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Foreign Exchange
MT380 & MT304
By
Mohammed
Naseeruddin
What is Foreign Exchange ?
Currency like any other traded goods, has a price . This price
can undergo dramatic changes over a shorts periods of time.
There are two main types of exchange rate systems viz , fixed
and floating .
In case of fixed exchanged rate system , the government of that
country decides a specific ratio of its currency with another
currency. E.G China maintained a fixed peg (ration) with US
dollar till year 2005 as 1 USD = 8 Chinese Yuan.
In floating exchange rate system, the Govt doesn't dictate any
rate. Its purely driven by the demand supply factors in the
market of the two currencies.
Devaluation vs. Revaluation
The custodian bank enters the instruction into its accounting systems
for reporting and valuation.
Types of settlements
Forward contracts:
e.g.
An Indian exporter exports goods with a bill value of $1000 on 1st
JAN when exchange rate is $1= 45 Rupee. US importer pays on
march 31st, after due credit period gets over. Exchange rate on 31st
march is $1=44 Rupees. then realized value of $1000 bill would be
Rupees 44,000( instead of Rupees 45,000). Here we can say , the
exporter faces transaction risk. They will be affected when price of
dollar goes up in terms of Indian rupees.
Transaction risk would be eliminated if the billing is in domestic
currency. In the above example if the bill value was Rupees 45,000
instead of “$ 1000” then exporter would have surety of getting the
correct value. However the American importer would be at risk
because for him he has to judge the dollar amount. This risk can be
hedge using forward contacts , futures, or options.
Activity daigram
Swap Contracts :
Risk in Foreign exchange market : Settlement of foreign exchange trade require the
payment of one currency and the receipt of another. It is important that both the customer
honor their contract. It is possible that either of the parties will default. This is called as
Credit Risk. e.g collapse of bank of herstatt in 1974 (German)
CLS is a global multi-currency settlement system that aims to eliminate foreign exchange
(FX) settlement risk due to time-zone differences. The CLS settlement service, provided by
CLS Bank, allows both legs of a FX trade submitted by members to be settled
simultaneously across the books of CLS Bank and therefore guarantees finality and
irrevocability of the settlements. It was launched in 2002.
It avoids the high value payment risk, works on PVP mechanism ( payment vs. Payment ) .
Settlement Risk
Transaction Risk
Counterparty Risk
Foreign Exchange Risk
Credit Risk
Speculation and Hedging :