Module2.

Foreign Exchange Foreign exchange markets, operations Exchange rate mechanism,

dealing, position, accounting &Reporting. Foreign exchange market in India. Foreign
Exchange exposure: Concept Types; Transaction exposure, Translation exposure, economic
exposure, hedging of exchange risk-concepts and methods

The foreign exchange market (also known as forex, FX, or the currency market) is an

over-the-counter (OTC) global marketplace that determines the exchange rate
for currencies around the world. Participants are able to buy, sell, exchange, and speculate
on currencies.

Foreign exchange markets are made up of banks, forex dealers, commercial

companies, central banks, investment management firms, hedge funds, retail
forex dealers, and investors.

 The foreign exchange market is an over-the-counter (OTC) marketplace

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

Forex Dealer?
An authorized forex dealer is a type of financial institution that has received
authorization from a relevant regulatory body to act as a dealer involved with
the trading of foreign currencies. Dealing with authorized forex dealers
ensures that your transactions are being executed in a legal and just way.
The National Futures Association (NFA) and Commodity Futures Trading
Commission (CFTC) authorize forex dealers in the United States

What Is a Central Bank?

A central bank is a financial institution given privileged control over the
production and distribution of money and credit for a nation or a group of
nations. In modern economies, the central bank is usually responsible for the
formulation of monetary policy and the regulation of member banks

What Is a Hedge Fund?

Hedge funds are alternative investments using pooled funds that employ
different strategies to earn active returns, or alpha, for their investors. Hedge
funds may be aggressively managed or make use
of derivatives and leverage in both domestic and international markets with
the goal of generating high returns (either in an absolute sense or over a
specified market benchmark).
What Is a Retail Foreign Exchange Dealer (RFED)?
A retail foreign exchange dealer (RFED) acts as a counterparty to an off-
exchange, over-the-counter (OTC) foreign currency transaction where buying
and selling of financial instruments do not involve any of the exchanges.

An exchange rate mechanism (ERM) is a way that central banks can influence the relative
price of its national currency in forex markets. The ERM allows the central bank to tweak
a currency peg in order to normalize trade and/or the influence of inflation.

Exchange rate mechanisms, or ERMs, are systems designed to control a

currency's exchange rate relative to other currencies. They are a key
monetary strategy used by central banks to have some control over a
country's monetary value.

At their extremes, floating ERMs allow currencies to trade

without intervention by governments and central banks, while fixed ERMs
involve any measures necessary to keep rates set at a particular value.
Managed ERMs fall somewhere between these two categories, with the
European Exchange Rate Mechanism (ERM II) being the most popular
example that's still in use today for countries looking to join Europe's monetary
union.

What Are Exchange Rate Mechanisms?

With no intervention, the value of one country's currency will naturally fluctuate
in relation to another's. Depending on many economic and socio-political
factors, these fluctuations can be large or small. Exchange rate mechanisms
are any measures a country puts in place to try to control these fluctuations.

Most currencies historically began on a fixed exchange rate mechanisms, with

their prices set to commodities like gold.1 In fact, the U.S. dollar was officially
fixed to gold prices until October of 1976, when the government removed
references to gold from official statutes.2 Some other countries began to fix
their currencies to the U.S. dollar itself to limit volatility, including the United
State's largest trading partner—China—who maintains some level of control to
this day.3

By the 1990s, many countries adopted flexible ERMs, which have remained
the most popular option in order to maintain liquidity and reduce economic
risks. Governments adopting flexible ERMs will usually intervene to some
degree or another to keep exchange rates within certain parameters.

How ERMs Work

Actively managed exchange rate mechanisms work by setting a reasonable
trading range for a currency's exchange rate and then enforcing the range via
interventions. For example, Japan may set an upper and lower bound on the
Japanese yen relative to the U.S. dollar. If the Japanese yen appreciates
above this level, the Bank of Japan can intervene by buying large quantities of
U.S. dollars and selling Japanese yen into the market to lower the price.

Other tools that can be used to defend exchange rates include tariffs and
quotas, domestic interest rates, monetary and fiscal policy, or switching to a
floating ERM. These strategies have mixed effects and reliability depending
on the situation. For example, raising interest rates can be an effective way to
increase a currency's valuation, but it's difficult to do if the economy is
performing well.

Since central banks can print their own domestic currencies in theoretically
unlimited quantities, most traders respect the limits of fixed or semi-fixed
ERMs. There are some famous cases of these fixed or semi-fixed ERMs
failing, though, including George Soros' famous run on the Bank of England.
In these instances, traders might utilize leverage to make enormous bets
against a currency that make interventions too expensive for central banks to
undertake without causing significant inflation.

EXAMPLES

Calculate Your Requirements

Need a foreign currency? Use exchange rates to determine how much foreign
currency you want, and how much of your local currency you'll need to buy it.

If heading to Europe you'll need euros (EUR), and will need to check
the EUR/USD exchange rate at your bank. The market rate may be 1.113, but an
exchange might charge you 1.146 or more. 

Assume you have $1,000 USD to buy Euros with. Divide $1,000 by 1.146 (what a
bank may charge) to get 872.60 euros. That is how many Euros you get for your
$1,000. Since Euros are more expensive, we know we have to divide, so that we
end up with fewer units of EUR than units of USD.

Now assume you want 1,500 euros, and want to know what it costs in USD. Multiply
1,500 by 1.146 to get 1,719 USD. Since we know Euros are more expensive,
one euro will cost more than one US dollar, that is why we multiply in this case.

ERMs in Practice
The most popular example of an exchange rate mechanism is the European
Exchange Rate Mechanism, which was designed to reduce exchange rate
variability and achieve monetary stability in Europe prior to the introduction of
the euro on January 1, 1999. The ERM was designed to normalize the
currency exchange rates between these countries before they were integrated
in order to avoid any significant problems with the market finding its bearings.

While the original European ERM has been dissolved, the European ERM II
was adopted in 1999 in order to help new members of the eurozone better
integrate. Countries involved include Estonia, Lithuania, Slovenia, Cyprus,
Latvia, and Slovakia, among others. Not all countries in the EU have adopted
the ERM II.5  6

China also maintains a flexible ERM with the U.S. dollar, but the People's
Bank of China has been notoriously unpredictable when defending it. For
example, the country decided to let its currency float to a large extent in a
controversial bid to become one of the world's official reserve currencies,
alongside the U.S. dollar and the euro. But, skeptics argued that the
devaluation simply made its exports cheaper at a time when the government
wanted to boost economic growth rates.

Basically a long position involves buying and a long position involves selling. In the

foreign exchange market, an investor simultaneously goes long on one currency –
the currency they buy, and short in the other – the currency they sell, whenever they open
a trading position.

What is exchange position?

Definition: The exchange position, or currency position of a bank is
the position from its day's purchases and sales, both ready and forward, of foreign
currencies. ... When the purchases of a day exceed the sales, the position is known
as “overbought” or 'Long'. In either case, the position is generally termed open.

How exchange rate is determined?

Currency prices can be determined in two main ways: a floating rate or a fixed rate.
A floating rate is determined by the open market through supply and demand on
global currency markets. Therefore, most exchange rates are not set but
are determined by on-going trading activity in the world's currency markets.

Rates change when currency values change. There are several key factors that
affect the movement and values of local and foreign currencies. These include three
key factors known as:

1. Interest rates
2. Money supply
3. Financial stability
Due to these factors, the demand for a particular country’s currency, depends on
what is happening in that country.

Interest rates

The interest rates a country’s central bank is setting is a key factor that will influence
the country’s exchange rate. Higher interest rates have positive impacts on the value
of the country’s currency. Investors are more likely to exchange their currency for
one with higher interest rates, and then save it in that country’s bank to benefit from
the higher interest rate.

Money supply

The money supply made available by a country’s central bank can influence the
value of the currency in the foreign exchange market. For example, if there is too
much money in circulation, there will be too much of it in exchange for very few
goods.

Currency holders will most likely bid up the costs of goods and services which will
trigger inflation. In the event that too much money is printed and in circulation in a
particular country, it triggers hyperinflation and drives down their currency value in
the foreign exchange market. Cash holders prefer to invest in countries with little or
no inflation.

Financial stability

The financial stability and economic growth of a country can affect its foreign
exchange rates. Investors are more likely to buy goods and services from countries
with a strong and growing economy. This means they will need more of such a
country’s currency to buy from them. this will increase the demand for such currency
and ultimately boosts its value in the foreign exchange market.

If the economy of the country is in a bad shape, investors are less likely to trade with
them. Investors are only interested in trading with countries that can provide gains
from holding government bonds in that currency

What is the current system of exchange rates?

Current international exchange rates are determined by a managed
floating exchange rate. A managed floating exchange rate means that each
currency's value is affected by the economic actions of its government or central
bank. The managed floating exchange rate hasn't always been used.

What is the reporting currency?

A reporting currency is the currency in which an entity's financial statements or
other financial documents are reported. ... Most often the currency used is
the currency of the country in which the parent company is legally registered.

 A reporting currency must be one currency, which makes it easier to

understand and follow financial documents.

Example of a Reporting Currency

ExxonMobil is a large oil company that conducts business across the world. It is
headquartered in the United States but has many subsidiaries spread out globally,
such as Esso Australia and Mobil Producing Nigeria. Esso Australia would conduct
its business in Aussie dollars and Mobil Producing Nigeria would conduct its
business in Nigerian naira.

When ExxonMobil is preparing its financial statements, it will require that both Esso
Australia and Mobil Producing Nigeria convert their financial figures into U.S.
dollars, because it is the currency of the United States, where ExxonMobil is
headquartered. The U.S. dollar is the reporting currency. If Esso Australia reported
AUD 1 million, it would convert that AUD 1 million into USD, which is approximately
$750,000. ExxonMobil would then use the $750,000 figure in its consolidated
financial reporting.

Because the United States adheres to the generally accepted accounting

principles (GAAP), ExxonMobil would have to follow GAAP guidelines on foreign
currency translation, which would require the use of the spot exchange rate or an
average rate for the period in question that is a close approximation. This would be
for monetary items, whereas non-monetary items would be done at a historic
exchange rate.

The foreign exchange market in India started when in 1978 the government allowed banks
to trade foreign exchange with one another. Foreign Exchange Market in India operates
under the Central Government of India and executes wide powers to control transactions
in foreign exchange.

What is Foreign Exchange Trading?

The FOREX market, also known as the Foreign Exchange Market, is a decentralized
global marketplace for foreign currency trading. The FOREX market is an OTC
(over-the-counter) market and foreign exchange rates are dictated by it. It also
entails selling, purchasing, and exchanging currencies at market rates. In terms of
trade rate, the Foreign Exchange Trading is the largest in the world.

Features of Foreign Exchange Market in India

The following are the characteristics of the foreign exchange market in India:
- Low Transaction Costs
Because of the lower online FOREX  trading costs, even small investors will make good
money. Unlike other investment options, FOREX traders only charge a small fee. The spread,
or the difference between buying and selling prices for a currency pair, is where the FOREX
commission is limited.
- Elevated Leverage

In the FOREX market, you can sell on margins, which are technically borrowed funds. The
return on your investment is rising exponentially, so the value of your investment is high.
Since the FOREX market is so unpredictable, trading with leverage (borrowed money) will
result in significant losses if the market goes against you. The foreign currency trading is a
two-edged sword. If the market is on your side, you will make a lot of money. If the market
goes against your bet, you will lose a lot of money.

- Extremely Transparent

The foreign exchange market in India is a transparent market in which traders have complete
access to market data and information necessary for successful transactions. Traders who
operate on open markets have more leverage over their investments and can make informed
decisions based on the information available.

- FOREX Market Accessibility

If you have an internet connection, you can access your foreign currency trading account
from anywhere. You can trade at any time and from any place. Since it is easy for traders to
position trade transactions at their leisure, the FOREX market has an advantage over other
markets.
> Types Of Foreign Exchange Market in India

The types of foreign exchange markets are as follows:

- Spot Market

In this market, transactions involving currency pairs happen quickly. In the spot market,
transactions require immediate payment at the current exchange rate, also known as the 'spot
rate.' The traders on the spot market are not exposed to the FOREX market's uncertainty,
which increases or lowers the price between trade and agreement.

- Futures Market
Future market transactions, as the name implies, require future payment and distribution at a
previously negotiated exchange rate, also known as the future rate. These agreements and
transactions are formal, which ensures that the terms of the agreement or transaction are set in
stone and cannot be changed. Traders who conduct major FOREX transactions and pursue a
consistent return on their assets prefer future market transactions.

- Forward Market

Forward market deals are identical to future market transactions. The main difference is that
in a forward market, the parties will negotiate the terms. The terms of the agreement can be
negotiated and adapted to the needs of the parties concerned. Flexibility is provided by the
forward market. 

Who regulates foreign exchange market in India?

Reserve Bank of India
The foreign exchange regulations in India are governed by the Foreign Exchange
Management Act, 1999 (“FEMA”). The apex foreign exchange regulatory authority in
India is the Reserve Bank of India (“RBI”) which regulates the law and is responsible
for all key approvals.

Types of Foreign Exchange Exposure | Foreign Exchange

the five main types of foreign exchange exposures that occurs due to
transactions with foreign entities.
The types are:
1. Transaction Exposure
2. Translation Exposure
3. Economic Exposure
4. Contingent Exposure
5. Competitive Exposure.
Type # 1. Transaction Exposure:
Transaction exposure occurs when the company bills its customers
in a foreign currency, say British pounds, and the currency
depreciates between the time the receivable is booked and collected.
Type # 2. Translation Exposure:
The risk that a company’s equities, assets, liabilities or income will
change in value as a result of exchange rate changes. This occurs
when a firm denominates a portion of its equities, assets, liabilities
or income in a foreign currency. Also known as “accounting
exposure”.
Considering a company has borrowed dollars to finance the import
of capital goods worth USD 10,000 @ Rs. 43 per dollar. The entry
was booked at this rate. The depreciation on the asset would be
provided accordingly assuming that the forex rate has not changed.

Type # 3. Economic Exposure to an Exchange Rate:

It is the risk that change in the rate affects the company’s
competitive position in the market and hence indirectly affects the
company’s bottom line.

Accountants use various methods to insulate firms from these types

of risks, such as consolidation techniques for the firm’s financial
statements and the use of the most effective cost accounting
evaluation procedures. In many cases, this exposure will be
recorded in the financial statements as an exchange rate gain (or
loss).

Type # 4. Contingent Exposure:

The principle focus is on the items which will have the impact on
the cash flows of the firm and whose values are not contractually
fixed in foreign currency terms. Contingent exposure has a much
shorter time horizon.
Typical situation giving rises to such exposures are:
1. An export and import deal is being negotiated and quantities and
prices are yet not to be finalised. Fluctuations in the exchange rate
will probably influence both and then it will be converted into
transactions exposure.

2. The firm has submitted a tender bid on an equipment supply

contract. If the contract is awarded, transactions exposure will arise.

3. A firm imports a product from abroad and sells it in the domestic

market. Supplies from abroad are received continuously but for
marketing reasons the firm publishes a home currency price list
which holds good for six months while home currency revenues may
be more or less certain, costs measured in home currency are
exposed to currency fluctuations.

In all the cases, currency movements will affect future cash flows.

Type # 5. Competitive Exposure:

This exposure refers to long-run changes in exchange rates and
encompasses the effects of an under or overvalued dollar. An
overvalued dollar makes New York products expensive in real terms
relative to similar products produced in other countries while an
undervalued dollar makes New Hampshire products inexpensive in
real terms on the world markets

Foreign Exchange Hedging: Definition & Methods

The foreign exchange market, or Forex, consists of many
international transactions of currency exchange that take place
between different countries, moving billions of dollars each day.
The fluctuations in the exchange rate of the different currencies
have become a form of investment, and currencies often make part
of the portfolio of commercial banks and many other investors.
However, people and investors in the Forex market are exposed to
risks as well. Exposure is the sensitivity to fluctuations in the value
of an asset, while risks refer to how much exposure can affect the
asset or operation. For example, an importer firm has a big
exposure to fluctuations in the currency exchange rate, but if that
rate has remained steady for the last few years, the risk is low.
Currencies tend to rise and fall constantly, so they can pose
important risks for investors, for importers, exporters and for local
industries that use foreign products or services in their processes.

International operators are exposed to sudden movements of the

currency exchange rate

The main risks in the foreign exchange are market are transaction
risks and translation risk.
Transaction risks are the impact of exchange rate fluctuations on
cash flows. Imagine you own U.S.-based company selling to a
Japanese firm, and you send products for 1,150 million yen (10
million dollars at the current exchange rate of 115 yen per dollar),
payable in 30 days. However, during that month, the yen loses value
and the rate changes to 120 yen per dollar. Suddenly, your payment
becomes 9.58 million, reducing your profit.
Translation risks involve an asset losing value because of currency
exchange variations. If your company also owns real estate in
Russia and the ruble devaluates, your property will worth less U.S.
dollars, so your asset loses value.

What Is Foreign Exchange Hedging?

 Hedging refers to different strategies that reduce the risks and minimize the impact of eventual
adverse movements in the market. It involves using financial instruments to increase protection
against unforeseen fluctuations, thus making cash flows more stable and predictable. As a result,
companies can estimate income, taxes and revenues more reliably.
However, hedging is not a way of making more money. It is rather a series of methods for
minimizing risks. Hedging reduces not only your potential loses, but it also reduces potential
sudden earnings.
For investors, hedging is like buying insurance on their assets or portfolios. Foreign exchange
hedging is common among investors and companies involved in international operations. It
allows them to manage their exposure to currency exchange movements and minimize the
impact of adverse fluctuations.
Some companies might choose to hedge 100% of the portfolio, while others might not hedge at
all. Most of them, however, are likely to hedge a percentage, so they partially protect themselves
but also accept some risks and leave the door open to additional earnings. It depends on their
particular tolerance to risk.

Main Methods for Hedging Foreign Exchange

Risk
Different assets and types of investments have different methods for hedging, so there is no
specific set of tools for hedging. In foreign exchange, however, hedging methods mostly consist
of specific contracts or agreements meant to exchange currency at a fixed rate.
Let's examine some of the most important and common options.

Forward Contracts
Forwards contracts or forwards are agreements between two parties to buy or a sell a specific
amount of currency at a predefined exchange rate. If the foreign currency you'll be exchanging
into domestic currency loses value, you will still receive the exchange rate specified in the
contract, so you won't lose any money. However, if the foreign currency appreciates, you will still
receive the same exchange rate, so there are no additional earning.

Types of hedging
 Forward exchange contract for currencies.
 Currency future contracts.
 Money Market Operations for currencies.
 Forward Exchange Contract for interest.
 Money Market Operations for interest.
 Future contracts for interest.
 Covered Calls on equities.
 What are the hedging strategies?
 A hedging strategy is a set of measures designed to minimise the risk of
adverse movements in the value of assets or liabilities. Hedging
strategies usually involve taking an offsetting position for the related asset or
liability.