NMIMS Assignment 2023

International Banking & Foreign Exchange Management

Question 1

Introduction:

The risk of losing money due to changes in exchange rates is known as foreign exchange
(Forex or FX) risk, and it can occur whenever a corporation engages in international trade.
Foreign exchange risk is a constant threat to businesses in today's interconnected world.
Therefore, it is crucial for businesses, particularly banks, to implement efficient risk
management systems to lessen the influence of foreign currency risk on financial results. This
study will describe the function of the foreign exchange market and cover several strategies
for managing foreign exchange risk, such as currency hedging.

Concept

Approaches to Handling Currency Risk:

A company's approach to managing foreign exchange risk will vary depending on its risk
tolerance, operational needs, and market circumstances. Common strategies for controlling
exposure to currency fluctuations include:

Inherited Protection: Natural hedging, often called operational or economic hedging, is a

strategy that involves arranging a company's activities in a way that lessens the effect of
changes in the value of a currency relative to another. A business can achieve currency parity
by, say, billing customers in the same currency for imported and exported goods, or by
setting up assembly lines in foreign markets and billing customers in their native currencies.
This lessens the need for additional hedging techniques and helps mitigate the effects of
currency rate volatility.

To exchange a certain amount of one currency for another at a future date at a predetermined
exchange rate, two parties enter into a forward contract. Companies can hedge against the
risk of exchange rate swings by locking in currency rates via forward contracts for future
transactions. To hedge against the risk of a decline in the value of its foreign currency
holdings, a corporation could, for instance, enter into a forward contract to buy the foreign
currency it will need three months from now at the current exchange rate.
When you hold an option, you have the right but not the responsibility to exchange a certain
amount of one currency for another at a set price (the strike price) and by a certain date (the
expiration date). Companies can hedge against unfavourable fluctuations in the exchange rate
and profit from positive ones with the help of options. Foreign exchange risk management
can be accomplished through the use of options such as call options, put options, and exotic
options by businesses.

The term "swap" refers to a type of financial contract in which two parties agree to swap
future cash flows under certain circumstances. Swaps can involve everything from interest
rates to currencies to commodities. Companies frequently utilise currency swaps to hedge
their exposure to currency fluctuations. Currency swaps involve the simultaneous exchange
and subsequent reversal of two currencies between two parties at a later period and at an
agreed-upon exchange rate. Companies can use currency swaps to gain the appropriate
exposure to foreign currencies while mitigating the risks that come with doing so.

To reduce exposure to currency fluctuations, investors can use a money market hedge by
borrowing or lending in a foreign currency. To balance a payment it will receive in a foreign
currency, a corporation can borrow that amount of money in the money market, then use it to
make the payment. This hedges the company's bets against currency fluctuations for a lower
overall foreign exchange risk.

Functioning of the Foreign Exchange Market:

The Forex market, or foreign exchange market, is a global decentralised market for the
trading of currencies. With over $6 trillion in daily trading volume, it is the largest and most
liquid financial market in the world. Banks, monetary establishments, corporations,
governments, and private dealers make up the bulk of the foreign exchange market.

The ability to convert one currency into another through the foreign exchange market is
fundamental to the smooth functioning of the international commerce and investment system.
Because of the global nature of its participants, the foreign exchange market is open around
the clock, five days a week.

Banks and other market participants form a network that facilitates the foreign exchange
market through electronic communication. These organisations serve as market
intermediaries, constantly quoting buy and sell prices for currencies. Supply and demand
variables, such as economic statistics, geopolitical events, and market mood, impact the
prices at which currencies are purchased and sold on the foreign exchange market.

There is no centralised exchange or clearinghouse for currency transactions because of the

decentralised nature of the foreign exchange market. Electronic trading platforms (ETPs) like
EBS, Reuters Dealing, and other ECNs are used instead of physical exchanges to complete
financial transactions. These exchanges allow for a streamlined and honest marketplace for
the instantaneous trading of currencies.

Market makers, speculators, and end-users are just few of the many sorts of participants in
the foreign exchange market. Currency liquidity is provided by market makers, who are
typically significant financial institutions constantly offering bid and ask prices. Currency
speculators, on the other hand, purchase and sell currencies based on their predictions of
future exchange rate fluctuations. Users (companies, governments, and people) participate in
the foreign exchange market to engage in international trade, purchase foreign assets, and
hedge against currency fluctuations.

Exchange rates, the prices at which one currency can be exchanged for another, are also
heavily influenced by the foreign exchange market. Interest and inflation rates, as well as
economic and geopolitical performance and market sentiment, can all affect exchange rates.
The financial performance of businesses involved in international commerce and investment
is very susceptible to fluctuations in exchange rates.

Conclusion

In order to facilitate international trade and investment, the foreign exchange market is an
integral part of the international monetary system. It's a location where people may buy, sell,
and trade currencies, and it also provides a number of mechanisms for hedging against
currency fluctuations, such as forward contracts, options, swaps, and money market hedges.
Foreign exchange risk can have a significant effect on a company's financial performance, so
it is important for businesses, including banks, to understand how the foreign exchange
market operates and the various methods for managing foreign exchange risk, such as
currency hedging.
Question 2

Introduction

The foreign exchange market is highly sensitive to changes in interest rates and inflation.
Currency values, exchange rates, and market mood can all be impacted by shifts in interest
and inflation rates, which in turn can shape the actions of market participants and the
dynamics of the foreign exchange market.

Concept

The cost of borrowing money and the rate of return on savings are determined by the
respective central banks of each country. A currency's value can rise or fall in response to
interest rate fluctuations because a nation's interest rate attracts international investors
seeking a higher return on their investments. The opposite is true for lower interest rates,
which can erode a currency's value as investors flee to other assets in search of higher returns.

Interest rates and currency exchange rates have a complex relationship that is influenced by
many variables. For instance, if a government boosts interest rates to fight inflation, it may
entice foreign investors looking for better returns, which could boost demand for the
country's currency and cause it to rise in value. However, if a country reduces interest rates to
spur economic growth, this may reduce demand for its currency, which could lead to a
decline in its value.

The rate at which prices across the board in an economy are increasing over time is known as
inflation. Increases in inflation can weaken a currency since one dollar can no longer buy as
many goods and services as it once could. Interest rates are also affected by inflation since
central banks use them as a tool for controlling inflation. When central banks boost interest
rates to combat inflation, the value of the currency may increase because of the increased
interest rate's appeal to foreign investors.

Foreign exchange market fluctuations can be affected by traders' anticipation of future

interest rate and inflation rate movements. Currency appreciation can occur before an interest
rate hike occurs if, for instance, investors buy a country's currency in anticipation of a future
interest rate increase as a hedge against the possibility of higher inflation.

Furthermore, differences in national interest rates might have an effect on the value of
different currencies. Investors frequently employ the carry trade to profit on interest rate
differences. To profit from the interest rate differential, investors in a carry trade borrow one
currency and put their money into another with a higher rate of return. The demand for the
currency with the higher interest rate may cause its value to rise, while the demand for the
currency with the lower interest rate may cause its value to fall.

Market sentiment and willingness to take risks can be affected by changes in interest rates
and inflation. An increase in interest rates or inflation may be seen as beneficial to a currency,
leading to stronger demand and possibly a higher currency value. On the other hand, lower
interest rates or inflation could be seen as bad for a currency, resulting in less demand and
therefore a weaker value. Since the supply and demand for a country's currency is affected by
the amount of money flowing into and out of the country, market mood and risk appetite can
also have an effect on currency exchange rates.

It's worth noting that a number of factors—including economic conditions, monetary policies,
geopolitical events, and market sentiment—can affect the nature and trajectory of the link
between interest rates, inflation, and the foreign exchange market. In addition, interest rate
and inflation management strategies employed by central banks and policymakers in various
nations can affect the foreign exchange market.

Conclusion

In essence, interest and inflation rates are major economic indicators that can have far-
reaching effects on the global currency market. Currency values, exchange rates, market
mood, and willingness to take risks can all be affected by shifts in interest rates and inflation.
Question 3a:

Introduction

The exchange rate between two currencies under a fixed exchange rate system is set by the
governments or central banks of those currencies. There is a prohibition against the currency
rate responding to supply and demand in the market. The central bank buys or sells its own
currency in the foreign exchange market to keep the exchange rate stable at a certain level.

Concept

Two common varieties of fixed exchange rate systems are as follows:

a. Pegged Exchange Rate System: In this system, one currency's value is fixed relative to
another or to a basket of currencies. If an economy has a pegged exchange rate system, the
central bank will buy or sell its currency on the foreign exchange market to keep the
exchange rate stable.

b. Currency Board Arrangement: Under this system, a country's central bank maintains a
reserve of foreign currency equal to the value of its domestic currency at all times. The
exchange rate is kept stable and the domestic currency is completely supported by foreign
currency reserves.

Businesses that engage in international transactions benefit from a fixed exchange rate system
because it: • provides stability and predictability in international trade and investment due to
fixed exchange rates; • reduces exchange rate risk; and • can help control inflation by limiting
the central bank's ability to print excessive amounts of money.

Constant central bank intervention to preserve the fixed exchange rate can be expensive and
drain foreign currency reserves, and it can also limit the central bank's ability to use interest
rates and other monetary tools to manage the domestic economy. These factors make the
fixed exchange rate system more susceptible to speculative attacks and currency crises.

Currency Exchange Rates That Float:

The value of one currency in terms of another is set by the foreign exchange market based on
the supply and demand for those currencies. Changes in economic fundamentals, interest
rates, inflation, geopolitical events, and market sentiment are just a few of the factors that can
cause the exchange rate to move up or down.
Floating exchange rates have many benefits.

 Because the exchange rate is left to the whims of the market, businesses and
governments are better able to adapt to shifting economic situations.
 Allows the central bank more leeway in managing the economy through interest rates
and other monetary tools.
 It decreases the Fed's need to constantly intervene in the currency market.

The drawbacks of a freely floating exchange rate system are:

 Uncertainty for companies involved in international commerce and investment may

result from increased volatility in exchange rates.
 Risk associated with fluctuations in the value of a country's currency, which affects
the prices of imported and exported goods.
 Countries may strive to weaken their currencies to obtain a competitive advantage in
international commerce, which could lead to competitive devaluations and currency
wars.

Conclusion

Both fixed and flexible exchange rate systems have their benefits and drawbacks. While fixed
exchange rate systems are reliable and consistent, they can restrict the central bank's ability to
implement monetary policy and require frequent intervention. Despite the advantages, the
volatility of exchange rates is a drawback of floating exchange rate regimes. When taking out
foreign loans or engaging in other forms of international trade, companies and policymakers
would do well to familiarise themselves with the nuances of the various exchange rate
systems.
Question 3b

Introduction

The most basic and prevalent form of foreign currency transaction is known as a "spot
transaction." Currency is traded at the foreign exchange market's current exchange rate, and is
delivered to the buyer or seller within two business days (the spot date). Spot transactions are
settled instantly, and the currency rate used is the market rate at the time.

If a company in the United States wishes to acquire items from a supplier in Japan and the
price is quoted in Japanese yen, the company will conduct a spot transaction to convert
dollars into yen at the market rate.

However, in a forward transaction, two currencies are exchanged at a mutually agreed upon
exchange rate, with delivery of the currencies occurring on a future date (the forward date).
In contrast to "spot" trades, "forward" trades are paid at a mutually agreed upon date in the
future rather than immediately.

Businesses and investors use forward transactions to hedge against currency fluctuations by
locking in an agreed-upon exchange rate for a future transaction. To hedge against the risk of
adverse exchange rate movements, a company may enter into a forward contract with a
financial institution to purchase foreign currency at a predetermined exchange rate, such as
the case where it expects to pay for imports in a foreign currency at a future date.

Concept

This is where spot and forward trades diverge most sharply:

Payment Schedule: The settlement date for a spot transaction is within two business days,
while the settlement date for a forward transaction is at a future date.

Spot transactions use the market exchange rate in effect at the time of the transaction, while
forward transactions use an agreed-upon exchange rate that will remain in effect for a set
amount of time in the future.

The immediate delivery of products, services, or investments is a common motivation for

spot transactions. Conversely, forward transactions are conducted for the objectives of
hedging, managing foreign exchange risk, or making forward exchange rate speculations.
Since the currency rate for spot transactions is determined by the current market rate, there is
more leeway for adjusting the exchange rate in the event of fluctuations. Forward
transactions, in contrast, offer security and assurance against fluctuations in currency rates
because the exchange rate is fixed at the time of the transaction.

Conclusion

In sum, there are two main forms of foreign currency transactions on the foreign exchange
market: spot transactions and forward transactions. Unlike forward transactions, which
involve exchanging currencies at a predetermined rate at a future date, spot transactions
include exchanging currencies at the current market rate and are finalised within two business
days. In order to effectively manage foreign exchange risk and conduct international
transactions, firms and investors must have a firm grasp of the distinctions between these two
types of transactions.