Foreign Exchange

Foreign exchange, or Forex, is the conversion of one country's currency into that of another. In a free economy, a country's currency is valued according to factors of supply and demand. In other words, a currency's value can be pegged to another country's currency, such as the U.S. currency, or even to a basket of currencies. A country's currency value also may be fixed by the country's government. However, most countries float their currencies freely against those of other countries, which keeps them in constant fluctuation. The value of any particular currency is determined by market forces based on trade, investment, tourism, and geo-political risk. Every time a tourist visits a country, for example, he or she must pay for goods and services using the currency of the host country. Therefore, a tourist must exchange the currency of his or her home country for the local currency. Currency exchange of this kind is one of the demand factors for a particular currency. Another important factor of demand occurs when a foreign company seeks to do business with a company in a specific country. Usually, the foreign company will have to pay the local company in their local currency. At other times, it may be desirable for an investor from one country to invest in another, and that investment would have to be made in the local currency as well. All of these requirements produce a need for foreign exchange and are the reasons why foreign exchange markets are so large.

The foreign exchange market (forex, FX, or currency market) is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies. The primary purpose of the foreign exchange is to assist international trade and investment, by allowing businesses to convert one currency to another currency. For example, it permits a US business to import British goods and pay Pound Sterling, even though the business' income is in US currencys. It also supports direct speculation in the value of currencies, and the carry trade, speculation on the change in interest rates in two currencies. In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary

management established the rules for commercial and financial relations among the world's major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system. The foreign exchange market is unique because of

its huge trading volume representing the largest asset class in the world leading to high liquidity; its geographical dispersion; its continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday; the variety of factors that affect exchange rates; the low margins of relative profit compared with other markets of fixed income; and the use of leverage to enhance profit and loss margins and with respect to account size.

As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding currency intervention by central banks. According to the Bank for International Settlements, as of April 2010, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume as of April 2007. Some firms specializing on foreign exchange market had put the average daily turnover in excess of US$4 trillion.[4] The $3.98 trillion break-down is as follows:

$1.490 trillion in spot transactions $475 billion in outright forwards $1.765 trillion in foreign exchange swaps $43 billion Currency swaps $207 billion in options and other products

Financial instruments Spot A spot transaction is a two-day delivery transaction (except in the case of trades between the US Currency, Canadian Currency, Turkish Lira, EURO and Russian Ruble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a direct exchange between two

currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction. Forward One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be one day, a few days, months or years. Usually the date is decided by both parties. Then the forward contract is negotiated and agreed upon by both parties.

Swap The most common type of forward transaction is the FX swap. In an FX swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not standardized contracts and are not traded through an exchange. Future

Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts. Option A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on

a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world. What Does Foreign-Exchange Risk Mean? 1. The risk of an investment's value changing due to changes in currency exchange rates. 2. The risk that an investor will have to close out a long or short position in a foreign currency at a loss due to an adverse movement in exchange rates. Also known as "currency risk" or "exchange-rate risk". FOREIGN EXCHANGE RISK MANAGEMENT DEFINITION Foreign exchange risk is the exposure of an institution to the potential impact of movements in foreign exchange rates. The risk is that adverse fluctuations in exchange rates may result in a loss in Local currency terms to the institution. Foreign exchange risk arises from two factors: currency mismatches in an institutions assets and liabilities (both on- and off-balance sheet) that are not subject to a fixed exchange rate vis-a-vis the Local currency, and currency cash flow mismatches. Such risk continues until the foreign exchange position is covered. This risk may arise from a variety of sources such as foreign currency retail accounts and retail cash transactions and services, foreign exchange trading, investments denominated in foreign currencies and investments in foreign companies. The amount at risk is a function of the magnitude of potential exchange rate changes and the size and duration of the foreign currency exposure. C. FOREIGN EXCHANGE RISK MANAGEMENT PROGRAMME Managing foreign exchange risk is a fundamental component in the safe and sound management of all institutions that have exposures in foreign currencies. It involves prudently managing foreign currency positions in order to control, within set parameters, the impact of changes in exchange rates on the financial position of the Foreign Exchange Risk Management institution. The frequency and direction of rate changes, the extent of the foreign currency exposure and the ability of counterparts to honour their obligations to the institution are significant factors in foreign exchange risk management. Although the particulars of foreign exchange risk management will differ among institutions depending upon the nature and complexity of their foreign exchange activities, a comprehensive foreign exchange risk management programme requires:

 establishing and implementing sound management policies; and

and prudent foreign exchange risk

developing and implementing appropriate and effective foreign exchange risk management and control procedures. Foreign Exchange Risk Management Policies Well articulated policies, setting forth the objectives of the institutions foreign exchange risk management strategy and the parameters within which this strategy is to be controlled, are the focal point of effective and prudent foreign exchange risk management. These policies need to include: a statement of risk principles and objectives governing the extent to which the institution is willing to assume foreign exchange risk; explicit and prudent limits on the institutions exposure to foreign exchange risk; and clearly defined levels of delegation of trading authorities. i) Statement of Foreign Exchange Risk Principles and Objectives Before foreign exchange risk limits and management controls can be set it is necessary for an institution to decide the objectives of its foreign exchange risk management programme and in particular its willingness to assume risk. The tolerance of each institution to assume foreign exchange risk will vary with the extent of other risks (e.g. liquidity, credit risk, interest rate risk, investment risk) and the institutions ability to absorb potential losses. As with other aspects of financial management, a trade-off exists between risk and return. Although the avoidance of foreign currency exposure or the hedging of such exposure may eliminate foreign exchange risk, such a position may not be desirable for other sound business reasons. Accordingly, the objective of foreign exchange risk management need not necessarily Foreign Exchange Risk Management be the complete elimination of exposure to changes in exchange rates. Rather, it should be to manage the impact of exchange rate changes within self imposed limits after careful consideration of a range of possible foreign exchange rate scenarios. ii) Foreign Exchange Risk Limits Each institution needs to establish explicit and prudent foreign exchange limits, and ensure that the level of its foreign exchange risk exposure does not exceed these limits. Where applicable, these limits need to cover, at a minimum:

 the currencies in which the institution is permitted to incur exposure; and the level of foreign currency exposure that the institution is prepared to assume. Foreign exchange risk limits need to be set within an institutions overall risk profile, which reflects factors such as its capital adequacy, liquidity, credit quality, investment risk and interest rate risk. Foreign exchange positions should be managed within an institutions ability to quickly cover such positions if necessary. Moreover, foreign exchange risk limits needs to be reassessed on a regular basis to reflect potential changes in exchange rate volatility, the institutions overall risk philosophy and risk profile. Authorised currencies will normally include currencies in which the institution may be called on to settle foreign exchange transactions. These are usually the currencies in which the institution or its customers conduct business. Limits on an institutions foreign exchange exposure should reflect both the specific foreign currency exposures that arise from daily foreign currency dealing or trading activities (transactional positions) and those exposures that arise from an institutions overall asset/liability infrastructure, both on- and off-balance sheet (structural or translational positions). The establishment of aggregate foreign exchange limits that reflect both foreign currency dealing and structural positions helps to ensure that the size and composition of both positions are appropriately and prudently managed and controlled and do not overextend an institutions overall foreign exchange exposure. i) Measurement of Foreign Exchange Risk Managing foreign exchange risk requires a clear understanding of the amount at risk and the impact of changes in exchange rates on this foreign currency exposure. To make these determinations, sufficient information must be readily available to permit appropriate action to be taken within acceptable, often very short, time periods. It is only through the accurate and timely recording and reporting of information on exchange transactions and currency transfers that foreign currency exposure can be measured and foreign exchange risk controlled. Accordingly, each institution engaged in foreign exchange activities needs to have an effective accounting and management information system in place that accurately and frequently records and measures: its foreign exchange exposure; and the impact of potential exchange rate changes on the institution. At a minimum, each institution should have in place monitoring and reporting techniques that measure:

 the net spot and forward positions in each currency or pairings of currencies in which the institution is authorised to have exposure; the aggregate net spot and forward positions in all currencies; and transactional and translational gains and losses relating to trading and structural foreign exchange activities and exposures.