2. INTRODUCTION
The FOREIGN EXCHANGE MARKET is a global, worldwide
financial market for trading currencies.
Most of the transactions are channelled through world wide
interbank market which is a wholesale market in which major
banks trade with each other.
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.
3. Foreign Exchange Exposure and Risk and Risk
Management
Foreign exchange rate is the price of one currency quoted in
terms of another currency.
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 firm’s
value due to uncertain changes in the rate of exchange.
Managing Foreign Exposure with the concept of Risk
Management is called Hedging.
5. Transaction Exposure
This risk involves the possible exchange loss or gain on
existing foreign currency denomination.
Transaction exposure arises from:
Purchasing or selling on credit goods or services
whose prices are stated in foreign currencies.
Borrowing or lending funds when repayment is
to be made in a foreign currency.
Acquiring assets or incurring liabilities
denominated in foreign currencies.
6. 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. Eg - ranbaxy
Four Methods to translate foreign currency to home currency:
1. Current/Non-Current Method: All current assets and current liabilities are
translated at current exchange rate and non current at historic rate.
2. Monetary/ Non-Monetary Method: All monetary assets(eg. cash, a/r,a/p)
and liabilities(loans) are translated at current exchange rate and non monetary
(like inventory , fixed asset) at historic price.
3. Temporal Method: Same as Monetary/Non-Monetary method BUT
inventory may be translated at current exchange rate IF it is shown at market
value
4. Current Rate Method: All balance sheet and income statement items are
translated at current exchange rate
7. 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.
8. Three types of Exposure
1. Translation or Accounting
Exposure
Change in FE rate =change in Accounting
statements
2. Transaction Exposure
change in FE rate = change in outstanding
obligations
3. Economic Exposure
Change in FE rate = change in future cash
flows
9. INTERNATIONAL PARITY RELATIONSHIPS
Managers of multinational firms, international
investors, importers and exporters, and
government officials deal with these fundamental
issues:
Are changes in exchange rates predictable?
How are exchange rates related to interest rates?
What, at least theoretically, is the “proper”
exchange rate?
To answer these questions we need to first
understand the economic fundamentals of
international finance, known as parity conditions.
10. ARBITRAGE AND THE LAW OF ONE PRICE
Identical goods sell for the same price worldwide.
If the prices after exchange-rate adjustment were
not equal, arbitrage of the goods ensures eventually
they will worldwide.
parity conditions resulting from these arbitrage
activities
1. Purchasing Power Parity (PPP)
2. The International Fisher Effect(IFE)
3. Interest Rate Parity (IRP)
4. Unbiased Forward Rate (UFR)
11. PURCHASING POWER PARITY
states that spot exchange rates between currencies
will change to the differential in inflation rates
between countries.
Price levels adjusted for exchange rates should be
equal between countries i.e One unit of currency
has same purchasing power globally.
PPP says the currency with the higher inflation
rate is expected to depreciate relative to the
currency with the lower rate of inflation.
12. PURCHASING POWER PARITY
1.In mathematical terms:
where et = future spot rate
e0 = spot rate
ih = home inflation
if = foreign inflation
t = the time period
t
f
t
ht
i
i
e
e
1
1
0
13. FISHER EFFECT
Nominal interest rate comprises of real interest rate
and expected rate of inflation.
The nominal Rate of interest is higher when higher
inflation rate is expected and lower when lower
inflation rate is expected.
1+nominal interest rate = (1+ real interest rate)(1+
inflation rate)
This is referred to as FISHER EFFECT
14. 14
The International Fisher Effect
Because of the arbitrage equilibrium exist in the
real returns of two countries, then as per fisher
effect nominal interest rate of two countries will
adjust exactly for change in inflation rates.
Nominal interest differential must be equal to
expected inflation rate differential in two
countries.
(1+rf/1+rd) = E(1+if)/E(1+id)
currencies with high interest rates tend to depreciate and
currencies with low interest rates tend to appreciate
15. Unbiased Forward Rate (UFR) Unbiased Forward
Rate (UFR) Unbiased Forward Rate (UFR)
Forward exchange rate is the rate that is currently paid for
delivery of a currency on some future date.
The unbiased forward rate (UFR) concept states that the forward
exchange rate, quoted at time t for delivery at time t+1, is equal to the
expected value of the spot exchange rate at time t+1.
Unbiased Forward Rate (UFR)
UFR can be written as: Ft t+1 = Et[St+1]
An unbiased predictor, however, does not mean the future spot
rate will actually be equal to what the forward rate predicts.
Unbiased prediction means that the forward rate will, on
average, overestimate and underestimate the actual future spot
rate in equal frequency and degree.
16. Interest Rate Parity
Characterizes the relationship between interest rate
and exchange rate of two countries.
This implies that exchange rate differential will be
equal to the interest rate differential between two
countries.
(1+rf)/ (1+rd) = f / s
Where : f = forward rate between two countries
s = spot exchange rate between two countries.
Interest Rate Parity
17. Hedging
Hedging is like 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.
19. FORWARD CONTRACT
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.
Future contract :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.
20. Forward Market Hedge Future Hedge
Contracts executed by banks Contracts executed by
brokerage houses of future
exchanges
Tailor-made contracts Standardised contracts
Price quoted reflects banker’s
perception of future price
Price paid is determined by
forces of demand and supply
Contract bilateral between two
parties
Contract with the future
exchange
21. 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.
FOREIGN CURRENCY OPTION
22. 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.
