Foreign Exchange Markets * What is Foreign Exchange?

It is the currency that facilitates the payment to other Countries to complete the transaction. * What is Foreign Exchange Market? It is a place at where money denominated in one currency is bought and sold with money denominated in another currency. *Where the Foreign Exchange Market is located It is not located in any one place. It is a global network of Banks, Brokers and Foreign Exchange Dealers connected by Electronic Communication Systems. Foreign Exchange Markets-2 What is Exchange Rate? It is simply the rate at which one currency is converted to another. How Exchange Rates are determined? There are two basic methods of determining exchange rates. (1) Fixed Exchange Rate (2) Flexible or Floating Exchange Rate Foreign Exchange Markets-3 Fixed Exchange Rate: The values of a set of currencies are fixed against each other at some mutually agreed on exchange rate. E.g.:-Before introduction of Euro in 2000 several member States of European Union operated under this system. Flexible or Floating Exchange rate: The Demand and Supply of currency determine the value of any two currencies. Foreign Exchange Markets-4 Free float: In this system no one interferes in determination of exchange rate except the market forces i.e. Supply and Demand. Dirty float: In this system when the exchange rate goes beyond a range the Central Bank of that Country intervenes in Foreign Exchange Market and try to maintain the value of its currency. Pegged Exchange Rate: The value of a currency is fixed relative to a reference currency, such as US Dollar, and the exchange rate between that Country and other Countries are determined by reference currency exchange rate. Foreign Exchange Markets-5 Cross Rates: The exchange rate between 2 non - US$ currencies. Calculating Cross Rates : When you want to know what the DM/W cross rate is, and you know DM2=US$ and W=0.55US$, then DM per W = DM2/US$ W0.55/US$ i.e. DM3.636= W. DM is the currency of Germany (Deutsche Mark) What is the currency of Korea (Won) Foreign Exchange Markets-6 The Foreign Exchange Market is a two tier one. The Interbank or Wholesale Market and the client or Retail Market. The players in Foreign Exchange Market includes the Buyers, the Sellers and the Intermediaries. The Buyers and Sellers are the International Trade and Investment companies as a major participants and the Tourists as a minor participants. The intermediaries include (a) Exchange Banks dealing in Foreign Exchange, (b) Bill brokers (c) Acceptance houses (d) Central Bank of the Country.

Cash and Spot Exchange Market When two parties agree to exchange currency and execute the deal immediately, the transaction is referred to as a Spot Exchange. The Spot Exchange Rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day. Bid = the price at which the bank is willing to buy. Ask = the price it will sell the currency. Percent Spread Formula (PS) = (Ask- Bid) X 100/Ask Spot exchange rates are reported daily in the financial news papers and nowadays in the internet also. Spot rates change continually, often on a day-to-day basis if not an hour to hour basis.

Settlement Date Value Date Settlement Date: Date monies are due. Value Date: 2nd Working day after date of original transaction SPOT TRANSACTIONS: An Example. Importing from Hong Kong to U.S. Step 1.Currency transaction: verbal agreement, U.S. importer specifies to his bank: (a).Account to debit(his account) & (b).Account to credit(exporter account) Step 2.Bank sends importer contract note including: amount of foreign currency, agreed exchange rate, confirmation of Step1 Step 3. Settlement: Correspondent bank in Hong Kong transfers HK$ from Nostro account to exporters. Step 4. On Value Date. U.S. bank debits importers account. * Nostro Account: A bank account held in a foreign country by a domestic bank, denominated in the currency of that country. Nostro accounts are used to facilitate settlement of foreign exchange and trade transactions. Conversely, accounts that are held by the domestic bank in its home country for foreign banks are called vostro accounts.

Exchange Rate Quotes The exchange rate can be quoted in 2 ways (1)One unit of foreign currency to a number of units of domestic currency: One US $ = Rs. 50 (2)A certain number of units of foreign currency to one unit of domestic currency: Re.1= US $ 0.02 Factors effecting exchange rates Change in the demand and supply of foreign currencies Trade and Commercial influence Stock Exchange influence Banking influence Capital movement Currency Conditions Arbitrage operations(speculation) Political Conditions Forward Exchange

When two parties agree to exchange currency and execute the deal at some specific date in the future, it is a FORWARD EXCHANGE, the rates governing such future transactions are referred to as FORWARD EXCHANGE RATES, the agreement between the parties are known as FORWARD EXCHANGE CONTRACT. When a firm enters into a forward exchange contract, it is taking out insurance against the possibility of future exchange rate fluctuations LERMS(Liberalized Exchange Rate Management System) According to LERMS introduced in March 1992 60% of all receipts under current transactions (merchandise exports and invisible receipts) could be converted at the free market exchange rate quoted by the authorized dealers. The remaining 40% are to be converted as per the rate specified by RBI. This 40% of receipts of current account is meant for the import of essential commodities. Foreign Exchange &Currency Futures Definitions of 'Currency Futures' A transferable futures contract that specifies the price at which a currency can be bought or sold at a future date. Currency future contracts allow investors to hedge against foreign exchange risk. Currency Futures means a standardized foreign exchange derivative contract traded on a recognized stock exchange to buy or sell one currency against another on a specified future date, at a price specified on the date of contract, but does not include a forward contract. Currency Futures market means the market in which currency futures are traded. 'Currency Futures explained Because currency futures contracts are marked-to-market daily, investors can exit their obligation to buy or sell the currency prior to the contract's delivery date. This is done by closing out the position. With currency futures, the price is determined when the contract is signed, just as it is in the foreign exchange market, only and the currency pair is exchanged on the delivery date, which is usually some time in the distant future. However, most participants in the futures markets are speculators who usually close out their positions before the date of settlement, so most contracts do not tend to last until the date of delivery. Currency Futures in India Currency Futures in India: (a)Only USD-INR contracts are allowed to be traded. (b) The size of each contract shall be USD 1000. (c) The contracts shall be quoted and settled in Indian Rupees. (d) The maturity of the contracts shall not exceed 12 months. (e) The settlement price shall be the Reserve Banks Reference Rate on the last trading day. Foreign Exchange Management Act The Foreign Exchange Management Act (FEMA) was an act passed in the winter session of Parliament in 1999 which replaced Foreign Exchange Regulation Act. This act seeks to make offenses related to foreign exchange civil offenses. It extends to the whole of India. FEMA, which replaced Foreign Exchange Regulation Act(FERA), had become the need of the hour since FERA had become incompatible with the pro-liberalization policies of the Government of India. FEMA has brought a new management regime of Foreign Exchange consistent with the emerging framework of the World Trade Organization (WTO). It is another matter that the enactment of FEMA also brought with it the Prevention of Money Laundering Act 2002, which came into effect from 1 July 2005. Unlike other laws where everything is permitted unless specifically prohibited, under this act everything was prohibited unless specifically permitted. Hence the tenor and tone of the Act was very drastic. It required imprisonment even for minor offences. Under FERA a person was

presumed guilty unless he proved himself innocent, whereas under other laws a person is presumed innocent unless he is proven guilty. Overview of FEMA The Foreign Exchange Management Act (1999) or in short FEMA has been introduced as a replacement for earlier Foreign Exchange Regulation Act (FERA). FEMA became an act on the 1st day of June, 2000. FEMA was introduced because the FERA didnt fit in with post-liberalization policies. A significant change that the FEMA brought with it, was that it made all offenses regarding foreign exchange civil offenses, as opposed to criminal offenses as dictated by FERA. The main objective behind the Foreign Exchange Management Act (1999) is to consolidate and amend the law relating to foreign exchange with the objective of facilitating external trade and payments. It was also formulated to promote the orderly development and maintenance of foreign exchange market in India. FEMA is applicable to all parts of India. The act is also applicable to all branches, offices and agencies outside India owned or controlled by a person who is a resident of India. The FEMA head-office, also known as Enforcement Directorate is situated in New Delhi and is headed by a Director. The Directorate is further divided into 5 zonal offices in Delhi, Mumbai, Kolkata, Chennai and Jalandhar and each office is headed by a Deputy Director. Each zone is further divided into 7 sub-zonal offices headed by the Assistant Directors and 5 field units headed by Chief Enforcement Officers. Main Features of FEMA Activities such as payments made to any person outside India or receipts from them, along with the deals in foreign exchange and foreign security is restricted. It is FEMA that gives the central government the power to impose the restrictions. Restrictions are imposed on people living in India who carry out transactions in foreign exchange, foreign security or who own or hold immovable property abroad. Without general or specific permission of the Reserve Bank of India, FEMA restricts the transactions involving foreign exchange or foreign security and payments from outside the country to India the transactions should be made only through an authorized person. Deals in foreign exchange under the current account by an authorized person can be restricted by the Central Government, based on public interest. Although selling or drawing of foreign exchange is done through an authorized person, the RBI is empowered by this Act to subject the capital account transactions to a number of restrictions. People living in India will be permitted to carry out transactions in foreign exchange, foreign security or to own or hold immovable property abroad if the currency, security or property was owned or acquired when he/she was living outside India, or when it was inherited to him/her by someone living outside India. Exporters are needed to furnish their export details to RBI. To ensure that the transactions are carried out properly, RBI may ask the exporters to comply to its necessary requirements. FEMA, Possession And Retention Of Foreign Currency, Regulations 2000 the Reserve Bank specifies the following limits for possession or retention of foreign currency or foreign coins, namely : possession without limit of foreign currency and coins by an authorized person within the scope of his authority ; possession without limit of foreign coins by any person;

retention by a person resident in India of foreign currency notes, bank notes and foreign currency travelers cheques not exceeding US$ 2000 or its equivalent in aggregate, provided that such foreign exchange in the form of currency notes, bank notes and travelers cheques; was acquired by him while on a visit to any place outside India by way of payment for services not arising from any business in or anything done in India; or was acquired by him, from any person not resident in India and who is on a visit to India, as honorarium or gift or for services rendered or in settlement of any lawful obligation; or was acquired by him by way of honorarium or gift while on a visit to any place outside India; or represents unspent amount of foreign exchange acquired by him from an authorized person for travel abroad FEMA, Possession And Retention Of Foreign Currency, Regulations 2000 contd.., Possession of foreign exchange by a person resident In India but not permanently resident therein : Without prejudice to clause (iv) of Regulation 3, a person resident in India but not permanently resident therein may possess without limit foreign currency in the form of currency notes, bank notes and travelers cheques, if such foreign currency was acquired, held or owned by him when he was resident outside India and, has been brought into India in accordance with the regulations made under the Act. Explanation : for the purpose of this clause, 'not permanently resident' means a person resident in India for employment of a specified duration (irrespective of length thereof) or for a specific job or assignment, the duration of which does not exceed three years. Foreign-Exchange Risk 1. The risk of an investment's value changing due to changes in currency exchange rates. 2. The risk that an investor will have to close out a long or short position in a foreign currency at a loss due to an adverse movement in exchange rates. Also known as "currency risk" or "exchange-rate risk". 3.This risk usually affects businesses that export and/or import, but it can also affect investors making international investments. For example, if money must be converted to another currency to make a certain investment, then any changes in the currency exchange rate will cause that investment's value to either decrease or increase when the investment is sold and converted back into the original currency. Types of Foreign-Exchange Risks Growth of international business has led to an increasing exposure to foreign exchange risk for many companies. Foreign exchange dealing results in three major kinds of exposure(risks) transaction exposure, economic exposure and translation exposure. Transaction exposure The transaction exposure component of the foreign exchange rates is also referred to as a shortterm 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 appreciates, Company A has to pay a larger amount in dollar terms leading to foreign currency exposure. 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. 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. Management of Exposures There are various number of instruments that are available to minimize the foreign exchange risk/exposure. The commonly used ones are Netting Leading Lagging Derivatives Swaps Options Futures Forward Contracts Netting netting means to allow a positive value and a negative value to set-off and partially or entirely cancel each other out. Settlement or payment netting: For cash settled trades, this can be applied either bilaterally or multilaterally and on related or unrelated transactions. Bilateral Net Settlement System: A settlement system in which every individual bilateral combination of participants settles its net settlement position on a bilateral basis. Multilateral Net Settlement System: A settlement system in which each settling participant settles its own multilateral net settlement position (typically by means of a single payment or receipt). Netting decreases credit exposure, increases business with existing counterparties, and reduces both operational and settlement risk and operational costs. LEADING AND LAGGING Leading and lagging are aggressive foreign exchange management tactics designed to take the advantage of expected exchange rate changes.

Leading is the payment of an obligation before due date while lagging is delaying the payment of an obligation after due date. A Lead strategy involves attempting to collect foreign currency receivables (payments from customers) early when a foreign currency value is expected to depreciate and paying foreign currency payables (to suppliers) before they are due when the value of that foreign currency is expected to appreciate. A Lag strategy involves delaying collection of foreign currency receivables if the value of that currency is expected to appreciate and delaying payments if the value of that currency is expected to depriciate. Derivatives, Swaps, Options A foreign exchange derivative is a financial derivative whose payoff depends on the foreign exchange rate(s) of two (or more) currencies. These instruments are commonly used for currency speculation and arbitrage or for hedging foreign exchange risk. A currency Swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. a foreign-exchange option (commonly shortened to just FX option or currency option) is a derivative financial instrument that gives the owner the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. THANK YOU