FOREX

Theforeign exchange market(forex,FX,

orcurrency market) is a global, worldwide
decentralized financial market for trading currencies.
The foreign exchange market determines the relative
values of different currencies by forces of demand and
supply, which is called Flexible Exchange Rate regime.
The primary purpose of the foreign exchange is to
assist international trade and investment, by allowing
businesses to convert one currency to another
currency.
In a typical foreign exchange transaction, a party
purchases a quantity of one currency by paying a
quantity of another currency.
Market Size and Liquidity
The foreign exchange market is the most liquid
financial market in the world.
Traders include large banks, central banks, institutional
investors, currency speculators, corporations,
governments, other financial institutions, and retail
investors.
According to the 2010 Triennial Central Bank Survey,
average daily turnover was US$3.98 trillion in April
2010 (vs. $1.7 trillion in 1998). Of this $3.98 trillion,
$1.5 trillion was spot foreign exchange transactions
and $2.5 trillion was traded in outright forwards, FX
swaps and other currency derivatives.
Foreign exchange trading increased by 20% between April
2007 and April 2010 and has more than doubled since 2004.
Foreign Exchange Exposure and Risk and Risk Management

Exposure refers to the degree to which a company is

affected by exchange rate changes.
Exchange rate risk is defined as the variability of a
firms value due to uncertain changes in the rate of
exchange.
Managing Foreign Exposure with the concept of Risk
Management is called Hedging.

Entering into an offsetting currency position so

whatever is lost/gained on the original currency
exposure is exactly offset by a corresponding
currency gain/loss on the currency hedge.
 USD-INR Spot Price- 1$- Rs 45
F1= Rs 44 r = .07
F2= Rs 50 rf = .02, t= 1 year

F0= S*e^{(r-rf)^t) = 47.30

Since F1<F0
CASE 1- Borrow Foreign Currency, 1000 USD @ 2% for 1 year
1. F0= 1000*e^(.02*1) = 1020.20
2. After 1 Year, You have to pay
44*1020.20 = Rs 44888.8
3. Conversion 1000 USD into INR = 1000*45 = Rs 45000
4. Invest in India, 45000 @ 7% for 1 year
45000*e(.07*1) = Rs 48252.86
4. Profit = 48262.86-44288.8 = Rs 3374.06

. CASE 2 F2>F0, Borrow INR and Invest in US

You will make the Profit of Rs 2747.14
Types of Exposure

Translation Exposure

Transaction Exposure

Economic Exposure
Transaction Exposure
The transaction exposure component of the foreign
exchange rates is also referred to as a short-term economic
exposure. This relates to the risk attached to specific
contracts in which the company has already entered that
result in foreign exchange exposures. A company may have
a transaction exposure if it is either on the buy side or sell
side of a business transaction. Any transaction that leads to
an inflow or outflow of a foreign currency results in a
transaction exposure.
For example, Company A located in the United States has a
contract for purchasing raw material from Company B
located in the United Kingdom for the next two years at a
product price fixed today. In this case, Company A is the
foreign exchange payer and is exposed to a transaction risk
from movements in the pound rate relative to dollar. If the
pound sterling depreciates, Company A has to make a
smaller payment in dollar terms, but if the pound
Sources of Transaction Exposure

Transaction exposure arises from:

Purchasing or selling on credit goods or
services whose prices are stated in
foreigncurrencies.
Borrowing or lending funds when repayment is
to be made in a foreign currency.
Being a party to an unperformed foreign
exchange forward contract.
Otherwise acquiring assets or incurring
liabilities denominated in foreign currencies.
Translation Exposure

Translation exposure of foreign exchange is of an

accounting nature and is related to a gain or loss
arising from the conversion or translation of the
financial statements of a subsidiary located in
another country.
A company such as General Motors may sell cars in
about 200 countries and manufacture those cars in
as many as 50 different countries. Such a company
owns subsidiaries or operations in foreign countries
and is exposed to translation risk. At the end of the
financial year the company is required to report all
its combined operations in the domestic currency
terms leading to a loss or gain resulting from the
movement in various foreign currencies
Economic Exposure

Economic exposure is a rather long-term effect of the

transaction exposure. If a firm is continuously
affected by an unavoidable exposure to foreign
exchange over the long-term, it is said to have an
economic exposure. Such exposure to foreign
exchange results in an impact on the market value of
the company as the risk is inherent to the company
and impacts its profitability over the years.
A beer manufacturer in Argentina that has its market
concentration in the United States is continuously
exposed to the movements in the dollar rate and is
said to have an economic foreign exchange exposure.
World Monetary System

The Pre World War: 18701914

transactions were facilitated by widespread participation in
the gold standard, by both independent nations and their
colonies. Great Britain was at the time the world's pre-eminent
financial, imperial, and industrial power, ruling more of the
world
Between the World Wars: 19191939
The years between the world wars have been described as a
period of de-globalisation, as both international trade and
capital flows shrank compared to the period before World War
I. During World War I countries had abandoned the gold
standard and, except for the United States, returned to it only
briefly. By the early 30's the prevailing order was essentially a
fragmented system of floating exchange rates .
World Monetary System

The Bretton Woods Era: 19451971

Under the Bretton Woods system, the US dollar
functioned as a reserve currency, so it too became
part of a nation's official international reserve
assets. From 1944-1968, the US dollar was
convertible into gold through the Federal Reserve
System, but after 1968 only central banks could
convert dollars into gold from official gold reserves
World Monetary System

The post Bretton Woods system: 1971 present,

Multi-Currency International Monetory System.
After 1973 no individual or institution could convert US
dollars into gold from official gold reserves. Since 1973,
no major currencies have been convertible into gold
from official gold reserves. Individuals and institutions
must now buy gold in private markets, just like other
commodities. Even though US dollars and other
currencies are no longer convertible into gold from
official gold reserves, they still can function as official
international reserves.
Determinants of FX rates

International parity conditions: Relative Purchasing Power

Parity, interest rate parity, Domestic Fisher
effect, International Fisher effect.
Balance of payments model- This model, however, focuses
largely on tradable goods and services, ignoring the
increasing role of global capital flows.
Asset market model
The asset market model of exchange rate determination
states that the exchange rate between two currencies
represents the price that just balances the relative supplies
of, and demand for, assets denominated in those currencies.
 Economic factors
Government Fiscal Policies
Government Budget Deficits or Surpluses
Balance of Trade Levels and Trends
Inflation Level and Trends
Economic Growth and health.
Productivity of Economy.

Political conditions
Internal, regional, and international political conditions and
events can have a profound effect on currency markets.
All exchange rates are susceptible to political instability and
anticipations about the new ruling party.
 Market Psychology

Long-term trends: Currency markets often move in

visible long-term trends.
"Buy the rumor, sell the fact": This market truism can
apply to many currency situations. It is the tendency for
the price of a currency to reflect the impact of a particular
action before it occurs and, when the anticipated event
comes to pass, react in exactly the opposite direction.
Economic numbers: While economic numbers can
certainly reflect economic policy, some reports and
numbers take on a talisman-like effect: the number itself
becomes important to market psychology and may have
an immediate impact on short-term market moves.
Hedging

Hedging is insurance. The purpose of hedging is

to reduce or eliminate risks, not to make profits.
Objectives
Minimize translation exposure.
Minimize transaction exposure.
Minimize economic exposure.
Minimize quarter-to-quarter earnings fluctuations arising
from exchange rate changes.
Minimize foreign exchange risk management costs.
Avoid surprises.
Opponents of Hedging

Opponents of currency hedging commonly make

the following arguments:
Stockholders are much more capable of diversifying
currency risk than the management of the firm.
Currency risk management does not add value to the
firm and it incurs costs.
Hedging might benefit corporate management more
than shareholders.
Proponents of Hedging

Reduction in risk in future cash flows improves the

planning capability of the firm.
Reduction of risk in future cash flows reduces the
likelihood that the firms cash flows will fall below a
necessary minimum (the point of financial distress).
Management has a comparative advantage over the
individual shareholder in knowing the actual
currency risk of the firm.
Individuals and corporations do not have same access
to hedging instruments or same cost.
To Hedge or Not
Hedging Strategies/ Instruments

Forwards
Futures
Options
Swaps
Foreign Debt
Forwards:-
A forward is a made-to-measure agreement between
two parties to buy/sell a specified amount of a
currency at a specified rate on a particular date in
the future. The Depreciation of the receivable
currency is hedged
against by selling a currency forward. If the risk is
that of a currency appreciation (if the firm has to
buy that currency in future say for import), it can
hedge by buying the currency forward.
Futures:-
A futures contract is similar to the forward contract
but is more liquid because it is traded in an
organized exchange i.e. the futures market.
Depreciation of a currency can be hedged by selling
futures and appreciation can be hedged by buying
futures.
Advantages of futures are that there is a central
market for futures which eliminates the problem of
double coincidence
Options:-
A currency Option is a contract giving the right, not the
obligation, to buy or sell a specific quantity of one foreign
currency in exchange for another at a fixed price; called the
Exercise Price or Strike Price. The fixed nature of the
exercise price reduces the uncertainty of exchange rate
changes and limits the losses of open currency positions.
Options are particularly suited as a hedging tool for
contingent cash flows, as is the case in bidding processes.
Call Options are used if the risk is an upward trend in price
(of the currency), while Put Options are used if the risk is a
downward trend
Swaps :-
A swap is a foreign currency contract whereby
the buyer and seller exchange equal initial
principal amounts of two different currencies at
the spot rate. The buyer and seller exchange
fixed or floating rate interest payments in their
respective swapped currencies over the term of
the contract. At maturity, the principal amount
is effectively re-swapped at a predetermined
exchange rate so that the parties end up with
their original currencies.
Foreign Debt:-Foreign debt can be used to
hedge foreign exchange exposure by taking
advantage of the International Fischer Effect
relationship.