FOREIGN EXCHANGE

Foreign exchange, or Forex, is the conversion of one country's currency into

that of another. In a free economy, a country's currency is valued according
to factors of supply and demand. In other words, a currency's value can be
pegged to another country's currency, such as the U.S. dollar, or even to a
basket of currencies. A country's currency value also may be fixed by the
country's government. However, most countries float their currencies freely
against those of other countries, which keeps them in constant fluctuation.
The value of any particular currency is determined by market forces based
on trade, investment, tourism, and geo-political risk. Every time a tourist
visits a country, for example, he or she must pay for goods and services
using the currency of the host country. Therefore, a tourist must exchange
the currency of his or her home country for the local currency. Currency
exchange of this kind is one of the demand factors for a particular currency.
Another important factor of demand occurs when a foreign company seeks to
do business with a company in a specific country. Usually, the foreign
company will have to pay the local company in their local currency. At other
times, it may be desirable for an investor from one country to invest in
another, and that investment would have to be made in the local currency as
well. All of these requirements produce a need for foreign exchange and are
the reasons why foreign exchange markets are so large.
Foreign exchange is handled globally between banks and all transactions fall
under the auspice of the Bank of International Settlements.
 Foreign Exchange

International Trade External Receipts and

Payments

Import Trade Current account

Export Trade Capital Account

Foreign Exchange Market

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

Factors that Affect Foreign Exchange Rates

Foreign Exchange rate (FOREX rate) is one of the most important means
through which a countrys relative level of economic health is determined. A
country's foreign exchange rate provides a window to its economic stability,
which is why it is constantly watched and analyzed. If you are thinking of
sending or receiving money from overseas, you need to keep a keen eye on
the currency exchange rates.
The exchange rate is defined as "the rate at which one country's currency
may be converted into another." It may fluctuate daily with the changing
market forces of supply and demand of currencies from one country to
another. For these reasons; when sending or receiving money internationally,
it is important to understand what determines exchange rates.
This article examines some of the leading factors that influence the
variations and fluctuations in exchange rates and explains the reasons
behind their volatility, helping you learn the best time to send money abroad.

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

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

Countrys Current Account / Balance of Payments

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

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

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

Political Stability & Performance

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

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

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

All of these factors determine the foreign exchange rate fluctuations. If you
send or receive money frequently, being up-to-date on these factors will help
you better evaluate the optimal time for international money transfer. To
avoid any potential falls in currency exchange rates, opt for a locked-in
exchange rate service, which will guarantee that your currency is exchanged
at the same rate despite any factors that influence an unfavorable
fluctuation.
For more information on transferring money abroad, learn about some
important tips for sending money overseas and your rights as an overseas
money sender.
Foreign Exchange Exposure
Foreign Exchange Exposure refers to the risk associated with the foreign
exchange rates that change frequently and can have an adverse effect on
the financial transactions denominated in some foreign currency rather than
the domestic currency of the company.
In other words, the firms risk that its future cash flows get affected by the
change in the value of the foreign currency, in which it has maintained its
books of accounts (balance sheet), due to the volatility of the foreign
exchange rates is termed as foreign exchange exposure.
It is not only those firms who directly make the financial transactions in the
foreign currency denominations faces the risk of foreign exposure, but also,
the other firms who are indirectly related to the foreign currency is exposed
to foreign currency risk.
For example, if Indian company is competing against the products imported
from China and if the Chinese yuan per Indian rupee falls, then the importers
enjoy decreased cost advantage over the Indian company. This shows, that
the companies not having any direct link to the forex do get affected by the
change in the foreign currency.
Transaction Exposure
The Transaction Exposure is a kind of foreign exchange risk involved in the
international trade wherein the cross-currency transactions (multiple
currencies) are involved. In other words, a risk faced by the company that
while dealing in the international trade, the currency exchange rates may
change before making the final settlement, is termed as a transaction
exposure.
If the Indian exporter has the receivable of $5,00,00, due five months hence,
but in the meanwhile the dollar depreciates relative to the rupee, then the
exporter will suffer the cash loss. But however, in the case of a payable of
the same amount, the exporter gains if the dollar depreciates relative to the
rupee.
Thus, once the cross-currency contract has been agreed upon by the firms
located in two different countries for the specific amount of goods and
money, the contract value may change with the fluctuations in the foreign
exchange rates. This risk of change in the exchange rates is called the
transaction exposure.
The greater the time gap between the agreement and the final settlement,
the higher is the risk associated with the change in the foreign exchange
rates. However, the companies could save themselves against the
transaction exposure through hedging techniques.

Operating Exposure
The Operating Exposure refers to the extent to which the firms future cash
flows gets affected due to the change in the foreign exchange rates along
with the price changes. In other words, a risk that firms revenue will be
adversely affected due to the substantial change in the exchange rate and
the inflation rate is called as operating exposure.
Operating Exposure, like transaction exposure, also involves the actual or
potential gain or loss, but the latter is specific in nature and deals with a
particular transaction of the firm, while the former deals with certain macro
level exposure wherein not only the firm under concern gets affected but
rather the whole industry observes the change with the change in the
exchange rates and the inflation rate. Thus, with operating exposure, the
entire economy is exposed to the foreign exchange risk.
Since, operating exposure is much broader in nature, and relates to the
entire investment of the firm so with the change in the exchange rates the
overall value of the firm gets altered. The firms value is comprised of the
operating cash flows and the total assets the firm possesses.
It is quite difficult to identify operating risk, as the cash flows largely depends
on the cost of firms inputs and the prices of its outputs which gets altered
significantly with the change in the foreign exchange rates. Also, such
exposure relates to the unseen challenges from the competitors, entry
barriers, etc., which are subjective in nature and are interpreted differently
by different experts. Thus, operating exposure influences the competitive
position of the firm substantially.

Translation Exposure
The Translation Exposure or Accounting Exposure is the risk of loss suffered
when stock, revenue, assets or liabilities denominated in foreign currency
changes with the movement of the foreign exchange rates.
In other words, the translation exposure stems from the requirement of
converting the subsidiarys assets and liabilities (operating in another
country) denominated in foreign currency in the home currency of the parent
company, at the time of preparing the consolidated profit and loss statement
and the balance sheet. Thus, any change in the foreign exchange rate will
have a considerable impact on the financial statements.
In translating the items denominated in foreign currency in the domestic
currency, an accountant encounters two issues:
1. Whether the financial statement items denominated in foreign
currency are converted at the current exchange rate or at the rate which was
prevailing at the time the transaction occurred (historical exchange rate)?
2. Whether the profit or loss that arises from the rate adjustments be
taken into the current period profit and loss statement or be postponed?
If there is any change in the exchange rate over the previous accounting
period, then the translation of the items denominated in the foreign currency
will result in foreign exchange gains or losses, except when there is a tax
implication on these items.
The translation exposure is concerned with the recorded profits and the
balance sheet values and does not affect the overall value of the firm. Since
the gains or losses suffered due to the translation of financial items has no
significant impact on the stock prices of the firm. And the investors do
believe that such risk can be diversified and hence does not demand any
extra premium for it.