FOREIGN EXCHANGE

MARKET
RISKS
 Evolution …. History….

 Different Countries – Different Langages

 Civilisation / Culture / Practices
 Different Governments / Governance / Rules
 Trade / Industries : Evolved / Grew
 Evolution …. History….
 Barter system
 Common Mode of Exchange
 Evolution of Money
 Convenience : Leather / Metal / Grains / Beads
 Different Monies / Values
 International Trade / Travelling
 Colonisation / Invasion : Mughals / East India
Co
 International Monetary System

 Bimetallism : Before 1875

 Classical Gold Standard : 1875 - 1914
 Interwar Period : 1915 - 1944
 Bretton Woods System : 1945 - 1972
 Flexible Exchange Rate Regime : Since 1973
 International Monetary System
Bimetallism : Before 1875
 Initially, only coins : Gold & Silver
 Value : Based upon Gold / Silver Content in the Coins
 Britain : Gold ; France : Bimetallic ; Germany : Silver
 British Pound to German Mark : Through French Franc
 Germany, Holland, China & India : Only Silver
 Other Metals were also used, in other countries
 International Monetary System
Classic Gold Standard :1875-1914

 Gold : Universal Fondness : Many Centuries Old

 Greek / Roman Empires and Earlier : Popular
 Even in India : Ancient Empires used Gold
 Gold Standard : Not Gold Coins : Money Backed by Gold
 France : 1850s, Germany:1875; USA : 1879; Japan : 1897
 International Monetary System
Classic Gold Standard :1875-1914
 Gold alone is assured of unrestricted coinage
 Two-way Convertibility between Gold & Currency
 Value of Money : Linked to Value of Gold in the country
 Gold may be freely imported / exported
 Net Trade Balance : Settled by Gold : Specie Flow Mech.
 Exchange Rate between 2 currencies : Gold Content
 (E.g.): UK : 6 Pound / Ounce; France : 12 Francs / Ounce
 1 Pound = 2 Francs
 During that period, Pound Sterling = $4.84 – $4.90
 Interwar
 After WW-I :
Period :1915-1944
 UK, France, Germany & Russia : Stopped Redemption
 Placed Embargo on Gold Exports
 Germany, Austria, Hungary, Poland : Hyperinflation
 Germany : Worst : 1923 : WPI : 1 Trillion Times
 Currency values not pegged to Gold : Fluctuation
 Acute Shortage of items : Devaluation : Exports..
 Gold Standard disappeared
 1919 : USA restored Gold Standard
UK, Switzerland, France, Scandinavian Countries : 1928
Most countries kept some gold out of Currency Float
1929 : Great Depression / Stock Market Crash : Erosion
UK experienced huge outflow of Gold: Chronic BOP issue
1931:UK, Canada, Sweden, Austria, Japan Got off Gold
Std
 Interwar Period :1915-1944

Huge erosion in Gold Stock across Europe

Massive Bank Failures in the US and other countries
Flight of Capital across borders
Half-hearted attempts to restore Gold Standard & Failure
Economic and Political Instabilities
 BRETTON WOODS SYSTEM : 1945-1972
• July 1944 : Reps of 44 Nations met at New Hampshire
• Agreement between countries : IMF formed
• British : International Reserve Asset : ‘bancor’
• Americans : Currency Pool from Member Countries
• Suggestions from America were built into Articles of IMF
• All countries agreed to peg their currencies par value to USD
• US $ then linked to Gold Price : $ 35 = 1 Ounce of Gold
• Called the Gold Exchange Standard, based on Dollar
• When market price of Gold fell below $ 35, became an issue
BRETTON WOODS SYSTEM : 1945-1972
 BRETTON WOODS SYSTEM : 1945-1972

• New asset created at IMF : SDR : Special Drawing Rights

• SDR : Initially average of 16 currencies : World Export
• 1981 : 5 currencies : USD, DM, Yen, PDS, FF
• Currently: 4 : USD : 45%; Euro :29%; Yen : 15%; PDS:11%
• SDR : Portfolio of Currencies
• Can be an attractive denomination for International Contracts
COMPOSITION OF SDR
 FLOATING EXCHANGE RATE : 1973 …

• Gold Rates : Widely beyond benchmark rate

• Higher inflation in the US - US$ un-attractive link currency
• Countries revalued their exchange rate with US$
• European and Japanese currencies were de-linked from US$
• US $, PDS, DM, Yen : Fluctuating against each other
• Gold ceased to be the standard for money value
• IMF returned half of their gold holding to member nations
• Central Banks of countries were authorised to intervene
 Current Foreign Currency Arrangement
1. Pegged to the US Dollar :Hong Kong
2. Pegged to Euro : Estonia
3. Pegged to Other Currencies : Single / Basket
• Narrow Range : 1%; Malaysia / China
4. European Monetary Union - Euro
5. Limited Flexibility : Israel / Romania
6. Managed Floating : 42 Countries
• Govt. intervenes: Singapore / India / Thailand
7. Independent Floating : 41 Countries
• Market Driven : UK / Canada / Japan / Australia
EXCHANGE RATES-1999 :
 FOREIGN EXCHANGE
• Means the money of a Foreign Country
• Bank Balances, Notes, Coins, Cheques, Drafts
Movement in US $
 FOREIGN EXCHANGE MARKET
The Foreign Exchange Market :
The physical and institutional structure through which the
money of one country is exchanged for that of another
country
The determination rate of exchange between currencies
Is where foreign exchange transactions are physically
completed

Foreign exchange transaction :

An agreement between a buyer and a seller
Fixed amount of one currency will be delivered for some
other currency
At an agreed Exchange Rate
At a specified date
 FOREX MARKET - FUNCTIONS
Forex Market is the mechanism by which participants:
• Transfer purchasing power between countries
• Obtain / provide credit for international trade
transactions
• Minimize exposure to the risks of exchange rate
changes
FOREX MARKET – PARTICIPANTS

• Reserve Bank of India (RBI)

• All Scheduled Commercial Banks (Authorised Dealers
only)
• Corporate Treasuries
• Public Sector/Government
• Inter Bank Brokerage Houses
• Resident Indians
• Non Residents
• Speculators and Arbitragers
BALANCE OF PAYMENT
 BALANCE OF PAYMENT

• Net Balance of All International Financial Transactions

• Country’s Total Exports – Total Imports
• Net ‘+’ : Favourable; ‘-’ : Un-Favourable
• One Country with All Other Countries
• ‘+’ with one country and ‘-’ with many possible
• Generally, world over, in US $
• Imports / Exports of Goods, Services, Cross-Border
Investments, Bank A/c, Bonds, Stocks, Real Estate etc.
 BALANCE OF PAYMENT
• Statistical record of a country’s international transactions
over a certain period of time presented in the form of
Double-Entry Book-keeping
• Over a Certain Period of time, same as national income a/c
• ‘+’ : Receipts : Credits : Sales, Financial Claims, Assets
• ‘-’ : Payments : Debits : Purchase, Obligations
• One Country with All Other Countries
• ‘+’ with one country and ‘-’ with many country possible
• Under 3 Heads : Current / Capital / Official Reserve A/c
 B O P – Current A/c
CONTAINS :
• Merchandise : Trade Balance : Tangible Goods : Oil,
Automobiles, Machines, Computers, Food Grains, Clothes, etc
• Services : Invisible Trade: Consulting, Royalties, Legal,
Patents, Insurance, Intellectual Properties, Tourism, etc.
• Factor Income : Interest, Dividend, Return on Investments
• Unilateral Transfers :Foreign Aid, Official /Personal Gifts,
Grants. This is the only Uni-directional flow

DEFICIT / SURPLUS :
• Deficit : Fund by Borrowings / From Accumulation
• Surplus : Collect IOUs from Foreign Countries
 B O P – Capital A/c
CONTAINS :
• FDI : Invest in a Company / Subsidiary in another Country
• Portfolio : Invest in Stocks / Bonds etc: No Transfer of
Control
• Other Investment : Deposits / Trade Credits, Currency, etc. to
utiilise advantage of Interest Rate Differential

B O P – Statistical Discrepancies
CONTAINS :
• Omitted / Mis-recorded Transactions
 BOP–
Overall Balance / Official Settlement Balance

Total of Current A/c, Capital A/c, Statistical Discrepancies

• ‘–’ : Owes to the rest of the World

• ‘+’ : Due from the rest of the World
• Settled accordingly : Loan / Gold / Forex / SDR
• Under the earlier Fixed Exchange Rate Regime :
Current A/c + Capital A/c = 0
• Under the present Flexible Exchange Regime :
Current A/c Surplus / Deficit : Change in Capital A/c
US - BOP – Year 2000 – $ - Billion
US - BOP – Year 2000 – $ - Billion
US - BOP – Year 2000 – $ - Billion
 International Reserve Assets /
US - BOP – Year 2000 – $ - Billion

Official Reserve Assets

• Gold
• Foreign Exchange
• SDR
• Reserve Position in the IMF

• Gold : No longer Popular : 3%

• 94% : Foreign Exchange
US - BOP – Year 2000 – $ - Billion
US - BOP – Year 2000 – $ - Billion

Markets & Institutions

 FX Markets
US - BOP – Year 2000 – $ - Billion

• Purchase / Sale of Foreign Currency

• Biggest Market : $ 1.2 Trillion / day!
• $ 200 per living person on this Earth!!
• Not a physical structure but Virtual
• Contains Wholesale / Retail Dealers
• Dealings through Two-way Quotes
• Network of Computers, Phones, Dealing
Machines
• Runs on Safe, Best Communication Systems
• Reuters and EBS : Largest vendors of Quotes
• 24 / 7 / 365; Most of the trading : 9 – 12 Hrs
 3 FX Market Segments
US - BOP – Year 2000 – $ - Billion

Australasia
Sydney, Tokyo, Hong Kong, Singapore, Bahrain
Europe
Zurich, Frankfurt, Paris, Brussels, Amsterdam London
North America
N Y, Montreal, Toronto, Chicago, San Francisco & L A
US - BOP – Year 2000 – $ - Billion
International FX Business
US - BOP – Year 2000 – $ - Billion
FX : Average Daily Turnover
Types of FX Markets – Two Tiers
Wholesale/Interbank :
• International Banks : Buy both for themselves
and for other retail clients

Retail / Client :
• Bank Customers : MNCs, Money managers,
Speculators
• Non – Bank Dealers : Investment Banks etc.
• Brokers : Match Buy / Sell requirements
• Central Banks : More to regulate Rates
 Deals in FX Markets
• Dealing Rooms : Secure Environment
• Individual Traders for Particular Currency
• Generally : Most Trades : US $ denominated
• Quotes : Direct (American) / Indirect (European)
• Two Way Quotes : Sell ( Bid ) / Buy ( Ask/Offer )
• Spread : Difference between Sell / Buy
• Inter-Bank: Standard Size: US $ 10 M (ten dollars)
• Real-Time Quotes : Immediate Decision : Freeze
• $/£ Quote : $ 1.5267 - $ 1.5272
Big Figure / Small Figure : Quotes :Small Figure
• Screen Based Trade : Automatically Appear
• Cross Currency : Through $ Rate S(€/£) = S($/£)
S($/€)
 FX Payment Gateways
US - BOP – Year 2000 – $ - Billion

SWIFT : Society for Worldwide Interbank Fin. Telecom

• Private Non-Profit Message Transfer System
• Headquarters in Brussels
• Switching Centers in Netherlands and Virginia
• All Constituents of the FX market connected through this
• Transactions involving All Currencies

CHIPS : Clearing House Interbank Payments System

• Along with Federal Reserve Bank System, provides a
Clearing House
• Settlement of Interbank USD Payments
 FX Rates
US - BOP – Year 2000 – $ - Billion

SPOT : Exchange Rate for Immediate Delivery

• Quoted and Traded everyday - Today
• Settlement in generally 2 working days
FORWARD : Exchange Rate for Future Delivery
• Quoted and Traded everyday - Today
• Settlement at agreed Rate at an Agreed Future Date

DIRECT QUOTE: American Terms

• Home Currency / 1 Unit of Foreign Currency
• $ 1 = Rs.43.64 ; £ 1 = Rs.68.96 ; € 1 = Rs.52.23
INDIRECT Quote : European Terms
• Foreign Currency / 1 Unit of Home Currency
• 1 / Direct Quote
• Re 1 = $ 0.2291; Re 1 = £ 0.0145 ; Re 1 = € 0.0191
 Forward Contract
Contracting today for Future Purchase / Sale :
• Premium ( for Sale ) / Discount ( for Purchase )
• Major Currencies : $ / £ / €
• Standard Maturities : 1,3,6,9,12 Months
• Other Maturities are also available
• Longer terms : Even up to 10 Years possible
• Notation : FN($ / £) ; ‘N’ : Number of Months : 1,3,6,9,…
• S ($ / £) Spot rate between $ and £

S($/SF) .6653
F1($/SF) .6660
F3($/SF) .6670
F6($/SF) .6684
 Swap Transaction
Simultaneous Sale ( Purchase ) of Spot against Forward :
• Account for about 50% - 60% in Interbank Trade
• Bulk of Trade :Swaps for Forwards
• FX Dealers Conversations / Quotes : ‘Forward Points’
Spot $/£ 1.5267–1.5272
One-Month 32–30
Three-Month 57–54
Six-Month 145–138
Spot $/£ : 1.5267–1.5272
Forward Point Outright Forward
Quotations Quotations
One-Month 32–30 1.5235–1.5242
Three-Month 57–54 1.5210–1.5218
Six-Month 145–138 1.5122–1.5134
 Risk - Forex
US - BOP – Year 2000 – $ - Billion

• Translation Risk – Accounting Risk

• Parent Company – Having Subsidiaries Globally
• A/c maintained in different Reporting Currencies
• Consolidation : Parent Company’s Home Currency
• Current Rate ( Balance Sheet Items )
• Temporal : Individual Assets Revalued – Existing Rate
• Monetary/Non-monetary: Current/Average/Historical
• Average Rate (P/L A/c Items)
• Impacts the Networth of Parent / Holding Company
• Transaction Risk
• Real Operating Risk
 Taxation
National / International
 Direct / Indirect Taxation
Direct Taxes - Direct tax is demanded from the very
persons who, it is intended or desired , should pay it”

Indirect Taxes - Indirect tax is demanded from the very

persons in the expectation and intention that he shall
indemnify himself at the expanse of others
 Direct Tax
Directly paid by the persons
on whom it is legally imposed
Impact is on the same persons
who pays the tax
Tax burden cannot be shifted
to other persons & consumer
directly pays to Local /State /
Center Governments.
Example: Income tax ,house
property tax, land and estate tax duties, Sales Tax, Octroi.
or service tax
Indirect Tax
Indirectly paid by the
other persons
Impact is on many persons
Tax burden can shift to the
other persons (other than the
payee).
Consumption taxes, Excise
 OTHER CLASSIFICATIONS
On basis of method of assessment
Specific taxes Ad valorem taxes
A physical measurement
SPECIFIC AND AD VALOREMlike Tax on value of a commodity.
TAXES
the weight or volume of a Definite percentage of value of
commodity. goods.
Example : Water Tax Example : Finished goods

Temporary and Permanent Taxes

Temporary taxes Permanent taxes
A tax on war profits to pay off Taxes on income
a large amount of debt in a
short period of time.
Example:Kargil war tax Example: property tax
 Taxation – Basics …
• Main Source of Revenue to the Governments
• Could be by Federal / Central Govt. / States / Local
• Residential Status is relevant
• Primary Types :
• Income Tax : Personal / Corporate
• With-holding Tax : On Payouts
• Value Added Tax
• An important factor in Funding Decisions
• Global Scenario : Complex : Different Countries …
AN EFFICIENT TAX SYSTEM
EQUALITY
CERTAINTY
SIMPLICITY
CONVINENCE
ECONOMY
PRODUCTIVITY
ELASTIC
DIVERSITY
 Taxation – Basics …
• It is a compulsory contribution imposed by a
public authority.
• Pre-decided.
• Dose not confer direct and proportional benefits
to tax payer.
• Tax policy to conform to criteria of buoyancy and
elasticity
 Taxation – 2 Objectives
• Tax Neutrality : 3 Criteria :
o Capital Export Neutrality –
Raises Tax Revenue but
Economic Resources allocated uniformly
Basic Assumption : World-wide Economic Efficiency
o National Neutrality –
This is a difficult concept
Income Taxed same way irrespective where earned
o Capital Import Neutrality -
Difference in Tax Rates in Different Countries
Value
• Tax Equity : Equitable Collection of Tax
 Taxes : Basis …
• Incomes : Taxed : Due or Receipt
• Based upon Residential Status
• Multiple Income Avenues :
• Capital Gains / Immovable Properties
• Business / Profession
• Dividend / Interest / Royalty / Mgmt. Fees …
• Personal : Artists / Musicians / Sportsmen
• Pensions
Income from 2 or More Countries
• Global Trade : Income earned in many countries
• Incomes : Capital / Revenue
• Tax on such earnings : Taxability : Once / More??
• Multiple Tax : Un-favourable for businesses
• What is the solution ???
• Some Countries accord Credit
• Other Countries enter into Treaties
• Between Countries
• Generally in line with UN Guidelines
• Understanding that Income taxed only once
• Treaties for Different pairs of Countries
• Most countries have Treaties with most others
• India : with 79 Countries
Income from 2 or More Countries
Income from 2 or More Countries
Tax Havens : ‘0’ Corporate Tax

• Bahamas
• Bahrain
• Bermuda
• Cayman Islands
 DTAA : Double Taxation
Avoidance Agreement
•Avoidance of Double Taxation
• How ???
• DTAAs / Treaties
• Governments define Criteria for Taxing
• Definition of Income / Rates / Dispute Resolution
• Facilitate Exchange of Information
• Unilateral
• Bilateral
DTAA - Objectives : 1994 Treaty
1. GENERAL PRINCIPLE : Taxed in only one country
2. AVOIDANCE OF DOUBLE TAXATION
• Allocation of exclusive taxing rights
• Facilitates Consultation
3. PREVENTION OF FISCAL EVASION
TAXES ON INCOME, PROFITS OR GAINS AND CAPITAL GAINS
•Transfer pricing adjustments
•Exchange of information
4. ENCOURAGEMENT OF TRADE & INVESTMENT
•Non-discrimination
 DTAA - Risks
• Potential Abuse
• Larger MNCs take advantage of loopholes
• Sophisticated Tax Planning : Countries lose
Tax Revenue
• May upset competition / equilibrium
• Transfer Pricing : Structured to benefit
• Limitation on Exchange of Information
• Tax Havens : Could become more popular
 DTAA – Way forward …
• Depends upon co-operation
• Develop Working Groups
• Increased Exchange of Best Practices
• Continuous knowledge sharing
• Identify Differences / Loopholes : Improve
• Move towards Common Code like IFRS
• Unified approach : Willingness to succeed