UNIVERSITY OF MUMBAI

PROJECT REPORT ON

FOREIGN EXCHANGE MARKET

MASTER OF COMMERCE (BANKING & FINANCE)
SUBJECT:-.INTERNATIONAL FINANCE
SEMESTER III
2015-2016

In Partial Fulfilmentof the Requirement uder Semester Based Credit

And Grading System for Post Gradutes (P.G)
Programme under Faculty of Commerce

SUBMITTED BY
VISHAKHA H MARU
ROLL NO:-36

PROJECT GUIDE
PROF:- SHEETAL MODY

K.P.B HINDUJA COLLEGE OF COMMERCE

315, NEW CHARNI ROAD, MUMBAI-400 004

[Link] (Banking and Finance)

3RD SEMESTER

FOREIGN EXCHANGE MARKET

SUBMITTED BY
Miss. VISHAKHA HARISH MARU
ROLL NO: 36

CERTIFICATE
This is to certify that Ms. MARU VISHAKHA HARISH of [Link]
BANKING AND FINANCE Semester- 3 [2015-2016] has successfully completed
the Project on FOREIGN EXCHANGE MARKET under the guidance of PROF
SHEETAL MODY.

Project Guide

________________

Course Coordinator

________________

Internal Examiner

________________

External Examiner

________________

Principal

________________

Date: ______
Place: Mumbai

DECLARATION

I, Ms. VISHAKHA HARISH MARU student of [Link]-Banking and

Finance, semester- 3 (2015-2016), hereby declare that I have completed the project
on .INTERNATIONAL FINANCE.
The information submitted is true and original copy to the best of my
knowledge.

VISHAKHA MARU

ACKNOWLEDGEMENT

I owe my special thanks to the Principle Dr. Chitra Natrajan and the Cocoordinator of [Link] PROF KULDEEP SHARMA for giving me an opportunity
for this project work. I would like to give my thanks to the Project Guide PROF
.SHEETAL MODY for her guidance and kind assessment that she has provided
me and the inspiration in valued guidance and ideas throughout the project. I am
also thankful to the library staff of K. P. B. Hinduja College Of Commerce who cooperated with me and even all those seen and unseen hands and heads which
helped me in her completion of this project.

INDEX
SR- NO.
CH

CH

CH

TOPICS

PAGE NO.

FOREIGN EXCHANGE MARKET

1-2

1.1

INTRIDUCTION

1.2

WHY DO ME MAKE USE OF FOREIGN EXCHANGE ?

2-3

1.3

CHARCHERISTIC OF FOREIGN EXCHANGE MARKET

3-5

1.4

FOREIGN EXCHANGE MEANING,FUNCTION,KIND.

5-6

1.5

FOREX MARKET PARTICIPANTS

6-7

1.6

FOREIGN EXCHANGE INSTRUMENTS.

THE FOREIGN EXCHANGE RATE

2.1

WHAT IS FOREIGN EXCHANGE RATE?

9-10

2.2

TYPES OF FOREIGN EXCHANGE

10-12

2.3

DETERMINATION OF EXCHANGE RATE

13-16

2.4

FACTOR INFLUENCE EXCHANGE RATE

16-19

FOREIGN

EXCHANGE

INSTRUMENT

&

RISK

20

MANAGEMENT

3.1

FOREIGN EXCHANGE INSTRUMENT

20-22

3.2
3.3

FOREIGN EXCHANGE RISK

TYPES OF RISK

22-23
24-26

3.4

TYPES OF EXPOUSURE

26-27

3.5

FOREIGN EXCHANGE RISK MANAGEMENT

28-30

4.

BIBOLOGRAPHY

CH:1 FOREIGN EXCHANGE MARKET

31

INTRODUCTION
The foreign exchange market (forex, FX, or currency market) is a
global decentralized market for the trading of currencies. This includes all aspects of buying,
selling and exchanging currencies at current or determined prices. In terms of volume of trading,
it is by far the largest market in the world. The main participants in this market are the larger
international banks. Financial centres around the world function as anchors of trading between a
wide range of multiple types of buyers and sellers around the clock, with the exception of
weekends. The foreign exchange market determines the relative values of different currencies.
The foreign exchange market works through financial institutions, and it operates on several
levels. Behind the scenes banks turn to a smaller number of financial firms known as dealers,
who are actively involved in large quantities of foreign exchange trading. Most foreign exchange
dealers are banks, so this behind-the-scenes market is sometimes called the interbank market,
although a few insurance companies and other kinds of financial firms are involved. Trades
between foreign exchange dealers can be very large, involving hundreds of millions of dollars.
Because of the sovereignty issue when involving two currencies, forex has little (if any)
supervisory entity regulating its actions.
The foreign exchange market assists international trade and investments by enabling currency
conversion. For example, it permits a business in the United States to import goods
from European Union member states, especially Eurozone members, and pay Euros, even though
its income is in United States dollars. It also supports direct speculation and evaluation relative to
the value of currencies, and the carry trade, speculation based on the interest rate differential
between two currencies.
In a typical foreign exchange transaction, a party purchases some quantity of one currency by
0paying with some quantity of another currency. The modern foreign exchange market began
forming during the 1970s after three decades of government restrictions on foreign exchange
transactions (the Bretton Woods system of monetary management established the rules for
commercial and financial relations among the world's major industrial states after World War II),

when countries gradually switched to floating exchange rates from the previous exchange rate
regime, which remained fixed as per the Bretton Woods system.

Why do we make use of the Foreign Exchange Market?

Trading in a domestic market is substantially different from doing business in an offshore
market. In the complex world of international trade, merchants face a number of risks that need
to be managed in order to ensure the success of their cross border transactions. In order to
protect themselves, these corporations apply hedging techniques using various foreign exchange
instruments and products in order to negate the impacts of exchange rate fluctuations. Successful
companies employ effective risk management techniques when making business decisions, and
evaluate commercial risk in an explicit and logical manner in order to offset financial loss
occasioned by the volatility in exchange rates (currency risk).
.

Characteristics of the Foreign Exchange Market

The Forex market does not exist physically, it is a framework where participants are connected
by computers, telephones and telex (SWIFT) and operates in most financial centres globally.
Because the Forex market is so highly integrated globally, it can operate 24 hours a day when
one major market is closed, another major market is open to facilitate trade occurring 24 hours a
day moving from one major market to another. Most exchanges of currency are made through
bank deposits i.e. transferred electronically from one account to another.
The volume of foreign exchange transactions worldwide is assumed to be approximately USD 2
trillion per day. The average daily turnover in the South African market is R11 billion per day
and Standard Bank is the recognised leader in the domestic foreign exchange market, handling
more than 30% of South Africa's foreign exchange volume. The Forex market is an over-thecounter market i.e. trading in financial instruments that are not listed or available on an officially
recognised exchange (such as the JSE Johannesburg Stock Exchange), but traded in direct
negotiation between buyers and sellers. Trading takes place telephonically or electronically.

The foreign exchange market is unique because of the following characteristics:

its huge trading volume representing the largest asset class in the world leading to
high liquidity;

its geographical dispersion;

its continuous operation: 24 hours a day except weekends, i.e., trading from
22:00 GMT on Sunday (Sydney) until 22:00 GMT Friday (New York);

the variety of factors that affect exchange rates;

the low margins of relative profit compared with other markets of fixed income; and

the use of leverage to enhance profit and loss margins and with respect to account size.

Foreign Exchange Market: Meaning, Functions and Kinds

Meaning:
Foreign exchange market is the market in which foreign currencies are bought and sold. The
buyers and sellers include individuals, firms, foreign exchange brokers, commercial banks and
the central bank.
Like any other market, foreign exchange market is a system, not a place. The transactions in this
market are not confined to only one or few foreign currencies. In fact, there are a large number of
foreign currencies which are traded, converted and exchanged in the foreign exchange market.

Functions of Foreign Exchange Market:

Foreign exchange market performs the following three functions:

1. Transfer Function:It transfers purchasing power between the countries involved in the
transaction. This function is performed through credit instruments like bills of foreign exchange,
bank drafts and telephonic transfers.

2. Credit Function:
It provides credit for foreign trade. Bills of exchange, with maturity period of three months, are
generally used for international payments. Credit is required for this period in order to enable the
importer to take possession of goods, sell them and obtain money to pay off the bill.

3. Hedging Function:
When exporters and importers enter into an agreement to sell and buy goods on some future date
at the current prices and exchange rate, it is called hedging. The purpose of hedging is to avoid
losses that might be caused due to exchange rate variations in the future.

Kinds of Foreign Exchange Markets:

Foreign exchange markets are classified on the basis of whether the foreign exchange
transactions are spot or forward accordingly, there are two kinds of foreign exchange
markets:
(i) Spot Market,
(ii) Forward Market.

(i) Spot Market:

Spot market refers to the market in which the receipts and payments are made immediately.
Generally, a time of two business days is permitted to settle the transaction. Spot market is of

daily nature and deals only in spot transactions of foreign exchange (not in future transactions).
The rate of exchange, which prevails in the spot market, is termed as spot exchange rate or
current rate of exchange.
The term spot transaction is a bit misleading. In fact, spot transaction should mean a
transaction, which is carried out on the spot (i.e., immediately). However, a two day margin is
allowed as it takes two days for payments made through cheques to be cleared.
(ii)

Forward Market:

Forward market refers to the market in which sale and purchase of foreign currency is settled on
a specified future date at a rate agreed upon today. The exchange rate quoted in forward
transactions is known as the forward exchange rate. Generally, most of the international
transactions are signed on one date and completed on a later date. Forward exchange rate
becomes useful for both the parties involved in the transaction.

Forward Contract is made for two reasons:

(a) To minimize the risk of loss due to adverse changes in the exchange rate (through hedging);
(b) To make profit (through speculation).

Forex Market Participants

Consumers and Travelers

Consumers may purchase goods in a foreign country or via the internet with their credit
card.

The amount consumers pay in the foreign currency will be converted to their home
currency on their credit card statement.

Travelers must go to a bank or currency exchange bureau to convert one currency (their
"home" currency) into another (the "destination" currency) when using cash to pay for goods
and services in a foreign country.

Travelers need to be aware of exchange rates to ensure they receive a fair deal.

Businesses

Businesses often need to convert currencies when they conduct trade outside their home
country.

Large companies need to convert huge amounts of currency; a multinational company

such as General Electric (GE) for instance, converts tens of billions of dollars each year.

Investors and Speculators

Investors and speculators require currency exchange whenever they deal in any foreign
investment, be it equities, bonds, bank deposits, or real estate.

Investors and speculators also trade currencies in an attempt to benefit from movements
in the currency exchange markets.

Commercial and Investment Banks

Commercial and investment banks trade currencies as a service to their commercial

banking, deposit, and lending customers.

These institutions also participate in the currency market for hedging and speculative
purposes.

Governments and Central Banks

Governments and central banks trade currencies to improve economic conditions or to

intervene in an attempt to adjust economic or financial imbalances.

Because they are non-profit, governments and central banks do not trade with the
intention of earning a profit, but because they tend to trade on a long-term basis, it is not
unusual for some trades to earn revenue.

Foreign Exchange Instruments

A number of foreign exchange instruments have been designed for effective hedging as well as
enhancement of returns. The following instruments and products are most common to the
Foreign Exchange Market to facilitate international trade and will be covered in future Forex
Bulletins: Spot transactions, Forward Transactions (FECs), Options (Derivatives of exchange
rates), International money transfers, Guarantees, Commercial Customer Foreign Currency
accounts, Documentary Credit and Collections,

CH:2 THE EXCHANGE RATE:INTRODUCTION:. In finance, an exchange rate (also known as a foreign-exchange rate, forex rate, FX
rate or Agio) between two currencies is the rate at which one currency will be exchanged for
another. It is also regarded as the value of one countrys currency in terms of another currency.
[1]

For example, an interbank exchange rate of 119 Japanese yen (JPY, ) to the United States

dollar (US$) means that 119 will be exchanged for each US$1 or that US$1 will be exchanged
for each 119. In this case it is said that the price of a dollar in terms of yen is 119, or
equivalently that the price of a yen in terms of dollars is $1/119.
Exchange rates are determined in the foreign exchange market,[2] which is open to a wide range
of different types of buyers and sellers where currency trading is continuous: 24 hours a day
except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday. The spot
exchange rate refers to the current exchange rate. The forward exchange rate refers to an
exchange rate that is quoted and traded today but for delivery and payment on a specific future
date..

What is foreign exchange rate or exchange rate?

An exchange rate is simply the price of one currency in terms of another. The process by which
that price is determined depends on the particular exchange rate mechanism adopted. In a
floating rate system, the exchange rate is determined directly by market forces, and is liable to
fluctuate continually, as dictated by changing market conditions. In a 'fixed', or managed rate
system, the authorities attempt to regulate the exchange rate at some level that they consider
appropriate. Such a system often seems appealing to those who are troubled by the uncertainties
of the present, highly volatile, floating rate environment.
But the choice of exchange rate regime involves considerations that extend beyond the stability
or otherwise of currency prices. This will become clearer after an examination of some
fundamentals of the foreign exchange market.

TYPES OF EXCHANGE RATE:[Link] EXCHANGE RATE.

[Link] EXCHANGE RATE.
[Link] EXCHANGE RATE.

Floating exchange rate:A floating exchange rate or fluctuating exchange rate is a type of exchange-rate regime in
which a currency's value is allowed to fluctuate in response to foreign-exchange
market mechanisms. A currency that uses a floating exchange rate is known as a floating
currency. A floating currency is contrasted with a fixed currency whose value is tied to that of
another currency, gold or to a currency basket.
In the modern world, most of the world's currencies are floating; such currencies include the
most widely traded currencies: the United States dollar, the euro, the Norwegian krone,
the Japanese yen, the British pound, and the Australian dollar. However, central banks often
participate in the markets to attempt to influence the value of floating exchange rates.
The Canadian dollar most closely resembles a "pure" floating currency, because the Canadian
central bank has not interfered with its price since it officially stopped doing so in 1998. The US
dollar runs a close second, with very little change in its foreign reserves; in contrast, Japan and
the UK intervene to a greater extent.
From 1946 to the early 1970s, the Bretton Woods system made fixed currencies the norm;
however, in 1971, the US decided no longer to uphold the dollar exchange at 1/35th of an ounce
of gold, so that the currency was no longer fixed. After the 1973Smithsonian Agreement, most of
the world's currencies followed suit. However, some countries, such as most of the Gulf States,
fixed their currency to the value of another currency, which has been more recently associated
with slower rates of growth. When a currency floats, targets other than the exchange rate itself
are used to administer monetary policy (see open-market operations).

Fixed exchange-rate .
A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate
regime where a currency's value is fixed against either the value of another single currency, to
a basket of other currencies, or to another measure of value, such asgold. There are benefits and
risks to using a fixed exchange rate. A fixed exchange rate is usually used in order to stabilize the
value of a currency by directly fixing its value in a predetermined ratio to a different, more stable
or more internationally prevalent currency (or currencies), to which the value is pegged. In doing
so, the exchange rate between the currency and its peg does not change based on market
conditions, the way floating currencies will do. This makes trade and investments between the
two currency areas easier and more predictable, and is especially useful for small economies in
which external trade forms a large part of their GDP.
A fixed exchange-rate system can also be used as a means to control the behavior of a currency,
such as by limiting rates ofinflation. However, in doing so, the pegged currency is then
controlled by its reference value. As such, when the reference value rises or falls, it then follows
that the value(s) of any currencies pegged to it will also rise and fall in relation to other
currencies and commodities with which the pegged currency can be traded. In other words, a
pegged currency is dependent on its reference value to dictate how its current worth is defined at
any given time. In addition, according to the MundellFleming model, with
perfect capitalmobility, a fixed exchange rate prevents a government from using
domestic monetary policy in order to achieve macroeconomicstability.
In a fixed exchange-rate system, a countrys central bank typically uses an open market
mechanism and is committed at all times to buy and/or sell its currency at a fixed price in order
to maintain its pegged ratio and, hence, the stable value of its currency in relation to the
reference to which it is pegged. The central bank provides the assets and/or the foreign currency
or currencies which are needed in order to finance any payments imbalances.[1]

Linked exchange rate

A linked exchange rate system is a type of exchange rate regime to link the exchange rate of
a currency to another. It is the exchange rate system implemented in Hong Kong to stabilise the
exchange rate between the Hong Kong dollar (HKD) and theUnited States dollar (USD).
The Macao pataca (MOP) is similarly linked to the Hong Kong dollar.
Unlike a fixed exchange rate system, the government or central bank does not actively interfere
in the foreign exchange market by controlling supply and demand of the currency in order to
influence the exchange rate. The exchange rate is instead stabilized by an exchange mechanism,
whereby the Hong Kong Monetary Authority (HKMA) authorises note-issuing banks to issue
new banknotes provided that they deposit an equivalent value of U.S. dollars with the HKMA.

Exchange-rate flexibility
.
A flexible exchange-rate system is a monetary system that allows the exchange rate to be
determined by supply and demand.[1]
Every currency area must decide what type of exchange rate arrangement to maintain. Between
permanently fixed and completely flexible however, are heterogeneous approaches. They have
different implications for the extent to which national authorities participate in foreign exchange
markets. According to their degree of flexibility, post-Bretton Woods-exchange rate regimes are
arranged into three categories: currency unions, dollarized regimes, currency boards and
conventional currency pegs are described as fixed-rate regimes; Horizontal bands, crawling
pegs and crawling bands are grouped into intermediate regimes; Managed and independent
floats are described as flexible regimes. All monetary regimes except for the permanently fixed
regime experience thetime inconsistency problem and exchange rate volatility, albeit to different
degrees.

 Determination of Exchange Rates

Three aspects of exchange rate determination are discussed below. First, there is a brief
description of some of the broad approaches to exchange rate determination. Second, there are
some comments on the problems of exchange rate forecasting in practice. Third, central bank
intervention and its effects on exchange rates are discussed.

Some approaches to exchange rate determination:

The Purchasing Power Parity Approach

Purchasing Power Parity (PPP) theory holds that in the long run, exchange rates will adjust to
equalize the relative purchasing power of currencies. This concept follows from the law of one
price, which holds that in competitive markets, identical goods will sell for identical prices when
valued in the same currency.
The law of one price relates to an individual product. A generalization of that law is the absolute
version of PPP, the proposition that exchange rates will equate nations overall price levels. More
commonly used than absolute PPP is the concept of relative PPP, which focuses on changes in
prices and exchange rates, rather than on absolute price levels. Relative PPP holds that there will
be a change in exchange rates proportional to the change in the ratio of the two nations price
levels, assuming no changes in structural relationships. Thus, if the U.S. price level rose 10
percent and the Japanese price level rose 5 percent, the U.S. dollar would depreciate 5 percent,
offsetting the higher U.S. inflation and leaving the relative purchasing power of the two
currencies unchanged.
PPP is based in part on some unrealistic assumptions: that goods are identical; that all goods are
tradable; that there are no transportation costs, information gaps, taxes, tariffs, or restrictions of
trade; and implicitly and importantlythat exchange rates are influenced only by relative
inflation rates.

But contrary to the implicit PPP assumption, exchange rates also can change for reasons other
than differences in inflation rates. Real exchange rates can and do change significantly over time,
because of such things as major shifts in productivity growth, advances in technology, shifts in
factor supplies, changes in market structure, commodity shocks, shortages, and booms.
In addition, the relative version of PPP suffers from measurement problems:What is a good
starting point, or base period? Which is the appropriate price index? How should we account for
new products, or changes in tastes and technology?
.

The Balance of Payments and the Internal- External Balance Approach

PPP concentrates on one part of the balance of paymentstradable goods and services and
postulates that exchange rate changes are determined by international differences in prices, or
changes in prices, of tradable items.
Other approaches have focused on the balance of payments on current account, or on the balance
of payments on current account plus long-term capital, as a guide in the determination of the
appropriate exchange rate.
But in todays world, it is generally agreed that it is essential to look at the entire balance of
paymentsboth current and capital account transactionsin assessing foreign exchange flows
and their role in the determination of exchange rates.
.

The Monetary Approach

The monetary approach to exchange rate determination is based on the proposition that exchange
rates are established through the process of balancing the total supply of, and the total demand
for, the national money in each nation. The premise is that the supply of money can be controlled
by the nations monetary authorities, and that the demand for money has a stable and predictable

linkage to a few key variables, including an inverse relationship to the interest ratethat is, the
higher the interest rate, the smaller the demand for money. In its simplest form, the monetary
approach assumes that: prices and wages are completely flexible in both the short and long run,
so that PPP holds continuously, that capital is fully mobile across national borders, and that
domestic and foreign assets are perfect substitutes. Starting from equilibrium in the money and
foreign exchange markets, if the U.S. money supply increased, say, 20 percent, while the
Japanese money supply remained stable, the U.S. price level, in time, would rise 20 percent and
the dollar would depreciate 20 percent in terms of the yen.
In this simplified version, the monetary approach combines the PPP theory with the quantity
theory of moneyincreases or decreases in the money supply lead to proportionate increases or
decreases in the price level over time, without any permanent effects on output or interest rates.
More sophisticated versions relax some of the restrictive assumptionsfor example, price
flexibility and PPP may be assumed not to hold in the short runbut maintain the focus on the
role of national monetary policies.

The Portfolio Balance Approach

The portfolio balance approach takes a shorter-term view of exchange rates and broadens the
focus from the demand and supply conditions for money to take account of the demand and
supply conditions for other financial assets as well. Unlike the monetary approach, the portfolio
balance approach assumes that domestic and foreign bonds are not perfect substitutes. According
to the portfolio balance theory in its simplest form, firms and individuals balance their portfolios
among domestic money, domestic bonds, and foreign currency bonds, and they modify their
portfolios as conditions change. It is the process of equilibrating the total demand for, and supply
of, financial assets in each country that determines the exchange rate.
.
These actions to balance portfolios will influence exchange rates. Accordingly, a nation with a
sudden increase in money supply would immediately purchase both domestic and foreign bonds,
resulting in a decline in both countries interest rates, and, to the extent of the shift to foreign

bonds, a depreciation in the nations home currency. Over time, the depreciation in the home
currency would lead to growth in the nations exports and a decline in its imports, and thus, to an
improved trade balance and reversal of part of the original depreciation
he portfolio balance channel postulates that the exchange rate is determined by the balance of
supply and demand for available stocks of financial assets held by the private sector. It holds that
sterilized intervention will alter the currency composition of assets available to the global private
sector, and that if dollar and foreign currency-denominated assets are viewed by investors as
imperfect substitutes, sterilized intervention will cause movements in the exchange rate to
reequilibrate supply and demand for dollar assets. The size of this portfolio balance effect would
depend on the degree of substitutability between assets denominated in different currencies and
on the size of the intervention operation.

.Factors influencing exchange rates

Foreign exchange rates are extremely volatile and it is incumbent on those involved with foreign
exchange - either as a purchaser, seller, speculator or institution - to know what causes rates to
move.
Actually, there are a variety of factors - market sentiment, the state of the economy, government
policy, demand and supply and a host of others.
The more important factors that influence exchange rates are discussed below:

Strength of the Economy :The strength of the economy affects the demand and supply of
foreign currency. If an economy is growing fast and is strong it will attract foreign currency
thereby strengthening its own. On the other hand, weaknesses result in an outflow of foreign
exchange. If a country is a net exporter (as were Japan and Germany), the inflow of foreign
currency far outstrips the outflow of their own currency. The result is usually a strengthening in
its value.

 Political and Psychological Factors: Political or psychological factors are believed to have an
influence on exchange rates. Many currencies have a tradition of behaving in a particular way
such as Swiss francs which are known as a refuge or safe haven currency while the dollar moves
(either up or down) whenever there is a political crisis anywhere in the world. Exchange rates
can also fluctuate if there is a change in government. Some time back, Indias foreign exchange
rating was downgraded because of political instability and consequently, the external value of the
rupee fell. Wars and other external factors also affect the exchange rate. For example, when Bill
Clinton was impeached, the US dollar weakened. During the Indo-Pak war the rupee weakened.
After the 1999 coup in Pakistan (October/November 1999), the Pakistani rupee weakened.
Economic Expectations :Exchange rates move on economic expectations. After the 1999 budget
in India there was an expectation that the rupee would fall by 7% to 9%. Since such expectations
affect the external value of the rupee, all economic data - the balance of payments, export
growth, inflation rates and the likes - are analysed and its likely effect on exchange rates is
examined. If the economic downturn is not as bad as anticipated the rate can even appreciate.
The movement really depends on the market sentiment - the mood of the market - and how
much the market has reacted or discounted the anticipated/expected information.
Inflation Rates : It is widely held that exchange rates move in the direction required to
compensate for relative inflation rates. For instance, if a currency is already overvalued, i.e.
stronger than what is warranted by relative inflation rates, depreciation sufficient enough to
correct that position can be expected and vice versa. It is necessary to note that an exchange rate
is a relative price and hence the market weighs all the relative factors in relative terms (in
relation to the counterpart countries). The underlying reasoning behind this conviction is that a
relatively high rate of inflation reduces a countrys competitiveness and weakens its ability to sell
in international markets. This situation, in turn, will weaken the domestic currency by reducing
the demand or expected demand for it and increasing the demand or expected demand for the
foreign currency (increase in the supply of domestic currency and decrease in the supply of
foreign currency).
Capital Movements : Capital movements are one of the most important reasons for changes in
exchange rates. Capital movements of foreign currency are usually more than connected with

international trade. This occurs due to a variety of reasons - both positive and negative. When
India began its economic liberalisation and invited Foreign Institutional Investors (FIIs) to
purchase equity shares in Indian companies, billions of US dollars came into the country
strengthening the currency. In 1996 and 1997, FIIs took several billion US dollars out of the
country weakening the currency. These were capital outflows. One of the reasons popularly
believed for the rupee not depreciating in the manner other South-east Asian currencies did in
1997-98 was because the rupee was not convertible on the capital account.
Speculation : Speculation in a currency raises or lowers the exchange rate. For instance, the
foreign exchange market in Kenya is very shallow. If a speculator enters and buys US $1 million,
it will raise the value of the US dollar significantly. If a few others do so too, the price of the US
dollar will rise even further against the Kenya shilling. The most famous speculator in foreign
currency is Mr George Soros who made over a billion pounds sterling in Europe (by correctly
predicting the devaluation of the pound) and then is believed to have triggered the free fall of the
currencies of South-east Asia.
. Balance of Payments : As mentioned earlier, a net inflow of foreign currency tends to
strengthen the home currency vis--vis other currencies. This is because the supply of the foreign
currency will be in excess of demand. A good way of ascertaining this would be to check the
balance of payments. If the balance of payments is positive and foreign exchange reserves are
increasing, the home currency will become stronger.

Governments Monetary and Fiscal Policies : Governments, through their monetary and fiscal
policies affect international trade, the trade balance and the supply and demand for a currency.
Increasing the supply of money raises prices and makes imports attractive. Fiscal surpluses will
slow economic growth and this will reduce demand for imports and encourage exports. The
effectiveness of the policy depends on the price and income elasticities of demand for the
particular goods. High price elasticity of demand means the volume of a good is sensitive to a
change in price. Monetary and fiscal policy support the currency through a reduction in inflation.
These also affect exchange rate through the capital account. Net capital inflows supply direct
support for the exchange rate. Central governments control monetary supply and they are
expected to ensure that the governments monetary policy is followed. To this extent they could

increase or decrease money supply. For example, the Reserve Bank of India, to curb inflation,
restricted and cut money supply. In Kenya, the central bank in order to attract foreign money into
the country is offering very high rates on its treasury bills. In order to maintain exchange rates at
a certain price the central bank will also intervene either by buying foreign currency (when there
is an excess in the supply of foreign exchange) and selling foreign currency (when demand for
foreign exchange exceeds supply). This is known as central bank intervention. It must be noted
that the objective of monetary policy is to maintain stability and economic growth and central
banks are expected to - by increasing/decreasing money supply, raising/lowering interest rates or
by open market operations - maintain stability.
Exchange Rate Policy and Intervention: Exchange rates are also influenced, in no small
measure, by expectation of change in regulations relating to exchange markets and official
intervention. Official intervention can smoothen an otherwise disorderly market. As explained
before, intervention is the buying or selling of foreign currency to increase or decrease its supply.
Central banks often intervene to maintain stability. It has also been experienced that if the
authorities attempt to half-heartedly counter the market sentiments through intervention in the
market, ultimately more steep and sudden exchange rate swings can occur.

Interest Rates : An important factor for movement in exchange rates in recent years is interest
rates, i.e. interest differential between major currencies. In this respect the growing integration of
financial markets of major countries, the revolution in telecommunication facilities, the growth
of specialised asset managing agencies, the deregulation of financial markets by major countries,
the emergence of foreign trading as profit centres per se and the tremendous scope for
bandwagon and squaring effects on the rates, etc. have accelerated the potential for exchange rate
volatility.
Kenya intrinsically has a very weak economy but the rates offered within the country have
always been very high. To illustrate this point the treasury bill rate in September 1998 was as
high as 23%. High interest rates attract speculative capital moves so the announcements made by
the Federal Reserve on interest rates are usually eagerly awaited - an increase in the same will
cause an inflow of foreign currency and the strengthening of the US dollar.

 Tariffs and Quotas : Tariffs and quotas exist to protect a countrys foreign exchange by reducing
demand. Till before liberalisation, India followed a policy of tariffs and restrictions on imports.
Very few items were permitted to be freely imported. Additionally, high customs duties were
imposed to discourage imports and to protect the domestic industry. Tariffs and quotas are not
popular internationally as they tend to close markets. When India lifted its barriers, several
industries such as the mini steel and the scrap metal industries collapsed (imported scrap became
cheaper than the domestic one). Quotas are not restricted to developing countries. The United
States imposes quotas on readymade garments and Japan has severe quotas on non-Japanese
goods.

CH:- 3 FOREIGN EXCHANGE INSTRUMENT & RISK

MANAGEMENT.
Foreign Exchange Instruments
A number of foreign exchange instruments have been designed for effective hedging as well as
enhancement of returns. The following instruments and products are most common to the
Foreign Exchange Market to facilitate international trade and will be covered in future Forex
Bulletins: Spot transactions, Forward Transactions (FECs), Options (Derivatives of exchange
rates), International money transfers, Guarantees, Commercial Customer Foreign Currency
accounts, Documentary Credit and Collections,
THE FOLLOWING ARE THE FOREIGN MARKET INSTRUMENTS:[Link] MARKET:A futures exchange or futures market is a central financial exchange where people can trade
standardized futures contracts; that is, a contract to buy specific quantities of
a commodity or financial instrument at a specified price with delivery set at a specified time in the
future. These types of contracts fall into the category of derivatives. Such instruments are priced
according to the movement of the underlying asset (stock, physical commodity, index, etc.). The

aforementioned category is named "derivatives" because the value of these instruments

are derived from another asset class.

[Link] MARKET:In finance, a forward contract or simply a forward is a non-standardized contract between two
parties to buy or to sell an asset at a specified future time at a price agreed upon today, making it a
type of derivative instrument This is in contrast to a spot contract, which is an agreement to buy or
sell an asset on its Spot Date, which may vary depending on the instrument, for example most of the
FX contracts have Spot Date two business days from today. The party agreeing to buy the
underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the
future assumes a short position. The price agreed upon is called the delivery price, which is equal to
the forward price at the time the contract is entered into.
The price of the underlying instrument, in whatever form, is paid before control of the instrument
changes. This is one of the many forms of buy/sell orders where the time and date of trade is not the
same as the value date where the securities themselves are exchanged.
The forward price of such a contract is commonly contrasted with the spot price, which is the price at
which the asset changes hands on the spot date. The difference between the spot and the forward
price is the forward premium or forward discount, generally considered in the form of a profit, or loss,
by the purchasing party.
Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange
rate risk), as a means ofspeculation, or to allow a party to take advantage of a quality of the
underlying instrument which is time-sensitive.
.

[Link] MARKET:The spot market or cash market is a public financial market in which financial instruments or
commodities are traded for immediate delivery. It contrasts with a futures market, in which delivery is
due at a later date. In spot market, settlement happens in t+2 working days, i.e., delivery of cash and
commodity must be done after two working days of the trade date. A spot market can be:

an organized market;

an exchange; or

over-the-counter (OTC)

Spot markets can operate wherever the infrastructure exists to conduct the transaction.

[Link] FOREIGN MARKET:Retail foreign exchange trading is a small segment of the larger foreign exchange
market where individuals speculate on the exchange rate between different currencies. This
segment has developed with the advent of dedicated electronic trading platformsand the internet
which have allowed individuals to access the global currency markets. In 2013 it had been
speculated that volume from retail foreign exchange trading represents 5 percent of the whole
foreign exchange market which amounts to $250 billion in daily trading turnover.[1]
Prior to the development of forex trading platforms in late 1990s forex trading was restricted to
large financial institutions.[2] It was the development of the internet, trading software and forex
brokers allowing trading on margin that started the growth of retail [Link] are able to
trade spot currencies with market makers on margin. Meaning they need to put down only a
small percentage of the trade size and can buy and sell currencies in seconds.

INTRODUCTION OF FOREIGN EXCHANGE RISK

The risk of an investment's value changing due to changes in currency exchange
rates. The risk that an investor will have to close out a long or short position in a foreign
currency at a loss due to an adverse movement in exchange rates. Also known as "currency risk"
or "exchange-rate risk. This risk usually affects businesses that export and/or import, but it can
also affect investors making international investments. For example, if money must be converted
to another currency to make a certain investment, then any changes in the currency exchange
rate will cause that investment's value to either decrease or increase when the investment is sold
and converted back into the original currency.
The risk that the exchange rate on a foreign currency will move against the position held
by an investor such that the value of the investment is reduced. For example, if an investor

residing in the United States purchases a bond denominated in Japanese yen, deterioration in the
rate at which the yen exchanges for dollars will reduce the investor's rate of return, since he or
she must eventually exchange the yen for dollars. Also called exchange rate risk.

CAUSES OF FLUCTUATIONS IN FOREIGN CURRENCY

1. Foreign exchange rates are influenced by domestic as well as international factors and
happenings.
2. Foreign exchange dealings cross national boundaries and rates move on the basis of
governmental regulations, fiscal policies, political instabilities and a variety of other
causes.
3. Foreign exchange rate movements, like the stock market, are influenced by sentiments
that may not always be logical.
4. Foreign exchange is traded hours a day at different markets and dealers cannot be in
control at all times.
5. The ratings of credit agencies can affect the exchange rate. For instance, when Indians
foreign exchange rating was downgraded by Moodys in the mid1990s, the value of
rupee fell.
6. A rate move instantaneously and very fast. A hesitation of a few seconds or minutes can
change a profit to a loss and vice versa

TYPES OF FOREIGN EXCHANGE RISK

Risks associated with foreign exchange may be broadly classified as:
1.
2.
3.
4.
5.
6.
7.

Transaction risk.
Position risk.
Settlement or credit risk.
Mismatch or liquidity risk.
Operational risk.
Sovereign risk.
Cross- country risk.

A. Transaction risk:
Any transaction leading to future receipts in any form or creation of long term asset. This consists
of a number of:

1.
2.
3.

Trading items (foreign currency, invoiced trade receivables and payables) and
Capital items (foreign currency dividend and loan payments)
Exposure associated with the ownership of foreign currency denominated assets and liabilities.

B. Position risk:
Bank dealings with customers continuously, both on spot and forward basis, results in positions
(buy i.e. long position or sell i.e. short position) being created in currencies in which these
transactions are denominated. A position risk occurs when a dealer in bank has an overbought
(long) or an oversold (short) position. Dealers enter into these positions in anticipation of a
favorable movement.
The risk arising out of open positions is easy to understand. If one currency is overbought and it
weakens, one would be able to square the overbought position only by selling the currency at a
loss. The same would be the position if one is oversold and the currency hardens.

C. Settlement or credit risk:

Also known as time zone risk, this is a form of credit risk that arises from transactions where the
currencies settle in different time zones. A transaction is not complete until settlement has taken
place in the latest applicable time zone. This is also referred to as Herstatt Risk. Arising from
the failure or default of a counterparty. Technically, this is a credit risk where only one side of the
transaction has settled. If a counterparty fails before any settlement of a contract occurs, the risk
is limited to the difference between the contract price and the current market price (i.e. an
exchange rate risk).
Settlement risk is the risk of a counterparty failing to meet its obligations in a financial transaction
after the bank has fulfilled its obligations on the date of settlement of the contract. Settlement risk
exposure potentially exists in foreign exchange or local currency money market business.

D. Mismatch or liquidity risk:

In the foreign exchange business it is not always possible to be in an ideal position where sales
and purchases are matched or according to maturity and there are no mismatched situations. Some
mismatching of maturities is in general unavoidable. Liquidity risk' arises from situations in which
a party interested in trading an asset cannot do it because nobody in the market wants to trade that
asset. Liquidity risk becomes particularly important to parties who are about to hold or currently
hold an asset, since it affects their ability to trade.
Manifestation of liquidity risk is very different from a drop of price to zero. In case of a drop of an
asset's price to zero, the market is saying that the asset is worthless. However, if one party cannot
find another party interested in trading the asset, this can potentially be only a problem of
the market participants with finding each other. This is why liquidity risk is usually found higher
in emerging markets or low-volume markets.

Liquidity risk is financial risk due to uncertain liquidity. An institution might lose liquidity if
its credit rating falls, it experiences sudden unexpected cash outflows, or some other event causes
counterparties to avoid trading with or lending to the institution. A firm is also exposed to liquidity
risk if markets on which it depends are subject to loss of liquidity.
Liquidity risk tends to compound other risks. If a trading organization has a position in an illiquid
asset, its limited ability to liquidate that position at short notice will compound its market risk.
Suppose a firm has offsetting cash flows with two different counterparties on a given day. If
the counterparty that owes it a payment defaults, the firm will have to raise cash from other
sources to make its payment. Should it be unable to do so, it too will default. Here, liquidity risk is
compounding credit risk.

E. Operational risk:
Operational risk are related to the manner in which transactions are settled or handled
operationally. Some of the risks are discussed below:
a)

Dealing and settlement: This functions must be properly separated, as otherwise there would be
inadequate segregation of duties.

b)

Confirmation: Dealing is usually done by telephone/telex/Reuters or some other electronic

system. It is essential that these deals are confirmed by written confirmations. There is a risk of
mistakes being made related to amount, rate, value, date and the likes.

c)

Pipeline transactions: There are, at times, faults in communication and often cover is not
available for pipeline transactions entered into by branches. There can be delays in conveying
details of transactions to the dealer for a cover resulting in the actual position of the bank being
different from what is shown by the dealers position statement.

d)

Overdue bills and forward contracts: The trade finance departments of banks normally monitor
the maturity of export bills and forward contracts. A risk exists in that the monitoring may not be
done properly.

F.

Sovereign risk: Another risk which banks and other agencies that deal in foreign exchange have
to be aware of is sovereign risk- the risk on the government of a country.

G.

Cross-country risk: It is often not prudent to have large exposures on any one country may go
through troubled times. I such a situation, the bank/entity that has an exposure could suffer large
losses. To control and limit risks arising out of cross country exposures, management normally lay
down cross country exposure limits. Risk management in foreign exchange is imperative as the
lack of these could even result in the bankruptcy and closure of the organization.

TYPES OF EXPOSURE

An Exposure can be defined as a Contracted, Projected or Contingent Cash Flow whose

magnitude is not certain at the moment. The magnitude depends on the value of variables such as
Foreign Exchange rates and Interest rates. Exposures can be broadly classified into three groups,
viz., Transaction, Economic and Translation exposure.
1.

Transaction exposure:
It is a measure of companys vulnerability to currency related losses arising from known,
contractual future cash payments or receipts in foreign currencies. The value of a firms cash
inflows received in various currencies will be affected by respective exchange rates of these
currencies when converted into the currency desired. Similarly, value of a firms cash outflows in
various currencies will be dependent on the respective exchange rates of these currencies. The
degree to which the value of future cash transactions can be affected by exchange rate fluctuations
is referred to as transaction exposure.

2.
3.

4.

Economic exposure:
The degree to which a firms present value of future cash flows can be influenced by exchange
rate fluctuations is referred to as economic exposure to exchange rates. Economic exposures thus
is a comprehensive effect of potential transaction exposure on the project investment of an MNC.

Translation exposure:
The exposure of MNCs consolidated financial statement to exchange rate fluctuations is known as
translation exposure. Accounting exposure, also called translation exposure, results from the need
to restate foreign subsidiaries financial statements into the parents reporting currency and is the
sensitivity of net income to the variation in the exchange rate between a foreign subsidiary and its
parent.

FOREIGN EXCHANGE RISK MANAGEMENT POLICY

The foreign exchange risk management policy should clearly define instruments in
which the bank is authorized to trade, risk limits commensurate with the banks activities,
regularity of reports to management, and who is responsible for producing such reports. The
policy should be reviewed on a regular basis, normally at least annually, to ensure that it remains

appropriate. The main points that need to be considered when drawing up a policy are given
below:
a) Open position limits commensurate with customer driven turnover, and
the banks appetite for market risk.
b) Separate limits should be allocated for each currency, together with an
overall cap limit. Banks that assume risk on a proprietary trading basis
should also introduce measures to limit intraday risk (normally a
maximum of five times the overnight cap limit).
c) Where a bank trades with counterparties other than members of their
own group located in Zone A countries, settlement and country limits
should be addressed and clearly defined.
d) Forward foreign exchange mismatch limits.
e) List of approved instruments.
f) Use of foreign exchange derivatives.
g) The expertise and experience of authorized personnel.
h) Authority to trade with counterparties other than group companies.
i) Monitoring and reporting systems.
j) Recording and follow up of limit excesses.
k) Impact on P&L of an adverse 10% movement in exchange rates on
maximum permitted exposure.
l) Imposition of a stop loss limit to restrict or prevent any further trading
other than client deals and hedging.
m) Segregation of duties.
n) Trading mandates for authorized personnel.
o) Limitation on out of hours trading.

p) List of authorized brokers (if applicable).

q) Code of Conduct for authorized personnel.

PROCEDURES AND SYSTEMS

The Commission requires banks to monitor their foreign exchange risk on a
frequent and timely basis. The Commission would expect banks that assume
any foreign exchange risk to be in a position to measure their positions on an
ongoing basis and to report to management daily. It follows from this that a
bank must have adequate procedures and systems for monitoring foreign
exchange risk. This requires:
a) A clear allocation of the responsibility for measuring and reporting
foreign exchange risk.
b) The maintenance of reliable systems that can produce accurate
reports promptly.
c) Active senior management involvement in, and clearly allocated
responsibility for, foreign exchange risk reporting.
d) Regular reporting to group or parent companies.
The system that produces the foreign exchange risk reports should be linked
to the banks core systems, and be capable of being reconciled to core data.
Reports should follow the principles of good management information, for
example:
a) Clarity
b) Highlight key information, in particular breaches or exceptions
c) Highlight unutilized limit capacity
d) Use of an exception based commentary

 Bibliography
Books :1. Managerial Economics by D.N. Dwivedi.
2. Managerial Economics by Chaturvedi.

WEBSITES:[Link] .com
[Link] exchange [Link]
[Link]
[Link]
[Link]
[Link]