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Question
Explain Foreign Exchange mechanism and Foreign Exchange Risk Management.

Answer
The foreign exchange market provides the physical and institutional structure through
which the money of one country is exchanged for that of another country, the rate of
exchange between currencies is determined, and foreign exchange transactions are
physically completed.
A foreign exchange transaction is an agreement between a buyer and a seller that a given
amount of one currency is to be delivered at a specified rate for some other currency.

Geographical Extent of the Foreign Exchange Market
Geographically, the foreign exchange market spans the globe, with prices moving and
currencies traded somewhere every hour of every business day.
The market is deepest, or most liquid, early in the European afternoon, when the markets
of both Europe and the U.S. East coast are open.
The market is thinnest at the end of the day in California, when traders in Tokyo and
Hong Kong are just getting up for the next day.
In some countries, a portion of foreign exchange trading is conducted on an official
trading floor by open bidding. Closing prices are published as the official price, or 'fixing'
for the day and certain commercial and investment transactions are based on this official
price.

The Size of the Market
In April 1992, the Bank of International Settlements (BIS) estimated the daily volume of
trading on the foreign exchange market and its satellites (futures, options, and swaps) at
more than USD 1 trillion. This is about 5 to 10 times the daily volume of international
trade in goods and services.
The market is dominated by trading in USD, DEM, and JPY respectively. The major
markets are London (USD 300 billion), New York (USD 200 billion), and Tokyo (USD
130 billion).

Functions of the Foreign Exchange Market
The foreign exchange market is the mechanism by which a person of firm transfers
purchasing power form one country to another, obtains or provides credit for
international trade transactions, and minimizes exposure to foreign exchange risk.

Transfer of Purchasing Power:
Transfer of purchasing power is necessary because international transactions normally
involve parties in countries with different national currencies. Each party usually wants to
deal in its own currency, but the transaction can be invoiced in only one currency.

Provision of Credit:
Because the movement of goods between countries takes time, inventory in transit must
be financed.

Minimizing Foreign Exchange Risk:
The foreign exchange market provides "hedging" facilities for transferring foreign
exchange risk to someone else.

Market Participants
The foreign exchange market consists of two tiers: the interbank or wholesale market,
and the client or retail market.
Individual transactions in the interbank market usually involve large sums that are
multiples of a million USD or the equivalent value in other currencies. By contrast,
contracts between a bank and its client are usually for specific amounts, sometimes down
to the last penny.

Foreign Exchange Dealers:
Banks, and a few nonbank foreign exchange dealers, operate in both the interbank and
client markets. They profit from buying foreign exchange at a bid price and reselling it at
a slightly higher ask price.
Worldwide competitions among dealers narrows the spread between bid and ask and so
contributes to making the foreign exchange market efficient in the same sense as
securities markets.
Dealers in the foreign exchange departments of large international banks often function
as market makers. They stand willing to buy and sell those currencies in which they
specialize by maintaining an inventory position in those currencies.
Participants in Commercial and Investment Transactions:
Importers and exporters, international portfolio investors, multinational firms, tourists,
and others use the foreign exchange market to facilitate execution of commercial or

investment transactions.
Some of these participants use the foreign exchange market to hedge foreign exchange
risk.
Speculators and Arbitragers:
Speculators and arbitragers seek to profit from trading in the market. They operate in
their own interest, without a need or obligation to serve clients or to ensure a continuous
market.
Speculators seek all of their profit from exchange rate changes.
Arbitragers try to profit from simultaneous exchange rate differences in different markets.
Central Banks and Treasuries:
Central banks and treasuries use the market to acquire or spend their country's foreign
exchange reserves as well as to influence the price at which their own currency is traded.
In many instances they do best when they willingly take a loss on their foreign exchange
transactions. As willing loss takers, central banks and treasuries differ in motive and
behavior form all other market participants.
Foreign Exchange Brokers:
Foreign exchange brokers are agents who facilitate trading between dealers without
themselves becoming principals in the transaction. For this service, they charge a small
commission, and maintain access to hundreds of dealers worldwide via open telephone
lines.
It is a broker's business to know at any moment exactly which dealers want to buy or sell
any currency. This knowledge enables the broker to find a counterpart for a client quickly
without revealing the identity of either party until after an agreement has been reached.

Transactions in the Interbank Market
Transactions in the foreign exchange market can be executed on a spot, forward, or swap
basis.
Spot Transactions:
A spot transaction requires almost immediate delivery of foreign exchange.
In the interbank market, a spot transaction involves the purchase of foreign exchange
with delivery and payment between banks to take place, normally, on the second
following business day.
The date of settlement is referred to as the "value date."
Spot transactions are the most important single type of transaction (43 % of all
transactions).
Outright Forward Transactions:
A forward transaction requires delivery at a future value date of a specified amount of
one currency for a specified amount of another currency.
The exchange rate to prevail at the value date is established at the time of the agreement,
but payment and delivery are not required until maturity.
Forward exchange rates are normally quoted for value dates of one, two, three, six, and
twelve months. Actual contracts can be arranged for other lengths.
Outright forward transactions only account for about 9 % of all foreign exchange
transactions.
Swap Transactions:
A swap transaction involves the simultaneous purchase and sale of a given amount of
foreign exchange for two different value dates.
The most common type of swap is a spot against forward, where the dealer buys a
currency in the spot market and simultaneously sells the same amount back to the same
back in the forward market. Since this agreement is executed as a single transaction, the
dealer incurs no unexpected foreign exchange risk.
Swap transactions account for about 48 % of all foreign exchange transactions.

Foreign Exchange Rates and Quotations
A foreign exchange rate is the price of a foreign currency.
A foreign exchange quotation or quote is a statement of willingness to buy or sell at an
announced rate.

Interbank Quotations:
The most common way that professional dealers and brokers state foreign exchange
quotations, and the way they appear on all computer trading screens worldwide, is called
European terms. The European terms quote shows the number of units of foreign
currency needed to purchase one USD:
CAD 1.5770 / USD
An alternative method is called the American terms. The American terms quote shows the
number of units of USD needed to purchase one unit of foreign currency:
USD 0.6341 / CAD
Clearly, those two quotations are highly related. Define the price of a USD in CAD to be
Also, define the price of a CAD in USD to be
Then, it must be that
Because CAD 1.5770 / USD = 1 / {USD 0.6341 / CAD}.
These rules also apply to forward rates as well. We will denote an outright forward quote
using the following notation:
Direct and Indirect Quotations:
A direct quote is a home currency price of a unit of foreign currency.
S(CAD /USD) = CAD1.5770 /USD
S(USD /CAD) = USD0.6341/CAD
( / )
1
( / )
S USD CAD
S CAD USD =
F(CAD /USD)
An indirect quote is a foreign currency price of a unit of home currency.
In the US, a direct quote for the CAD is
USD 0.6341 / CAD
This quote would be an indirect quote in Canada.
Bid and Ask Quotations:
Interbank quotations are given as "bid" and "ask".
A bid is the exchange rate in one currency at which a dealer will buy another currency
An ask is the exchange rate at which a dealer will sell the other currency.
Dealers buy at the bid price and sell at the ask price, profiting from the spread between
the bid and ask prices: bid < ask.
Bid and ask quotations are complicated by the fact that the bid for one currency is the ask
for another currency:
Example 4.1: A dealer provides you the following quote:
USD 0.6333 - 0.6349/ CAD.
This suggests that the bid price for the CAD is USD 0.6333/CAD and
that the ask price is USD 0.6349/ CAD.
The indirect version of this quote would be
CAD 1.5750 - 1.5790/USD
Clearly, a dealer willing to purchase CAD at a price of USD 0.6333/USD is implicitly
willing to sell USD at the reciprocal price of CAD 1.5790/USD.
The spread between bid and ask prices exists for two reasons:
1. Transaction costs and dealers as financial intermediaries and
2. Profits.
( / )
1
( / )
( / )
1
( / )
S CAD USD
S USD CAD
S CAD USD
S USD CAD
b
a
a
b
=
=


The Law of One Price and Cross Rates
The law of one price states that homogenous goods and assets should have the same price
everywhere (efficient markets and free trade).
Cross Rates:
Many currency pairs are only inactively traded, so their exchange rate is determined
through their relationship to a widely traded third currency (generally the USD):
For example, imagine that an investor in Thailand would like to purchase some Barbados
Dollars (BBD). As both currencies are quoted against the USD, the investor can figure
out the price of the Thai Baht (THB) against the BBD. Assuming that the exchange rates
are:
Quotations:
Thai Baht:
Barbados Dollars:
THB 41.6982/USD
BBD 2.0116/USD
The cross rate is THB/BBD is:
In general, the formula for cross rate is:
THB BBD
BBD USD
THB USD 20.7289 /
2.0116 /
41.6982 /
=
( / ) ( / )
( / )
( / )
( / ) S i USD S USD J
S j USD
S i USD S i j = =
3.8 Summary
The foreign exchange market is the mechanism by which a person of firm transfers
purchasing power form one country to another, obtains or provides credit for
international trade transactions, and minimizes exposure to foreign exchange risk.
A foreign exchange transaction is an agreement between a buyer and a seller that a
given amount of one currency is to be delivered at a specified rate for some other
currency.
A foreign exchange rate is the price of a foreign currency. A foreign exchange
quotation or quote is a statement of willingness to buy or sell at an announced rate.
The foreign exchange market consists of two tiers: the interbank or wholesale market,
and the client or retail market. Participants include banks and nonbank foreign
exchange dealers, individuals and firms conducting commercial and investment
transactions, speculators and arbitragers, central banks and treasuries, and foreign
exchange brokers.
Transactions are effectuated either on a spot basis or on a forward or swap basis. A
spot transaction is for an (almost) immediate value date while a forward transaction is
for a value date somewhere in the future.
Quotations can be classified either as European and American terms or as direct and
indirect quotes.
In the real world, quotations include a bid-ask spread. A bid is the exchange rate in
one currency at which a dealer will buy another currency. An ask is the exchange rate
at which a dealer will sell the other currency. The spread is the difference between the
bid price and the ask price. This spread reflects the existence of commissions and
transaction costs.
A cross rate is an exchange rate between two currencies, calculated from their
common relationship with a third currency.  

Foreign Exchange Risk Management
Many firms are exposed to foreign exchange risk - i.e. their wealth is affected by movements in exchange rates - and will seek to manage their risk exposure. This page looks at the different types of foreign exchange risk and introduces methods for hedging that risk.
Types of foreign exchange risk
Transaction risk
This us the risk of an exchange rate changing between the transaction date and the subsequent settlement date, i.e. it is the gain or loss arising on conversion.
This type of risk is primarily associated with imports and exports. If a company exports goods on credit then it has a figure for debtors in its accounts. The amount it will finally receive depends on the foreign exchange movement from the transaction date to the settlement date.
As transaction risk has a potential impact on the cash flows of a company, most companies choose to hedge against such exposure. Measuring and monitoring transaction risk is normally an important component oftreasury risk management.
The degree of exposure is dependent on:
(a) The size of the transaction, is it material?
(b) The hedge period, the time period before the expected cash flows occurs.
 The anticipated volatility of the exchange rates during the hedge period.
The corporate risk management policy should state what degree of exposure is acceptable. This will probably be dependent on whether the Treasury Department is been established as a cost or profit centre.
Economic risk
Transaction exposure focuses on relatively short-term cash flows effects; economic exposure encompasses these plus the longer-term affects of changes in exchange rates on the market value of a company. Basically this means a change in the present value of the future after tax cash flows due to changes in exchange rates.
There are two ways in which a company is exposed to economic risk.
Directly: If your firm's home currency strengthens then foreign competitors are able to gain sales at your expense because your products have become more expensive (or you have reduced your margins) in the eyes of customers both abroad and at home.
If your firm's home currency strengthens then foreign competitors are able to gain sales at your expense because your products have become more expensive (or you have reduced your margins) in the eyes of customers both abroad and at home.
Indirectly: Even if your home currency does not move vis-a -vis your customer's currency you may lose competitive position. For example suppose a South African firm is selling into Hong Kong and its main competitor is a New Zealand firm. If the New Zealand dollar weakens against the Hong Kong dollar the South African firm has lost some competitive position.
Even if your home currency does not move vis-a -vis your customer's currency you may lose competitive position. For example suppose a South African firm is selling into Hong Kong and its main competitor is a New Zealand firm. If the New Zealand dollar weakens against the Hong Kong dollar the South African firm has lost some competitive position.
Economic risk is difficult to quantify but a favoured strategy to manage it is to diversify internationally, in terms of sales, location of production facilities, raw materials and financing. Such diversification is likely to significantly reduce the impact of economic exposure relative to a purely domestic company, and provide much greater flexibility to react to real exchange rate changes.
Translation risk
The financial statements of overseas subsidiaries are usually translated into the home currency in order that they can be consolidated into the group's financial statements. Note that this is purely a paper-based exercise - it is the translation not the conversion of real money from one currency to another.
The reported performance of an overseas subsidiary in home-based currency terms can be severely distorted if there has been a significant foreign exchange movement.
If initially the exchange rate is given by $/1.00 and an American subsidiary is worth $500,000, then the UK parent company will anticipate a balance sheet value of 500,000 for the subsidiary. A depreciation of the US dollar to $/2.00 would result in only 250,000 being translated.
Unless managers believe that the company's share price will fall as a result of showing a translation exposure loss in the company's accounts, translation exposure will not normally be hedged. The company's share price, in an efficient market, should only react to exposure that is likely to have an impact on cash flows.
Hedging transaction risk - the internal techniques
Internal techniques to manage/reduce forex exposure should always be considered before external methods on cost grounds. Internal techniques include the following:
Invoice in home currency
One easy way is to insist that all foreign customers pay in your home currency and that your company pays for all imports in your home currency.
However the exchange-rate risk has not gone away, it has just been passed onto the customer. Your customer may not be too happy with your strategy and simply look for an alternative supplier.
Achievable if you are in a monopoly position, however in a competitive environment this is an unrealistic approach.
Leading and lagging
If an importer (payment) expects that the currency it is due to pay will depreciate, it may attempt to delay payment. This may be achieved by agreement or by exceeding credit terms.
If an exporter (receipt) expects that the currency it is due to receive will depreciate over the next three months it may try to obtain payment immediately. This may be achieved by offering a discount for immediate payment.
The problem lies in guessing which way the exchange rate will move.
Matching
When a company has receipts and payments in the same foreign currency due at the same time, it can simply match them against each other.
It is then only necessary to deal on the forex markets for the unmatched portion of the total transactions.
An extension of the matching idea is setting up a foreign currency bank account.
Bilateral and multilateral netting and matching tools are discussed in more detail here.
Decide to do nothing?
The company would "win some, lose some".
Theory suggests that, in the long run, gains and losses net off to leave a similar result to that if hedged.
In the short run, however, losses may be significant.
One additional advantage of this policy is the savings in transaction costs.
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Hedging transaction risk - the external techniques
Transaction risk can also be hedged using a range of financial products. These are introduced below with links to more detailed pages.
Forward contracts
The forward market is where you can buy and sell a currency, at a fixed future date for a predetermined rate, i.e. the forward rate of exchange. This effectively fixes the future rate.
Money market hedges
The basic idea is to avoid future exchange rate uncertainty by making the exchange at today's spot rate instead. This is achieved by depositing/borrowing the foreign currency until the actual commercial transaction cash flows occur. This effectively fixes the future rate.
Futures contracts
Futures contracts are standard sized, traded hedging instruments.
The aim of a currency futures contract is to fix an exchange rate at some future date, subject to basis risk.
Options
A currency option is a right, but not an obligation, to buy or sell a currency at an exercise price on a future date. If there is a favourable movement in rates the company will allow the option to lapse, to take advantage of the favourable movement. The right will only be exercised to protect against an adverse movement, i.e. the worst-case scenario.
A call option gives the holder the right to buy the underlying currency.
A put option gives the holder the right to sell the underlying currency.
Options are more expensive than the forward contracts and futures but result in an asymmetric risk exposure.
Forex swaps
In a forex swap, the parties agree to swap equivalent amounts of currency for a period and then re-swap them at the end of the period at an agreed swap rate. The swap rate and amount of currency is agreed between the parties in advance. Thus it is called a fixed rate/fixed rate swap.
The main objectives of a forex swap are:
To hedge against forex risk, possibly for a longer period than is possible on the forward market.
Access to capital markets, in which it may be impossible to borrow directly.
Forex swaps are especially useful when dealing with countries that have exchange controls and/or volatile exchange rates.
Currency swaps
A currency swap allows the two counter parties to swap interest rate commitments on borrowings in different currencies.
In effect a currency swap has two elements:
An exchange of principal in different currencies, which are swapped back at the original spot rate - just like a forex swap.
An exchange of interest rates - the timing of these depends on the individual contract.
The swap of interest rates could be fixed for fixed or fixed for variable.

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