lOMoARcPSD|11729826

International Finance

International Business Finance (Indira Gandhi National Open University)

Scan to open on Studocu

Studocu is not sponsored or endorsed by any college or university

Downloaded by Jelani Greer ([email protected])
 lOMoARcPSD|11729826

BALANCE OF PAYMENT
BOP refers to the summary of all transactions between citizens of two countries for a given period. It
summarizes all the transaction that taken place between its residents and foreigners in a given period. Usually
one year. It is a systematic record of all economic transaction between the resident of one country and the
resident of rest of the world in a year. The BOP shows all the flow of a country’s revenue from other countries
and its payments to other countries for a given period of time. In short BOP records the inflow and out flow of
foreign exchanges.
According to IMF “ BOP of a country is a systematic record of all economic transaction between its residents
and the residents of the rest of the world during a specified accounting period”. It is a way of listing receipts and
payments in international transaction for a country. In words of RBI “ BOP is a statistical statement that
systematically summarizes, for a specified time period, the economic transactions of an economy with the rest
of the world”.
Items include in BOP
1- Payment for merchandise imports and receipt for merchandise export
2- Loans to the investment in foreign countries and enterprises
3- Money made to foreign carriers and receipt for foreign goods carried within national boarders.
4- Payment and receipt for services to and from foreign countries
5- Gift, donation, award etc paid or received by a country
Importance of BOP
1- It provides valuable and detailed information to govt about the international position about the country
2- It provides detailed information regarding the demand and supply of country’s currency
3- It provides useful data to country’s economic analysis
4- BOP data can be used to evaluate the performance of the country in international economic competition
5- It is useful to international managers
COMPONENTS OF BOP
There are three components of BOP. Current account, capital account and official reserve account.
1- Current account
It includes imports and exports of goods and services. It is a record of trade in goods and services
among countries. Only transactions of current nature resulting in income or expenditure are recorded on the
current account. A surplus in the current accounts represents an inflow of funds while a deficit represents an
outflow of funds. It consists of current account receipt and current account payments. The various item
included in current accounts are
1- Visible trade or merchandise trade (it means import and export of goods)
2- Invisible trade or service trade (it refers to import and export service. It includes all payments and
receipts for service like shipping, insurance, banking, tourism etc
3- Factor income (this consist of payment and receipts of interest, dividend and other income on foreign
investment)
4- Unilateral transfer (these are gift and grants by both pvt and govt sector. This consists of remittance by
migrants to their family, gifts, donations and subsidies, foreign aid compensation etc.
The net value of visible and invisible trade balance is the balance on current account. If the credit is
more than the debit, it is known as current account surplus. If the debit is more than credit, it is known as
current account deficit.
2- Capital account
It consists of capital transaction. The capital transactions are short term flows and long term flows.
Capital comes in to the country by borrowing, sale of overseas asset, and investment in the country by
foreigners. This item is referred to as capital flows and recorded as credit items in the BOP. Capital
inflows are in effect, a decrease in the country’s holding of foreign asset or increase liabilities to
foreigners. That is why capital inflows are recorded as credits. Similarly, capital leaves the country due
to lending, buying of overseas asset and purchase of domestic asset owned by foreign residents. These
items represents as capital outflows. These are recorded as debit items in capital account. Capital
outflows in effect, an increase in the country’s holding of foreign asset or decrease in liabilities to

Downloaded by Jelani Greer ([email protected])

 lOMoARcPSD|11729826

foreigners. That is why these are recorded as debit items. In short capital account measures capital flows
in to and out to a country.
Components of capital account
1- Direct investment (these are investments in enterprises or properties located in one country that are
effectively controlled by the residents of another country. These are long term capital out flows)
2- Portfolio investment (it represents sales and purchases of foreign financial assets such as stocks and
bonds that do not involve in a transfer of management control. It comprises equity securities and
debt securities.)
3- Other investment (it includes transactions in currency, bank deposits, short term loans, short term
securities, money market instruments and so on. These are short term capital flows or long term
portfolio investments.)
4- International loans (these are borrowings from or lending to international institutions like IMF,
European Union etc
3- Errors and omissions
Errors and omissions is a balancing item so that total credits and debits of the three accounts must equal
in accordance with the principles of double entry book-keeping so that the balance of payments of a
country always balances in the accounting sense .
4- Official reserve account
These are held by monitory authorities of a country. These are govt owned assets. These are generally
accepted for settling the international climes. The official settlements account or official reserve assets
account is, in fact, a part of the capital account. “The official settlements account measures the change in
nation’s liquidity and non-liquid liabilities to foreign official holders and the change in a nation’s
official reserve assets during the year. The official reserve assets of a country include its gold stock,
holdings of its convertible foreign currencies and SDRs, and its net position in the IMF.” It shows
transactions in a country’s net official reserve assets.
Disequilibrium in Balance of Payments
Disequilibrium in the BOP of a country may be either a deficit or a surplus. A deficit or surplus in BOP of a
country appears when its autonomous receipts (credits) do not match its autonomous payments (debits). If
autonomous credit receipts exceed autonomous debit payments, there is a surplus in the BOP and the
disequilibrium is said to be favorable. On the other hand, if autonomous debit payments exceed autonomous
credit receipts, there is a deficit in the BOP and the disequilibrium is said to be unfavorable or adverse.
Causes of disequilibrium
1. Temporary Changes (or Disequilibrium):
There may be a temporary disequilibrium caused by random variations in trade, seasonal fluctuations, the
effects of weather on agricultural production, etc. Deficits or surpluses arising from such temporary causes are
expected to correct themselves within a short time.
2. Fundamental Disequilibrium:
Fundamental disequilibrium refers to a persistent and long-run BOP disequilibrium of a country. It is a chronic
BOP deficit, according to IMF.
It is caused by such dynamic factors as: (1) Changes in consumer tastes within the country or abroad which
reduce the country’s exports and increase its imports. (2) Continuous fall in the country’s foreign exchange
reserves due to supply inelasticity’s of exports and excessive demand for foreign goods and services. (3)
Excessive capital outflows due to massive imports of capital goods, raw materials, essential consumer goods,
technology and external indebtedness. (4) Low competitive strength in world markets which adversely affects
exports. (5) Inflationary pressures within the economy which make exports dearer.
3. Structural Changes (or Disequilibrium):
Structural changes bring about disequilibrium in BOP over the long run.
They may result from the following factors:
(a) Technological changes in methods of production of products in domestic industries or in the industries of
other countries. They lead to changes in costs, prices and quality of products.
(b) Import restrictions of all kinds bring about disequilibrium in BOP.

Downloaded by Jelani Greer ([email protected])

 lOMoARcPSD|11729826

(c) Deficit in BOP also arises when a country suffers from deficiency of resources which it is required to import
from other countries.
(d) Disequilibrium in BOP may also be caused by changes in the supply or direction of long-term capital flows.
More and regular flow of long-term capital may lead to BOP surplus, while an irregular and short supply of
capital brings BOP deficit.
4. Changes in Exchange Rates:
Changes in foreign exchange rate in the form of overvaluation or undervaluation of foreign currency lead to
BOP disequilibrium. When the value of currency is higher in relation to other currencies, it is said to be
overvalued. Opposite is the case of an undervalued currency. Overvaluation of the domestic currency makes
foreign goods cheaper and exports dearer in foreign countries. As a result, the country imports more and exports
less of goods. There is also outflow of capital. This leads to unfavourable BOP. On the contrary, undervaluation
of the currency makes BOP favourable for the country by encouraging exports and inflow of capital and
reducing imports.
5. Cyclical Fluctuations (or Disequilibrium):
Cyclical fluctuations in business activity also lead to BOP disequilibrium. When there is depression in a
country, volumes of both exports and imports fall drastically in relation to other countries. But the fall in
exports may be more than that of imports due to decline in domestic production. Therefore, there is an adverse
BOP situation. On the other hand, when there is boom in a country in relation to other countries, both exports
and imports may increase. But there can be either a surplus or deficit in BOP situation depending upon whether
the country exports more than imports or imports more than exports. In both the cases, there will be
disequilibrium in BOP.
6. Changes in National Income:
Another cause is the change in the country’s national income. If the national income of a country increases, it
will lead to an increase in imports thereby creating a deficit in its balance of payments, other things remaining
the same. If the country is already at full employment level, an increase in income will lead to inflationary rise
in prices which may increase its imports and thus bring disequilibrium in the balance of payments.
7. Price Changes:
Inflation or deflation is another cause of disequilibrium in the balance of payments. If there is inflation in the
country, prices of exports increase. As a result, exports fall. At the same time, the demand for imports increase.
Thus increase in export prices leading to decline in exports and rise in imports results in adverse balance of
payments.
8. Stage of Economic Development:
A country’s balance of payments also depends on its stage of economic development. If a country is
developing, it will have a deficit in its balance of payments because it imports raw materials, machinery, capital
equipment, and services associated with the development process and exports primary products. The country
has to pay more for costly imports and gets less for its cheap exports. This leads to disequilibrium in its balance
of payments.
9. Capital Movements:
Borrowings and lendings or movements of capital by countries also result in disequilibrium in BOP. A country
which gives loans and grants on a large scale to other countries has a deficit in its BOP on capital account. If it
is also importing more, as is the case with the USA, it will have chronic deficit. On the other hand, a developing
country borrowing large funds from other countries and international institutions may have a favourable BOP.
But such a possibility is remote because these countries usually import huge quantities of food, raw materials,
capital goods, etc. and export primary products. Such borrowings simply help in reducing BOP deficit.
10. Political Conditions:
Political condition of a country is another cause of disequilibrium in BOP. Political instability in a country
creates uncertainty among foreign investors which leads to the outflow of capital and retards its inflow. This
causes disequilibrium in BOP of the country. Disequilibrium in BOP also occurs in the event of war or fear of
war with some other country.
Adjustment mechanism

Downloaded by Jelani Greer ([email protected])

 lOMoARcPSD|11729826

1. Adjustment through Exchange Depreciation (Price Effect):

Under flexible exchange rates, the disequilibrium in the balance of payments is automatically solved by the
forces of demand and supply for foreign exchange. An exchange rate is the price of a currency which is
determined, like any other commodity, by demand and supply. “The exchange rate varies with varying supply
and demand conditions, but it is always possible to find an equilibrium exchange rate which clears the foreign
exchange market and creates external equilibrium.’ This is automatically achieved by depreciation of a
country’s currency in case of deficit in its balance of payments.
Depreciation of a currency means that its relative value decreases. Depreciation has the effect of encouraging
exports and discouraging imports. When exchange depreciation takes place, foreign prices are translated into
domestic prices. Suppose the dollar depreciates in relation to the pound. It means that the price of dollar falls in
relation to the pound in the foreign exchange market. This leads to the lowering of the prices of U.S. exports in
Britain and raising of the prices of British imports in the U.S. When import prices are higher in the U.S., the
Americans will purchase less goods from the Britishers. On the other hand, lower prices of U.S. exports will
increase exports and diminish imports, thereby bringing equilibrium in the balance of payments.
2. Devaluation or Expenditure-Switching Policy:
Devaluation raises the domestic price of imports and reduces the foreign price of exports of a country devaluing
its currency in relation to the currency of another country. Devaluation is referred to as expenditure switching
policy because it switches expenditure from imported to domestic goods and services. When a country devalues
its currency, the price of foreign currency increases which makes imports dearer and exports cheaper. This
causes expenditures to be switched from foreign to domestic goods as the country’s exports rise and the country
produces more to meet the domestic and foreign demand for goods with reduction in imports. Consequently, the
balance of payments deficit is eliminated.
3. Direct Controls:
To correct disequilibrium in the balance of payments, government also adopts direct controls which aim at
limiting the volume of imports. The government restricts the import of undesirable or unimportant items by
levying heavy import duties, fixation of quotas, etc. At the same time, it may allow Imports о essential goods
duty free or at lower import duties, or fix liberal import quotas for them.
For instance the government may allow free entry of capital goods, but impose heavy import duties on
luxuries.’ Import quotas are also fixed and the importers are required to take licenses from the authorities in
order to import certain essential commodities in fixed quantities.
In these ways, imports are reduced in order to correct an adverse balance of payments. The government also
imposes exchange controls. Exchange controls have a dual purpose. They restrict imports and also control and
regulate the foreign exchange. With reduction in imports and control of foreign exchange, visible and invisible
imports are reduced. Consequently, an adverse balance of payment is corrected.
4. Adjustment through Capital Movements
A country can use capital imports to correct a deficit in its balance of payments. A deficit can be financed by
capital inflows. When capital is perfectly mobile within countries, a small rise in the domestic rate of interest
brings a large inflow of capital. The balance of payments is said to be in equilibrium when the domestic interest
rate equals the world rate. If the domestic interest rate is higher than the world rate, there will be capital inflows
and the balance of payments deficit is corrected.
5. Adjustment through Income Changes:
Given the foreign exchange rate and prices in a country, an increase in the value of exports, causes an increase
in the incomes of all persons associated with the export industries. These, in turn create demand for other goods
and services within the country. This will raise the incomes of persons engaged in the latter industries and
services. This process will continue and the national income increases by the value of the multiplier.
6. Stimulation of Exports and Import Substitutes:
A deficit in the balance of payments can also be corrected by encouraging exports. Exports can e encouraged by
producing quality products, by reducing exports through increased production and productivity, and by better
marketing. They can also be increased by a policy of import substitution it means that the country produces
those goods which it imports.
In the beginning, imports are reduced u in the long run exports of such goods start. An increase in exports
causes the national income to rise by many times through the operation of the foreign trade multiplier. The

Downloaded by Jelani Greer ([email protected])

 lOMoARcPSD|11729826

foreign trade multiplier expresses the change in income caused by a change in exports. Ultimately, the deficit in
the balance of payments is removed when exports rise faster than imports.
7. Expenditure-Reducing policies:
A deficit in the balance of payments implies an excess of expenditure over income. To correct it expenditure
and income should be brought into equality. For this expenditure reducing monetary and fiscal policies are used.
A contractionary or tight monetary policy relates to cut in interest rates to reduce money supply and a
contractionary fiscal policy relates to reduction in government expenditure and or increase in taxes.
Thus expenditure reducing policies reduce aggregate demand through higher taxes and interest rates, thereby
reducing expenditure and output. The reduction in expenditure and output, in turn, reduces the domestic price
level. This gives rise to switching of expenditure from foreign to domestic goods. Consequently, the country’s
imports are reduced and the balance of payments deficit is corrected.
Relation between BOP and foreign exchange rates
A change in a country's balance of payments can cause fluctuations in the exchange rate between its currency
and foreign currencies. The reverse is also true where a fluctuation in relative currency strength can alter the
balance of payments. There are two different and interrelated markets at work: the market for all financial
transactions on the international market (balance of payments) and the supply and demand for a specific
currency (exchange rate).
These conditions only exist under a free or floating exchange rate regime. The balance of payments does not
impact the exchange rate in a fixed-rate system because central banks adjust currency flows to offset the
international exchange of funds.
The world has not operated under any single rules-based or fixed exchange-rate system since the end of Bretton
Woods in the 1970s
Suppose a consumer in France wants to purchase goods from an American company. The American company is
not likely to accept euros as payment; it wants U.S. dollars. Somehow the French consumer needs to purchase
dollars (ostensibly by selling euros in the forex market) and exchange them for the American product. Today,
most of these exchanges are automated through an intermediary so that the individual consumer doesn't have to
enter the forex market to make an online purchase. After the trade is finally made, it is recorded in the current
account portion of the balance of payments.
The same holds true for investments, loans or other capital flows. American companies normally don't want to
receive foreign currencies to finance their operations; foreign investors need to send them dollars. Capital flows
between countries show up in the capital account portion of the balance of payments.
As more U.S. dollars are demanded to satisfy the wants of foreign investors or consumers, upward pressure is
placed on the price of dollars. In other words, it costs relatively more to exchange for dollars, in terms of
foreign currencies.
The exchange rate for dollars may not actually rise if other factors are concurrently pushing down the value of
dollars. For example, expansionary monetary policy might increase the supply of dollars.
Foreign exchange market
1- purchasing power parity theory (PPP)
Purchasing power parity (PPP) is a theory of exchange rate determination and a way to compare the average
costs of goods and services between countries. The theory assumes that the actions of importers and exporters,
motivated by cross country price differences, induces changes in the spot exchange rate. In another vein, PPP
suggests that transactions on a country's current account, affect the value of the exchange rate on the foreign
exchange market. This contrast with the interest rate parity theory which assumes that the actions of investors,
whose transactions are recorded on the capital account, induces changes in the exchange rate.

PPP theory is based on an extension and variation of the "law of one price" as applied to the aggregate economy

The Law of One Price

The law of one price says that identical goods should sell for the same price in two separate markets when there
are no transportation costs and no differential taxes applied in the two markets

Downloaded by Jelani Greer ([email protected])

 lOMoARcPSD|11729826

2- Interest rate parity theory (IRP)

Interest Rate Parity theory states that equilibrium is achieved in international financial markets when the
forward rate differential is approximately equal to the interest rate differential. In other words, the forward rate
differ from the spot rate by an amount that represents the interest rate differential. In this process, the currency
of a country with a lower interest rate should be at forward premium in relation to the currency of a country
with higher interest rate. It is also called covered interest rate parity.
Assumptions
1- When a currency is converted to another, or when a financial security is bought or sold, there are no
costs involved. That is transaction cost is zero.
2- Money can freely flow between both countries and there is full mobility of capital.
3- An investor can choose to invest in financial securities that are denominated in the currency of the
country where he resides or to invest in financial securities that are denominated in the currency of a
foreign country. If he chooses to invest in foreign currency denominated financial securities, he will
hedge his foreign exchange risk through operating in the forward market.
As per the interest rate parity the difference in exchange rate between two currencies is due to difference in
interest rates. The currency with higher interest rate will depreciate, while the currency with lower interest rate
will appreciate. If the difference in exchange rate is not difference in interest rate, it will lead to an opportunity
for arbitrage
ARBITRAGE IN FORWARD MARKET
ARBITRAGE
Buying in one market (say, spot market) and simultaneously selling in another market (say, futures market) to
make risk free profits when there is substantial mismatch between two prices is called arbitrage. Arbitrage is
described as risk free because participants are not speculating on market movements. Instead, they bet on the
mis-pricing of a share/asset that has happened between to related markets.
In short, when you earn by selling and buying same security at different rates in different markets, it is called
Arbitrage. It is a highly technical field. Market’s mis-pricing is taken advantage by traders to make risk free
gains.
DEFINITION of 'Covered Interest Arbitrage’
A strategy in which an investor uses a forward contract to hedge against exchange rate risk. Covered interest
rate arbitrages the practice of using favorable interest rate differentials to invest in a higher-yielding currency,
and hedging the exchange risk through a forward currency contract. Covered interest arbitrage is only possible
if the cost of hedging the exchange risk is less than the additional return generated by investing in a higher-
yielding currency. Such arbitrage opportunities are uncommon, since market participants will rush in to exploit
an arbitrage opportunity if one exists, and the resultant demand will quickly redress the imbalance. An investor
undertaking this strategy is making simultaneous spot and forward market transactions, with an overall goal of
obtaining riskless profit through the combination of currency pairs. Covered interest arbitrage is not without its
risks, which include differing tax treatment in various jurisdictions, foreign exchange or capital controls,
transaction costs and bid-ask spreads.
International Fisher Effect
International Fisher Theory states that an estimated change in the current exchange rate between any two
currencies is directly proportional to the difference between the two countries’ nominal interest rates at a
particular time.
According to International Fisher Theory hypothesis, the real interest rate in a particular economy is
independent of monetary variables. With the assumption that real interest rates are calculated across the
countries, it can also be concluded that the country with lower interest rate would also have a
lower inflation rate. This will make the real value of the country’s currency rise over time. This theory is also
known as the assumption of Uncovered Interest Parity.
According to the generalized International Fisher Theory, the real interest rates should be same across the
borders. But the validity of generalized Fisher theory largely depends on the integration of the capital market.
That is, the capital in the market needs to be free to flow across borders. Usually the capital markets of the

Downloaded by Jelani Greer ([email protected])

 lOMoARcPSD|11729826

developed countries are integrated in nature. It has been seen that in the underdeveloped countries the currency
flow is restricted.
The International Fisher Theory observation holds that a country with higher interest rate will also be inclined
to have a higher inflation rate. The International Fisher Theory also estimates the future exchange rates based on
the nominal interest rate relationships. The estimate of the spot exchange rate 12 months from now is calculated
by multiplying the current spot exchange rate by the nominal annual U.S. interest rate and then dividing it by
the nominal annual British interest rate.
FACTORS INFLUENCING EXCHANGE RATE
Foreign Exchange rate (Forex rate) is one of the most important means through which a country’s relative level
of economic health is determined. A country's foreign exchange rate provides a window to its economic
stability, which is why it is constantly watched and analyzed. If you are thinking of sending or receiving money
from overseas, you need to keep a keen eye on the currency exchange rates.
The exchange rate is defined as "the rate at which one country's currency may be converted into another." It
may fluctuate daily with the changing market forces of supply and demand of currencies from one country to
another. For these reasons; when sending or receiving money internationally, it is important to understand what
determines exchange rates. It is price paid in the home currency for unit of foreign currency.
Factors influencing exchange rates are
1. Inflation Rates
Changes in market inflation cause changes in currency exchange rates. A country with a lower inflation rate
than others will see an appreciation in the value of its currency. The prices of goods and services increase at a
slower rate where the inflation is low. A country with a consistently lower inflation rate exhibits a rising
currency value while a country with higher inflation typically sees depreciation in its currency and is usually
accompanied by higher interest rates
2. Interest Rates
Changes in interest rate affect currency value and dollar exchange rate. Foreign exchange rates, interest rates,
and inflation are all correlated. Increases in interest rates cause a country's currency to appreciate because
higher interest rates provide higher rates to lenders, thereby attracting more foreign capital, which causes a rise
in exchange rates
3. Country’s Current Account / Balance of Payments
A country’s current account reflects balance of trade and earnings on foreign investment. It consists of total
number of transactions including its exports, imports, debt, etc. A deficit in current account due to spending
more of its currency on importing products than it is earning through sale of exports causes depreciation.
Balance of payments fluctuates exchange rate of its domestic currency.
4. Government Debt
Government debt is public debt or national debt owned by the central government. A country with government
debt is less likely to acquire foreign capital, leading to inflation. Foreign investors will sell their bonds in the
open market if the market predicts government debt within a certain country. As a result, a decrease in the value
of its exchange rate will follow.
5. Terms of Trade
Related to current accounts and balance of payments, the terms of trade is the ratio of export prices to import
prices. A country's terms of trade improves if its exports prices rise at a greater rate than its imports prices. This
results in higher revenue, which causes a higher demand for the country's currency and an increase in its
currency's value. This results in an appreciation of exchange rate.
6. Political Stability & Performance
A country's political state and economic performance can affect its currency strength. A country with less risk
for political turmoil is more attractive to foreign investors, as a result, drawing investment away from other
countries with more political and economic stability. Increase in foreign capital, in turn, leads to an appreciation
in the value of its domestic currency. A country with sound financial and trade policy does not give any room
for uncertainty in value of its currency. But, a country prone to political confusions may see a depreciation in
exchange rates.

Downloaded by Jelani Greer ([email protected])

 lOMoARcPSD|11729826

7. Recession
When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to acquire
foreign capital. As a result, its currency weakens in comparison to that of other countries, therefore lowering the
exchange rate.
8. Speculation
If a country's currency value is expected to rise, investors will demand more of that currency in order to make a
profit in the near future. As a result, the value of the currency will rise due to the increase in demand. With this
increase in currency value comes a rise in the exchange rate as well.
9. Market expectations
Like any other financial markets, foreign exchange markets react to any news that may have a future effect.
News of potential surge in inflation in India may cause currency sellers to sell rupees, anticipating a future
decline in rupee value. This leads to depreciation of rupee value.
10. Changes in bank rate
11. Stock exchange activities
12. Structural changes
14. National budgetary influence
15. Banking operations
INTERNATIONAL MONETORY SYSTEM
International monetary systems are sets of internationally agreed rules, conventions and supporting institutions,
that facilitate international trade, cross border investment and generally the reallocation of
capital between nation states. They provide means of payment acceptable between buyers and sellers of
different nationality, including deferred payment. To operate successfully, they need to inspire confidence, to
provide sufficient liquidity for fluctuating levels of trade and to provide means by which global imbalances can
be corrected. The systems can grow organically as the collective result of numerous individual agreements
between international economic factors spread over several decades. Alternatively, they can arise from a single
architectural vision as happened at Bretton Woods in 1944.
Exchange rate mechanism
An exchange rate mechanism is based on the concept of fixed currency exchange rate margins. However, there
is variability of the currency exchange rates within the confines of the upper and lower end of the margins. This
currency exchange rate mechanism is also commonly called a semi-pegged currency system. There are two types of
ER mechanisms: –
Floating ER – no intervention by governments or central banks
Fixed ER – officials strive to keep the ER fixed (or pegged) even if the rate that they choose is not the
equilibrium rate. Managed Exchange Rates fall in-between these two category
The most notable exchange rate mechanism was the one that was in effect in Europe. The goal of the European
Exchange Rate Mechanism was to reduce exchange rate variability and achieve monetary stability in Europe
prior to the introduction of the single currency - the euro - on January 1, 1999.
Floating (Flexible) Exchange Rates • No Government Interference • Market Forces dictate equilibrium
exchange rates • Value of a nation’s currency allowed to “float” down or up • End of the 1990’s – these are the
norm
Fixed Exchange Rates • Predominant exchange rate system in the world for most of 20th century (1900’s –
1970s) • In a fixed exchange rate system, the value of a nation’s currency is fixed (pegged) to a fixed amount of
a commodity or to another currency • Commodity – usually Gold (Gold Standard); Currency – US$. • Under a
fixed exchange rate, national Supply and Demand for currency may vary, but the nominal exchange rate does
not • Monetary authorities ensure that the rate does not change • Typically, there are bands set above/below the
par value that allow for some small fluctuation in the exchange rate • Governments must act to counter and
appreciation
THE GOLD STANDARD 1876-1914
A monetary system in which a country's government allows its currency unit to be freely converted into fixed
amounts of gold and vice versa. The exchange rate under the gold standard monetary system is determined by
the economic difference for an ounce of gold between two currencies. The gold standard was mainly used from
1875 to 1914 and also during the interwar years. The use of the gold standard would mark the first use of

Downloaded by Jelani Greer ([email protected])

 lOMoARcPSD|11729826

formalized exchange rates in history. However, the system was flawed because countries needed to hold large
gold reserves in order to keep up with the volatile nature of supply and demand for currency. After World War
II, a modified version of the gold standard monetary system, the Bretton Woods monetary system created as its
successor. This successor system was initially successful, but because it also depended heavily on gold reserves,
it was abandoned in 1971.
Features
 Monetary unit is defined in terms of gold. For example, before World War I, sovereign was the standard
coin in the U.K. Its weight was 123.17447 grains with 11/12 purity.
 Other forms of money (e.g. token coins and paper money) are also in circulation. But they are
convertible into gold.
 Coinage is unlimited and free of cost.
 There is free and unlimited melting of gold coins.
 The government buys and sells gold at fixed prices and thereby maintains parity between the face value
and intrinsic value of the standard coin.
 There is free import and export of gold.
 Gold is unlimited legal tender for all types of payments. All values are expressed in terms of gold.
Merits
1. Public Confidence:
Since the standard coin is made of gold, it is universally acceptable. Thus, gold coin standard enjoys full
confidence of the public.
2. Automatic Working:
It is automatic in working and needs no government intervention. Money supply depends upon the volume of
gold reserves and money supply can be changed in accordance with the changes in the volume of gold reserves.
3. Price Stability:
Since there are no frequent changes in the supply of gold, this system ensures reasonable degree of internal
price stability.
4. Exchange Stability:
Free and unrestricted import and export of gold under gold coin standard ensures stability in foreign exchange
rates. This promotes international trade.
5. Simplicity:
This is the simplest form of gold standard which can be easily understood by the common people.
Demerits
1. Fair-Weather Standard:
It is fair-weather standard; it operates smoothly during peace times but fails to work properly and to inspire
public confidence at the time of economic crisis.
2. Wastage of Gold:
There is great deal of wastage of gold under this standard. Circulation of gold coins suffers depreciation.
Moreover, since paper currency is fully backed by gold, gold remains idle while in reserves.
3. Not Automatic:
Gold coin standard operates automatically with the cooperation of the participating countries. After World War
I, in the absence of international cooperation, this standard ceased to be automatic in its functioning.
4. Price Stability Unreal:
Under this system, internal price stability is unreal. Various factors like discoveries of new gold mines, changes
in the techniques of production of gold, changes in imports and exports of gold, lead to changes in the price of
gold, and hence cause fluctuations in the internal prices.

5. Less Effective:
Gold currency standard is not the only standard for achieving the objective of price and exchange stability.
Critics point out that a managed currency system is more effective in ensuring stability in internal price level
and external exchange rate.
6. Deflation Oriented:

Downloaded by Jelani Greer ([email protected])

 lOMoARcPSD|11729826

Mrs. Joan Robinson regards gold coin standard as deflation - oriented because the gold losing countries will
compulsorily reduce the currency (thus generating deflation), while the gold receiving countries generally do
not expand the currency (thus generating inflation).
THE BRETTON WOODS SYSTEM 1944-1972
A landmark system for monetary and exchange rate management established in 1944. The Bretton Woods
Agreement was developed at the United Nations Monetary and Financial Conference held in Bretton Woods,
July 1 to July 22, 1944. Major outcomes of the Bretton Woods conference included the formation of
the International Monetary Fund and the International Bank for Reconstruction and Development and, most
importantly, the proposed introduction of an adjustable pegged foreign exchange rate system. Currencies were
pegged to gold and the IMF was given the authority to intervene when an imbalance of payments arose.
The Bretton Woods system of international monetary management established the rules for commercial
and financial relations among the world's major industrial states. The Bretton Woods system was the first
example of a fully negotiated monetary order intended to govern monetary relations among independent nation-
states. Bretton Woods system were an obligation for each country to adopt a monetary policy that maintained
the exchange rate by tying its currency to gold and the ability of the IMF to bridge temporary imbalances of
payments.
Features
 US dollar-based system :- Officially, the Bretton Woods system was a gold-based system which treated
all countries symmetrically, and the IMF was charged with the responsibility to manage this system.
 It was an adjustable peg system :- This means that exchange rates were normally fixed but permitted to
be adjusted infrequently under certain conditions
 Capital control was tight.
 Macroeconomic performance was good
Reasons for failure
1- As in the case of Gold Standard, this system also did not provide for any revision in the price of gold.
Due to inflation, it became uneconomical to produce gold. This led to the suspension of gold production
in various countries leading to stagnation of gold reserves which had an adverse impact on international
liquidity.
2- The system did not provide for any revaluation of parities due to which surplus countries such as West
Germany and Japan continued to enjoy export competitiveness against the US economy. This
aggravated the US trade deficit.
3- The system did not provide for a revision in the price of gold in terms of USD. Due to this, it was not
possible to devalue the US Dollar despite continued trade deficit. The devaluation of the dollar would
have adversely affected all countries having USD reserves.
4- The continued trade deficit of the US created an over-supply of USD in the international financial
markets which reduced the acceptability of the USD. When the Gold Convertibility Clause was invoked,
the US authorities could not honor their commitment to redeem USD against gold. This failure on the
part of the US led to the collapse of the system in 1971.
Floating exchange rate system
System in which a currency's value is determined solely by the interplay of the market forces of demand and
supply, instead of by government intervention. However, all central banks do try to defend these rates within a
certain range by buying or selling their country's currency as the situation warrants.
Advantages
1- The system is simple to operate. This system does not result in deficit or surplus of foreign exchange.
The exchange rate moves automatically and freely
2- It helps in the promotion of foreign trade
3- The adjustment of exchange rate is a continues process
4- The possibility of speculation is reduced
5- It removes the problem of international liquidity
6- It is very economical. There is no idle holding of foreign currency reserves
7- There is no need of international institutional arrangements
Disadvantages

Downloaded by Jelani Greer ([email protected])

 lOMoARcPSD|11729826

1- It is difficult to define a freely flexible exchange rate.

2- Higher volatility: Floating exchange rates are highly volatile. Additionally, macroeconomic
fundamentals can’t explain especially short-run volatility in floating exchange rates.
3- Use of scarce resources to predict exchange rates: Higher volatility in exchange rates increases the
exchange rate risk that financial market participants face. Therefore, they allocate substantial resources
to predict the changes in the exchange rate, in an effort to manage their exposure to exchange rate risk.
4- Tendency to worsen existing problems: Floating exchange rates may aggravate existing problems in the
economy. If the country is already experiencing economic problems such as higher inflation or
unemployment, floating exchange rates may make the situation worse.
5- It breaks up the world market
6- It is not suited for the less developed countries
Fixed Exchange Rate system
A country's exchange rate regime, under which the government or central bank ties the official exchange rate to
another country's currency (or the price of gold). The purpose of a fixed exchange rate system is to maintain a
country's currency value within a very narrow band. Also known as pegged exchange rate. Fixed rates provide
greater certainty for exporters and importers. This also helps the government maintain low inflation, which in
the long run should keep interest rates down and stimulate increased trade and investment.
Merits
1- It simplifies exchange transaction
2- It encourages long term investment by various investors across the glob
3- There is no fear of currency fluctuations
4- It is the best for small countries. It provides stability to international trade
5- It is less inflationary
6- It imposes a discipline on monitory authorities to follow responsible financial policies with countries
7- It promotes international trade
8- It contribute in raising productivity through increased international division of labor and specialization
9- It promotes economic integration
10- It stimulates the growth of money and capital market
Demerits
1- It scarifies the objective of full employment and stable prices
2- There is a fear of speculation
3- A country has to bear a share of burden of the disturbances and policy mistakes
4- The exchange rate with a country cannot remain fixed for a long period
5- It fails to solve the problem of BOP disequilibrium
6- There is a need to undertake pegging operations. For this purpose it is necessary to maintain sufficient
reserves of foreign currencies
7- It requires complicated exchange control mechanism
INTERNATIONAL MONETORY SYSTEM
The International Monetary Fund came into existence on December 27,1945 when 29 countries signed its
Article of Agreement agreed at a conference held in USA in 1944.The IMF commenced financial operations on
March 1,1947.The IMF is the central institution of International Monetary System. It is primarily a supervisory
institution for co-ordinating the efforts of member countries to achieve greater co-operation in the formulation
of economic policies. Thus IMF is an international organization that overseas the global financial system by
observing exchange rates and balance of payments and also offers financial and technical assistance.IMF has
185 members.

Purpose or objectives of IMF

1- To promote international monetary co-operation.
2- To ensure stability in foreign exchange rates.
3- To eliminate exchange control.
4- To help member-nations to achieve balanced economic growth.

Downloaded by Jelani Greer ([email protected])

 lOMoARcPSD|11729826

5- To eliminate or reduce BOP disequilibrium.

6- To promote investment in backward and underdeveloped countries.

FUNCTIONS OF IMF
1- To gives advice to the member countries on economic and monetary matters.
2- It had created a monetary reserve fund.
3- Lending foreign currencies to member countries against their national currencies.
4- It stabilizes the foreign exchange rate.
5- Reduces tariff and other trade restrictions among the member countries.
6- Conducts research studies and publishes the reports
7- Provides machinery for international consultancy.
8- It conducts short term training courses on monitory policies and BOPs for employees of member
countries
OPERATIONS OR SCHEMES OF IMF
1- Financial resources
It includes quota subscription of member countries, amount received from sale of gold, loan of
member countries etc. When a country joins the IMF, it is given a quota. The quota is expressed in special
drawing rights (SDR).
2- Lending
The IMF lends money only to member countries having BOP problems. A member country With BOP
problem can immediately withdraw from the IMF the 25% of its quota.
3- Other credit facilities
Since the 1960’s ,the IMF has created several new credit facilities for its members .These are:
 Buffer Stock Financing Facility(BSFT)
 Extended Fund Facility(EFF)
 Supplementary Reserve Facility(SRF)
 Enhanced Structural Adjustment Facility(ESAF)
 Compensatory and Contingency Financing Facility(CCFF)
 Systematic Transformation Facility (STF) etc…
4- Determination of par values
The exchange rate system set up by the article of agreement was called par value system. Under this system,
each member is required to express the par value of its currency in terms as a common denominator or in US
dollar at a value of $35 per fine ounce of gold.
5- Other services
 It sends specialists and experts to solve BOP problems.
 It provides technical assistance.
 Set up three departments to solve banking and fiscal problems. They are Central Banking Service
Department ,Fiscal Affairs Department and IMF Institute
Conditionality of lending
When the IMF provides financial assistance to member countries, it must ensure that the members are
pursuing policies that will improve or eliminate their external payments problems. The explicit commitment
that members make to implement corrective measures in return for the assistance from the IMF is called
Conditionality. A country has to fulfill the conditionality's for getting a loan from the IMF
The broad guidelines or conditions of IMF are:
 The recipient country is required to undertake such tax reforms as provide incentives to the
producers to enhance domestic production.
 The prices of products of public enterprises should not be administered as these would entail
loss in efficiency for these undertakings.
 The borrowing country should take appropriate steps to ensure export promotion and conserve
energy in the interest of development.

Downloaded by Jelani Greer ([email protected])

 lOMoARcPSD|11729826

 The investment program of the country should be oriented to the objectives of steady growth.
The IMF laid down some more conditionality's after the 1995 Mexican and the Asian financial crisis.
These include:
 To liberalize trade by removing exchange and import controls.
 To eliminate all subsidies so that export s are not in an advantageous position in relation to the
other trading countries
 To treat foreign lenders on a equal footing with domestic lenders
Role of IMF in providing international liquidity
The IMF is an international monitory institution. It is the principle source of supply of international liquidity to
its 184 members. Over these years it has adopted the following measures to increase international liquidity.
1- Quotas
2- Selling gold
3- Borrowings
4- Reserves tranche
5- Credit tranche
6- New credit facilities
7- IDA replenishments
8- Special drawing rights (SDR)
In 1969, the IMF introduced a scheme for the creation and issue of SDRs as conditional reserve asset to
influence the level of world reserves and to solve the problem of international liquidity. It is a special
scheme which has a unit value fixed in gold. SDR is the international money existing only in the IMF’s
books and changing hands only in the ledger. But the members accept it as payment. Therefore this
international money is known as paper gold. It represents a new form of international paper money
which can be used by member countries to solve their BOP difficulties unconditionally and
automatically. Under the SDR system the member countries can use SDRs to settle its international debt
with other countries, in addition to gold, dollars, pounds and normal rights with the IMF.
Features of SDR
1- SDRs are new additional international reserve asset
2- SDRs are like coupons
3- SDRs are transferable asset
4- SDR is the liability of the IMF but asset of the holder
5- It is not backed by asset like key currency
6- It is created on the basis of fundamental principles of credit creation
7- It is allocated among member countries on the basis of quota allotted to them
Uses of SDRs
1- To make use of US dollars, UK pounds and French francs to improve BOP position in exchange of
SDRs.
2- To make payment to IMF general account
3- To obtain balances of its own currency held by another country, in exchange of the SDR by agreement
with that country
4- To use swap arrangements
5- To make donation and settle financial agreements
Merits of SDRs
1- It is a new form of international monitor reserve
2- It cannot be demonetized like gold
3- It is costless to produce
4- It improves international liquidity
5- It is unconditional and automatic
Demerits of SDRs
1- It is an inequitable scheme
2- It is not linked with development finance

Downloaded by Jelani Greer ([email protected])

 lOMoARcPSD|11729826

3- The interest rate on the use of SDR is high

4- It fails to distribute social saving

INTERNATIONAL FINANCIAL MARKETS AND INSTRUMENTS

International financial markets undertake intermediation by transferring purchasing power from lenders and
investors to parties who desire to acquire assets that they expect to yield future benefits. International financial
transactions involve exchange of assets between residents of different financial centre across national
boundaries. International financial centre's are reservoirs of savings and transfer them to their most efficient use
irrespective of where the savings are generated.
Functions
1- The interactions of buyers and sellers in the markets determine the prices of the assets traded which is
called the price discovery process.
2- The financial markets ensure liquidity by providing a mechanism for an investor to sell a financial asset.
3- The financial markets reduce the cost of transactions and information.
International financial market may be classified in to two. One is International money market and other is
international capital market.
International money market
It is the market that trade debt securities or instrument with maturities of one year and less. It is represented by
the flow short term funds. In this market, money and other liquid asset such as treasury bills, bills of exchange
etc can be borrowed or lent for a period of one year or less than one year. International banks or short term
securities comes under this segment.
International Money Market Instruments
1- Eurodollar certificates of deposits
2- Euro notes
3- Euro commercial papers
4- Medium-term Euro notes
1- Eurodollar Certificates Of Deposits:-
Eurodollar certificates of deposits are US dollar-denominated CDs in foreign banks. The maturities on
Eurodollar CDs are less than one year. Eurodollar CDs are issued in two forms- Tap CDs and Tranche CDs
2- Euro Notes :-
Euro notes are short-term notes similar to commercial paper. These are like promissory notes issued by
companies for obtaining short-term funds. These have maturities of 3-6 months.
3- Euro Commercial Papers:-
These are another short-term debt instruments. These are issued by the dealers of commercial papers
without involving a bank. ECPs have longer maturity going up to one year.
4- Medium-term Euro notes:-
It is an extension of short-term euro notes. Issued for medium term (1 to 5 years). Medium term euro
notes are issued to get medium term funds in foreign currency without any need for redemption and
fresh issue.
International capital markets
Capital markets deal with instruments whose maturity exceeds one year or which lack definite maturity. It is a
market where shares, bonds and other kind of securities are traded and where fresh capital can be raised.
International capital market instruments
1- International bonds
2- Global depository receipts (GDR)
3- International equities
1- International bonds
It is a debt instrument issued by international agencies, Governments and companies for borrowing
foreign currency for a specified period of time. It is divided in to two, one is foreign bonds and other is
euro bonds.

Downloaded by Jelani Greer ([email protected])

 lOMoARcPSD|11729826

2- Global depository receipts (GDR)

Depository receipt is a negotiable certificate issued by a financial institution (depository banks) to
represents the ownership of shares. These shares are deposited with a local custodian appointed by a
depository. This depository issue receipts against the deposit of shares. Such receipts are called
depository receipts. These receipts are divided in to three. They are GDR, ADR and international
depository deposits. Overseas depository bank is a bank authorized by the issuing company to issue
GDR against the ordinary shares of the issuing company.
FOREIGN EXCHANGE MARKET: MEANING, FUNCTIONS AND KINDS!
Meaning:
Foreign exchange market is the market in which foreign currencies are bought and sold. The buyers and sellers
include individuals, firms, foreign exchange brokers, commercial banks and the central bank.
Like any other market, foreign exchange market is a system, not a place. The transactions in this market are not
confined to only one or few foreign currencies. In fact, there are a large number of foreign currencies which are
traded, converted and exchanged in the foreign exchange market.
Functions of Foreign Exchange Market:
Foreign exchange market performs the following three functions:
1. Transfer Function:
It transfers purchasing power between the countries involved in the transaction. This function is performed
through credit instruments like bills of foreign exchange, bank drafts and telephonic transfers.
2. Credit Function:
It provides credit for foreign trade. Bills of exchange, with maturity period of three months, are generally used
for international payments. Credit is required for this period in order to enable the importer to take possession of
goods, sell them and obtain money to pay off the bill.
3. Hedging Function:
When exporters and importers enter into an agreement to sell and buy goods on some future date at the current
prices and exchange rate, it is called hedging. The purpose of hedging is to avoid losses that might be caused
due to exchange rate variations in the future.
Kinds of Foreign Exchange Markets:
Foreign exchange markets are classified on the basis of whether the foreign exchange transactions are
spot or forward accordingly, there are two kinds of foreign exchange markets:
(i) Spot Market,
(ii) Forward Market.
(i) Spot Market:
Spot market refers to the market in which the receipts and payments are made immediately. Generally, a time of
two business days is permitted to settle the transaction. Spot market is of daily nature and deals only in spot
transactions of foreign exchange (not in future transactions). The rate of exchange, which prevails in the spot
market, is termed as spot exchange rate or current rate of exchange.
The term ‘spot transaction’ is a bit misleading. In fact, spot transaction should mean a transaction, which is
carried out ‘on the spot’ (i.e., immediately). However, a two day margin is allowed as it takes two days for
payments made through cheques to be cleared.
(ii) Forward Market:
Forward market refers to the market in which sale and purchase of foreign currency is settled on a specified
future date at a rate agreed upon today. The exchange rate quoted in forward transactions is known as the
forward exchange rate. Generally, most of the international transactions are signed on one date and completed
on a later date. Forward exchange rate becomes useful for both the parties involved in the transaction.
Forward Contract is made for two reasons:
(a) To minimize the risk of loss due to adverse changes in the exchange rate (through hedging);
(b) To make profit (through speculation).
Features of foreign exchange market
 Foreign exchange market is the only market which is open 24 hours a day, except for weekends
unlike equity or commodities market which are open only for few hours.

Downloaded by Jelani Greer ([email protected])

 lOMoARcPSD|11729826

 Volume of transactions which are executed in foreign exchange market is extremely huge
because of many big players in foreign exchange market. Foreign exchange markets are more
liquid than any other market because of this reason.
 Foreign Exchange Market are present in every country and therefore geographically they are
located everywhere in the world, which makes them quite unique.
 Foreign exchange markets are the most difficult market to trade in as the exchange rates of
countries are affected by so many factors like interest rates, liquidity, geo political factor and so on.
 Foreign exchange market is a big player market, because mostly it is the big banks and
government who are the players in foreign exchange market.
Foreign exchange Market Participants
Central Banks
A Central Bank will intervene to buy or sell currencies if they believe it is substantially under or
overvalued and that it is having a negative effect on the economy. The national central banks play a key role in
the foreign exchange markets as many central banks have very substantial foreign exchange reserves, thus their
intervention power is significant.
Commercial Banks
Banks are licensed deposit taking institutions, they also support a variety of other services including foreign
exchange. These banks will trade currencies among themselves as part of the system of balancing accounts.
While exchange rates for their largest customers are extremely competitive, small and medium sized enterprises
and individuals will typically pay a large premium when transacting foreign exchange with their local branch.
The interbank market caters for both the majority of commercial turnover as well as enormous amounts of
speculative trading every day. It is not uncommon for a large bank to trade billions of dollars on a daily basis.
Hedge Funds
Their influence has increased significantly in the last few years thanks to the overall growth in their industry
and abundance of funds at their disposal; however the net effect of this group depends on the investment
decisions they make. With the growth of the FX industry they have been, where ever possible, investing heavily
in foreign securities and other foreign financial instruments.
Brokers
They can be classified into Interbank and Client brokers with the influence of the former declining in the last
few years due o the shift of businesses to electronic trading systems. The advent of online pricing systems has
revolutionized the operational capabilities of this market and changed the traditional role of brokers. But even in
the past, most banks were unable to service the needs of small to medium sized organizations as well as
commercial & private clients, with large corporations as their main targeted market. Thus keeping in mind the
client’s needs ability to invest a certain amount of minimum margin and still be able to trade on competitive
spreads led to the advent of Online Broking Companies and ForexCT.com belongs to this group.
Investors/Speculators
Given that the Forex market has high liquidity, a large amount of leverage and the 24/7 operational nature of the
market, it has been an attractive playing field for speculators. The service provided by speculators to a market is
primarily that by risking their own capital in the hope of profit, they add liquidity to the market and make it
easier for others to offset risk, including those who may be classified as hedgers and arbitrageurs.
Foreign exchange rate
Currencies are traded in foreign exchange market at an exchange rate. It is the price of one currency in terms of
other. It is the price paid in the home currency for a unit of foreign currency. It is price at which one national
currency can be converted in to another national currency.
Quoting in foreign exchange market
Direct quotation
A direct quote gives the unit of local currency per unit of foreign currency. For example, Rs 45=US$1, is a
direct quotation for US dollars in India. This means one dollar could be bought for 45 rupees. Thus direct quite
shows the number of Indian rupee required to buy one unit of foreign currency.
Indirect quotation

Downloaded by Jelani Greer ([email protected])

 lOMoARcPSD|11729826

The indirect quote represents the number of units foreign currency that can be purchased for one Indian rupee.
Thus in the case of indirect quotation, exchange rate is given in terms of unit of foreign currency as equivalent
to fixed a number of units of home currency. For example, in India 0.0222US$=1rupee. This means with one
Indian rupee, we can buy 0.0222US$. thus indirect quotation expresses the foreign currency per home currency.
Spot Transactions: This type of transaction accounts for almost a third of all FX market transactions. Two
parties agree on an exchange rate and trade currencies at that rate. Although spot transactions are popular, they
leave the currency buyer exposed to some potentially dangerous financial risks.
Forward Transactions: One way to deal with the FX risk is to engage in a forward transaction. In this
transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree
on an exchange rate for any date in the future and the transaction occurs on that date, regardless of what the
market rates are then. The date can be a few days, months or years in future.
Futures: Foreign currency futures are forward transactions with standard contract sizes and maturity dates �
for example, 500,000 British pounds for next November at an agreed rate. These contracts are traded on a
separate exchange set up for that purpose.
Swap: The most common type of forward transaction is the currency swap. In a swap, two parties exchange
currencies for a certain length of time and agree to reverse the transaction at a later date.
Options: To address the lack of flexibility in forward transactions, the foreign currency option was developed.
An option is similar to a forward transaction. It gives its owner the right to buy or sell a specified amount of
foreign currency at a specified price at any time up to a specified expiration date .
Spot rate
A spot contract is a contract of buying or selling a commodity, security or currency for settlement (payment and
delivery) on the spot date, which is normally two business days after the trade date. The settlement price (or
rate) is called spot price or spot rate.
Forward rate
A spot contract is in contrast with a forward contract where contract terms are agreed now but delivery and
payment will occur at a future date. The settlement price of a forward contract is called forward price or forward
rate.
Spot rates can be used to calculate forward rates. In theory, the difference in spot and forward prices should be
equal to the finance charges, plus any earnings due to the holder of the security, according to the cost of carry
model.
Cross rate
A cross rate is the currency exchange rate between two currencies, both of which are not the official currencies
of the country in which the exchange rate quote is given in.
Forward Premium
When dealing with foreign exchange (FX), a situation where the spot futures exchange rate, with respect to the
domestic currency, is trading at a higher spot exchange rate then it is currently. A forward premium is
frequently measured as the difference between the current spot rate and the forward rate, but any expected
future exchange rate will suffice.
It is a reasonable assumption to make that the future spot rate will be equal to the current futures rate.
According to the forward expectation's theory of exchange rates, the current spot futures rate will be the future
spot rate. This theory is routed in empirical studies and is a reasonable assumption to make in the long term.
Forward Discount
In a foreign exchange situation where the domestic current spot exchange rate is trading at a higher level then
the current domestic futures spot rate for a maturity period. A forward discount is an indication by the market
that the current domestic exchange rate is going to depreciate in value against another currency.
A forward discount means the market expects the domestic currency to depreciate against another currency, but
that is not to say that will happen. Although the forward expectation's theory of exchange rates states this is the
case, the theory does not always hold.
Forward rate quotations
Outright Forward quote

Downloaded by Jelani Greer ([email protected])

 lOMoARcPSD|11729826

It is a forward currency contract with a locked-in exchange rate and delivery date. An outright forward
contract allows an investor to buy or sell a currency on a specific date or within a range of dates. Foreign
exchange forward contracts function in a very similar fashion to standard forward contracts.
Companies that make large purchases from foreign business can use outright forward contracts to cover costs.
For example, a French company that buys materials from a Chinese supplier may be required to provide
payment for half of the total value of the payment now and the other half in six months. The first payment can
be covered with a spot trade, but in order to reduce currency risk exposure, the French company locks in the
exchange rate with an outright forward. If the company still requires the currency in six months, it can purchase
it at the agreed-upon rate.
Factors affecting the forward rate
The spot rates are the current rates of the market, you have to make the immediate payment if you like the rate
there is no additional cost involved. Whereas forward exchange rates or forward rates is like insurance which is
selected when you are not sure to transact in the current date but want to have today’s rate for your future
payment. You do not want to expose your transaction against negative exchange rate movement. Currency
hedging is the utmost thing for individuals as well as businesses when they invest money in forex.
The reputed and well known forex companies do not charge any commission fee when you use currency
hedging service by choosing forward exchange rate but they do charge some service fee. The spot rates and
forward exchange rates are related to each other through the interest rate parity.So, in simple the difference
between these two rates is actually the interest rate difference of those two currencies. Currency rate of each
nation is governed by its political and economical factors. Changes in the value of currency rate automatically
cause the change in exchange rate values.
Forward rates are also affected by the supply and demand of the currencies. Supply and demand of the
currencies are influenced by several economical factors, foreign trade, political stability, domestic debt levels,
monetary policy, central bank and the activities of international investors. Capital flows, given their size and
mobility are of great importance in determining exchange rates.Your countries’ trade in goods and services also
impact the currency rate thus investors keep an eye on the trade flow of both the countries whose currencies are
being traded.
The currencies with higher short-term real interest rates is more attractive to international investors than lower
interest rate currencies. Such currencies are more advantageous of capital mobility which allows an
organization to invest and divest internationally. Some currencies are attar during specific financial time of the
year. Some of the example of such currencies are the Swiss franc, the U.S. Dollar and the Canadian dollar.
Two Currency Arbitrage
A forex strategy in which a currency trader takes advantage of different spreads offered by brokers for a
particular currency pair by making trades. Different spreads for a currency pair imply disparities between the
bid and ask prices. Currency arbitrage involves buying and selling currency pairs from different brokers to take
advantage of this disparity.
For example, two different banks (Bank A and Bank B) offer quotes for the US/EUR currency pair. Bank A sets
the rate at 3/2 dollars per euro, and Bank B sets its rate at 4/3 dollars per euro. In currency arbitrage, the trader
would take one euro, convert that into dollars with Bank A and then back into euros with Bank B. The end
result is that the trader who started with one euro now has 9/8 euro. The trader has made a 1/8 euro profit if
trading fees are not taken into account.
Triangular Arbitrage
It is the process of converting one currency to another, converting it again to a third currency and, finally,
converting it back to the original currency within a short time span. This opportunity for riskless profit arises
when the currency's exchange rates do not exactly match up. Triangular arbitrage opportunities do not happen
very often and when they do, they only last for a matter of seconds. Traders that take advantage of this type of
arbitrage opportunity usually have advanced computer equipment and/or programs to automate the process.
TT Buying Rate (TT stands for Telegraphic Transfer)
This is the rate applied when the transaction does not involve any delay in realization of the foreign exchange
by the bank. In other words, the nostro account of the bank would already have been credited. The rate is
calculated by deducting from the interbank buying rate the exchange margin as determined by the bank.

Downloaded by Jelani Greer ([email protected])

 lOMoARcPSD|11729826

Though the name implies telegraphic transfer, it is not necessary that the proceeds of the transaction are
received by telegram. Any transaction where no delay is involved in the bank acquiring the foreign exchange
will be done at the TT rate.
Transaction where TT rate is applied is;
 Payment of demand drafts, mail transfers, telegraphic transfers, etc drawn on the bank where banks nostro
account is already credited
 Foreign bills collected. When a foreign bill is taken for collection, the bank pays the exporter only when the
importer pays for the bill and the banks nostro account abroad is credited
 Cancellation of foreign exchange sold earlier. For instance, the purchaser of a bank draft drawn on New
York may later request the bank to cancel the draft and refund the money to him. In such case, the bank will
apply the TT buying rate to determine the rupee amount payable to the customer.
Bill Buying Rate
This is the rate to be applied when a foreign bill is purchased. When a bill is purchased, the rupee equivalent of
the bill value is paid to the exporter immediately. However, the proceeds will be realized by the bank after the
bill is presented to the drawee at the overseas centre. In case of a usance bill, the proceeds will be realized on
the due date of the bill which includes the transit period and the usance period of the bill.
Foreign exchange risk
Exchange risk simply means the risk associated with the rate at which one currency exchanged with another. It
is the possibility of loss on account of unfavorable movement in foreign exchange rates. The exchange rate
depends upon the supply and demand for the currency. This leads to fluctuation in exchange rates. This may
result in profit or losses to the holders on foreign currency. Types of risks are: systematic risk, market risk,
interest rate risk, legal risk, operation risk and counter party risk.
Exchange exposure
Foreign exchange exposure is said to exist for a business or a firm when the value of its future cash flows is
dependent on the value of foreign currency / currencies. If a British firm sells products to a US Firm, cash
inflow of British firm is exposed to foreign exchange and in case of the US based firm cash outflow is exposed
to foreign exchange. Foreign exchange exposure is the risk associated with activities that involve a global firm
in currencies other than its home currency. Essentially, it is the risk that a foreign currency may move in a
direction which is financially detrimental to the global firm.
Types
1- Transactions exposure
It is inherent in all foreign currency denominated transactions. It involves the risk arising out of
the various type of transactions that require settlement in foreign currency. The transaction may
be export of goods or service or import of goods and service. This type of risk arises due to
fluctuations in exchange rate between the time at which the contract is concluded in foreign
currency and at the time at which settlement is made.
2- Translation exposure (accounting exposure)
It arises due to a company having foreign branches or foreign subsidiaries, whose accounts are to
be consolidated with the account of the parent branch at the end of the year. At the time of
finalizing of accounts, the foreign currency assets and liabilities are to be converted to domestic
currency. At this time translation exposure arises due to fluctuations in exchange rates.
3- Operating exposure
As the economy becomes increasingly globalized, many firms are subjected to international
competition. The fluctuations in exchange rate shall alter the competitive position of firms in
domestic market as well as foreign market. this will affect their operating cash flows. This is
known as operating exposure.
Hedging
In the context of financial markets, hedging means eliminating the risk in an asset or liability. It is a technique
of managing the risk attached to asset including foreign exchanges. In short, hedging means covering the risk.
Firms engaged in international business shall hedge their exposure to currency risk. In the context of foreign
exchange risk, hedging means entering to transaction for eliminating or reducing foreign exchange risks. It is a
transaction intended to reduce the risk of loss from price fluctuations. Hedging the currency risk would mean

Downloaded by Jelani Greer ([email protected])

 lOMoARcPSD|11729826

buying foreign currency at a future date at pre agreed exchange rate, and pricing products using that currency
exchange rate.
Foreign exchange risk management techniques
Some techniques are available to manage the risk associated with assets like securities and foreign exchanges.
All these techniques can be classified in to three internal techniques, external techniques, and other techniques.
Internal techniques
1- Leading and lagging ( if the domestic currency expected to depreciate against foreign currency, then
payments are preponed to take advantages of lesser rate of foreign currency but receipts are postponed.
This is leading. If domestic currency expected to appreciate against foreign currency, payments are
postponed, while receipting are preponed. This is known as lagging)
2- Netting ( parent company and its subsidiaries periodically settle on the net balance basis instead of
making two way flows of money paying and receiving. This is called netting)
3- Sourcing ( if sourcing of the material is shifted to a third currency. The adverse effect of exchange
appreciation on export competitiveness is minimized by sourcing goods from the importing country it
self or from countries whose currencies are not appreciating)
4- Relocating
5- Multi currency assets and liabilities (this technique is based on the simple adage. “do not put all eggs in
one basket” if assets and liabilities are denominated in difference currencies the adverse fluctuation in
one currency will be compensated by favorable fluctuations in the other currency)
6- Money market hedge
7- Arbitrage operations
8- Interest rate ceiling
9- Caps, floors and collars
10- Matching receipts and payments
11- Cross currency roll over
12- Re- invoicing centre
External techniques
1- Forwards (: One way to deal with the FX risk is to engage in a forward transaction. In this transaction,
money does not actually change hands until some agreed upon future date. A buyer and seller agree on
an exchange rate for any date in the future and the transaction occurs on that date, regardless of what the
market rates are then. The date can be a few days, months or years in future.)
2- Futures (: Foreign currency futures are forward transactions with standard contract sizes and maturity
dates � for example, 500,000 British pounds for next November at an agreed rate. These contracts are
traded on a separate exchange set up for that purpose.)
3- Options (To address the lack of flexibility in forward transactions, the foreign currency option was
developed. An option is similar to a forward transaction. It gives its owner the right to buy or sell a
specified amount of foreign currency at a specified price at any time up to a specified expiration date)
4- Swaps (The most common type of forward transaction is the currency swap. In a swap, two parties
exchange currencies for a certain length of time and agree to reverse the transaction at a later date.)
Other techniques
1- Careful choice of the invoice currency
2- Cross hedging
3- Hybrid derivatives

Downloaded by Jelani Greer ([email protected])