or instance, the spot date for a transaction done on 6ednesday @- th Banuary 3444 will be @4th Banuary. $ince there is no such date as @4th ebruary 3444, the one month forward contract will mature on @= th ebruary. But this happens to be a $unday. $o the +alue date for a one. month contract done on @-th Banuary 3444 will be @5th ebruary. In fact for one month transactions done against the rupee on any day between @@ nd Banuary to @-th Banuary 3444, the +alue date is @5th ebruary, through a combination of rules "ii% and "iii%. H. There is another exception in cases "here the spot date is the last date of the !onth& In that case, the +alue date for a one.month forward contract is the last working day of the subse7uent month. "If spot is @= th ebruary, one month forward will be D3st ; and not @=th March% ebruary, would
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"In the abo+e example, holidays other than @5th Banuary, $aturdays and $undays ha+e been ignored. 0lso, the same rules apply to two, three, four months1 forwards.% 6hile the rules appear somewhat complicated, it is essential to understand them thoroughly. They go+ern not only the +alue dates of standard maturity of forward exchange contracts, but also the maturities of one month>two months, etc., deposits in the offshore market. orward transactions can also be structured to gi+e one of the parties to the transaction an option to determine any +alue date within a prescribed period. $uch options are re7uired because the party may not know in ad+ance the precise date on which he would be able to deli+er the currency. ?ne example of this would be an exporter desiring to sell forward foreign currency to his bank, but not knowing in ad+ance the precise date of shipment, after which he has a foreign currency claim on his buyer. In India, the option period is limited to a month.
Cross Rate Ca&cu&ation

Most trading in the world forex markets is in the terms of the #$ dollar ; in other words, one leg of most exchange trades is the #$ currency. Therefore, margins between bid and offered rates are lowest 7uotations if the #$ dollar. The margins tend to widen for cross rates, as the following calculation would show. 9onsider the following structure: ,B! 3.KK P #$& 3.5@4K>4= 2#' 3.KK P #$& 3.3@-5>=K
HK

In this rate structure, we ha+e to calculate the bid and offered rates for the euro in terms of pounds. Aet us see how the offered "selling% rate for euro can be calculated. $tarting with the pound, you will ha+e to buy #$ dollars at the offered rate of #$& 3.5@4K and buy euros against the dollar at the offered rate for euro at #$& 3.3@=K. The offered rate for the euro in terms of ,B!, therefore, becomes 2#' "3.5@4KT3.3@=K%, i.e. 2#' 3.HHH3 per ,B!, or more con+entionally, ,B! K.54@G per euro. $imilarly, the bid rate the euro can be seen to be 2#' 3.HHGH per ,B! "or ,B! K.543= per euro%. Thus, the 7uotation becomes ,B! 3.KK P 2#' 3.HHH3>GH. It will be readily noticed that, in percentage terms, the difference between the bid and offered rate is higher for the 2#': pound rate as compared to dollar: 2#' or pound: dollar rates.
For*ard Rate Ca&cu&ation

The interest parity principle can be used to calculate forward rates. or these calculations, it is essential to remember the way in which the maturity dates of spot and forward transactions are calculated and work out the interest for the actual number of days in+ol+ed. ?n riday, 3@th ebruary 3444, the spot rate for euros was 2#' 3.KK P #$& 3.3@-5>=K. That day1s spot transaction would mature on Tuesday, the 35th ebruary, 3Dth and 3Hth being $aturday and $unday. Therefore, a one month forward transaction "or deposit% contracted on riday 3@th ebruary would mature only on 35th March, i.e. @= days after the spot date "i.e. the date on which the currency will be deposited%. The one month offshore market interest rates pre+alent on the 3@ th ebruary for spot maturity transactions were as follows: #$& H.@->D@ 3G>35N p.a. 2#' D.3>35 G>D@N p.a. 6e can now proceed to calculate the forward rates. The steps in+ol+ed to calculate the offered rate for euros would be as follows:
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Borrow #$& 3.3@=K for one month in the spot market on the 3@ th ebruary at H. 3G>35. Buy euros spot at #$& 3.3@=K per 2#'. &eposit euros for one month at D.3>35 per cent. "It should be noted that all the abo+e transactions ha+ing done in the spot market on the 3@th ebruary, currencies will change hands on the 35th ebruary%. 9alculate the forward rate by e7uating the maturing amount of principal and interest in the two currencies ; remember, interest has to be calculated for @= days and, as is the practice for both dollars and euros, on a D5K.day year basis. "Iote that for borrowings and buying euros the rates used are the market1s )offered* ratesM similarly the )bid* rate for euro deposits has to be used to calculate the interest on the euro deposit% 0ssuming that #$& 3.3@=K was borrowed, the principal and interest to be repaid on maturity would be F 3.3D@D on 35th March as follows: #$& 3.3@=K Q #$& U"3.3@=K T H.4D-G T @=% > "3KK T D5K%V P #$& 3.3D@D ?n the other hand, the deposit of euro 3.KK at D.3>35 per cent would fetch 2#' 3.KK@H as follows: . 2#' 3.KK Q 2#' U"3.KK T D.K5@G T @=% > "3KK T D5K%V 27uating the two, the offered one.month forward rate for the euro, therefore, comes to #$& "3.3D@D> 3.KK@H% or F 3.3@45.
H@
0 contract can now be entered into to sell 2#' 3.KK@H, deli+ery 35 th March, at #$& 3.3@45 per euro on a fully hedged basis. The receipt of this comes to F 3.3@43 per 2#'. The one.month forward 7uotation therefore is F 3.3@43>45. It will be noticed that the margin between the bid and offered rates is higher than for the spot rate. In practice, this widening of margins can used to determine whether a forward margin is a premium or discount. The spot rate is #$& 3.3@-5>=K per 2#' and the one.month forward margin is 7uoted as K.3G>35 cents. 6e are not sure whether this is a premium or a discount on the euro. If it were a discount on the euro, forward euros would be cheaper. The forward rate would therefore be #$& 3.3@53>5H per euro, deducting the margin from the spot rate. That case the spread is actually lower "D )basis* points%. $ince the spread on forwards has to be wider, the margin cannot be a discount. 9onsidering it as a premium we get the forward 7uote as #$& 3.3@43>45 per euro, and this is the correct position. ?n other point should be noted as regards the calculation of forward rates using the money market route. 9onsider how the offered rate for euros was calculated ; the money market position was )short* in dollars "represented by the borrowing% and )long* in euros "represented by the deposit%. Iow, an offer can be made for euros against dollars ; the maturing euro deposit can be paid out in meeting the offered euros while the incoming dollars will be used to repay the dollars borrowed, ending to with a s7uare position. In other words, in the money market you are )long* in the currency you ha+e to pay out and )short* in the currency the counterparty is to pay you. 0gain, the amount to be borrowed>deposited has to e such that, together with interest, it e7uals the contract amount. In the abo+e example, if you are writing a contract to offer a million euros at #$& 3.3@45, the euro deposit plus interest thereon should total 2#' 3 mn. $o the euros to be bought with the dollar borrowing need to be 2#' 44-,5@H, which with interest at
HD

D.K5@GN p.a. becomes 2#' 3 mn in @= days. The principal amount of the dollar borrowing needed is therefore F "44-,5@H T 3.3@=K% or N 3,3@G,D@K. For*ard Rates To Customers: Non - Do&&ar Currencies The market one.month forward fixed date deli+ery euro: rupee rates can be calculated by crossing the one.month forward F>2#' exchange rates "#$& 3.3@43>45 per euro% with one month forward 's.>F exchange rates "'s. H@.G= > H@.5= per F% calculated earlier as follows: Sa&e. or o##ered. rate 4urchase. or 2id. rate
For euros against ru$ee For euros against ru$ee H@.5@T3.3@45 's H=.3HD5 H@.G=T3.3@43 's H=.K--3 The customer rate would be arri+ed after loading the appropriate margin and rounding off ; say 's. H-.4= > H=.@H. 2arlier, we had calculated the one.month dollar: euro rate as #$& 3.3@43>45. This was of course for deli+ery on a fixed day ; namely 35 th March 3444 and the dollar was at a discount +is.W.+is the euro. If the two.month forward rate was, say, #$& 3.3DK5>3@ per 2#', the bid and offered second month option rates for the euro would be #$& 3.3@43>3.3D3@. "i.e. the bid, or buying , rate for the euro includes one month1s premium on the euro while the offered, or selling, rate for the euro includes the full two months1 premium%. The spread between the bid and the offered rates is now much wider ; a cost the counterparty pays for the flexibility of choosing the +alue date for the transaction on any day in the second month. For*ard Rate C S$ot Rate I 4remium ) G Discount In foreign exchange market forward transaction are necessary for following reasons: ?ne can hedge or co+er an existing future financial, commercial or trade related exchange risk.
HH
These types of deals, in combination of spot deals, are used for money market operations through O$60! transactions1. Taking a +iew of the market, these can be used for speculation
4remium
6hen a currency is costlier in future "forward% as compared to spot, the currency is said to be at premium +is.W.+is another currency. In O&irect 'ate1 premium is always added from both buying and selling rate and in OIndirect 'ate1 premium is always deducted to both buying and selling rate.
Discount
6hen a currency is cheaper in future "forward% as compared to spot, the currency is said to be at discount +is.W.+is another currency. In O&irect 'ate1 discount is always deducted from both buying and selling rate and in OIndirect 'ate1 discount is always added to both buying and selling rate. It can be mentioned here that to a+oid confusion, it is the base currency for which the premium>discount is always mentioned. Factors A##ecting 4remium)Discount orward differentials are relati+ely but are not constant and therefore, +ary from time to time. The following factors affect forward differentials:
HG
7< Su$$&y and demand #or the currency #or a sett&ement date< If for a currency for a particular settlement date, there are more buyers than sellers the forward differential will go up. $imilarly, if a currency for a particular settlement date, there are more sellers then buyers the forward differential will go down. This is all the more true when there is restriction of capital flows. /< !ar"et ex$ectation Market expectations about the de+elopment in interest differentials and exchange rates of the currencies on account of +arious factors. :< Interest rate di##erentia&s Interest rate differentials between the currencies exchanged. In fact, this is the only factor, which affects the forward differentials pro+ided capital flows are free from restrictions. orward differentials are a function of interest differentials and if they are at +ariance with each other they will gi+e rise to Oarbitrage1 opportunities. This is based on simple logic of trade off between interest earned on one currency and opportunity foregone to earn interest in another currency. I&&ustration: S$ot US3 7 C DE! 7<J000 Interest #$F X D N per annum, &2M X 5 N per annum.
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In the abo+e scenario, there is an opportunity for arbitrage if the exchange rates remain the same for a period of one year. ?ne can borrow #$F 3KK for one year X D N per annum, con+ert it into &2M and place the same deposit for one year X 5N. The cash flows for the transaction will be as under: US3 5orro*s +s$ot1 K : L Se&&s US3 s$ot against DE! 4&aces DE! on de$osit #or one year K 6L Tota& recei$t o# DE! a#ter one year 4ays interest in US3 Tota& $ayment in US3 Con'erts DE! in US3 K 7<J and recei'es US3 Net gain . 3KK .D . 3KD Q 3K5 D DE! Q 3GK Q4 Q 3G4 . 3G4
Thus, a person can make #$F D in 3 year by borrowing #$F 3KK for 3 year X D N p.a., con+ert it into &2M and lace the same as deposit for 3 year X 5N. :owe+er, we ha+e presumed that exchange rate remains the same. The forward exchange rate of #$F>&2M will be ad/usted by market forces to eliminate arbitrage opportunities. Therefore, #$F>&2M rate would be the same. #$F 3KD P &2M 3G4 Therefore, #$F 3 P &2M 3.GHD5 Thus K.KHD5 represents the forward differential between spot and one year. It may be noted that #$F is at a premium against &2M.
!erchant Rates
H-

The exchange rates 7uoted by 0uthori8ed &ealers in India, for transactions with merchants are known as OMerchant 'ates1. The rates 7uoted by banks for dealing in interbank market are known as OInter bank rates1. There are four types of merchant rates that are used in India TT "Buying% 'ate TT "$elling% 'ate Bill "Buying% 'ate Bill "$elling% 'ate
Factors A##ecting Exchange Rates
H=

In a free market, it is the demand and supply of the currency which should determine the exchange rates but demand and supply is the dependent on many factors, which are ultimately the cause of the exchange rate fluctuation, some times wild. The +olatility of exchange rates cannot be traced to the single reason and conse7uently, it becomes difficult to precisely define the factors that affect exchange rates. :owe+er, the more important among them are as follows Balance of payments. $trength of economy. iscal policy.
Interest rates. Monetary policy. !olitical factor. 2xchange control. 9entral bank inter+ention. $peculation. Technical factors. 2xpectation of the foreign exchange market.
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FOREIBN EAC@ANBE RIS

Cour business is open to risks from mo+ements in competitorsE prices, raw material prices, competitorsE cost of capital, foreign exchange rates and interest rates, all of which need to be "ideally% managed.
GK

This section addresses the task of managing exposure to oreign 2xchange mo+ements. These 'isk Management ,uidelines are primarily an enunciation of some good and prudent practices in exposure management. They ha+e to be understood, and slowly internalised and customised so that they yield positi+e benefits to the company o+er time. It is imperati+e and ad+isable for the 0pex Management to both be aware of these practices and appro+e them as a policy. ?nce that is done, it becomes easier for the 2xposure Managers to get along efficiently with their task.
Foreign Exchange Ex$osure

oreign exchange risk is related to the +ariability of the domestic currency +alues of assets, liabilities or operating income due to unanticipated changes in exchange rates, whereas foreign exchange exposure is what is at risk. oreign currency exposure and the attendant risk arise whene+er a business has an income or expenditure or an asset or liability in a currency other than that of the balance. sheet currency. Indeed exposures can arise e+en for companies with no income, expenditure, asset or liability in a currency different from the balance.sheet currency. 6hen there is a condition pre+alent where the exchange rates become extremely +olatile the exchange rate mo+ements destabili8e the cash flows of a business significantly. $uch destabili8ation of cash flows that affects the profitability of the business is the risk from foreign currency exposures.
!ar"et Forecasts
After deter!ining its Exposures, the co!pany has to for! an idea of "here the !ar/et is headed& The company will focus on forecasts for the next 5 months, as forecasts for periods beyond 5 months can be unreliable.
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The focus of the 0pex Management is to be aware of the &irection or the Big Trend in rates. The underlying assumptions behind the forecasts the !robability that can be assigned to the forecast coming true the possible extent of the mo+e The 'isk 0ppraisal exercise and Benchmarking decisions will be based on such forecasts.
@edging
This is the !ost visi#le and gla!orised part of the Exposure 0anage!ent function& Ho"ever, the Trader is li/e the 1river in a car rally, "ho needs to follo" the general directions of the 2avigator& :edging strategies will be designed to meet the 2xposure Management ob/ecti+es, as represented by the Benchmarks The 2xposure Management 9ell will be accorded full operational freedom to carry out the hedging function on a day.to.day basis
:edges will be undertaken only after appropriate $top.Aoss and Take.!rofit le+els ha+e been predetermined The company will use all hedging techni7ues a+ailable to it, as per need and re7uirement. In this regard, it will pass a Board 'esolution authorising the use of the following: 3. 'upee. oreign 9urrency orward 9ontracts @. 9ross 9urrency orward 9ontracts D. H. orward.to. orward 9ontracts '0s
G. 9urrency $waps
G@

5. Interest 'ate $waps -. 9urrency ?ptions =. Interest 'ate ?ptions 4. ?thers, as may be re7uired Suggestion: Indian companies with si8eable #$ &ollar denominated exposures are extremely +ulnerable to sudden drastic mo+es in the #$&.II' rate. They can, to an extent, insulate themsel+es from such shocks by undertaking hedges in currencies other than 'upee. &ollar. or instance, a &ollar payable can be hedged by selling a currency "say $terling !ound% in order to buy &ollars, instead of selling the 'upee. The choice of currency would, of course, depend on the trend and forecast for the currency"s% at that point of time. It is easier and safer to generate profits from a 9ross.9urrency orward 9ontract and a 's 3 Aac profit thereon is e7ui+alent to sa+ing a 3K paise depreciation in the 'upee "on #$& 3 million%
Sto$ Eoss
2xposure Management should not be undertaken without ha+ing a $top.Aoss policy in place. 0 $top.Aoss policy is based on the following two fundamental principles: 3. To err is human @. 0 stitch in time sa+es nine It is appropriate to recount here some words from a speech &r 0lan ,reenspan, 9hairman of the #$ ederal 'eser+e, deli+ered in &ecember 344-, on the 0sian financial crisis. :e says,
GD
)There is a significant bias in political systems of all +arieties to substitute hope "read, wishful thinking% for possibly difficult pre.empti+e policy mo+es. There is often denial and delay in instituting proper ad/ustments 'eality e+entually replaces hope and the cost of the delay is a more abrupt and disrupti+e ad/ustment than would ha+e been re7uired if action had been more pre.empti+e. 6hether an 2xposure is hedged or not, it is assumed that the decision to hedge> not to hedge is backed by a View or orecast, whether implicit or explicit. 0s such, $top Aoss is nothing but a commitment to re+erse a decision when the +iew is pro+en to be wrong.
Suggestions: $top Aosses should be acti+ated when 9ritical le+els in the rate being monitored are reached, which clearly tell that the +iew held has been pro+en wrong. The factors> assumptions behind a +iew either change or are pro+en wrong. The 2xposure Manager should be accorded flexibility to set appropriate $top.Aosses for each trade. The 2xposure Manager should, howe+er, make sure he has set a stop.loss for positions he enters into, on an a priori basis.
6hile Benchmarks will be based upon the Big Trend and will incorporate a certain amount of room for error, the 2xposure Manager should be careful to not +iolate the Benchmark on the wrong side.
GH
Re$orting and Re'ie*

There needs to be continuous monitoring whether the 2xposures are headed where they are intended to reach. 0s such, the 2xposure Management acti+ities need to be reported and re+iewed. Re$orting The 2xposure Manager will prepare the following 'eports on a regular basis: %hat it sho*s Re$ort Name MTM 'eport 2xposure I0V 'eport V0' 'eport The Mark.to.Market !rofit> Aoss status on ?pen orward 9ontracts The 0ll.in.all exchange> interest rate achie+ed on each 2xposure, and profitability +is.a.+is the Benchmark 2xpected changes in o+erall 2xposure due to forecasted exchange> interest rate mo+ements 4eriodicity &aily, closing
ortnightly Monthly
Revie" 0 monthly 'e+iew meeting will consider the following:
Issue
On the 2asis o#
4oints to 2e re'ie*ed
GG

2xposure !erformance 2xposure I0V 'eport Is the Benchmark being met> betteredS 6hat are the chances of the Benchmark being +iolated on the wrong sideS 'easons for Benchmark being +iolated on wrong side Market $ituation 'e+iews of market de+elopments orecasts of market mo+ements Benchmarking :edging $trategy ?perational issues The abo+e two MTM and 2xposure I0V 'eports 2xposure ManagerEs experiences &oes the Benchmark need to be changedS Is the strategy working wellS ?r does it need to be finetuned> o+erhauledS ?perational problems to be sol+ed Is the Big Trend still in placeS ?r has it changedS
Bro*th In Foreign Currency Ex$osure

0lmost all corporate treasurers ha+e found foreign currency exposure management the most difficult, onerous, indeed terrifying challenge, but perhaps also the most exciting, and occasionally e+en a rewarding acti+ity. The sheer discipline of ha+ing to watch almost e+ery aspect of world news e+ery day is itself demanding, yet fascinating. This is essential whether you are trading foreign currencies for profit on a daily basis as a few large companies do, or you are deciding whether and when to establish or change a three. month, 3@ month or fi+e year hedged position.
G5

9ompare the scene today with fi+e or ten years ago. More and more companies are trading and in+esting outside their home territories. Volatility of exchange rates Increased +isibility of foreign exchange losses. or example, $hell F3G=Km using Y forwards, (ashima ?il F3HGKm using currency deri+ati+es and 0llied Ayons F@-Gm using currency options Increasingly, more fund managers in a growing number of countries are in+esting in foreign securities. #p to the early 34=Ks imbalances in trading flows seemed to dri+e currencies. Today globalisation and the remo+al of constraints on the mo+ement of capital in most ?29& countries means that capital flows seem to be much more influential. 9oordinated inter+ention by central banks, or the threat of such, pro+ides some stabilisation, but no certainty. &eep secondary markets in futures and options again pro+ide some balancing effect, but a factorial increase in sophistication. ey terms in #oreign currency ex$osure It is important that you are familiar with some of the important terms which are used in the currency markets and throughout these sections: De$reciation G A$$reciation &epreciation is a gradual decrease in the market +alue of one currency with respect to a second currency. 0n appreciation is a gradual increase in the market +alue of one currency with respect another currency. So#t Currency - @ard Currency
G-

0 soft currency is likely to depreciate. 0 hard currency is likely to appreciate.
De'a&uation G Re'a&uation &e+aluation is a sudden decrease in the market +alue of one currency with respect to a second currency. 0 re+aluation is a sudden increase in the +alue of one currency with respect to a second currency. %ea"en G Strengthens If a currency weakens it losses +alue against another currency and we get less of the other currency per unit of the weaken currency ie. if the Z weakens against the &M there would be a currency mo+ement from @ &M>Z3 to 3.= &M>Z3. In this case the &M has strengthened against the Z as it takes a smaller amount of &M to buy Z3. Eong 4osition - Short 4osition 0 short position is where we ha+e a greater outflow than inflow of a gi+en currency. In Y short positions arise when the amount of a gi+en currency sold is greater than the amount purchased. 0 long position is where we ha+e greater inflows than outflows of a gi+en currency. In Y long positions arise when the amount of a gi+en currency purchased is greater than the amount sold.
G=
Foreign Exchange Strategies +#x1 and Techni?ues

In simple terms, oreign 2xchange 2xposure occurs when business takes place in a
currency other than your base currency. But not necessarily /ust then. 0ny company selling products o+erseas or importing goods from abroad has a foreign exchange exposure. Indeed, e+en a company manufacturing and selling only in one country can ha+e a significant degree of economic exposure to changing foreign exchange rates. It must be noted that a sterling based company doing business in the domestic marketplace will suffer foreign exchange exposure if any of its competitors are based in a foreign country e+en though prices are in sterling. or example, a #( +ideo manufacturer making e7uipment sourced entirely from the #( parts and sold entirely to the #( market has a Bapanese Cen exposures if the company has Bapanese competitors, because a weak Bapanese Cen "unlikely recently% gi+es his Bapanese competitors in the #( market an ad+antage. or a group such as I9I, with manufacturing plants in HK countries, selling organisations in another 5K and sales in at least 3GK of the 35K or so so+ereign states, the management of foreign exchange risk has long been a task of the treasury function. The im$ortant ?uestions raised 3. 6hat types of exposure are to be managedS There are three main types of risk, which we will consider in a later section. 6e must analysis this exposure and the company should ha+e a clear policy and direction from the Board. 9ompanies may differ in the way they conceptualise foreign exchange risk "especially economic exposure%. The industry type will sometimes shape the way the treasurer +iews the exposure. 2xposures can gi+e rise to cash flow effects and others are accounting "affecting financial statements%. $ince these positions are sub/ect to rapid change. 9hanges in foreign currencies need to be anticipated. @. 6hat sources of financial information should your company ha+e in identifying their exposureS 6hat currency>interest rate expertise input is there when marketing>purchasing decision are madeS :ow effecti+e are the company and
G4

their ad+isors at forecasting future currency ratesS The time hori8on of the information sources is important. The extent to which a company belie+es it can forecast exchange rate mo+ements will be a basic determinant of its risk management positions. D. 6hat is the companyEs attitude to riskS The company may choose to hedge e+erything or nothing. This will be discussed in the next section. H. 6hich exposure reducing techni7ues should it employS 6hat knowledge of instruments and what they achie+e does the treasurer ha+eS, $hould we use internal or external instrumentsS. 6hat controls should be placed on these proceduresS Budgement of risk and reward and feedback of the results of the strategy adopted. 0nswers to these 7uestions will build up a picture of what is re7uired and will highlight the conflict, which will need to be resol+ed in order to settle on a sensible and efficient approach to exposure management.
Com$any strategy to current ris"

0 common problem in managing currency risk is that companies only realise that they ha+e a risk when the exposure has been generated. :owe+er, currency risk management
5K

should begin before exposure risks ha+e been generated otherwise fundamental operating decisions ha+e been taken on the basis of complete information. 9ompanies approaches to exposure +ary widelyM perhaps by the nature of the business, the competition or the culture of the company. 0 company could accept a high degree of risk and expect commensurate returns or it could be +ery risk a+erse and be prepared to pay 7uite a high price for certainty. Indeed it may ha+e no stance on currency at all and take e+erything as it comes with a Eswings and roundaboutsE approach. If a company decides to take an acti+e approach to foreign currency management this will centre around the concept of hedging. :edging a particular currency exposure means establishing an offsetting currency position such that whate+er is lost or gained on the original currency exposure is exactly offset by a corresponding foreign exchange gain or loss on the currency hedge. Volatile foreign earnings can cause +olatile growth which is more costly than slow stable growth. :edging can reduce the companyEs +olatility of cash flows because the companyEs payments and receipts are not forced to fluctuate in accordance with currency mo+ements. This can, in the extreme, reduce the possibility of bankruptcy and therefore allow easier access to credit and lower interest payments due to lower percei+ed risk. :edging should also allow for greater certainty about future receipts and payments and conse7uently enhanced budgetary decisions. Most hedging strategies are costly in terms of fees, premiums or the time in+ol+ed.
@edging in'o&'es ta"ing an e?ua& and o$$osite $osition to the asset or &ia2i&ity *hich is ex$osed< 2xposed asset "or liability% loses +alue the hedge compensates by increasing in +alue. 2xposed asset "or liability% gains +alue, the hedge compensates by decreasing in +alue. :owe+er, it is often not as clear.cut as hedging can in+ol+e different policies: Static @edging . where the o+erriding concern to a+oid risk.
53

Dynamic hedging . where we Ltake a +iewL and can foresee an opportunity to make a gain in market and acti+ate the hedging policy accordingly. The treasurerEs approach will depend on Management attitude to risk. The policy in hedging or co+ering can range from lea+ing the risk entirely open "KN co+er% to a fully co+ered position "3KKN%. No co'er $ome treasurers will argue that they do not manage foreign exchange risk as exchange mo+ements should be matched by price mo+ements according to the purchasing power parity theory. The !urchasing !ower !arity theory specifies a precise relationship between relati+e inflation rates of two countries and their exchange rate. Thus although the price of imports will increase if the home currency depreciates the cost of producing domestically should also increase due to inflation. or this argument to be +alid purchasing power parity must hold and e+en if it does hold the time hori8on o+er a long period this may not help the importer in the short term. There are si8able de+iations for the theory in the real world. 0nother argument for deciding to do nothing in relation to foreign currency risk is that forecasting the direction of foreign exchange mo+ements is as close to a 8ero sum gain as you can get "in the long term a+erage foreign exchange gains will cancel out foreign exchange losses% $hareholders should be left to make their own /udgments about the effect of currency mo+ements on their companyEs profits. This assumes that the shareholderEs ha+e complete information and are able to access the hedging markets. It also assumes that company can sur+i+e in the long term and the company will not be sent into foreign exchange recei+ership because of foreign exchange losses before it recei+es any gains. 0lternati+ely, some companies may not hedge because they do not consider it will ha+e a significant material impact on their cash flows. 700L Co'er
5@

#nder this system the company would tend to hedge most or all their net positions in the foreign currency. ?f course not all of this hedging will be beneficial, in fact it is argued that such a policy will on a+erage result in the same cash flows and outflows as not hedging. :owe+er, it does pro+ide the ad+antages of knowing with certainty future cash inflows and outflows in the home currency and this should aid company planning in such areas as pricing and profit margins. A'eraging 0 treasurer who feels they can estimate the future sales re+enue of the company fairly accurately may choose to dampen the effects of +olatile exchange rates by co+ering a proportion of a year1s expected receipts o+er a number of preceding years.
or example, the following company estimates rench sales in 3445 to be @KK million. They base their hedging on a+erage of rates of the pre+ious four years.
$ales 'e+enue for in 3445
Cear in which co+er was taken out for a percentage of 3445Es re+enue
344G GKm @KKm . $plit @GN into the pre+ious four years @GN
344H GKm @GN
344D GKm @GN
344@ GKm @GN
'ate achie+ed in 3445
5D

@GN of each of the rates for 344@ 0t the a+erage >Z 2xchange rate 3@ 33 3K.G 3K to 344G. 'ate achie+ed is therefore 3K.=-G
O$$ortunistic @edging $ome companies will choose to hedge only in those situations in which they expect a currency to mo+e in a direction that will make hedging feasible ie only hedge future foreign currency payments when they expect appreciation in the foreign currency.
4ercentage Co'er 9o+ers percentage of known currency which allow uncertainty in forecasting currency +olumes. $uch uncertainty will be greater o+er longer periods. Se&ecti'e @edging #nder this policy the treasurer would co+er according to their forecast mo+ements in exchange rates. #sually all the companyEs exposure would not be left to the forecasting ability of the treasurer. :owe+er, in many, a proportion of the risk is left to be hedged at the discretion of the treasurer. ?b+iously the controls and guidelines gi+en to the treasurer on the maximum exposed position or maximum loss are +ery important under this policy. Currency trading In other words this is speculating. In some companies the treasurer will not only be in+ol+ed with hedging but will buy and sell currencies "going LlongL and LshortL% on
5H

occasions unrelated to the underlying business needs. Most sur+eys of treasurers indicate that they do not operate this policy "or admit to operate with this policy%. 3. 6hat is the pre+ious experience of the treasurer and what is their ability to forecast. There are numerous methods of forecasting but can be grouped into four areas: Technical This in+ol+es the use of the historical exchange rate data to predict future +alues. These can be complicated techni7ues based on a number of different time series models.
undamental This is based on fundamental relationships between economic +ariables and exchange rates. ,i+en the current +alues of these +ariables and their historical impact on a currencyEs +alue the company can de+elop exchange rate pro/ections.
Market.Based This is forecasting based on current market indicators such as the current spot rate and the forward rate. Mixed Io single method has pro+ed entirely reliable or superior to others conse7uently treasurers may use a combination of forecasting techni7ues. @. ?+erall profitability of company The effect of currency mo+ements on the profitability of the company is ob+iously +ery important. 6ould any potential mo+ements ha+e a material effect
5G

on profitsS. 0s we will see this is not as easy a 7uestion to answer as it may appear on first +iewing. It is not only companies who ha+e sales and costs in o+erseas currencies who are effected by exchange rate mo+ements but also those companies whose competitors may be
based internationally. 9urrency risk management should be integrated with the operating side of the business. Therefore the treasurer should liaise with other departments on decisions on production, purchasing and management as these can all ha+e currency implications. D. 9ompetitors 6ith Y problems it is +ery important that the treasurer considers the nature of the companyEs competitors. They must ask 7uestions about where their competitor1s costs are sourced i.e., in what currencies, in which currencies is their income flows and do they undertake any hedging techni7ues. Iot all of this information will be a+ailable but the treasurer must attempt to consider these areas. This is best illustrated by a few examples. Telstart, a #( company, produces +ideos. Most of its re+enues are in the #(. 0bout half of its expenses re7uire outflows in Bapanese Cen "to pay for Bapanese materials%. Most of TelstartEs competition is from #( companies that ha+e no international business at all. If the Cen strengthens, TelstartEs will incur higher expenses when paying for the Bapanese materials. Because its competition is not affected in a similar manner, Telstart is at a competiti+e disad+antage when the mark strengthens. Bonhams, a #( company, produces furniture and has no international business. Its ma/or competitors import most of their furniture from Iorway, then sell it out of retail stores in the #(. If the, Iorwegian (rona strengthensM #( retail stores will likely ha+e to pay higher prices for the furniture from Iorway, and may pass
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some or all of the higher cost on to customers. 9onse7uently, some customers may shift to furniture produced by Bonhams. Thus, Bonhams is expected to be fa+ourably affected by a strong Iorwegian (rona. 0rm+erse is a #( wholesale company that imports expensi+e high.7uality suits and sells them to retail stores around the #(. Its main competitors also import high.7uality suits and sell it to retail stores. Ione of these competitors hedge their exposure to exchange rate mo+ements. The treasurer of 0rm+erse told the board of directors that the firmEs performance would be more +olatile o+er time if it hedged its exchange rate exposure. If 0rm+erse hedged its imports, then it would ha+e an ad+antage o+er the competition when the sterling weakened "since its competitors would pay higher prices for the suits%, and could possibly gain market share or would ha+e a higher profit margin. It would be at a disad+antage relati+e to the competition when sterling strengthened and may lose market share or be forced to accept a lower profit margin. 6hen 0rm+erse does not hedge, the amount paid for imports would depend on exchange rate mo+ements, but this is also true for all of its competitors. Thus, 0rm+erse is more likely to retain its existing market share.
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Forex & Risk Management Com$any $o&icy $&anning

In relation to Y exposure controls are +ery important. It is +ery necessary for a treasurer operating in a fast changing world of currency +alues, to do so knowing you ha+e clear parameters within which they can work. It is not good enough to lea+e the treasurer to Edo the best for the companyE because hindsight will always show that they will not ha+e maximised the opportunity. It follows then that the Board of &irectors needs to understand the risks it generates when transacting business. rom full knowledge of extent of the risks, the Board can then lay down rules, operating parameters and responsible flexibility by way of rules, guidelines, limits, and checks to construct a sensible framework, which the Treasury department works within. It is a safeguard both for the company and indi+idual. These rules will include: The amount of co+er to be takenM The maximum open position in each currencyM and The dealing limit permitted with each institution. The Treasury area is the beneficiary of a bewildering array of financial product, techni7ues and ser+ices, which allows it infinite flexibility when managing exchange rate risk. The Board must be assured that temptations to run excessi+e risks for high rewards are not succumbed to. Cou will need to know how your exchange risks emerge from the business you do, you will need to appreciate the nature of the products and thereby decided on the operating culture of the company, which you are meant to promote. Informed flexible management within responsi+e parameters would gi+e you the necessary efficiencies whilst making the most of sensibly calculated opportunities.
!easuring #oreign exchange ex$osure

Accounting and Economic Ex$osure
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6e can define exposure as the degree to which a company is affected by exchange rate changes. But there are different types of exposure, which we must consider. To begin with consider accounting and economic exposure. 0ccounting exposure arises from the need for reporting and consolidation to con+ert the financial statements of foreign operations from local currencies to home currency. 2conomic exposure relates to the economic conse7uences of currency changes on a companyEs +alue. To de+elop an effecti+e strategy for managing currency risk, management must determine what is at risk. This determination re7uires an appropriate definition of Y risk. But there is a ma/or discrepancy between accounting practice and economic reality in terms of measuring exposure. 0ccounting measures of exposure focus on the effect of currency changes on pre+ious decisions of the firm as reflected in book +alues of assets and liabilities incurred. :owe+er, book +alues and market +alues, which reflect future cash flows typically, differ. 'etrospecti+e accounting techni7ues cannot account for the economic effects of a de+aluation>re+aluation on the +alue of a company because these effects are prospecti+e in nature. 2conomic exposure is the extent to which the +alue of the company "as measured by the present +alue of its expected cash flows% will change when exchange rates change. inancial theory suggests that managers should be concerned with economic reality since managers are assumed to be maximising the +alue of the firm. In practice many managers are preoccupied with potential accounting based currency gains or losses. This makes sense if their earnings are tied to earnings and not market +alue or if they belie+e the stock market cannot properly appraise the +alue of the firm. :owe+er, there is a large body of e+idence that suggests that the stock market can Esee throughE accounting manipulations. 6e can further consider exposure in the under the three main headings which companies would analysis their Y problem . E transactionE exposures, EeconomicE exposure and Etrans&ationE exposure . although different types of EeconomicE exposure such as Ecompetiti+eE exposure are sometimes considered separately.
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Transaction Ex$osure Transaction exposure materialises when, and as soon as, a contractual obligation arises in a currency other than your reporting currency ie. the booking of a transaction at one rate of exchange whereas the e+entual receipt or payment of cash comes in at a different rate of exchange. The exposure may well not appear immediately or e+er in the accounting records. Transaction exposure can be considered short term economic exposure. or example, consider goods sold by a #( manufacturer at an in+oice price of $wfr GKK,KKK at a time when the Y rate is $wfr 3.4K to Z3.KKM payment is due in 4K days. 0fter 4K days by the rate is $wfr @.KK to Z3.KK "ie. sterling has strengthened%. The +alue of the sale initially recorded in the books of the manufacturer was Z@5D,3G-.=4 but they recei+e only Z@GK,KKK. This is called a closed exchange as it has been completed. 0n open exchange is a transaction across two currencies, which has not yet been completed. 9onsider the effect of exchange rate mo+ements on #( company profits gi+en a difference between the currency of costs and the currency of profits: If the costs in ZEs ":ome% and the income is in the o+erseas currency ie. "F% and the current rate is F@>Z3.
a. Z weakens [ F3>Z3 therefore income increases in ZEs +alue. b. Z $trengthening [ ZD>Z3 income decreases in ZEs +alue. The increase in +olatility of all currencies has made transaction exposure +ery dangerous, but it is comparati+ely easy to identify because it is specified and discrete being linked with indi+idual items of business. It may also be used to describe transactions, which are confidently expected to be booked soon, and transactions, which are forecast, as long as the forecast is a reasonably close one. There is a point in time . not clearly definable . when EtransactionE exposures merge into EeconomicE exposures. In general, transaction exposures are relati+ely easy to identify. or example, a #$ company exporting to a ,erman customer in &eutchsemarks has a transaction exposure to the #$ dollar>&eutchsemark exchange rate on the money they are due to recei+e for sales they
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ha+e already made. $imilarly, a rench importer is at risk if sterling rises and they ha+e in+oices to pay in sterling. Transaction exposures arise on cash mo+ements, including di+idends and interest as well as sales and purchases, and affect the profit and loss account in a +ery direct way. #( company orders products from ,ermany paying in &M when products deli+ered in 4K days. 0s the Z cost will increase. 0s price of &M rises the Z cost of the importerEs orders rises. 6ith rising costs the +alue of
the firm will be reduced Transaction exposure is by its nature of uncertain timing, and its co+er should not be considered in a static or item.by.item manner. The exposure in an on.going business is e+er e+ol+ing . changing day by day or e+en hour by hour . as business is won, orders are placed, payables paid, recei+ables recei+ed, or co+er taken. It is not often that the treasurer can say at any particular time that they ha+e co+ered all their foreign exchange exposure. Taking a broader, o+erall and forward looking +iew, more efficiently co+ers it. 9ompanies usually try to determine the net amount of inflows and outflows in each currency and determine the o+erall exposure to those currencies. or example, if a #( has two subsidiaries Y and C and subsidiary Y has a net cash inflow of &M 3,KKK,KKK and subsidiary C has a net cash outflow of &M 3,@GK,KKK, the consolidated net cash outflow is &M @GK,KKK for the chosen period. Therefore any currency mo+ement between the &M and the Z will be offset in the two subsidiaries apart from the outstanding consolidated flow. This information wills ofcourse usually be uncertain and companies ha+e sometimes to deal with possible ranges of cash inflows and outflows. 0fter the net cash inflow or outflow is established the company may try to predict possible ranges for each currency against the home currency to try and get some estimate of the le+el of exposure.
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0nother important consideration for a treasurer is currency correlations. If a #( company has costs in &M but its income is mainly in 0ustrian $chillings. It would appear that the company has two currency exposures to deal with the &M>Z and the $ch>Z. But assume the &eutshemark and $chilling +alues to the Z are highly positi+ely correlated. This means that when the &M appreciates against the Z the $ch will also appreciate by about the same degree and similarly for any depreciation. If the currencies simultaneously appreciate against the Z, the &M costs will increase as it will take more ZEs to buy &M, howe+er the receipts in $ch will be worth more in terms of ZEs. Two highly correlated currencies can act as the same currency e+en if they are not 3KK per cent correlated.
!rotecti+e measures to guard against transaction exposure in+ol+e entering into foreign currency transactions whose cash flows exactly offset the cash flows of the transaction exposure. !rotecti+e measures include orward contracts
!rice ad/ustment clauses 9urrency options Borrowing and lending in the foreign currency In+oice in home currency 0nother related type of exposure is called pre.transactional exposure which occurs before a transaction has taken place. 0ny time a company produces a price list, or markets a bid or tender in a currency other that their home currency they are lea+ing themsel+es open to the effect of currency mo+ements making the prices in the list or tenders worth less in the home currency. This type of exposure is contingent on the transaction being carried out.
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Trans&ationa& Ex$osure Translational exposure is the risk of the net worth of a company changing because of the fluctuating home +aluation of assets and liabilities denominated in foreign currencies. It arises from con+erting a multinationalEs o+erseas subsidiaries translated from local currency to home currency prior to consolidation with the parentEs financial statements. This may include foreign currency loans and in+estments. If the subsidiaryEs balance sheet is unchanged from one year.end to the next, the subsidiary is unaffected. :owe+er, the group may not due to mo+ements on foreign currency. or example, at a particular time, a #( company has an 0ustralian subsidiary which has a net worth of 0F5m and is in the parent companyEs book at ZHm because the exchange rate used was 0F3.G P Z3. But in the due course of time when the exchange rates change to 0F@ P Z3 then the 0ustralian subsidiary will be +alued in the accounts of its parent at ZD "0Z5m X 0F@ P Z3%. In 0ustralia the unit is still worth 0F5. Iothing has changed. It is still generating its normal profit, but looked at in sterling terms it has lost @GN of its worth. If we wish to protect against this risk we must consider selling 0ustralian dollars. Translation exposure does not represent real mo+ements of cash between different currency systems, but can clearly impact both the consolidated profit and loss account \ the consolidated balance sheet. :owe+er le+el of assets and liabilities can effect financial ratios calculated using balance sheet figures which causes practical problems where the company has restrictions on its le+el of borrowings placed by co+enants. Translational exposure can be managed by fully, matching assets \ liabilities in the o+erseas currency, whene+er possible, But this may result in losing control of consolidated gearing. There is also the problem of trying to match assets to liabilities in countries where there are no sophisticate capital markets or in other cases a perfect match is not necessarily desirable. 9ompanies ha+e attempted to get round this problem by either using grouping currencies together \ using proxy currency or basket currency. If currency +alues change foreign exchange translation gains or losses may result. 0ssets and liabilities that are translated at the current exchange rate are considered to be exposedM these translated at a historic exchange rate will maintain their home currency
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+alues. Translation exposure is difference between exposed assets and exposed liabilities. 0 greater amount of exposed assets than liabilities will gi+e rise to a positi+e exposure while a greater amount of liabilities than assets will gi+e rise to a negati+e exposure. &epending on the way the currency mo+es will gi+e rise to translation gains or losses as illustrated below:
2xposed 0ssets
2xposed Aiabilities
!ositi+e 2xposure oreign 9urrency &e+alues Translation loss Translation ,ain oreign 9urrency 'e+alues
2xposed 0ssets
2xposed Aiabilities
Iegati+e 2xposure oreign 9urrency &e+alues Translation ,ain Translation Aoss oreign 9urrency 'e+alues
The amount of translation exposure depends on the degree of foreign in+ol+ement of a multinationalEs o+erseas subsidiaries, the location of these foreign subsidiaries and the correlation between that currency and the home currency and the methods for accounting
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for the translation. 9ontro+ersies among accountants centre on which assets and liabilities are exposed and on when accounting deri+ed Y gains and losses should be recognised.
9ompanies ha+e at least three a+ailable methods for managing their translation exposure: 0d/usting fund flows 2ntering into forward contracts 2xposure netting Basic hedging strategy for reducing translation exposure is to increase hard currency "likely to appreciate% assets and decrease soft currency "likely to depreciate% assets, while simultaneously decreasing hard currency liabilities and increasing soft currency liabilities. Thus if de+aluation appears likely, the basic hedging strategy would be: 'educe le+el of cash Tighten credit terms to decrease accounts recei+able Increase local currency borrowing &elay accounts payable $ell the weak currency forward But acti+ities not automatically +aluable. If the market recognises the likelihood of currency appreciation, this recognition will be reflected in the costs of +arious hedging techni7ues. :edging exchange risk costs money and the costs need to be scrutinised like any other purchase of insurance.
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Economic Ex$osure The definition of EeconomicE and Ecompetiti+eE exposures +aries, and is less important than the underlying concepts. 0 EtransactionE exposure is one, which is readily identifiable in the currency in which it arises. ?nce the exposure is uncertain, or not genuinely in the currency in which the transaction is settled, it is usually called an EeconomicE exposure rather than a transaction exposure. The longer.term change in +alue relationship between two currencies gi+es rise to 29?I?MI9 exposure. It is the most subtle and insidious of all the types of exposure, and has the potential to ruin a company, but to do it in a +ery surreptitious manner. It arises when it is thought that future cash flows will be affected by changing exchange rates. 2conomic exposure can thus be thought of as the extent to which the present +alue of future cash flows is affected by exchange rate mo+ements. Transaction exposure is a subset of economic exposure. :owe+er economic exposure is taking place on a continuing basis, it has no time limit, nor a defined direction of mo+ement. It is simple to spot the influence of the expected change in exchange rates on forecasted sales columns. But the significance of changes in the +alue of competitorsE currencies, which appear unrelated to your operations, should not be underestimated. It is important to appreciate a competitorEs ability to take a greater market share or larger profit because changing exchange rates ha+e mo+ed in their fa+our. The term EeconomicE exposure may be used to describe any exposure, which is forecast to become a transaction exposure in due course . although, if the forecast can be made fairly accurately, this would often be regarded rather as a transaction exposure. The simplest example is when a forecast transaction does not occur. Iext yearEs sales budget for example "as opposed to next weekEs% can only be an estimate. If we forecast sales in pesetas of GKK million but only achie+ed DKK million, the difference of @KK million is an exposure which we expected but which ne+er occurred. It could therefore ha+e been
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unwise to hedge the whole exposure. 0nother example is where the currency underlying the economics of the goods or ser+ice is not the same as the currency of payment. $uppose for example that a company is paying for fuel in rench rancs but the price of the fuel in the medium term is linked to the #$ dollar . because that is the currency in which oil is traded internationally. The fuel purchases which ha+e already been in+oiced but not paid clearly represent a rench ranc risk . a transaction exposure. But future purchases represent a #$ dollar risk . an economic exposure. If the dollar strengthens, the cost will rise, so that the company must buy dollars if it wishes to hedge against this risk. 2conomic exposures relate directly to the competiti+e position for a firm within the e+er more global trading community. or example, both Baguar and !orshe sell cars to the #$ market where they compete at the luxury end. Both clearly ha+e an economic exposure to the le+el of the #$ dollar against their home currencies. They also ha+e because of the cost base in their manufacturing territories, an economic exposure to the Z>&M rate. 0s mentioned at the outset, an economic exposure to Y rates can exist for an indigenous industry. Many examples can be cited from the early 34=Ks when the relati+e strength of sterling ga+e importers sufficient incenti+e to undermine #( producers who had, hitherto, strong positions in their domestic market. This type of economic exposure is +ery difficult to analyse. (odak recognises its economic exposure . in relation to u/i "Bapan%
As price of Yen rises
Kodak is able to market more effective in
Japan while Fuji is at a disadvantage in US
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Ris" A$$raisa&
This exercise is aimed at determining *here the com$anyMs ex$osures stand 'isGNG'is mar"et #orecasts< The following 'isks will be considered. 3. Ris" to the Ex$osure or Ha&ue at Ris" +HAR1
,i+en a particular +iew or forecast, V0' tries to determine by how much the company1s underlying cashflows are affected. The V0' is the answer
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to the 7uestion, )If the 'ate actually mo+es to xx.xxxx, how much !rofit> Aoss does the company makeS* /< Forecast Ris" 6hat is the likelihood of the rate actually mo+ing to xx.xxxx and what is the likelihood of a forecast going wrong. It is imperati+e to know this before deciding on a Benchmark and de+ising a hedging strategy. :< !ar"et and Transaction Ris"
This will take into consideration the risks attached with each particular market and the likelihood of a transaction not going through smoothly. or instance, The 'upee is gi+en to sudden swings in sentiment, whereas the &eutschemark is generally more predictable. The monetary and time costs of hedging with a nationalised bank are generally higher than with a pri+ate> foreign bank. ! Systems Ris" The risks that arise through gaps or weaknesses in the 2xposure Management system. or example:
Re$orting Ba$
6here there are delays> errors in reporting exposures to the 2xposure Management cell
Im$&ementation Ba$ 6here there is a gap between the decision to hedge and the implementation of such hedge decision.
5enchmar"ing
This exercise aims to state where the company would like its exposures to reach.
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The company will set a Benchmark for its 2xposure Management practices. The Benchmarks will be set for 5 months periods. The Benchmark will reflect and incorporate the following: The ?b/ecti+e of 2xposure Management, or in other words, L$hould 2xposure Management be conducted on a !rofit 9entre or 9ost 9entre basis SL The orecasts discussed and agreed upon earlier. Mathematically, the Benchmark should be the !robabilistic 2xpectation of the rate in 7uestion. The orecast risk, Market and Transaction risk, and $ystems risk as determined earlier. 'oom for error in keeping with the $top Aoss !olicy to be decided The Benchmark will be realistic and achie+able. Suggestions: 9ompanies whose exposures are of long.term 9apital nature can look to manage them on a 4ro#it 9entre basis, since the exposures are not open to day.to.day business risks. 9ompanies whose exposures are of short.term 'e+enue nature should manage them on a Cost 9entre basis, since the exposures impact the !\A 0ccount directly. 0 small note on the !rofit> 9ost centre concept: #nder this concept, the 2xposure Manager is re7uired to generate a I2T 4ro#it Centre profit on the exposure o+er time. This is an aggressi+e stance implying a high degree of risk appetite on the part of 0pex Management. 0 company with a strong position in its daily bread and butter business can afford to take some financial risks and can opt for this concept. The Benchmarks under a !rofit.9entre concept would take the form of )The total cost of a foreign currency loan should be reduced by at least @G bp o+er
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a one year period, from the forecasted rate of x.x N p.a.*. #nder this concept, the 2xposure Manager would be re7uired to ensure that Cost Centre the cashflows of the company are not ad+ersely affected beyond a certain point. This is a defensi+e strategy, implying a lower risk appetite. 0 company whose cash.flows are +olatile, or whose underlying business is not on a +ery sound footing would be ad+ised to adopt this concept. The Benchmarks under a 9ost.9entre concept would take the form of ) oreign 2xchange fluctuations should add no more than xN to the cost of Imported 'aw Material o+er and abo+e the budgeted cost.*
Ex$osure Ana&ysis
0n 2xposure can be defined as a 9ontracted, !ro/ected or 9ontingent 9ash low whose magnitude is not certain at the moment. The magnitude depends on the +alue of +ariables such as oreign 2xchange rates and Interest rates. The company will determine and analyse its oreign 2xchange exposures. 1eter!ination: The following cash flows> transactions will be considered for the purpose of exposure management. Haria2&e ) Cash F&o*s

Transaction Ty$e Both 9apital and 'e+enue in nature 0ll Interest !ayments> 'eceipts 0ll ?pen hedge transactions Both 9apital and 'e+enue in nature
9ontracted oreign 9urrency 9ash lows oreign Interest 'ates, whether loating or ixed 9ash lows from :edge Transactions !ro/ected> 9ontingent 9ash lows
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9ash lows abo+e F3KK,KKK>. in +alue will be brought to the notice of the 2xposure Manager, as soon as they are pro/ected. It is the responsibility of the 2xposure Manager to ensure that he recei+es the re7uisite information on exposures from +arious sections of the company in time.
Ana&ysis These exposures will be analysed and the following aspects will be studied:

oreign 9urrency 9ash lows> $chedules Variability of 9ashflows . how certain are the amounts and> or +alue datesS Inflow.?utflow Mismatches > ,aps Time Mismatches > ,aps 9urrency !ortfolio Mix loating > ixed Interest 'ate ratio
?b/ecti+es of risk management Minimi8e 9osts Maximi8e 'e+enue $tabili8e Margins in the uture
Foreign Exchange 4o&icy

0 good foreign exchange policy is critical to the sound risk management of any corporate treasury. 6ithout a policy decision are made as.hoc and generally without any consistency and accountability. It is important for treasury personnel to know what
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benchmarks they are aiming for and it1s important for senior management or the board to be confident that the risk of the business are being managed consistently and in accordance with o+erall corporate strategy.
Scenario 4&anning - !a"ing Rationa& Decisions

The recognition of the financial risks associated with foreign exchange mean some decision needs to be made. The key to any good management is a rational approach to decision making. The most desirable method of management is the pre.planning of responses to mo+ements in what are generally +olatile markets so that emotions are dispensed with and pre+ious careful planning is relied upon. This approach helps eliminate the panic factor as all outcomes ha+e been considered including Oworst case scenarios1, which could result from either action or inaction. :owe+er e+en though the worst case scenarios are considered and plans ensure that e+en the Oworst case scenarios1 are acceptable "although not desirable%, the pre.planning focuses on achie+ing the best result.
Ris" !anagement From !erchant>s 4oint O# Hie*

For*ard Exchange Contract In international trade transaction, exporters and importers run the risk of exchange rate mo+ement against them. This happens on account of exchange rate fluctuation, which is so +ery common. The facts ha+e been further aggra+ated by the fact that many countries
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ha+e adopted floating exchange rate system, and this has contributed to the +olatility of exchange rates. 0t times the exchange rate fluctuations are substantial. 2.g. &uring the south east 0sian crisis, Indian rupee lost around 3@ N in the last 7uarter of 344-. 2+en the countries like Bapan and $ingapore, despite ha+ing some strong economies, saw their currencies going down in rather short span of time. Need For For*ard Exchange Contracts The risk on account of exchange rate fluctuation, in international trade transactions increases if the time period needed for completion of transaction in longer. It is not uncommon in international trade, on account of logistics, the time frame cannot be foretold with clock precision. 2xporters and importers alike, cannot be precise as to the time when the shipment will be made as sometimes space on the ship is not a+ailable, while at the other, there are delays on account of congestion of port, etc. In international trade there is considerable time lag between entering in to a sales>purchase contract, shipment of goods and payment. In the meantime, if exchange rate mo+es against the party who has to exchange his home currency into foreign currency, he may end up in loss. 9onse7uently, buyers and sellers want to protect them against exchange rate risk. ?ne of the methods by which they can protect themsel+es is entering into a foreign exchange forward contract.
I&&ustration 2.g. Aet us consider an exporter in India exporting shirts to #$0. 6hile 7uoting the price per shirt he must ha+e arri+ed at the sale price by taking into consideration the cost of shirt say 's. HH and if he wants a profit of 's. 3 per shirt, he would like to sell the shirt for 's. HG. :e expects the payment to be recei+ed after one month and when he actually recei+ed the payment the exchange rate is #$F3 P 's. HD.=K. It can be easily seen that instead of making profit he has ended in loss of @K paise. To a+oid this type of uncertainty, the exporter would like to get lock in an exchange rate for future by entering into forward exchange forward contract. :e may get an exchange rate say one month
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forward say #$F P 's. HH.-G. Though it appears that he has not made 'e. 3 per shirt but in the bargain he has insulated himself against the ad+erse exchange rate mo+ement. :e has in the process ensured for himself a profit of -G paise per shirt irrespecti+e of the exchange rate after one month, when he is likely to recei+e the foreign exchange. For*ard Exchange For*ard Contract orward exchange forward contract is a contract wherein two parties agree to deli+er certain amount of foreign exchange at an agreed rate either at a fixed future date or during a fixed future period. If the merchants are sure about the remittance or the payment of 2 then they can choose the fix date forward exchange contract, in which they are bound by the date on which they ha+e to meet their part of liability in the agreement. If customers are not sure about the date of remittance or the payment of the foreign exchange they can enter into the option period forward exchange contract. Both the types are explained below.
"#
ixed date foreign exchange forward contract If under the foreign exchange forward contract, foreign exchange is to be deli+ered at fixed date, the contract is known as fixed date foreign exchange contract.
$# ?ption foreign exchange forward contract If under the foreign exchange forward contract foreign exchange is to be deli+ered in future, during a specified period, the contract is known as option foreign exchange forward contract. In this type of contract there is no option for taking>deli+ery of foreign exchange. $uch contracts pro+ide for option as far as date of deli+ery of foreign exchange is concerned. 6hile entering into a option
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forward contract first date and the last date for exercising option for gi+ing>taking deli+ery of foreign exchange is always fixed. In India, like de+eloped countries, there are not many instruments a+ailable for hedging foreign exchange risk. 0s a result the merchants ha+e to hedge their foreign exchange exposures through forward contracts only. or merchants this is the only tool a+ailable to minimi8e the risk due to ad+erse foreign exchange fluctuation.
Ex$orters 4oint O# Hie*

I&&ustration If on the 3st January 2000 exporter signs an export contract. He expects to get the dollar remittance during the June. Now lets assume that in first January exchange rate between dollar and rupee is 43. !00 and due to the ad"erse fluctuation of exchange rate the actual rate in June is 43.!000 so we can infer from the abo"e that export may loose 24 paise per dollar. #s per instrument a"ailable in $ndia exporter may enter a forward exchange contract with a ban%. &hile entering the contract with ban%' ban% will gi"e him a forward rate for June adding the premium to the spot rate of first January. (et suppose it is 43.)400 so exporter can earn * paise my exchange rate between dollar and rupee is 43. !00 and due to the ad"erse fluctuation of exchange rate the actual rate in Japan is 43.!000 so we can infer from the abo"e that the export may loose 24 paise per dollar. #s per instrument a"ailable in $ndia exporter may enter a forward exchange contract with a
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ban%. &hile entering the contract with ban%' ban% will gi"e him a forward rate for June adding the premium to the spot rate of first January. (et us suppose it is 43.)400 so exporter can earn * paise may cancel and reboo% the contract as many as times they want.
Importers !oint ?f View

IEEUSTRATION Aet suppose on first Banuary an importer signs a deal with foreign party. :e expects to pay the bill on March. ?n first Banuary the exchange rate is HK.-GKK. 0nd the importer expects that the dollar will depreciate in the month of March. $o the importer will enter into the agreement with the bank for the forward exchange contract. The bank will gi+e him the forward rate. If the rate is lower than the today1s rate then the importer will enter into the contract with the bank. 0nd the rate is high then he will not enter into the contract. In India importers can1t cancel the contract. They can cancel the contract at once and roll o+er for the future date. This way importers and exporters can minimi8e the risk due to the ad+erse foreign exchange rate mo+ement.
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Forex & Risk Management 5an">s 4oint O# Hie*

C&assi#ication o# Ris"s oreign exchange dealings entail many types of risks for banks I.low e+er for the purpose of broad classifications the following are the ma/or types of risks. 3. !osition or exchange rate risk. "'isk from the market mo+ement% @. 9redit or counterpart risk "'isk from the customers% D. Mismatch or li7uidity risk" 'isk due to improper transaction% H. ?perational risk. "'isk due to operating system% G. Aegal risk.
4osition or Exchange Rate Ris" +Ris" #rom the mar"et mo'ement1

6hen a dealer buys or sells foreign currency the bank gets in to a position and if purchases are more than sales, it is said to ha+e o+erbought>long>plus position. If sales are more than purchases it is said to ha+e o+ersold>sold minus position In simple terms an excess of assets o+er liabilities is called net long position and con+ersely, liabilities in excess of assets results to a short position $ince these positions are taken at the particular rate and if the rate mo+es ad+ersely then the bank can suffer a loss. To illustrate if a bank has gone in to long position in a currency which is depreciating it will result in exchange loss because when foreign currency assets are con+erted in to local currency the bank reali8e lesser amount as compared to the amount paid for ac7uiring these assets. $imilarly if a bank hasM gone in to short position currency which is appreciating, it will result in exchange loss because when the liability so created is to be paid, the bank will ha+e to shell out more amount of local currency In these days when exchange rates are fluctuating continuously., from moment to moment times wild, it is prudent on the part of
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bank to ha+e some checks and balances so that loss incurred in such a situation is manageable. Eimits #or the 2an"s to minimise the ris" 3% Day &ight &imits This limit is fixed for the dealing room operations. It means dealer cannot take position more than the day light limit fixed by the management. &ealers can cross the limit after prior appro+al from the management for specific cases.
@% O'ernight &imits &uring the daytime, position can be monitored continuously and correcti+e actions can be taken same is not possible at the night $o o+ernight limits are fix conser+ati+ely. But the same time it is big enough to accommodate pipeline transactions D% Cut &oss &imit Bank is ha+ing open position and if the rate mo+es against the bank then bank may loss. &ealer has the free hand to deal and he ne+er know that what will be the loss. If the rate goes against then bank max1 loss to pre+ent this limit is fixed by the management 0 maximum a dealer will loss due transaction is called the cut loss limit. 0s for example, if the permissible amount of 7uantum of absolute loss translates in to HK point mo+ement of the rate on a position of one million The cut loss has to be applied by the dealer x+ hen there is an ad+erse mo+ement of twenty points on a position of two million
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H% Credit or counter $arty ris" This is a risk due to inability or unwillingness of the counterpart to meet its obligations o+er this kind of risk bank has not proper control but bank can a+oid or minimi8e the risk b taking following actions: By fixing counterpart limits By appropriate measurements of exposure 9redit e+aluation and monitoring By following sound operating procedure This risk can be classified into two ways: 3% 4reGsett&ement Ris" !re settlement risk is the risk of loss due to counterparty defaulting on a contract during the life of a transaction. This exposure is also referred to as the replacement cost. 0 key tool for effecti+e management of this risk is the fixation of exposure limits on counterparties @% Sett&ement Ris" $ettlement risk is the risk arising when a bank performs on its obligation under a contract prior to the counterparty does so this risk fre7uently arises in international transactions because of the time 8one differences. The credit risk can also be classified in to: 71 Contract Ris"
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If before the performance of the contract, the counter party fails the contract has to be canceled. In the mean time if rate has mo+ed against it, then the loss is to be born by the bank as the contract is to be closed at the on going market rates.
/1 C&ean Ris" In an exchange contract the currencies are to be exchanged on the +alue dates The time 8one difference between +arious centre sometimes results in situations when one bank has already paid the amount of currency to be gi+en before recei+ing the amount the currency to be recei+ed the counter party fails, it may result in total loss. :1 So'ereign Ris" If the counter party bank is situated in different country then there is a possibility of ha+ing so+ereign risk. 0lso because of the political and economic factors in that country. If a country suspends the foreign currency payments the bark may stand to lose, although the counter party ha+e performed its part of the contract in local currency. The bank while fixing counter party limits for the o+erseas bank has to gi+e due weightage to the political stability, health of the economy, a+ailability of financial infrastructure, and expected state interference in financial transactions, particularly foreign exchange transactions. Ei?uidity ris" is the risk that bank will be unable to meet its funding re7uirements or execute a transaction at a reasonable price Market li7uidity risk is the risk of bank not being able to exit or offset positions 7uickly at a reasonable price. If a bank has undertaken a swap i.e. bought and sold same amount of foreign currency for different +alue dates, it does not ha+e exchange position but runs the risk of mismatches
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thus created These are also called gaps These gaps gi+e rise to risk on account of forward premium discount mo+ing against the bank. 6e ha+e already seen that the forward differentials are nothing but interest differentials. It is not uncommon, particularly now a days that interest rate differentials of two currencies may widen or narrow down. Mismatches or gaps are the result of unmatched forward maturities witch create une+en cash inflows and ?ut flows. If the forward differentials go against the bank, the bank may incur a loss in co+ering the gaps at a cost higher than pro+ided for. In India forward market being +ery shallow and being dri+en by pure supply and demand for forwards, mo+ements in forward differentials are wild and erratic. This occurrence is more fre7uent after introduction of A2'M$ and allowing integration of money and forex markets albeit limited. The following limits are fixed for managing mismatch ris". 71 Indi'idua& Ba$ Eimits +IBE1 oreign currency purchases and sales with +alue dates falling in a particular month may not be e7ual. This will gi+e rise to either o+erbought or o+ersold position in that month. But if the o+erall position of the bank in a particular currency is s7uare it is but natural that the bank will ha+e an opposite open position in any other months. This is called gap. Banks put a ceiling in a form of I,A for each month. The dealer cannot ha+e a position in a particular month exceeding the said limit although o+erall position of the bank may be s7uare /1 Aggregate Ba$ Eimits +ABE1 This limit is the absolute total "ignoring plus>minus% of all the o+er bought and o+ersold position bank is ha+ing for all the month in a particular currency. :1 Tota& Aggregate Ba$ Eimits +TABE1
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Total aggregate gap limit is the total of all T0,A1s in all currencies put together. This not only ensures controlling une+en cash flows on account of mismatches but puts under control trading in forward also. Trading in forwards is also called running a swap book1 #ncontrolled mismatches can create li7uidity problem for the bank, which may ultimately result in unintended losses.
Exchange dea&ings and ris" managements #or the 2an"s The bank, dealing in foreign exchange has not only to look for profits but also has also to ensure that the losses, which may be incurred in foreign exchange dealings, are minimi8ed. The foreign exchanged dealing is risk reward business and therefore the lure for profits is +ery strong. But it is not free from risk. oreign exchange dealings ha+e got certain special features, which make the transactions all the more risky. These are as follows: The foreign exchange dealings are transnational arid therefore prices of foreign currencies are sub/ect to the control>restrictions of the go+ernments of the foreign countries. These are also dependent upon their fiscal and monetary policies and the same are dictated buy the needs of their domestic economy oreign exchange dealings in+ol+e two currencies and therefore the exchange rate is influenced by domestic as well as international issues>factors The foreign exchange market is a @H hours market and different time 8ones for foreign exchange dealings at different centers offer threat of risk ad+erse mo+ement of rates on account of unexpected de+elopments. The foreign exchange dealings are to be undertaken at a +ery fast speed and pace there is no time for second thoughts. Therefore the fast decision making process itself opens the foreign exchange dealing to risk
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,lobally, foreign exchange dealing operations are undertaken with a +iew to maximi8e profits of bank :owe+er till the year 3443 in India foreign exchange dealings operations were sub/ect to stringent controls and the only ob/ecti+e of the dealing was to conduct co+er operations so as to facilitate international business The regulatory en+ironment in India hardly offered any scope for free foreign exchange dealings. :owe+er with introduction of liberali8ed exchange rate management system a new dimension has been added. 'upee has now becomes a free.floating currency under modified liberali8ed exchange rate management system "A2'M$% and the market forces of demand and supply decide rupee exchange rate. 'eser+e Bank of India slowly but steadily has been liberali8ing foreign exchange markets with a +iew to, a% 2nsure sufficient +olume as far as demand and supply for a particular currency is concerned and thus pa+ing the was for competiti+e prices for +arious currencies for co+ering merchant transactions. b% To de+elop lndian foreign exchange markets so that dealer de+elops dealing skills and sophistication. c% To keep Indian foreign exchange market getting integrated with the global foreign exchange market in due course of time 0s and when rupee becomes fully con+ertible on current as well as capital account The ris" management $rocess Banks should ha+e a comprehensi+e and accurate risk management process co+ering both trading and non.trading acti+ities. This procedure should enable the management to access exposure on a consolidated basis it should be easily understood by the dealers,
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back office staff, senior management and the Board of &irectors. $uch a procedure will help in controlling and limiting the risk taking acti+ities at all the le+els Eimiting Ris"s ,lobal limits should be set up for the banks local interbank business as well as its transactions in the o+erseas markets The limit system should be consistent with the banks o+erall risk management process and ade7uacy of its capital to undertake such acti+ities 0t present the open exchange position limit and the gap limits for maturity mis. matches fixed by each bank re7uire appro+al of 'BI Management has to set an upper limit for losses, bearing in mind the banks capital and earning performance. Based on the risk control analysis and the upper limit for losses, a system of risk curbing limit has to be set up which should be related to credit risks and market price risks ?+erall limits are to be set and appro+ed by the management for each category of risks 0ppropriate +alues at risks models ha+e to be de+eloped for 7uantifying the extent of market risk for a gi+en le+el of confidence. Interna& Audit The nature and scope of internal audit +aries widely between banks. :owe+er, its approach will generally be designed to ensure that established procedures are adhered to and are operating effecti+ely. Thus an important part of its work will be to re+iew the ade7uacy and timeliness of key management reports. $uch as those relating to limit excesses and maturity periods, and to ensure that appropriate action is initiated in response to this information. ?ther tasks of the internal audit department will include statutory and regulatory compliance re+iews, data processing control re+iews and back
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office efficiency re+iews or the internal audit function to he beneficial, it is essential that its reports are submitted promptly to senior management. Ha&ue At Ris" Banks trading in securities, foreign exchange, and deri+ati+es but with the increased +olatility in exchange rates and interest rates, managements ha+e become more conscious about the risks associated with this kind of acti+ity 0s a matter of fact more and more banks hake started looking at trading operations as lucrati+e profit making acti+ity and their treasuries at times trade aggressi+ely. This has forced the regulator1 authorities to address the issue of market risk apart from credit risk, these market players ha+e to take an account of on.balance sheet and off.balance sheet positions. Market risk arises on account of changes in the price +olatility of traded items, market sentiments and so on. ,lobally the regulators ha+e prescribed capital ade7uacy norms under which, the risk weighted +alue for each group of assets owned by the bank is calculated separately, and then added up The banks ha+e to pro+ide capital, at the prescribed rate, for total assets so arri+ed at. :owe+er this does not take care of market risks ade7uately. :ence an alternati+e approach to manage risk was de+eloped for measuring risk on securities and deri+ati+es trading books. #nder this new.approach the banks can use an in.house computer model for +aluing the risk in trading books known as OV0A#2 0T 'I$( M?&2A "Va' M?&2A%. #nder Va' model risk management is done on the basis of holistic approach unlike the approach under which the risk weighted +alue for each group of assets owned by a bank is calculated separately. FRA =s. S%A4S. Futures. O$tions
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loating exchange rate system has created a climate of uncertainty, particularly amongst the corporates who ha+e transnational trade relations and ha+e inflows and outflows in +arious currencies. 6ith the passage of time international trade has also grown adding more market players. The increasing world output and liberali8ed international trade has dramatically increased cross.border flow of goods, ser+ices and in+estments. 'emo+al of exchange control restrictions on capital flows has added to not only exchange rate +olatility but also interest rate +olatility as both influence each other particularly in the countries where there are no controls on capital outflows and inflows. Volatility in interest rates and exchange rates results in risks to the banks and corporates. This ga+e rise to the needs for managing these risks although elimination of the same was not possible The banks responded by designing products for risk management. These are popularly known as Oderi+ati+e products1, as the underlying is different from these deri+ati+es The popular ones among them are orward rate agreements " '01s%, interest rate swaps "I'$%. 9urrency swaps, futures, options etc There are many further complex products like 9aps, loors, 9ollars, $waptions etc. orward 'ate 0greement " '0% is a contract between two parties fixing a rate of interest on a notional amount of principle for future loan or deposit for a period commencing horn a agreed future date. '01s are usually o+er.the.counter products for interest rate risk management and are similar to financial futures. Initially '01s were a+ailable for #$$ and British pound sterling only. '01s ha+e now become a+ailable in almost in any currency including 29# "2#'?%. Iow '01s as a financial product are being increasingly used by non.financial corporations for interest rate risk management 0n acti+e broker market has also de+eloped for '01s with two was 7uotes in the more acti+e currencies both bid and offer price being 7uoted on continuous basis
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'01s are generally used by: Banks to alter their exposure to interest rate mo+ements without interfering with their li7uidity profile. Borrower, lenders and in+estors to hedge against the future ad+erse interest rate mo+ements. $peculators by taking a +iew and seeking to profit from unpredictable interest rate mo+ements arbitrageurs using mispricing of '01s against other financial Instruments. FRAGo$eration Typically, a buyer of '0 wishes to minimi8e exposure to rising interest rates as a
borrower and a lender is seeking to minimi8e the exposure to falling interest rates. Aet us suppose that a corporate has to borrow #$$ 3G million, hence three months on a floating rate, say at AIB?' "Aondon Interbank ?ffered 'ate% rate but is comfortable at a rate, say maximum of 5 GN p a. $hould the interest rate rise during the inter+ening period i.e. from now till the actual date of borrowing, its calculations can go awry and may be the corporation suffers loss on account of rise in interest rates. The borrower can protect against such an e+entuality by buying an '0. %ho $ays and recei'es the sett&ement $roceeds If a corporation had agreed to buy an '0, then if the benchmark interest, say AIB?' rises and is at -N per annum on the fixing date i.e., rate rises abo+e the fixed rate of 1'0, the seller of the '0 will pay compensation amount and the buyer of the '0 will recei+e the compensation amount If the benchmark interest rate, say AIB?' is at 5N per annum on fixing date i.e., the rate remains lower than the fixed rate of '0. the buyer of the '0 will pay compensation amount and the seller of the '0 will recei+e the compensation amount.
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S%A4 In foreign exchange markets swap means simultaneous purchase and sell of the same amount of currency for two different +alue dates. In case of a swap as the bank buys and sales the same amount of currency against another currency, no exchange position is created. Therefore in a swap deal there in no exchange rate risk howe+er as +alue dates are different mismatch is created. Aet us consider the following transactions undertaken by a bank. Bank buys #$$ 3 million spot and simultaneously sells #$F I million one month forward 6e can appreciate from the abo+e illustrations that after undertaking a swap transaction, though no exchange position is created but as the inflows_ out flows do not match, the bank runs the risk of forward differentials "interest differentials% mo+ing against it. Banks enter in to forward purchase > sale contracts with customers bank and at that point of time co+er for the same +alue date many not be a+ailable. :owe+er if a bank, which has entered in to a forward contract, does not co+er its position, run exchange risks Therefore, it co+ers the transaction on spot basis i.e. if it bought #$$ 3 million two months forward, it will sell #$$ I million spot and s7uare its position Therefore to correct the mismatch of spot and two months forward it will do a swap by buying spot and selling two months forward. Theoretically a bank, which enters in to a forward contract with a customer to a+oid risk on account of exchange rate mo+ement, always co+ers itself. :owe+er the customer may not take gi+e deli+ery1 of foreign exchange on due date i.e. the customer may gi+e>take early deli+ery or cancel the contract or may extend the
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contract and as the bank co+ers itself in inter bank market by doing opposite deal, to meet its commitment may ha+e to do a swap.
I&&ustration or example if a bank entered in to a forward sale contract for say, 0pril DK and if the customer recei+ed the import documents on March D3st he may re7uest the bank to remit the foreign exchange on March D3st against the forward contract booked for 0pril DK, initially. Thus the bank may ha+e to under take the swap in the inter bank market by buying for March D3,3 and selling the same amount forward for 0pril DK. a% Banks undertake swap transaction for funding operations. $uppose a bank has to pay today against an AI9 opened by it and as at that point of time its Iostro account does not ha+e sufficient balance the bank to a+oid o+erdraft interest and in order to a+oid default, will undertake a swap in the inter bank market by buying cash and selling say spot or forward. Thus bank is in a position to fund its Iostro ac through swap without ha+ing exchange rate risk. b% Banks undertake swap transactions to take ad+antage of arbitrage opportunities buy con+erting one currency in to another temporarily without creating any exchange position. c% $ome banks undertake swap transactions for running a O swap book1. This is generally done by doing a forward > forward swap. d% oreign exchange swaps are used to manufacture a currency fund through one currency in another currency. Interest Rates G Ca$s. Co&&ars. F&oors
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9orporates who ha+e interest rate risk use Interest 'ate. 9aps, 9ollars, loors for
hedging their risk. Their instruments protect the corporates from interest rate +olatility. These are also used as by more enterprising fund managers to fund their medium ; term pro/ects with short ; term as they can hedge their exposure and thus gain confidence that e+en substantial +olatility in interest rates will ha+e no effect on profitability of their company. Interest Rate Ca$s: Interest rate is agreement between a bank and a corporate borrower with floating rate whereby the bank in return for a premium, undertakes to bear the extra cost on account of interest rate going up beyond the agreed rate during the agreed period. This instrument caps the interest payment of the borrower as and rise abo+e the cap will be borne by the bank selling cap to the corporate. If a corporate is in+esting in a pro/ect by borrowing at A3B?' Q3.GN and if the pro/ect is profitable at the maximum interest cost of say 4N per annum, in order to hedge against floating rate, the best thing the corporate could do is to buy a cap of 4N per annum. If the rate goes abo+e 4N , the corporate is protected as the seller of the cap will compensate the buyer for the :difference. In case the interest rate remains lower, the corporate can en/oy this benefit. Interest Rate F&oor: Interest 'ate loor is an agreement under which a bank and a corporate lender on floating basis agree that the bank for a premium will set floor on the interest income earned by the corporate lender. $uppose the corporate is funding its 4N assets by borrowing on f3oatin basis. The assets become loss.making proposition if the floating interest goes beyond 4N. The corporate by paying a lump sum premium can buy a floor, which will ensure a return of 4N on the assets. Incase the interest rise abo+e, 4N. The corporate will en/oy the extra interest Interest Rate Co&&ars:
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If a corporate takes a +iew that the interest rates will remain in a range, it can combine cap and floor to achie+e the ob/ecti+e. If we consider a situation where corporate had a bought a cap on interest rate at 4N, and if it is of the +iew that the interest rate will not fall below, say -N Therefore it buys a )collar* of between -N and 4N on interest payment that it has to pay The corporate loose the benefit if interest falls below -o but for foregoing this, it pays less premium It has protected its upside risk at a +ery low cost.
Financia& Futures
0 future contract is a firm obligation to gi+e or to take deli+ery of the commodity of specific 7uantity and 7uality at a specific date at an agreed price. The seller is called Othe short1 and the buyer is called Othe long1. urther it re7uires that all the futures contracts be bought and sold on Odesignated contract markets1. There are basically @ types of future in the market and these are differentiated on the basis of underlying. If the underlying is a commodity futures and if the underlying is a Ofinancial instrument1 these are known as financial futures. inancial futures are a+ailable in the market with the following underlying: Interest 'ates 9urrency 2xchange 'ates $hare !rice Indices @edging through Financia& Futures:
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uture can be used for hedging interest rate risk in a fairly simple way. $ince the ob/ecti+e is to eliminate interest rate risk for a transaction to be taken in future Aet us take an illustration I&&ustration $uppose one has bonds carrying a coupon of say -K1 and if it is feared that interest rate will go up in futures and therefore bond price will fall, as these are 7uoted as under Bond price P face +alue ` coupon P 3KK ` - P 4D ?ne can hedge by selling futures, say at 4D the pre+ailing price as of now. Thus the seller is short at a price of 4D per bond. If the interest rate mo+es to say =N, the price of the bond will be Bond price P face +alue ` coupon P 3KK`=P4@ ?ne can buy back X 4@ and whate+er loss he would suffer on account of selling bonds held by him originally will be recouped by doing the transaction in futures market.
Currency Futures
0 currency futures contract is an agreement to buy or sell at Ofutures exchange1 a standard 7uantity of a foreign exchange at a future date at the price agreed to between the parties to the contract. 0lthough the contracts are traded between the @ parties, howe+er, for clearing purposes Oclearing house1 of Ofutures exchange1 is the counterparty to a large extent. ?nce a futures contract has been entered in to the short "seller% has to gi+e deli+ery to the long "buyer% of the underlying. :owe+er physical deli+ery in the futures contract is
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uncommon and most of the contracts are settled by offsetting futures transaction or are cash settled. O$tions 0n O?ption 9ontract1 is a contract under which the buyer has a Oright1 but not an O?bligation1 to buy or sell a specific 7uantity of a gi+en asset at a specified price at or before a particular date in future. To ac7uire this right, the buyer pays the premium to the seller "also called as option writer%. If the buyer chooses to exercise his right to buy or sell the asset the seller has to he obligation to deli+er or take deli+ery of the underlying asset. The potential loss to an option seller is unlimited and to the buyer it is limited to of premium paid
CURRENT AFFAIRS
Uniting Asia Through a Common Currency
6ith the introduction of the 2uro on Ban1 3st 3444, the world is slowly shifting towards a three currency system ; &ollar, Cen and the 2uro. This will gi+e the concerned countries tremendous competiti+e ad+antage o+er their 0sian counterparts. To counter this possible threat there has been talk in the 0sian financial circles about the feasibility of introducing an 0sian common currency based on the 2uro. :owe+er we need to be clear as to why countries form unions on the basis of a single currency. 6ell, currency unions are generally formed as a part of a more comprehensi+e strategy to integrate the economies that wish to be a part of the union. 0 common currency is usually followed by synergising the +arious legal frameworks, framing free trade agreements and migration laws. 2ntering a currency union, thus, is a foreign policy decision of immense importance and needs a careful and detailed analysis of the pros and cons. 0t this point I would like to differentiate between two terms that can be confused . L 9urrency +nion, and L-ollarisationL. 6hile the former implies a formation of a new
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common 9entral Bank with a new currency for all the member countries, the latter simply is the adaptation of the currency of a nation by another "example: adaptation of #$ F by 0rgentina%. It has been noticed that there is a general international mo+e towards currency union or dollarisation. The article briefly explains the +arious pros and cons in+ol+ed in forming an 0sian currency union along with the issues that need to be tackled before such an integrated system can come into existence .
6hat can 0sia gain from the single currencyS
0 common currency will lead to reduction in the transaction costs for the traders. $ince business within 0sia will be conducted in the common currency, it will eliminate the need for currency con+ersion.
'eduction in the Iominal 2xchange 'ate #ncertainty for the traders of the member countries is likely. This reduced uncertainty should ideally gi+e a fillip to the intra.union trade.
0cting as a union would pro+ide the countries with a bargaining power +is a +is the rest of the world, which indi+idual nations cannot achie+e.
0 +ery important ad+antage that the single currency would ha+e o+er the dollar and euro is the fact that 0sia has control o+er the ma/or oil reser+es "$audi 0rabia, (uwait, Iran etc.%. This will, in turn , ha+e the following implications: 0sia will be able to pressuri8e the world into trading in their common currency. $ignificant impro+ement in the B?! of the member states will be possible leading to reduced dependence on the +arious sources of external aid.
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It will lead to greater market transparency by making prices of the products across nations "within the union% easily comparable.
%hat can 2e the F&i$side o# such a system( The first thing that comes to the mind when we talk about the disad+antages of a single currency is: L 6ho will ha+e control o+er the +arious countries1 monetary policySL 0 nation must be prepared to lose some degree of control o+er its monetary policy and be satisfied with a reduced ability to offset demand shocks and to influence their own inflation rates. 'ecent international experience suggests that this loss can pro+e to be of great significance "the fact that 0rgentina went through se+ere recession was primarily because of its tie up of the #$ F%. Transition to the common currency ; the way I see it: 3. The transition should broadly be on the lines of euro. @. The single currency should be introduced in a phased manner gi+ing ample opportunities to the member states to ad/ust and adapt to the changed en+ironment. D. 0t the time of introduction, the exchange rate between the common and indi+idual currencies should be irre+ocably fixed. H. The countries be allowed to use both the currencies during the transition period. G. I now mo+e o+er to the +arious issues that seem to be important and need due attention if the transition from multiple to single currency is to be smooth and successful: a. $trategic: there are compelling reasons as to why formation of an 0sian trade block "0sian monetary union% will be a strategic mo+e with great conse7uences. The union will comprise of two of the fastest growing economies on the planet "India and china%. It will also offer a single largest market for a range of commodities from computers to cars. This will enhance the bargaining power of the block gi+en the saturating 0merican and 2uropean markets.
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b. 2conomic: introduction of the single currency impacts more than /ust currency of payment , it has se+eral economic effects as well: irms that practice price discrimination "charging different prices in different geographical markets and thereby reaping hea+y profits% will lose this luxury after the system comes into force. 9ompanies, which will be able to charge their customers in the currency units of their choice, will become more popular than their competitors. The 0sian monetary union will be able to impose tariffs on the goods from non.0sian countries. This would make their products more expensi+e and would aid in increasing the sales of 0sian countries to the fellow member states. c. Technical: this basically deals with need to make +arious financial information systems of the countries compatible with the common currencies. 0s a result a larger percentage of the accounts of the concerned countries of the world will need updation. or a country like India it may pro+e to be a blessing in disguise because of its cheap and skilful software professional pool also it will ha+e an opportunity to de+elop the financial system at a much lower cost.
d. !olitical: to me this is easily the most +ital ingredient in the recipe of a successful 0sian currency. ,i+en the heterogeneity among the 0sian countries ;the form of go+ernment, language, culture, +alues, religion, etc, a financially united 0sia will only be a dream if these differences are not harmoni8ed and a collecti+e effort made. More o+er relations between the
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countries are not friendly. to say least, Indo.!ak and Bapanese.(orean relations are cases in point. Conc&usion: 0lthough, when one looks at the possibility of the largest continent in the world using the same currency unit, it seems impressi+e and rewarding, the +ery fact that +arious nations would gain and lose to +arious extents poses ma/or obstacles. 6hyS or instance, would oil.producing nations share their natural ad+antage with other 0sian statesS Through this article I ha+e tried to bring to light the gains 0sia can reap if it becomes one solid block and the pit falls on that path. The reasoning and explanation , howe+er , is not exhausti+e. 6hether or not 0sia should follow the path of 2urope ought to be discussed at appropriate forums and the regional conflicts, policy di+ergence be sorted out. It will no doubt be a long drawn process but once accomplished it will go a long way in fostering ?#' future.
GLOSSARY AND NOTES

Arbitrage The simultaneous purchase and sale of identical or equivalent financial instruments or commodity futures in order to benefit from a discrepancy in their price relationship.
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Around Used in quoting forward "premium / discount". "Five-five around" would mean five points on either side of the present spot value. At Par Forward Spread When the forward price is equivalent to the spot price. At the Price Stop-Loss Order stop-loss order that must be e!ecuted at the requested level regardless of mar"et conditions. an! Notes #aper issued by the central ban"$ redeemable as money and considered to be full legal tender. ase "urrenc# The currency in which the %#air& will be traded$ usually listed first. 'n U()/*#+ , United (tates )ollars are the base currency. ear $ar!et mar"et in which prices are declining. id The price that the mar"et participants are willing to pay. (ee offer. rea!awa# gap price gap which occurs in the beginning of a new trend$ most commonly after trading reopens following the wee"end. 't may also appear after the completion of ma-or chart formations.
rea!-E%en Point The price of a financial instrument at which the option buyer recovers the premium. retton &oods
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The site of the conference which in ./00 led to the establishment of the post war foreign e!change system that remained intact until the early ./12s. The conference resulted in the formation of the '3F. The system fi!ed currencies in a fi!ed e!change rate system with .4 fluctuations of the currency to gold or the dollar. u'' $ar!et mar"et in which prices are rising. u#ing Se''ing F( 5uying and selling in the foreign e!change mar"et always happens in the currency which is quoted first. "5uy dollar/mar"" means buy the dollar/sell the mar". Traders buy when they e!pect a currency6s value to rise and sell when they e!pect a currency to fall. "ab'e)Ster'ing term used in the foreign e!change mar"et for the U( )ollar/5ritish #ound rate. "entra' an! central ban" provides financial and ban"ing services for a country6s government and commercial ban"s. 't implements the government6s monetary policy$ as well$ by changing interest rates. "entra' Rate 7!change rates against the 78U adopted for each currency within the 73( . 8urrencies have limited movement from the central rate according to the relevant band. "'osed position transaction which leaves the trade with a 9ero net commitment to the mar"et with respect to a particular currency. "'osing Range *or Range+ The high and low prices$ or bids and offers$ recorded during the period. "ontract unit of trading for a financial or commodity future. lso$ the actual bilateral agreement between the parties :buyer and seller;.
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"orre'ation statistical measure referring to the relationship between two or more variables :events$ occurrences etc.;. Typically the (wiss Franc is closely correlated with the 7uro )ollar. "ost o, "arr# The interest rate parity$ where the forward price is determined by the cost of borrowing money in order to hold the position. "o%ered -nterest Rate Arbitrage n arbitrage approach which consists of borrowing currency $ e!changing it for currency 5$ investing currency 5 for the duration of the loan$ and$ after ta"ing off the forward cover on maturity$ showing a profit on the entire set of deals. "ross-Rate The e!change rate between two currencies$ e.g.$ +en /French franc. "urrenc# The type of money that a country uses. 't can be traded for other currencies on the foreign e!change mar"et$ so each currency has a value relative to another. 'f one U( dollar can buy ..<< )eutschmar"s$ then one )eutschmar" can buy 2.=< U( dollars. Da# Order n order that is placed for e!ecution during only one trading session. 'f the order cannot be e!ecuted that day$ it is automatically cancelled. Da# Trading >efers to establishing and liquidating the same position or positions within one day6s trading$ thus ending the day with no established position in the mar"et. )ay trading does ?@T mean trading every day. Dea'er n individual or firm acting as a principal$ rather than as an agent$ in the purchase and/or sale of securities.
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Dea'ing S#ste.s @n-line computers which lin" the contributing ban"s around the world on a one-on-one basis De'i%er# The tender and receipt of an actual commodity or financial instrument$ or cash in settlement of a foreign e!change contract. De'i%er# Date The date of maturity of the contract$ when the e!change of the currencies is made. This date is more commonly "nown as the value date in the FA or 3oney mar"ets. Discount Rate The interest rate at which eligible depository institutions may borrow funds directly from a 8entral 5an" or the Federal >eserve 5an". 'n the United (tates of merica $ this rate is controlled by the Federal >eserve. Econo.ic and $onetar# /nion *E$/+ The irrevocable fi!ing of e!change rates between member currencies and their replacement by a single 7uropean currency$ the euro. The euro is to be issued by a future 7uropean central ban"$ to be independent of political control and federal in nature. ll countries which fulfill the five convergence criteria in .//B will proceed to 73U in C222. The UD and )enmar" have secured optouts from 73U. (weden 6s -oining is sub-ect to ratification by #arliament. European "urrenc# /nit bas"et of the member currencies. s a composite unit$ the 78U consists of all the 7uropean 8ommunity currencies$ which are individually weighted. 't was created by the 7uropean 3onetary (ystem with the eventual goal of replacing the individual 7uropean member currencies. European $onetar# S#ste. system designed to stabili9e$ if not eliminate$ e!change ris"s between member states of the 73( as part of the economic convergence policy of the 7U. 't permits currencies to move in a measured fashion :divergence indicator; within agreed bands :the parity grid; with respect to the 78U and
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consequently with each other. 'taly and the UD are currently not part of the system. @nly Eermany and the 5enelu! are within the current narrow band. Euro.ar!et ma-or catalyst to the acceleration of Fore! trading was the rapid development of the 7urodollar mar"etF where U( dollars are deposited in ban"s outside the U( . (imilarly$ 7uromar"ets are those where assets are deposited outside the currency of origin. The 7urodollar mar"et first came into being in the ./<2s when >ussia 6s oil revenue-- all in dollars -- was deposited outside the U( in fear of being fro9en by U( regulators. That gave rise to a vast offshore pool of dollars outside the control of U( authorities. The U( government imposed laws to restrict dollar lending to foreigners. 7uromar"ets were particularly attractive because they had far less regulations and offered higher yields. From the late ./B2s onwards$ U( companies began to borrow offshore$ finding 7uromar"ets a beneficial center for holding e!cess liquidity$ providing short-term loans and financing imports and e!ports. Gondon was$ and remains the principal offshore mar"et. 'n the ./B2s$ it became the "ey center in the 7urodollar mar"et when 5ritish ban"s began lending dollars as an alternative to pounds in order to maintain their leading position in global finance. Gondon 6s convenient geographical location :operating during sian and merican mar"ets; is also instrumental in preserving its dominance in the 7uromar"et. Entr# Order There are three basic orders that are commonly used for entriesH 3ar"et orders $ (top orders $ and Gimit orders . ?ot all of these orders are available on every e!change or with every bro"er. +ou should chec" the bro"er you will be trading on for a list of the available order types Entr# Point The entry point is based on a particular time or price where the trader wishes initiate his trade in the mar"et. 7ntry points are created based on a set of rules or calculations that are determined by a particular trading method. 7ntry points should either be based on a particular mar"et set-up$ a signal$ or a hybrid of these two.
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E0posure The total amount of money loaned to a borrower or country. 5an"s set rules to prevent overe!posure to any single borrower. 'n trading operations$ it is the potential for running a profit or loss from fluctuations in mar"et prices. E0it Point The e!it point is a trading method6s criteria to e!it the mar"et and close out the e!isting open position. 5efore we enter the mar"et$ we should be aware of where our e!it point will be or what will cause us to e!it our position. This can be accomplished based on one the followingH Target #rofit $ Gimit @rder or (top @rder . Foreign E0change "enters Gondon is the largest centre of foreign e!change trading. ?ew +or" $ To"yo $ (ingapore $ Iurich and Jong Dong are also important. Foreign E0change $ar!et 3ar"et where currencies are traded internationally. bout a trillion :million million; dollars-worth of foreign e!change is traded globally every day$ ma"ing Fore! larger than all bond mar"ets put together. 8urrency mar"ets e!ist in the form of spot$ forward$ futures and options mar"ets. Foreign e!change transactions are made up ofH Trade flows which ma"e up <4 to .24 of total Fore! transactions$ 'mports which usually need to be paid in the currency of the country from which they originate$ 7!ports which are usually paid for in one6s own currency K trade deficit therefore causes a currency to depreciate L$ Flow-ons which are created when a large trade is split up into several smaller trades and (peculation which is short-term investment based on e!pected currency movements.
Futures E0change-traded contracts
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They are firm agreements to deliver :or ta"e delivery of; a standardi9ed amount of something on a certain date at a predetermined price. Futures e!ist in currencies$ money mar"et deposits$ bonds$ shares and commodities. Gap The price Eap between consecutive trading ranges :i.e. the low of the current range is higher than the high of the previous range; Go'd Standard The original system for supporting the value of currency issued. The price of gold is fi!ed against the currency$ which means that an increased supply of gold does not lower the price of gold but causes prices to increase. Gross Sett'e.ent process where full payment of each transaction is made rather than clearing a group of transactions as currently occurs in the Fore! mar"et. Gross Do.estic Product Total value of a country6s output$ income or e!penditure produced within the country6s physical borders. Gross Nationa' Product Eross domestic product plus %factor income from abroad" - income earned from investment or wor" abroad. 1ard "urrenc# currency whose value is e!pected to remain stable or increase in terms of other currencies. 1edging strategy used to offset mar"et ris"$ whereby one position protects another. Usually it involves opposite positions in the cash mar"et and futures mar"et at the same time. -$F 'nternational 3onetary Fund$ established in ./0= to provide international liquidity on a short and method designed to eliminate capital ris".
33G

medium term and encourage liberali9ation of e!change rates. The '3F supports countries with balance of payments problems with the provision of loans. -ncon%ertib'e "urrenc# 8urrency which cannot be e!changed for other currencies$ either because this is forbidden by the foreign e!change regulations or because there are no buyers / sellers for that currency. -n,'ation 8ontinued rise in the general price level in con-unction with a related drop in purchasing power. (ometimes referred to as an e!cessive movement in such price levels. -nitia' $argin The margin is a returnable deposit required to be lodged by buyers and sellers with the clearing house to secure a new futures or options position. -nter-ban! Rates The bid and offer rates at which international ban"s place deposits with each other. The basis of the 'nterban" mar"et. -nter-dea'er ro!er specialist bro"er who acts as an intermediary between mar"et-ma"ers who wish to buy or sell securities to improve their boo" positions$ without revealing their identities to other mar"et-ma"ers. -nterest Arbitrage (witching into another currency by buying spot and selling forward$ and investing proceeds in order to obtain a higher interest yield. 'nterest arbitrage can be inward$ i.e. from foreign currency into the local one or outward$ i.e. from the local currency to the foreign one. (ometimes better results can be obtained by not selling the forward interest amount. 'n that case$ some treat it as no longer being a complete arbitrage$ as if the e!change rate moved against the arbitrageur$ the profit on the transaction may create a loss. :see also rbitrage;. -nterest Parit# @ne currency is in interest parity with another when the difference in the interest rates is equali9ed by the forward e!change margins. For instance$ if the operative interest rate in *apan is M4 and in
335

the UD =4$ a forward premium of M4 for the *apanese +en against sterling would bring about interest parity. -nter%ention ction by a central ban" to affect the value of its currency by entering the mar"et. 8oncerted intervention refers to action by a number of central ban"s to control e!change rates. Li.it Order Gimit orders are the opposite of stop orders. 5y their nature$ limit orders require prices to be traveling in a direction opposite the current price. The primary intent of a limit order is to place a buy order somewhere below$ or a sell order somewhere above the present mar"et price. Unli"e a stop$ which becomes a mar"et order at the prescribed price$ a limit order must be filled at better than the prescribed price Liabi'it# 'n terms of foreign e!change $ the obligation to deliver to a counterparty an amount of currency either in respect of a balance sheet holding at a specified future date or in respect of an unmatured forward or spot transaction. L- OR The Gondon 'nterban" @ffered >ate$ the rate charged by one ban" to another for lending money. Li2uidation ny transaction that offsets or closes out a position. Li.it Order n order to buy or sell a specified amount of a security at a specified price or better. Li.ited "on%ertibi'it# When residents of a country are prohibited from buying other currencies even though nonresidents may be completely free to buy or sell the national currency. Li2uidit# The ability of a mar"et to accept large transactions.
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Long The holding of an e!cess of a particular currency F the opposite of short. $ar!et Set-/p 3ar"et set-ups are used to generate entry points for trades. For e!ampleH "when the close of the second bar is higher than the close of the two previous bars on a M2 minute chart$ 5uy at the open of the ne!t bar." mar"et set- up can also be based on a price pattern or chart formation. "5uy the mar"et at the brea" out of an inverted head and shoulder before .CH22 noon " would be an e!ample of this concept. $argin *See Per,or.ance ond+ :.; )ifference between the buying and selling rates$ also used to indicate the difference between spot or forward. :C; For options the sum required as collateral from the writer of an option. :M; For futures a deposit made to the clearing house on establishing a futures position account. :0; The percentage reserve required by the U( Federal >eserve to ma"e an initial transaction . $ar!et Order n order for immediate e!ecution given to a bro"er to buy or sell at the best obtainable price. mar"et order is used to enter the mar"et at whatever the current price may be$ without any restrictions on what the price should be. 'n Fore! trading$ a bro"er6s dealing software usually only allows mar"et orders at the current mar"et price displayed on the trader6s screen. $ini.u. Price F'uctuation (mallest increment of price movement possible. lso referred to as a "tic"." $onetar# Po'ic# central ban"6s management of a country6s money supply. 7conomic theory underlying monetary policy suggests that controlling the growth of the amount of money in the economy is the "ey to controlling prices and therefore inflation. Jowever$ central ban"s6 monetary capability is severely limited by global money movements. This forces them to use the indirect tool of e!change rate manipulation.
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$ost Fa%oured Nation *$FN+ n underta"ing to give the rate of tariff concession offered to members of the E TT. 3ore concessionaire rates can e!ist. $o%ing A%erage way of smoothing a set of data$ widely used in price time series. Na!ed -nter%ention central ban" type of intervention in the foreign e!change mar"et$ which consist solely of the foreign e!change activity. This type of intervention has a monetary effect on the money supply and a long-term effect on foreign e!change. Nostro Account foreign currency current account maintained with another ban". The account is used to receive and pay currency assets and liabilities denominated in the currency of the country in which the ban" is resident. Note financial instrument consisting of a promise to pay rather than an order to pay or a certificate of indebtedness. Odd Lot non-standard amount for a transaction$ e.g. anything other than an even million. O,,er lso called "as"". 'ndicates a willingness to sell a contract at a given price. :(ee bid.; Open -nterest The total number of outstanding option or futures contracts that have not been closed out by offset or fulfilled by delivery. n indicator of the depth or liquidity of a mar"et :the ability to buy or sell at or near a given price; Used for ris"- and/or asset-management. Out-Trades situation that results when there is some confusion or error on a trade. difference in pricing$
334

with both traders thin"ing they were buying$ for e!ample$ is one reason why an out-trade may occur. O%er The "ounter *OT"+ mar"et conducted directly between dealers and principals via a telephone and computer networ" rather than a regulated e!change-trading floor. These days @T8 trading is seen as "consumerfriendly$" meaning that it is interested in getting the buyer and seller the best possible price. (ome see this as what share trading is all about. Jowever$ mar"et ma"ers$ many of whom create mar"et movements purposefully$ feel they are being elbowed out by @T8$ and that speculation$ arbitrage and "smart-trading" are undermined by the new mar"et. O%erheated *Econo.#+ 's an economy where high-growth rates place pressure on production capacity resulting in increased inflationary pressures and higher interest rates. O%ernight Li.it ?et long or short position in one or more currencies that a dealer can carry over into the ne!t dealing day. #assing the boo" to other ban" dealing rooms in the ne!t trading time 9one reduces the need for dealers to maintain these unmonitored e!posures. Par :.; The nominal value of a security or instrument. :C; The official value of a currency. Parit# The value of one currency in terms of another. Parit# Grid term used in the conte!t of the 7uropean 3onetary (ystem$ which consists of the upper$ central and lower intervention points between member currencies. Pegged or Pegging The agreement between countries which %fi!es& the e!change rate between their currencies to a
3@K

set value$ e.g. . U() N M=2 +en. Usually this value cannot fluctuate more than a fi!ed amount according to the terms of the agreement :.4 - .24; Position The net total commitments in a given currency$ either long or short$ in the form of open contracts. :(ee open interest.; Principa' dealer who buys or sells stoc" for his/her own account. Pro,it Target #oint at which a trader intends to e!it the mar"et. s soon as an intended profit is reached$ the trade will be closed. Target profits should be a derivative of a trader6s ris"-to-reward ratio. Purchasing Power Parit# 3odel of e!change rate determination stating that the price of a good in one country should equal the price of the same good in another country$ e!changed at the current rate. lso "nown as the law of one price. P#ra.iding The use of cash generated by positive variation margins on a futures position to increase the si9e of the position$ each reinvestment in successively smaller increments. 3uota :.; :C; limit on imports or e!ports. country6s subscription to the '3F.
3uote n indicative price. The price quoted for information purposes onlyO not to deal. Range The difference between the highest and lowest price recorded during a given trading session.
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Rate :.; The price of one currency in terms of another$ normally against U() :C; ssessment of the credit worthiness of an institution. Reser%e "urrenc# currency held by a central ban" on a permanent basis as a store of international liquidity$ these are normally )ollar$ )eutschemar"$ and (terling . Reser%es Funds held against future contingencies$ normally a combination of convertible foreign currency$ gold$ and ()>s. @fficial reserves are to ensure that a government can meet near term obligations. They are an asset in the balance of payments. Reser%e Re2uire.ent The ratio of reserves to deposits$ e!pressed as a fraction prescribed by national ban"ing authorities Ris! The degree of uncertainty associated with an investment. The main elements that contribute to the overall ris" of an investment are volatility$ liquidity and leverage. ll things being equal$ a high degree of volatility and leverage ma"es an investment more ris"y. 5uyers may not always be matched by sellers$ meaning an investor can be left holding an asset that is falling in price. Ris!)Return The relationship between the ris" and return on an investment. Usually$ the more ris" you are prepared to ta"e$ the higher the return you can e!pect. )epositing your money in a ban" is safe and therefore a low return is regarded as sufficient. 'nvesting in the stoc" mar"et e!poses you to more ris" :from capital losses; and so investors will e!pect a higher return. Ris! $anage.ent The identification and acceptance or offsetting of the ris"s threatening the profitability or e!istence of an organi9ation. With respect to foreign e!change$ it involves among others consideration of mar"et$ sovereign$ country$ transfer$ delivery$ credit$ and counterparty ris".
3@@

Ris! ) Reward Ratio >is"-reward ratio is a predetermined amount of how much a trader is willing to ris" versus how much they want to ma"e. ratio of MH. would imply that the trader is willing to ris" no more than one pip for each potential pip of profit. This ratio should be based on technical analysis as well as psychological requirements. Without a properly set ratio$ the game of probabilities is hard to win. SDR (pecial )rawing >ight. the '3F. Se''ing rate >ate at which a ban" is willing to sell foreign currency. Sett'e.ent Price figure determined by the closing range that is used to calculate gains and losses in futures mar"et accounts. (ettlement prices are used to determine gains$ losses$ margin calls$ and invoice prices for deliveries. :(ee closing range.; Specu'ator @ne who attempts to anticipate price changes and$ through buying and selling futures contracts$ aims to ma"e profitsF does not use the futures mar"et in connection with the production$ processing$ mar"eting or handling of a product. The speculator has no interest in ma"ing or ta"ing delivery. Spot :.; The most common foreign e!change transaction :C; (pot requires settlement within two business days$ sub-ect to value date calculation. Spot Price)Rate The price at which the currency is currently trading in the spot mar"et. Spread The simultaneous price of contracts for the same currency. spread has nothing to do with the standard bas"et of five ma-or currencies in fi!ed amounts as defined by
3@D

direction in which the mar"et moves$ but only with the difference between the %5')& and % (D& prices of each contract. Steri'i4ation 8entral 5an" activity in the domestic money mar"et to reduce the impact on money supply of its intervention activities in the Fore! mar"et. Stop Loss Order @rder given to ensure that$ should a currency wea"en by a certain percentage$ a short position will be covered even though this involves ta"ing a loss. certain price before an order is placed. Swap The simultaneous purchase and sale of the same amount of a given currency for two different dates. 'n essence$ swapping is somewhat similar to borrowing one currency and lending another for the same period. Technica' Ana'#sis 's concerned with past price and volume trends and often with the help of chart analysis in a mar"et in order to be able to ma"e forecasts about future price developments of the commodity being traded. Tender :.; a formal offer to supply or purchase goods or services. :C; 'n the UD the term for the wee"ly Treasury 5ill issue. Thresho'd o, Di%ergence safety feature for the 73($ which creates an emergency e!it for currencies$ which become the singular focus of various adverse forces. The threshold of divergence indicates when the specific country with the pressured currency should ta"e additional steps other then simple central ban" intervention in the foreign e!change mar"ets. stop requires the mar"et to pass through a
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Thin $ar!et mar"et in which trading volume is low and in which consequently bid and as" quotes are wide and the liquidity of the instrument traded is low. Trend The general direction of the mar"et. /nder-5a'uation n e!change rate is normally considered to be undervalued when it is below its purchasing power parity. 5e'ocit# o, $one# The speed with which money circulates or turnover in the economy. 't is calculated as the annual national incomeH average money stoc" in the period. 5o'ati'it# measure of the amount by which an asset price is e!pected to fluctuate over a given period. ?ormally measured by the annual standard deviation of daily price changes :historic;. 8an be implied from futures pricing$ implied volatility. 5o'u.e The number of transactions made during a specified period of time. &or'd an! ban" made up of members of the '3F whose aim is to assist in the development of member states by ma"ing loans where private capital is not available
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