FOREIGN EXCHANGE

Introduction to Foreign Exchange

Foreign Exchange is the process of conversion of one currency into another currency. For
a country its currency becomes money and legal tender. For a foreign country it becomes the
value as a commodity. Since the commodity has a value its relation with the other currency
determines the exchange value of one currency with the other. For example, the US dollar in
USA is the currency in USA but for India it is just like a commodity, which has a value which
varies according to demand and supply.

Foreign exchange is that section of economic activity, which deals with the means, and
methods by which rights to wealth expressed in terms of the currency of one country are
converted into rights to wealth in terms of the current of another country. It involves the
investigation of the method, which exchanges the currency of one country for that of another.
Foreign exchange can also be defined as the means of payment in which currencies are converted
into each other and by which international transfers are made; also the activity of transacting
business in further means.

Most countries of the world have their own currencies The US has its dollar, France its
franc, Brazil its cruziero; and India has its Rupee. Trade between the countries involves the
exchange of different currencies. The foreign exchange market is the market in which currencies
are bought & sold against each other. It is the largest market in the world. Transactions
conducted in foreign exchange markets determine the rates at which currencies are exchanged
for one another, which in turn determine the cost of purchasing foreign goods & financial assets.
The most recent, bank of international settlement survey stated that over $900 billion were traded
worldwide each day. During peak volume period, the figure can reach upward of US $2 trillion
per day. The corresponding to 160 times the daily volume of NYSE.

1
History Of Exchange Rate Systems

1. The Gold standard:

This is the oldest system which was in the operation till the beginning of the First World
War and a for few years thereafter that it was basically from1870-1914. The essential feature of
this system was that the government gave an unconditional guarantee to convert their paper
money to gold at a prefixed rate at any point of time or demand. This fixing of the price of gold
fixes exchange rate between paper monies.

Under the gold standard, the values of currencies were fixed in terms of gold. Before the
breakdown of the Bretton –wood system in the early 1970s.each member country of the IMF
defined the value of its currency in terms of gold or the US dollar. These countries had to
maintain (or peg) the market value of its currency within plus or minus 1% of the par value.

2. Gold bullion standard & gold specie standard:

These were two types of gold standard.

Under the gold specie standard, gold performed a dual function. It was the internationally
recognized means of payments for the settlement of debits and credits on international account.
At the same time gold coins were the one accepted medium of exchange and payment in the
domestic market.

Under the gold bullion standard the money in circulation was partly of paper. Paper
money could be exchanged any time for gold at the bank of issue.

It was a fair expectation that only a certain proportion of paper money would be
exchanged in this way. Thus the bank of issue no longer needed to hold full gold coverage, and
the lower the coverage rate fixed, the greater were the possibilities of creating money open to the
money authorities. For this reason the volume of paper money in circulation was always in
excess of the holding of monetary metal.

2
 The basis of money remains a fixed weight of gold but the currency in circulation consist
of paper notes with the authorities standing ready to convert unlimited amounts of paper
currency in to gold and vice-versa, on demand at a fixed conversation ratio. Thus a pound
sterling note can be exchanged for say ‘x’ ounces of gold while a dollar note can be converted
into say ‘y’ ounces of gold on demand.

3. Gold Exchange Standard:

Gold exchange standard was established in order to create additional liquidity in the
international markets. Hence the some of countries committed themselves to convert their
currencies into the currency of some other country on the gold standard rater than into gold.

The authorities were ready to convert at a fixed rate, the paper currency issued by them
into the paper currency of another country, which is operating a gold specie or gold bullion
standard. Thus, if rupees are freely convertible into dollars and dollars in turn into gold, rupee
can be said to be on a gold exchange standard.

The operation of the Gold Standards or Gold Specie standard was automatic and
functioned in the following manner. A country with a balance of payments deficit had to part
with some of its gold leading to deflation in the particular country.

4. Bretton Wood System:

Already long recognized as one of the strongest nations in the world – both economically
and militarily – the United States of America assumed an important role in the global economy.
Having emerged from World War I with its industrial might intact, the inherent strength of the
U.S. dollar allowed this currency to become a very popular form of legal tender in transactions
outside of the United States.

The outbreak of the Second World War in 1939 introduced new economic pressures in
many nations. In a few short years, Europe and had been decimated, both literally and
figuratively. If there was to be any global economic stability after the defeat of the Axis Powers,
the U.S. and its almighty dollar would surely need to play a role in building that stability. To lay

3
the groundwork, a conference of Allied nations was held in rural New Hampshire in 1944.
Known as the Bretton Woods Conference, the meeting was intended to foster international
cooperation and economic stability in the years following the war. Participating nations agreed to
create a gold-based exchange rate for their own individual currencies. At this time, the value of
the U.S. dollar was set at $35 per ounce of gold, and the currency exchange rates of participating
nations were expressed in terms of gold.

The Breton Woods Conference also led to the creation of the World Bank and the
International Monetary Fund – two important entities that would help to ensure the flow of
capital and currency between nations during the rebuilding phase.
For obvious reasons, foreign exchange between allied and Axis powers were suspended during
wartime. Exchanges with the German mark resumed in 1950, and exchanges with the Japanese
yen resumed in 1956.

Triffins Paradox:(Few contradictions given by professor R.Triffin)

The bretton woods system had some contradictions which were pointed out by Prof.
R.triffen which were: - the system depended on the dollar performing and its role as a key
currency. Countries other than the U.S had to accumulate dollar balances, as the dollar was the
means of International payment. This meant that the US deficits started mounting,(plus point or
growing) other countries started losing faith in the ability of the US to convert their dollar asset
into gold.

4
Advantages of Forex Market
Although the forex market is by far the largest and most liquid in the world, day traders
have up to now focus on seeking profits in mainly stock and futures markets. This is mainly due
to the restrictive nature of bank-offered forex trading services. Advanced Currency Markets
(ACM) offers both online and traditional phone forex-trading services to the small investor with
minimum account opening values starting at 5000 USD.
There are many advantages to trading spot foreign exchange as opposed to trading stocks
and futures. Below are listed those main advantages.
 Commissions:
ACM offers foreign exchange trading commission free. This is in sharp contrast to (once
again) what stock and futures brokers offer. A stock trade can cost anywhere between USD 5 and
30 per trade with online brokers and typically up to USD 150 with full service brokers. Futures
brokers can charge commissions anywhere between USD 10 and 30 on a round turn basis.
 Margins requirements:
ACM offers a foreign exchange trading with a 1% margin. In layman's terms that means
a trader can control a position of a value of USD 1'000'000 with a mere USD 10'000 in his
account. By comparison, futures margins are not only constantly changing but are also often
quite sizeable. Stocks are generally traded on a non-margined basis and when they are, it can be
as restrictive as 50% or so.
 24 hour market:
Foreign exchange market trading occurs over a 24 hour period picking up in Asia around
24:00 CET Sunday evening and coming to an end in the United States on Friday around 23:00
CET. Although ECNs (electronic communications networks) exist for stock markets and futures
markets (like Globex) that supply after hours trading, liquidity is often low and prices offered
can often be uncompetitive.
 No Limit up / limit down:
Futures markets contain certain constraints that limit the number and type of transactions
a trader can make under certain price conditions. When the price of a certain currency rises or
falls beyond a certain pre-determined daily level traders are restricted from initiating new
positions and are limited only to liquidating existing positions if they so desire.

5
This mechanism is meant to control daily price volatility but in effect since the futures currency
market follows the spot market anyway, the following day the futures market may undergo what
is called a 'gap' or in other words the futures price will re-adjust to the spot price the next day. In
the OTC market no such trading constraints exist permitting the trader to truly implement his
trading strategy to the fullest extent. Since a trader can protect his position from large unexpected
price movements with stop-loss orders the high volatility in the spot market can be fully
controlled.
 Sell before you buy:
Equity brokers offer very restrictive short-selling margin requirements to customers. This
means that a customer does not possess the liquidity to be able to sell stock before he buys it.
Margin wise, a trader has exactly the same capacity when initiating a selling or buying position
in the spot market. In spot trading when you're selling one currency, you're necessarily buying
another.

6
 TYPES OF EXCHANGE RATES SYSTEM

The exchange rate is formally defined as the value of one currency in terms of another. There
are different ways in which the exchange rates can be determined. Exchange rates may be fixed,
floating, or with limited flexibility. Different systems have different methods of correcting the
disequilibrium between international payments and receipts. One of the basic functions of these
mechanisms
(a) Fixed Exchange Rate System: As the name suggests, under a fixed (or pegged) exchange
rate system the value of a currency in terms of another is fixed. These rates are determined
by governments or the central banks of the respective countries. The fixed exchange rates
result from countries pegging their currencies to either some common commodity or to some
particular currency. As the reference value rises and falls, so does the currency pegged to it.
A currency that uses a fixed exchange rate is known as a fixed currency. The opposite of a
fixed exchange rate is a floating exchange rate.

There are generally some provisions for correction of these fixed rates in case of a
fundamental disequilibrium. Examples of this system are the gold standard and the Bretton
Woods system.

(b) Floating Exchange Rate System : Under this system, the exchange rates between
currencies are variable as the exchange rate regime. These rates are determined by the
demand and supply for the currencies in the international market. These, in turn depend on
the flow of money between the countries, which may result either due to international trade
in goods or services, or due to purely financial flows. Hence, in case of a deficit or surplus
in the balance of payments (difference between the inflation rates, interest rates and
economic growth of the countries are some of the factors which result in such imbalances),
the exchange rates get automatically adjusted and this leads to a correction in the imbalance.

7
Floating exchange rates can be of two types; Free Float and Managed Float

a. Free Float: The exchange rate is said to be freely floating when its
movements are totally determined by the market. There is no intervention at all either
by the government or by the central bank. The current and expected future demand
and supply of currencies change on a day-to-day, and even on a moment-to-moment
basis; as the market receives, analyzes and reacts to economic, political and social
news. This, in turn, changes the equilibrium in the currency market and the exchange
rate is determined accordingly. As the reactions to events do not follow a set pattern,
the resultant movements in the exchange rates turn out to be quite random. Hence, a
lot of volatility is observed in the markets following a free float system. This system
is also known as the clean float.

b. Managed Float: The volatility of exchange rates associated with a

clean float increases the economic uncertainly faced by players in the international
markets. A sudden appreciation of the domestic currency (a currency appreciates
when it becomes dearer vis-à-vis other currency and vise versa) would make the
domestic goods more expensive in the international markets (as the same number of
units of domestic currency, representing the good’s cost, would then translate into a
higher number of units of the foreign currency). This may result in making the
domestic product uncompetitive, and hence reduce the exports. If any industry is
totally dependent on exports, it may even get wiped out. A sudden depreciation may
lead to increased prices of imported goods, thereby increasing the inflation rate in the
economy. These uncertainties increase the risk associated with international trade
and investments, and thus reduce the overall efficiency of the world economic
system. In order to reduce these inefficiencies, central banks generally intervene in
the currency markets to smoothen the fluctuations. Such a system is referred to as a
managed float or a dirty float. This management of exchange rates can take three
forms;

8
1. The central bank may occasionally enter the market in order to
smoothen the transition from one rate to another, while allowing the market to follow
its own trend. The aim may be to avoid fluctuations, which may not be in accordance
with the underlying economic fundamentals, and speculative attacks on the currency.
2. Some events are liable to have only a temporary effect on the markets.
In the second variation, intervention may take place to prevent these short-and-
medium-term effects. While letting the markets find their own equilibrium rates in
the long-term, in accordance with the fundamentals.
3. In the third variation, through officially the exchange rate may be
floating, in reality the central bank may intervene regularly in the currency market,
thus unofficially keeping it fixed. For example, the rupee-dollar exchange rate was
maintained at Rs.31.37 to a dollar for around two years in 1993-94.

9
Exchange Rates under Fixed and Floating Regimes
With floating exchange rates, changes in market demand and market supply of a currency
cause a change in value. In the diagram below we see the effects of a rise in the demand for a
currancy (perhaps caused by a rise in exports or an increase in the speculative demand for
currancy). This causes an appreciation in the value of the currancy.

Changes in
currency supply
also have an
effect. In the
diagram below there is an increase in currency supply (S1-S2) which puts downward pressure on
the market value of the exchange rate.

10
 NEED AND IMPORTANCE OF FOREX MARKETS

Foreign exchange markets represent by far the most important financial markets in the
world. Their role is of paramount importance in the system of international payments. In order to
play their role effectively, it is necessary that their operations/dealings be reliable. Reliability
essentially is concerned with contractual obligations being honored. For instance, if two parties
have entered into a forward sale or purchase of a currency, both of them should be willing to
honour their side of contract by delivering or taking delivery of the currency, as the case may be.

Reason for Trading in Foreign Exchange

Foreign Exchange is the prime market in the world. Take a look at any market trading
through the civilised world and you will see that everything is valued in terms of money. Fast
becoming recognised as the world's premier trading venue by all styles of traders, foreign
exchange (forex) is the world's largest financial market with more than US$2 trillion traded
daily. Forex is a great market for the trader and it's where "big boys" trade for large profit
potential as well as commensurate risk for speculators.
Forex used to be the exclusive domain of the world's largest banks and corporate
establishments. For the first time in history, it's barrier-free offering an equal playing-field for
the emerging number of traders eager to trade the world's largest, most liquid and accessible
market, 24 hours a day. Trading forex can be done with many different methods and there are
many types of traders - from fundamental traders speculating on mid-to-long term positions to
the technical trader watching for breakout patterns in consolidating markets.

Opportunities From Around the World

Over the last three decades the foreign exchange market has become the world's largest
financial market, with over $2 trillion USD traded daily. Forex is part of the bank-to-bank

11
currency market known as the 24-hour interbank market. The Interbank market literally follows
the sun around the world, moving from major banking centres of the United States to Australia,
New Zealand to the Far East, to Europe then back to the United States.

FACTORS AFFECTING FOREIGN 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, India’s foreign exchange rating was downgraded

12
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 m 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 country’s 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. Recently India witnessed
about $20bn of Foreign Institutional Investors (FIIs) investment coming in, which resulted

13
appreciation of Indian Rupee. In 1996 and 1997, FIIs took several billion US dollars out of the
country due to ASEAN Crisis 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-à-vis other currencies. This is because the supply of the foreign currency will be in
excess of demand. If the balance of payments is positive and foreign exchange such the market
has reacted or discounted the anticipated/expected reserves are increasing, the home currency
will become stronger.

Government’s 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 elasticity’s of demand for the particular goods. High price elasticity of
demand means the volume of a good is sensitive to a change in price.

14
 Monetary and fiscal policy supports 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
government’s 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

15
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 country’s 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.

Exchange Control

The purpose of exchange control is to manage the supply and demand balance of the
home currency by the government using direct controls basically to protect it. Currency control
is the restriction of using or availing of foreign currency at home/abroad.

In India, up to liberalisation in the nineties there was very severe exchange control.
Access to foreign currency was tightly controlled and the same was released only for permitted
purposes. This was because Indian exports had not taken off and there were still large imports.
There are several countries that maintain their rates at artificial levels such as Bangladesh.

16
 India is now fully, convertible on the current account but not as yet on the capital
account. This, to an extent, possibly saved India when the run on currencies took place in Asia in
1997. If the Indian rupee was fully convertible and there were no exchange control restrictions,
the rupee would have been open for speculation. There would have been large outflows at a time
of concern resulting in a snowballing plunge in its value.

As long as the par value system prevailed, the rates could not go beyond the upper and
lower intervention points. The only real question under the fixed rate system was whether the
balance of payments and foreign exchange reserves had deteriorated to such an extent that a
devaluation was imminent or possible.
Countries with strong balance of payments and reserve positions were hardly called upon
to revalue their currencies. Hence, a watch had to be kept only on deficit countries. However,
under generalised floating regime, exchange rates are influenced by a multitude of economic,
financial, political and psychological factors. But the relative significance of any of these factors
can vary from time to time making it difficult to predict precisely how any single factor will
influence the rates and by how much.

Summary

Exchange rates are dynamic and constantly changing. These changes occur due to several
factors - Market Sentiment, Political Happenings, Economic Situations, Interest Rates, Inflation,
Government Policy and Speculation. Several of these are normally short-term but can extend to
the medium and long-term.

Exchange rate management is a delicate skill and has to be undertaken carefully as it

affects the long-term health of the economy and the country’s competitiveness in trade.

17
The Role of Forex in the Global Economy

Over time, the foreign exchange market has been an invisible hand that guides the sale of
goods, services and raw materials on every corner of the globe. The forex market was created by
necessity. Traders, bankers, investors, importers and exporters recognized the benefits of
hedging risk, or speculating for profit. The fascination with this market comes from its sheer
size, complexity and almost limitless reach of influence.

The market has its own momentum, follows its own imperatives, and arrives at its own
conclusions. These conclusions impact the value of all assets -it is crucial for every individual or
institutional investor to have an understanding of the foreign exchange markets and the forces
behind this ultimate free-market system.

Inter-bank currency contracts and options, unlike futures contracts, are not traded on
exchanges and are not standardized. Banks and dealers act as principles in these markets,
negotiating each transaction on an individual basis. Forward "cash" or "spot" trading in
currencies is substantially unregulated - there are no limitations on daily price movements or
speculative positions.

18
 FUNDAMENTAL IN EXCHANGE RATE

Typically, rupee (INR) a legal lender in India as exporter needs Indian rupees for payments for
procuring various things for production like land, labour, raw material and capital goods. But the
foreign importer can pay in his home currency like, an importer in New York, would pay in US
dollars (USD). Thus it becomes necessary to convert one currency into another currency and the
rate at which this conversation is done, is called ‘Exchange Rate’.
Exchange rate is a rate at which one currency can be exchange in to another currency, say USD 1
= Rs. 42. This is the rate of conversion of US dollar in to Indian rupee and vice versa.

METHODS OF QUOTING EXCHANGE RATES

There are two methods of quoting exchange rates.

 Direct method:
For change in exchange rate, if foreign currency is kept constant and home currency is kept
variable, then the rates are stated be expressed in ‘Direct Method’ E.g. US $1 = Rs. 49.3400.

 Indirect method:
For change in exchange rate, if home currency is kept constant and foreign currency is kept
variable, then the rates are stated be expressed in ‘Indirect Method’. E.g. Rs. 100 = US $ 2.0268
In India, with the effect from August 2, 1993, all the exchange rates are quoted in direct
method, i.e.
US $1 = Rs. 49.3400 GBP1 = Rs. 69.8700

 Method of Quotation

19
 It is customary in foreign exchange market to always quote tow rates means one rate for
buying and another for selling. This helps in eliminating the risk of being given bad rates i.e. if a
party comes to know what the other party intends to do i.e., buy or sell, the former can take the
latter for a ride.
There are two parties in an exchange deal of currencies. To initiate the deal one party asks
for quote from another party and the other party quotes a rate. The party asking for a quote is
known as ‘Asking party’ and the party giving quote is known as ‘Quoting party’

BASE CURRENCY
Although a foreign currency can be bought and sold in the same way as a commodity, but
they’re us a slight difference in buying/selling of currency aid commodities. Unlike in case of
commodities, in case of foreign currencies two currencies are involved. Therefore, it is necessary
to know which the currency to be bought and sold is and the same is known as ‘Base Currency’.

BID & OFFER RATES

The buying and selling rates are also referred to as the bid and offered rates. In the dollar
exchange rates referred to above, namely, $ 1.6290/98, the quoting bank is offering (selling)
dollars at $ 1.6290 per pound while bidding for them (buying) at $ 1.6298. In this quotation,
therefore, the bid rate for dollars is $ 1.6298 while the offered rate is $ 1.6290. The bid rate for
one currency is automatically the offered rate for the other. In the above example, the bid rate for
dollars, namely $ 1.6298, is also the offered rate of pounds.

CROSS RATE CALCULATION

20
 Most trading in the world forex markets is in the terms of the US dollar – in other words,
one leg of most exchange trades is the US currency. Therefore, margins between bid and offered
rates are lowest quotations if the US dollar. The margins tend to widen for cross rates, as the
following calculation would show.

Consider the following structure:

GBP 1.00 = USD 1.6290/98
EUR 1.00 = USD 1.1276/80
In this rate structure, we have to calculate the bid and offered rates for the euro in terms
of pounds. Let us see how the offered (selling) rate for euro can be calculated. Starting with the
pound, you will have to buy US dollars at the offered rate of USD 1.6290 and buy euros against
the dollar at the offered rate for euro at USD 1.1280. The offered rate for the euro in terms of
GBP, therefore, becomes EUR (1.6290*1.1280), i.e. EUR 1.4441 per GBP, or more
conventionally, GBP 0.6925 per euro. Similarly, the bid rate the euro can be seen to be EUR
1.4454 per GBP (or GBP 0.6918 per euro). Thus, the quotation becomes GBP 1.00 = EUR
1.4441/54. It will be readily noticed that, in percentage terms, the difference between the bid and
offered rate is higher for the EUR: pound rate as compared to dollar: EUR or pound: dollar rates.

21
FOREX MARKETS V/S OTHER MARKETS

FOREX MARKETS OTHER MARKETS

The Forex market is open 24 hours a day, 5.5 Limited floor trading hours dictated by the
days a week. Because of the decentralised clearing time zone of the trading location, significantly
of trades and overlap of major markets in Asia, restricting the number of hours a market is
London and the United States, the market remains open and when it can be accessed.
open and liquid throughout the day and overnight.
Most liquid market in the world eclipsing all Threat of liquidity drying up after market
others in comparison. Most transactions must hours or because many market participants
continue, since currency exchange is a required decide to stay on the sidelines or move to
mechanism needed to facilitate world commerce. more popular markets.
Commission-Free Traders are gouged with fees, such as
commissions, clearing fees, exchange fees
and government fees.
One consistent margin rate 24 hours a day allows Large capital requirements, high margin
Forex traders to leverage their capital more rates, restrictions on shorting, very little
efficiently with as high as 100-to-1 leverage. autonomy.
No Restrictions Short selling and stop order restrictions.

22
 FOREX EXCHANGE RISK
Any business is open to risks from movements in competitors' prices, raw material prices,
competitors' cost of capital, foreign exchange rates and interest rates, all of which need to be
(ideally) managed. This section addresses the task of managing exposure to Foreign Exchange
movements.
These Risk Management Guidelines are primarily an enunciation of some good and
prudent practices in exposure management. They have to be understood, and slowly internalised
and customised so that they yield positive benefits to the company over time.
It is imperative and advisable for the Apex Management to both be aware of these
practices and approve them as a policy. Once that is done, it becomes easier for the Exposure
Managers to get along efficiently with their task.

Foreign Exchange Exposure

Foreign exchange risk is related to the variability of the domestic currency values of
assets, liabilities or operating income due to unanticipated changes in exchange rates, whereas
foreign exchange exposure is what is at risk. Foreign currency exposure and the attendant risk
arise whenever a business has an income or expenditure or an asset or liability in a currency
other than that of the balance-sheet currency. Indeed exposures can arise even for companies
with no income, expenditure, asset or liability in a currency different from the balance-sheet
currency. When there is a condition prevalent where the exchange rates become extremely
volatile the exchange rate movements destabilize the cash flows of a business significantly. Such
destabilization of cash flows that affects the profitability of the business is the risk from foreign
currency exposures.
We can define exposure as the degree to which a company is affected by exchange rate
changes. But there are different types of exposure, which we must consider.
Adler and Dumas defines foreign exchange exposure as ‘the sensitivity of changes in the real
domestic currency value of assets and liabilities or operating income to unanticipated changes
in exchange rate’.

23
In simple terms, definition means that exposure is the amount of assets; liabilities and operating
income that is any risk from unexpected changes in exchange rates.

Key terms in Foreign Currency Exposure

It is important that you are familiar with some of the important terms which are used in
the currency markets and throughout these sections:
DEPRECIATION - APPRECIATION
Depreciation is a gradual decrease in the market value of one currency with respect to a
second currency. An appreciation is a gradual increase in the market value of one currency with
respect another currency.
SOFT CURRENCY – HARD CURRENCY
A soft currency is likely to depreciate. A hard currency is likely to appreciate.
 DEVALUATION - REVALUATION
Devaluation is a sudden decrease in the market value of one currency with respect to a
second currency. A revaluation is a sudden increase in the value of one currency with respect to a
second currency.
WEAKEN - STRENGTHENS
If a currency weakens it losses value against another currency and we get less of the other
currency per unit of the weaken currency ie. if the £ weakens against the DM there would be a
currency movement from 2 DM/£1 to 1.8 DM/£1. In this case the DM has strengthened against
the £ as it takes a smaller amount of DM to buy £1.
LONG POSITION – SHORT POSITION
A short position is where we have a greater outflow than inflow of a given currency. In
FX short positions arise when the amount of a given currency sold is greater than the amount
purchased. A long position is where we have greater inflows than outflows of a given currency.
In FX long positions arise when the amount of a given currency purchased is greater than the
amount sold.

24
Advantages Disadvantages between Currencies
The majority of Indian corporate have at least 80% of their foreign exchange transactions
in US Dollars. This is wholly unacceptable from the point of view of prudent Risk Management.
"Don't put all your eggs in one basket" is the essence of Risk Diversification, one of the
cornerstones of prudent Risk Management.

Disadvantages of $-Rupee Advantages of Major currencies

1. The very nature or structure of the $-Rupee
market can be harmful because it is small, thin
and illiquid. Thus, dealer spreads are quite wide
and in times of volatility, the price can move in
large gaps
1.By diversifying into a more liquid market,
such as Euro-Dollar, the risk arising from
the Structure of the Indian Rupee Market
can be hedged

2. Impacted in full by the Trend of the market. 2. Trends in one currency can be hedged by
For instance, if the Rupee is depreciating, its offsetting trends in another currency. Refer
impact will be felt in full by an Importer to graphs and calculations below.

3.Dollar-Rupee, in particular, brings the
following risks:
1) Lack of Flexibility...Payables once covered
cannot be cancelled and rebooked
2) Unpredictability...Dollar-Rupee is not a
freely traded currency and hence extremely
difficult to predict. The normal tools of
currency forecasting, such as Technical
Analysis are best suited to freely traded markets
3) Lack of Information...Price information on
Dollar-Rupee is not freely available to all
market participants. Only subscribers to
expensive "quote services" can get accurate
information
3. These constraints do not apply in the case
of the Major currencies:
1) Flexibility...Hedge contracts in Euro-
Dollar or Dollar-Yen etc. can be entered
into and squared off as many times as
required
2) Predictability...the Majors are much more
predictable and liquid than Dollar-Rupee
and hence Entry-Exit-Stop Loss can be
planned with ease, accuracy and
effectiveness
3) Free Information...The Internet provides
LIVE and FREE prices on these currencies.

25
 4.$-Rupee rose 2.35% from mid-June to 11th 4.Euro-Rupee fell 4.63% over the same
Aug. period

5.· An Importer with 100% exposure to USD, 5.An Importer with 25% exposure to the
saw its liabilities rise from a base of 100 to Euro saw its liability rise from a base of 100
102.35 to only 100.60

Even if a Corporate does not have a direct exposure to any currency other than the USD,
it can use Forward Contracts or Options to create the desired exposure profile. Thankfully, this is
permitted by the RBI. This is not Speculation. It is prudent, informed and proactive Risk
Management.

26
 As seen, the bad news is that Dollar-Rupee volatility has increased. The good news is that
forecasts can put you ahead of the market and ahead of the competition.
If you look at the chart below you will observe, Dollar-Rupee volatility has increased from 5
paise per day in 2004 to about 20 paise per day today. It is set to increase further, to 35-45 paise
per day over the next 12 months.
Now the question here is, how do you protect your business from Forex volatility? Just need
to track the Market every moment and by any dealer’s forecasts. They help keep you on the right
side of the market. They have an enviable track record (look at the chart on the right hand top) to
back up profits from high volatile market. Take the services of many FX-dealers that include
long-term forecasts, daily updates as well as hedging advice for the corporates.

27
 THE UNITED STOCK EXCHANGE

The United Stock Exchange of India (USE) is an Indian stock exchange. It is the fourth pan
India exchange to be launched for trading financial instruments in India over the last 140 years.
United Stock Exchange, India’s newest stock exchange marks the beginning of a new chapter in
the development of Indian financial markets.

USE represents the commitment of ALL 21 Indian public sector banks, respected private banks
and corporate houses  to build an institution that is on its way to becoming  an enduring symbol
of India’s modern financial markets. USE launched its operations on 20 Sept 2010

Sophisticated financial products such as currency and interest rate derivatives are exciting
introductions to Indian markets and hold immense opportunities for businesses and trading
institutions alike. Consequently, USE’s strong bank promoter base allows a build-up of a highly
liquid marketplace for these products. It also provides the necessary expertise to reach out to
Indian businesses and individuals, educate them on the benefits of these markets and facilitate
easy access to them.

USE also boasts of Bombay Stock Exchange, as a strategic partner. As Asia’s oldest stock
exchange, BSE lends decades of unparalleled expertise in exchange technology, clearing &
settlement, regulatory structure and governance. Leveraging the collective experience of its
founding partners, USE has developed a trustworthy and state of the art exchange platform that
provides a truly world class trading experience.

In the years to come, USE aims to become India’s most preferred stock exchange, providing a
range of sophisticated financial instruments for diverse market participants to trade on and
manage their risks efficiently.

USE began operations in the future contracts in each of the following currency pairs:

1. United States Dollar-Indian Rupee (USD-INR)

2. Euro-Indian Rupee (EUR-INR)
3. Pound Sterling-Indian Rupee (GBP-INR)
4. Japanese Yen-Indian Rupee (JPY-INR)

CONCLUSION

28
 In a universe with a single currency, there would be no foreign exchange market, no
foreign exchange rates, and no foreign exchange. But in our world of mainly national currencies,
the foreign exchange market plays the indispensable role of providing the essential machinery
for making payments across borders, transferring funds and purchasing power from one currency
to another, and determining that singularly important price, the exchange rate. Over the past
twenty-five years, the way the market has performed those tasks has changed enormously.
Foreign exchange market plays a vital role in integrating the global economy. It is a 24-
hour in over the counter market –made up of many different types of players each with it set of
rules, practice & disciplines. Nevertheless the market operates on professional bases & this
professionalism is held together by the integrity of the players.

The Indian foreign exchange market is no expectation to this international market

requirement. With the liberalization, privatization & globalization initatited in India. Indian
foreign exchange markets have been reasonably liberated to play there efficiently. However
much more need to be done to make over market vibrant, deep in liquid.

Derivative instrument are very useful in managing risk. By themselves, they do not have
any value nut when added to the underline exposure, they provide excellent hedging mechanism.
Some of the popular derivate instruments are forward contract, option contract, swap, future
contract & forward rate agreement. However, they have to be handle very carefully otherwise
they may throw open more risk then in originally envisaged.

29