Question 2 Explain foreign exchange market. Write about all the types of foreign
exchange markets. Explain the participants in foreign exchange markets.
Answer 2
Foreign Exchange market (forex market) deals with purchase and sale of foreign
currencies. The bulk of the market is over the counter (OTC) i.e. not through an
exchange which is well regulated.
International trade and investment essentially requires foreign markets. Banks act as
intermediaries and perform currency exchange transactions by quoting purchase and
selling prices.
In India the Foreign Exchange Management Act (FEMA) 1999 is the law relating to forex
transactions and its aim is to develop, liberalise and promote forex market and its
effective utilisation.
Types of foreign exchange market
1. Spot market Spot market is a market in which a currency is bought or sold for
immediate delivery or delivery in the very near future. Trading in the spot market
is for execution on the second working day. Both the delivery and payment take
place on the second day. The rate quoted is called as spot rate, the date of
settlement known as value date and the transactions called spot transactions.
2. The forward market involves contracts for delivery of foreign exchange at a
specified future date beyond the spot date and the transaction is called a forward
transaction. The rate that is quoted at the time of the agreement is called the
forward rate and it is normally quoted for value dates of one, two, three, six or
twelve months.
3. Unified and dual markets Unified markets are found where there is only one
market for foreign exchange transactions in a country. They have greater liquidity,
increased price discovery, lower short-run exchange rate volatility and reliable
access to foreign exchange. In contrast, dual markets are found in countries with
multiple exchange markets. For example, a country may consider forex market
for current account transactions and a different exchange for capital transactions
or market for trade transactions and another market for regulated transactions
like India had in the early 1990s, when dual exchange rates prevailed.
4. Offshore and onshore markets During the earlier stages of financial
development, forex market operated onshore i.e. within India. But after
liberalisation of the economy, offshore markets have developed and instruments
based on foreign currencies issued by Indian firms are traded in foreign markets.
Participants
The participants in forex market are the RBI at the apex, authorised dealers (ADs)
licensed by the central bank, corporates and individuals engaged in exports and imports.
1. Corporates Corporates operate in the forex market when they have import,
export of goods and services and borrowing or lending in foreign currency. They
sell or buy foreign currency to or from ADs and form the merchant segment of the
market.
2. Commercial banks Banks trade in currencies for their clients, but much larger
volume of transactions come from banks dealing directly among themselves.
3. RBI RBI intervenes in forex market to ensure reasonable stability of exchange
rates, as forex rates impact, and in turn are impacted, by various macroeconomic indicators like inflation and growth.
4. Exchange brokers They facilitate trade between banks by linking the buyers
and sellers. Banks provide opportunities to brokers in order to increase or
decrease their selling rate and buying rate for foreign currencies. Exchange
brokers also specialise in specific currencies that have lower demand and supply
to add value to banks. In India, many banks deal through recognised exchange
brokers.
7. Monitoring risk i.e. reviewing the methods regularly vis--vis their efficacy in
controlling risk, and updating methods from time to time in keeping with changes
in the organisation and the environment
Tools available for managing risks
Risk management tools do analysis and implementation of methods for mitigating risks.
The major tools available for risk are:
1. Failure Mode Effects Analysis (FMEA): This tool is used for identifying the cost
of potential failures in business. This method can be applied during analysis and
design phases of new business to identify the risk of failure. The FMEA method is
divided into three steps:
a. The first step is identifying the elements causing failure.
b. The second step is studying the modes of failure.
c. The last step is assessing the probability and effects of failure
2. Fault Tree Analysis (FTA): The tool is used as a deductive technique to analyse
reliability and safety of an organisation. It is usually implemented for dynamic
systems. It provides the foundation for analysis and justification for changes and
additions of various actions to reduce risks.
3. Process Decision Program Chart (PDPC): The tool identifies the different
levels of risk and the countermeasure tasks. The process of planning is essential
before the tool is used for measuring risks. It includes identifying the element
causing risk. The next process consists of identifying the context of problem and
measures to reduce risks.
4. Risk calculations: This method is the continuous scanning of risks at various
phases of the business, to identify the most common ones and assigning high
priority to them. This calculation is obtained by the following methods:
a. Risk exposure: The probability of the risk occurrence and total loss to
the organisation provides the overall exposure of specific risk.
Risk Exposure (RE): Probability of risk occurring x Total loss due to the
risk
b. Risk reduction leverage (RRL): The value of the return on investment
for countermeasures is obtained. The reduction in the risk exposure
and cost of countermeasure helps in prioritising the possible
countermeasures.
Risk reduction leverage (RRL) = Reduction in Risk Exposure Cost of
countermeasure
c. Managing risk: Once the risks are identified and calculated the best
plan which reduces risk exposures is chosen. If abandonment is
considered, the risk management chooses alternative actions to
counterpart the risk. If it is reduction method it changes the current
action by adding new action to reduce the risk. The contingency
planning depends upon the risk exposure and reduction leverage.
5. Foreign exchange market activity: Foreign investor demand for debt securities
influences the interest rate. Higher inflows of foreign capital lead to increase in
domestic money supply which in turn leads to higher liquidity and lower interest
rates.
Micro factors
Micro factors, meaning factors specific to the borrower, which play a role in the interest
rate, are:
1. Individual credit and payment track record, credit rating
2. Industry in which the business is operating
3. Extent of leveraging of the company viz. debt-equity ratio
4. Quality of prime security and collateral
5. Loan amount
Question 5 Explain the contents of working capital. Write down the need for
working capital.
Answer 5
As stated above, working capital comprises the working assets of a firm. What are these
assets? Look at the items in these examples.
1. A trading business for instance may have to purchase and store products to be
sold, paying for them before they can be sold and cashed. A factory that
produces and sells products has to store raw materials and finished goods,
besides having some unfinished materials under process.
2. A company may also need to allow the customers to pay later instead of insisting
on cash at the point of delivery.
3. Payments in advance may be required for certain expenses like annual
insurance, deposit for renting the office, foreign currency and tickets for foreign
travel or advance fees/deposits for statutory registrations.
4. And finally the business must have some idle cash and bank balances for making
spot payments.
Each of these requirements takes the form of a working asset:
1. The first is a working asset or a current asset called inventories.
2. The second item is called trade receivables or accounts receivable
3. The third set of items are prepayments, advances and deposits
4. The final item is cash & cash equivalents.
These assets together comprise the working capital of a business.
It is worth repeating here that there is a separate set of assets including land, building,
machines etc. that make up the fixed capital of the company. We are not talking about
those assets here.
Need for working capital
Can a business run without the need to invest in working assets like trade receivables
and inventories? Let us study the following case.
1. Pachai is a vendor of pani-puris in a makeshift stall of his own at the end of the
street in which he lives.
2. Every morning he goes to the market and buys the ingredients to make pani-puris
for the day, estimating the quantity based on anticipated sales. He buys more in
the weekends, naturally.
3. He does not pay for the material as he buys on credit.
4. Through the day he does the processing of the pani-puris to the stage needed,
and at 4 pm sets up the stall and runs it till 8 30 p.m.
5. As he sells the pani-puris he collects cash, and at 8.30 or earlier, depending upon
the demand, he sells his days produce completely.
6. He goes across to the vendor from whom he bought the ingredients and pays for
the supply, and returns home with the balance money, which is his profit.
7. The cycle is repeated day after day.
Here is a businessman who, you might say, does not require working capital at all: no
idle cash, no deposits, no receivables and no inventories. But this is an extreme case
under ideal conditions.
If the produce is not sold fully it becomes inventory for the next day. Or the vendor might
want a security deposit. Or Pachai may think about expanding by selling a part of his
produce in bulk to another stall-owner, who will pay once a week. In all these cases he
will need to worry about working capital.
All businesses small, medium or big need working capital for survival and growth.
The more widespread the activity, the greater is the need. It is of paramount importance
for the financial health of a business to assess the requirement reasonably correctly,
finance it sensibly and control it effectively and make sure the working assets keep
working, are current and do not get stuck. This is the essence of working capital
management.
Question 6 Explain the concepts and benefits of integrated treasury. Explain the
advantages and disadvantages of operating treasury.
Answer 6
The concept of integrated treasury works on the principle that Treasury can be a single
unifying force of a companys activities in the money market, capital market and forex
market; and can help the company derive synergy. Synergy is a powerful advantage in
business because it brings together two or more activity domains and achieves a total
effect that is greater than the sum of all the individual domains.
Thus a decision related to money market instruments, for example, is taken after
reviewing possible forex actions that could enhance the benefit of the decision.
The Indian rupee is freely convertible on current account and partially convertible on
capital account. This has made it possible to take a combined approach to a treasury
issue.
The major functions of integrated treasury are as follows:
1. Ensuring liquidity reserve
2. Deploying surplus funds in securities with low risk and moderate profits
3. Managing multi-currency operations
4. Exploring opportunities for profitable placements in money market, securities
market and forex market
5. Managing the sum total of treasury risks with some balancing actions as between
the three markets
The benefits of integrated treasury are:
1. Improved cash planning and better monitoring of the cash position
2. Constant watch on the impact of treasury activities on the balance sheet
3. Greater financial control by integrating budgetary control and financial information
The advantages of operating treasury as a profit centre than as a cost centre are:
1. Individual business units can be charged a market rate for the service provided,
thereby making their operating costs more realistic.
2. The treasurer is motivated to provide services as economically as possible to make
profits at the market rate.
The disadvantages are:
1. The profit concept is a temptation to speculate. For example, the treasurer might
swap funds from the currencies that are expected to depreciate and risk the company
cash values.
2. Management time could be wasted in arguments between Treasury and business
units over the charges for services, distracting the latter from their main operations.
3. The additional administrative costs may be excessive.