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It refers to the regulation of foreign exchange transaction of the country by
the government or any other authorized agency. It is effective in fixed rate system. According to
professor Haberlour, ³Exchange control is a state regulation excluding the free play of economic
forces from the foreign exchange market´.







 

 
 




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One of the important objectives of exchange control is
protection of balance of payments. In normal times the adverse balance of payments caused
value of country's currency to fall and helps in restoring equilibrium. But there are conditions
under which a fall in the exchange value and currency has no effect on imports and exports.
Under such situations, measures are adopted to stabilize the exchange value of currency at level
higher than would b possible under free conditions.

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The exchange value of a currency is sometimes fixed
and maintained at higher level to lighten the burden of foreign debts contracted in terms of
foreign currencies. By overvaluing currency, the foreign exchange earnings of the country from
exports are increased in cases where the demand is inelastic and the prices in terms of the home
currency to be paid for essential imports get reduced.

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Sometimes the currency is undervalued to help in raising
certain conditions in thought desirable to stabilize the exchange rate at what can be called the
equilibrium level, i.e., the level determined by market forces. Short-term fluctuations are
eliminated by deliberate action of authorities.
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Exchange regulation in
certain conditions is thought desirable to stabilize the exchange rate at what can be called the
equilibrium level, i.e., the level determined by market forces. Short-term fluctuations are
eliminated by deliberate action of authorities.
'
 

  

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When the country suffers from exceptionally heavy
outflow of capital caused by loss of confidence on the part of nationals of the country or
foreigners in the economy of the country or its currency, certain exchange controls over
remittances from and the country are necessary.
'

 


Exchange control is an important part of economic policy in any
planned economy. Planning involves a very careful use of foreign exchange resources of the
country so that only those goods are imported which are essential for the implementation of the
plans. Exchange controls are resorted to regular the exports and imports in the light of plans.
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One of the objectives of exchange
regulations is to encourage certain economic activities in the country. Certain industries can be
developed by reducing the imports of commodities produced by them and restricting the
availability of foreign exchange to pay for them. For example tourist traffic in the country is
encouraged by making available to the tourists home currency at favorable rates.

, 





 
1. Unilateral method
‡ Exchange intervention
‡ Exchange equalization fund method
‡ Exchange restriction method
2. Bilateral or multilateral method
‡ Exchange clearing agreement
‡ Transfer moratorium
‡ Payment agreement
‡ Standstill agreement
‡ Compensation agreement

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The following are the major risks in foreign exchange dealings

O Open Position Risk

O Cash Balance Risk
O ßaturity ßismatches Risk
O Credit Risk
 O Country Risk
O Overtrading Risk
O Fraud Risk, and
O Operational Risks


  
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The open position risk or the position risk refers to the risk of change in exchange rates affecting
the overbought or oversold position in foreign currency held by a bank. Hence, this can also be
called the rate risk. The risk can be avoided by keeping the position in foreign exchange square.
The open position in a foreign currency becomes inevitable for the following reasons:

O The dealing room may not obtain reports of all purchases of foreign currencies made by
branches on the same day.
O The imbalance may be because the bank is not able to carry out the cover operation in the
interbank market.
O Sometimes the imbalance is deliberate. The dealer may foresee that the foreign currency
concerned may strengthen.

*


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Cash balance refers to actual balances maintained in the nostro accounts at the end-of each day.
Balances in nostro accounts do not earn interest: while any overdraft involves payment of
interest. The endeavor should, therefore, be to keep the minimum required balance in the nostro
accounts. However, perfection on the count is not possible. Depending upon the requirement for
a single currency more than one nostro account may be maintained. Each of these accounts is
operated by a large number of branches. Communication delays from branches to the dealer or
from the foreign bank to the dealer may result in distortions.

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This risk arises on account of the maturity period of purchase and sale contracts in a foreign
currency not coinciding or matching. The cash flows from purchases and sales mismatch thereby
leaving a gap at the end of each period. Therefore, this risk is also known as liquidity risk or gap
risk

ßismatches in position may arise out of the following reasons:

O Under forward contracts, the customers may exercise their option on any day during the
month which may not match with the option under the cover contract with the market
with maturity towards the month end.
O ·on-availability of matching forward cover in the market for the volume and maturity
desired.
O Small value of merchant contracts may not aggregative to the round sums for which
cover contracts are available.
O In the interbank contracts, the buyer bank may pick up the contract on any day during the
option period.
O ßismatch may deliberately
O create to minimize swap costs or to take advantage of changes in interest differential or
the large swings in the demand for spot and near forward currencies.

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Credit Risk is the risk of failure of the counterparty to the contract Credit risk as classified into
(a) contract risk and (b) clean risk.

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arises when the failure of the counterparty is known to the bank before it
executes its part of the contract. Here the bank also refrains from the contract. The loss to
the bank is the loss arising out of exchange rate difference that may arise when the bank
has to cover the gap arising from failure of the contract.
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 the bank has executed the contract, but the counterparty does
not. The loss to the bank in this case is not only the exchange difference, but the entire
amount already deployed. This arises, because, due to time zone differences between
different centers, one currently is paid before the other is received.
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Also known as µsovereign risk¶ or µtransfer risk¶, country risk relates to the ability and
willingness of a country to service its external liabilities. It refers to the possibility that the
government as well other borrowers of a particular country may be unable to fulfil the
obligations under foreign exchange transactions due to reasons which are beyond the usual credit
risks. For example, an importer might have paid for the import, but due to moratorium imposed
by the government, the amount may not be repatriated.


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A bank runs the risk of overtrading if the volume of transactions indulged by it is beyond its
administrative and financial capacity. In the anxiety to earn large profits, the dealer or the bank
may take up large deals, which a normal prudent bank would have avoided. The deals may take
speculative tendencies leading to huge losses. Viewed from another angle, other operators in the
market would find that the counterparty limit for the bank is exceeded and quote further
transactions at higher premium. Expenses may increase at a faster rate than the earnings. There
is, therefore, a need to restrict the dealings to prudent limits. The tendency to overtrading is
controlled by fixing the following limits:

O A limit on the total value of all outstanding forward contracts; and

O A limit on the daily transaction value for all currencies together (turnover limit).

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Frauds may be indulged in by the dealers or by other operational staff for personal gains or to
conceal a genuine mistake committed earlier. Frauds may take the form of the dealings for oneµs
own benefit without putting them through the bank accounts. Undertaking unnecessary deals to
pass on brokerage for a kick back, sharing benefits by quoting unduly better rates to some banks
and customers, etc. The following procedural measures are taken to avoid frauds:

O Separation of dealing form back-up and accounting functions.

O On-going auditing, monitoring of positions, etc., to ensure compliance with procedures.
 O Regular follow-up of deal slips and contract confirmations.
O Regular reconciliation of nostro balances and prompts follow-up unreconciled items.
O Scrutiny of branch reports and pipe-line transactions.
O ßaintenance of up-to records of currency position, exchange position and counterparty
registers, etc.

 
".

These risks include inadvertent mistakes in the rates, amounts and counterparties of deals,
misdirection of funds, etc. The reasons may be human errors or administrative inadequacies. The
deals are done over telecommunication and mistakes may be found only when the written
confirmations are received later.

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Currency options provide corporate treasurer another tool for hedging foreign exchange risks
arising out of firms operations. Unlike forward contract, options allow the hedger to gain from
favorable exchange rate movements, while been unprotected from unfavorable movements.
However forward contracts are costless while options involve up front premium cost. Examples
are:


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In late February an American importer anticipates a yen payment of JYP 100 million to a
Japanese supplier sometime late in ßay. The current USD/JYP spot is 0.007739 (which implies
a JYP/USD rate of 129.22.). A June yen call option on the PHLX, with strike price of $0.0078
per yen is available for a premium of 0.0108 cents per yen or $0.000108 per yen. Each yen
contract is for JPY 6.25 million. Premium per contract is therefore: $(0.000108 * 6250000) =
$675.

The firm decides to purchase 16 calls for a premium of $10800 .In addition there is a brokerage
fee of $20 per contract. Thus the total expense in buying the option is $11,120.The firm has in
effect ensured that its buying rate for yen will not exceed $0.0078+ $(11120/100,000,000)=
$0.0078112 per yen.

The price the firm will actually end up paying for yen depends on the spot rate at the time of
payment .For further clarification the following 2 e.g. are considered:

O Yen depreciates to $0.0075 per yen (Yen / $ 133.33) in late ßay when the payment
becomes due .The firm will not exercise its options. It can sell 16 calls in the market
provided the resale value exceeds the brokerage commission it will have to pay. (The
June calls will still have some positive premium) .It buys yen in the spot market .In this
case the price per yen it will have paid is $0.0075 + $0.0000112 ± ${(Sale of value
options ± 320) /100000000}

If the resale value of the options is less than $320, it will simply let the options lapse .In this case
the effective rate will be $0.0075112 per yen or yen 133.13 per $. It would have been better to
leave the payable uncovered. The forward purchase at $0.0078 would have fixed the rate at that
value and would be worse than the option.

O Yen appreciates to $0.08

·ow the firm can exercise the options and procure the yen at the strike price of $0.0078.In
addition, there will be transaction cost associated with the exercise. Alternatively, it can sell the
option and buy the yen in the spot market. Assume that June yen calls are trading at $0.00023per
yen in late ßay. With the latter alternative, the dollar will be $800000- $(0.00023 * 16*
6250000)+ $320= $777320. Including the premium, the effective rate the firm has paid is
$(0.0077732+0.0000112) = $0.0077844.


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A German chemical firm has supplied goods worth Pound 26 million to a British customer. The
payment is due in two months. The current DEß/GBP spot rate is 2.8356 and two month
forward rate is 2.8050. An American put option on sterling with 3 month maturity and strike
price of DEß 2.8050 is available in the interbank market with a premium of DEß 0.03 per
sterling. The firm purchases a put option on pound 26 million .The premium paid is DEß (0.03 *
26000000) = DEß 780000. There are no other costs.

Effectively the firm has put a floor on the value of its receivable at approximately DEß 2.7750
per sterling (= 2.8050-0.03). Again two e.g. are considered:

O The pound sterling depreciates to DEß 2.7550 .The firm exercises its put option and
delivers pound 26 million to the bank at the price of 2.8050. The effective rate is 2.7750.
It would have been better off with a forward contract.

Sterling appreciates to DEß 2.8575. The option has no secondary market and the firm allows it
to lapse. It sells the receivable in the spot market. ·et of the premium paid, it obtains an effective
rate of 2.8275, which is better than forward rate. If the interest forgone on premium payment is
accounted for, the superiority of the option over the forward contract will be slightly reduced.

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/ In finance, a / is a derivative in which counterparties exchange certain
benefits of one party's financial instrument for those of the other party's financial instrument. The
benefits in question depend on the type of financial instruments involved. For example, in the
case of a swap involving two bonds, the benefits in question can be the periodic interest (or
coupon) payments associated with the bonds. Specifically, the two counterparties agree to
exchange one stream of cash flows against another stream. These streams are called the   of
the swap. The swap agreement defines the dates when the cash flows are to be paid and the way
they are calculated. Usually at the time when the contract is initiated at least one of these series
of cash flows is determined by a random or uncertain variable such as an interest rate, foreign
exchange rate, equity price or commodity price.
The cash flows are calculated over a notional principal amount, which is usually not exchanged
between counterparties. Consequently, swaps can be in cash or collateral.

Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in
the expected direction of underlying prices.



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A is currently paying floating, but wants to pay fixed. B is currently paying fixed but wants to
pay floating. By entering into an interest rate swap, the net result is that each party can 'swap'
their existing obligation for their desired obligation. ·ormally the parties do not swap payments
directly, but rather, each sets up a separate swap with a financial intermediary such as a bank. In
return for matching the two parties together, the bank takes a spread from the swap payments.

The most common type of swap is a ³plain Vanilla´ interest rate swap. It is the exchange of a
fixed rate loan to a floating rate loan. The life of the swap can range from 2 years to over 15
years. The reason for this exchange is to take benefit from comparative advantage. Some
companies may have comparative advantage in fixed rate markets while other companies have a
comparative advantage in floating rate markets. When companies want to borrow they look for
cheap borrowing i.e. from the market where they have comparative advantage. However this
may lead to a company borrowing fixed when it wants floating or borrowing floating when it
wants fixed. This is where a swap comes in. A swap has the effect of transforming a fixed rate
loan into a floating rate loan or vice versa.

For example, party B makes periodic interest payments to party A based on a ` interest
rate of LIBOR +70 basis points. Party A in return makes periodic interest payments based on a
fixed rate of 8.65%. The payments are calculated over the

 amount. The first rate is
called ` , because it is reset at the beginning of each interest calculation period to the then
current reference rate, such as LIBOR. In reality, the actual rate received by A and B is slightly
lower due to a bank taking a spread.
 


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According to interest rate parity the difference between the (risk free) interest rates paid on two
currencies should be equal to the differences between the spot and forward rates.

If interest rate parity is violated, then an arbitrage opportunity exists. The simplest example of
this is what would happen if the forward rate was the same as the spot rate but the interest rates
were different, then investors would:

1. borrow in the currency with the lower rate

2. convert the cash at spot rates
3. enter into a forward contract to convert the cash plus the expected interest at the same
rate
4. invest the money at the higher rate
5. convert back through the forward contract
6. Repay the principal and the interest, knowing the latter will be less than the interest
received.

Therefore, we can expect interest rate parity to apply. However, there is evidence of forward rate
bias.

* 


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Assuming the arbitrage opportunity described above does not exist, then the relationship for US
dollars and pounds sterling is:

   

where r is the sterling interest rate (till the date of the forward),
 is the dollar interest rate,
 is the forward sterling to dollar rate,
 is the spot sterling to dollar rate
Unless interest rates are very high or the period considered is long, this is a very good
approximation:



Where  is the forward premium:  

The above relationship is derived from assuming that covered interest arbitrage opportunities
should not last, and is therefore called covered interest rate parity.

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Assuming uncovered interest arbitrage leads us to a slightly different relationship:



where E[S] is the expected change is exchange rates.

This is called uncovered interest rate parity.

As the forward rate will be the market expectation of the change in rates, this is equivalent to
covered interest rate parity - unless one is speculating on market expectations being wrong.

The evidence on uncovered interest rate parity is mixed.

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" is a theory, which establishes the fact that
the exchange rates between currencies are in equilibrium in the event of equality in the
purchasing power of each of the countries. This precisely means that the ratio of the price level
of a fixed amount of goods and services of the two countries and the exchange rate between
those two countries must be equivalent. PPP is based on the µLaw of One Price¶. If the inflation
rate within a country¶s economy increases then the value of the currency needs to depreciate to
revive the PPP. In the absence of transportation and other similar expenses, the competitive
market will equalize the price of an identical object in two countries when the prices are
expressed by the same currency. However, one has to be careful with the Law of one Price. The
application of the Law of One Price is contingent upon certain conditions. They are:

A competitive market must be present in both the countries for the goods and services

The law is only applicable to the goods that can be traded between the countries.

Transport expenses and other transaction expenses must be checked since they are considered
hindrances in trading.

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There are two types of PPP. They are:

Absolute Purchasing Power Parity that is based on the maintenance of equal prices in two
concerned countries.

Relative PPP describes the inflation rate. This describes the appreciation rate of a currency,
which is decided by calculating the difference between the exchange rates of two countries.