The
understanding of foreign exchange is a must for Multi- national Enterprises and
small export and import companies if they want to be effective. The exchange
rate can exercise an influence on a wholesaler or a retailer where they buy or
sell products. It also can influence a manufacturer who buys raw materials or
components and produces products or can affect the location of capital that a
company needs in order to expand.
In a business situation, there is a
fundamental difference between making payment in the domestic market and making
payment abroad. A domestic transaction, involves only one currency; in a
foreign transaction, two or more currencies may be used. For example, an Indian
company that exports Rs.10 million worth of diamond to a US distributor will
ask the US buyer to remit payment in rupees, unless the Indian company has some
specific use for US dollar. That can be in case the Indian company imports
components from US and can use the dollar to pay the US exporter.
The various kinds of instruments
used for making payment abroad are collectively referred to as foreign exchange. Sometimes it is
difficult to understand and relate to different currencies. An understanding of
foreign exchange includes knowing the national and global context in which
exchange rates are determined and how foreign exchange is used in international
transactions. In this chapter we discuss the meaning of foreign exchange,
nature of foreign exchange market, its various characteristics,
Spot Rates and
Forward Rates, Foreign Exchange Swaps, Futures and Options, the determination
of exchange rate
EXCHANGE
RATE
Each country has
a currency in which the prices of goods and services are quoted- the dollar in
the United States, the euro in European market, the pound sterling in Britain,
the yen in Japan, the rupee in India, and the peso in Mexico. Exchange rates
play an important role in international trade because they permit us to compare
the prices of goods and services produced in different countries.
Households and firms use exchange
rates to translate foreign prices into domestic currency. Once the prices of
domestic goods and imports have been expressed in terms of the same currency,
households and firms can work out the relative prices that affect international
flows.
An exchange rate is the number of
units of one currency that must be given to acquire one unit of another
currency.
Spot rate
The spot rate is the
current market price or 'cash' rate. Spot transactions do not require immediate
settlement, or payment 'on the spot'. The settlement date is usually the second
business day after the deal date on which the transaction is made by the two
pars ties. The exchange process is known as settlement. The sport rate also
applies to over-the-counter (OTC) transactions, usually involve nonblank
customers and require same-day settlement.
The forward rate is a
contractual rate between a foreign-exchange trader and the trader’s client for
delivery of foreign currency sometime in the future, after at least two
business days but generally after at least one month.
The Spot Market
Most foreign currency
transactions take place between foreign-exchange traders. The traders quote the
rates, who work for foreign-exchange brokerage houses or commercial banks. The
traders always quote a bid (buy) and offer (sell) rate. The bid is the price at
which the trader is willing to buy foreign currency. The offer is at which the
trader is willing to sell foreign currency. In the spot market. The spread is
the difference between the bid and offer rate in the spot market. It is
the margin on which the trader earns a profit on the transaction.
The Cross Rate is another important definition that applies
to the spot market. The cross rate is computed from two other exchange rates. Since
most foreign-currency transactions are denominated in terms of U.S. dollars, it
is common to see two non-dollar currencies related to each other by a cross
rate. For example, if we use the
indirect quotes for the Swiss franc and German mark and figure the cross rate
with the franc as the quoted currency and the market as the base currency will
be franc/mark.
The Forward Market
Other than spot transaction, transactions may be entered into
on one day but not settled after two business days. These transactions are called
as forward market. For example, an Indian exporter of diamond might sell
diamond to a U.S. importer with immediate delivery but payment not required for
thirty days. The U.S. importer is obliged to pay in U.S. dollars in thirty days
and may enter into a contract with a trader to deliver dollars in thirty days
at a forward rate, the rate today for future delivery.
Direct Quotes for US
Dollars and Euro
Rate British Euro
Forward
(90 day) 1.87670 1.29940
Spot 1.87695 1.29930
Points -25 +10
The premium or discount can also be
computed in terms of an annualized percentage using the following formula:
Premium or discount =
F-S/SX12/N X 100
Where
F = the forward rate on
the day the contract is entered into
S = the spot rate on that
day
N = the number of months
forward
100 is used to convert the
decimal figure to a percentage
We can compute discount or
premium using this formula.
Discount 1.87670-1.87695/ 1.87695 X 12/3 X100 = -0.05327
We can say that the
British pound is selling at a discount of 0.05327 percent per annum under the
spot rate.
Forward markets do not exist for all currencies in all
countries.
Quoting Conventions: What the Numbers Mean
Currencies are always quoted in pairs. One unit of the base
currency (first currency in the pair) represents the number of units of the
second currency of the pair as indicated by the exchange rate.
Example: USD/CHF @
1.4000. This means 1 US dollar purchases 1.4000 Swiss francs.
Example: USD/JPY @
120.50. This means that 1 US dollar purchases 120.50 Japanese yen.
In
the OTC spot FX market, currencies are always quoted in pairs: for instance, a
trader cannot simply trade the US dollar (USD); instead, he/she must trade the
US dollar against another pair, such as the Japanese yen (JPY) or Swiss franc
(USD/CHF). The spot FX market involves speculation upon the exchange rate
between two currencies, and hence the two currencies whose exchange rate is
being speculated upon must be identified via the quoting conventions.
Suppose
a trader purchase 1 lot of EUR/USD at a rate of 1.0795. What does this mean?
The quoting convention in the OTC spot FX market essentially means that 1 unit
of the base currency (first currency in the pair) purchases the number of units
measured by the exchange rate of the counter currency (second currency in the
pair). So, in the aforementioned example, 1 euro purchases 1.0795 US dollars.
From
a speculation viewpoint, it is beneficial to think from the perspective of the
first currency in the pair (the base currency). If you believe the base
currency will rise in value, then you would buy the pair; alternatively, if you
believe the base currency will fall in value, then you would sell the pair and
profit as the exchange rate moved down.
FOREIGN EXCHANGE MARKET MECHANISM
The various aspects of the spot and forward foreign-exchange
markets, such as the types of transactions, the important countries where
foreign exchange is traded, and the major currencies traded on a daily basis. Different
institutions, such as banks and brokers, also play their role in trading
currencies and the procedures they follow in making the trade. Some of the
specific nonblank markets are also there where derivatives are traded.
Foreign Currency Market
Commercial banks conduct most of the foreign-exchange
transactions. The foreign exchange market is voluminous
All non-spot foreign-exchange instruments are collectively
known as derivatives. The outright forward is a forward contract that is not
connected to a spot transaction. Foreign exchange forward contract
is a commitment by the client to buy or sell one currency against another at a
fixed rate for delivery on a specified future date, or during a period.
Corporate can buy/ sell outright dollars to hedge genuine underlying exposure
with certain restrictions Onshore Inter- bank forward market is liquid up to 1
year A foreign exchange forward contract allows you to protect yourself against
future exchange rate fluctuations, usually for periods of up to 12 months. The
exchange rate is locked in for a specific future date (or series of dates) for
the purpose of purchasing or selling foreign currency. The issue of forward contracts is in amounts
of $20,000 or more. The Real benefits of forward contract may be said as:
- Guarantees that a rate will apply at a future date: you can choose a specific date or a 30-day option for partial foreign currency transactions (minimum amount $5,000).
- Protects your accounts receivable from fluctuations; you know what rate will apply when payment is received.
- Simplifies the implementation of a selling price policy; makes determining the price of your products in foreign currency easier because you know what exchange rate will apply when you receive payment for them.
- Also allows you to lock in the dollar value of a debt denominated in a foreign currency when payable at a later date; prevents the cost of your supplies from being affected by a drop in the loonie.
A
Swap is a transaction involving the
exchange of two currency amounts on a specific date and a reverse exchange of
the same amounts at a later date. A Currency Swaps is a foreign exchange transaction in which the bank agrees
to exchange specified amount of one currency for another currency at a fixed
price. The bank and the client agree to exchange cash flow for both
principle and interest Rupee interest rates swaps
The Bank contracts to exchange a fixed interest liability for a floating interest rate liability or vice versa on behalf of the client. No exchange of principle amount, only difference in cash flows are settled Benchmark rates from NSE MIBOR, Reuters MIBOR, T-Bills rates are normally used. If you have accounts receivable and payable in the same currency but at different dates, a swap may be your best option. Let's say you've taken out a loan in Canadian dollars to import raw materials from the US to produce goods you will export back to the US. You can sell us the borrowed Canadian dollars to get US dollars to pay your suppliers, and simultaneously make a forward purchase of Canadian dollars (in the amount of the loan at maturity) for the sale of the US dollars you'll receive following the sale of your product. This gives you both access to Canadian dollars and protection against exchange rate fluctuations. Swaps may be usually made in amounts of $20,000 or more.
The Bank contracts to exchange a fixed interest liability for a floating interest rate liability or vice versa on behalf of the client. No exchange of principle amount, only difference in cash flows are settled Benchmark rates from NSE MIBOR, Reuters MIBOR, T-Bills rates are normally used. If you have accounts receivable and payable in the same currency but at different dates, a swap may be your best option. Let's say you've taken out a loan in Canadian dollars to import raw materials from the US to produce goods you will export back to the US. You can sell us the borrowed Canadian dollars to get US dollars to pay your suppliers, and simultaneously make a forward purchase of Canadian dollars (in the amount of the loan at maturity) for the sale of the US dollars you'll receive following the sale of your product. This gives you both access to Canadian dollars and protection against exchange rate fluctuations. Swaps may be usually made in amounts of $20,000 or more.
An option is the right but not the obligation to buy or sell a foreign currency within a certain time period or on a specific date.
Currency options allow you to build strategies to meet your needs. The Real benefits of currency options may be stated as
· Options give the right, but not the obligation, to buy or sell currencies at a fix date and rate. Options may usually be taken in amounts of $20,000 or more.
- A small contract premium applies, based on the spot rate, date selected and currency volatility.
- Options allow you to make a profit when exchange rates shift in your favour and protect you when the opposite occurs.
- Available in $US, euros, FS, ¥, and £ or in other currencies upon request.
Over-the-counter (OTC) Currency Options
Currency options are useful hedging tools, providing the option buyer with the
protection against currency fluctuations, while still allowing the buyer to
benefit from favorable currency movements. OTC currency options give the buyer
the right to buy (call options) or sell (put options) a specified amount of a
currency at a predetermined price (strike rate) on or before the option matures
(expiry date). The OTC currency options market is a very liquid market with
tight two way prices quoted round-the-clock. Premiums on options are settled
two business days after trade date. Options involve risk and are not suitable
for all investors. For general information on the uses and risks of options,
you can obtain a copy of Characteristics and Risks of Standardized Options from
Smith Barney, Options Department, 390Greenwich Street, New York, NY 10013 or
from your Smith Barney Financial Consultant.
The
futures contracts are similar to forward contract in that it specifies an
exchange rate sometime in advance of the actual exchange of currency. However,
it is not so flexible as a forward contract because it is for a specific
currency amount and a specific maturity date. On the other hand, a forward
contract can be adjusted to fit the size of the transactions and the maturity
date Forward contracts very much depend on a client’s relationship with a
bank’s foreign exchange trader, but a futures contract can be entered into by
anyone through a securities broker.
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