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KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE UNIT III FOREX MANAGEMENT Foreign Exchange Markets – Spot Prices and Forward Prices – Factors influencing Exchange rates – The effects of Exchange rates in Foreign Trade – Tools for hedging against Exchange rate variations – Forward, Futures and Currency options – FEMA – Determination of Foreign Exchange rate and Forecasting. Contents 3.1 INTRODUCTION ................................................................................................................................. 3 3.2 FOREIGN EXCHANGE MARKETS - MEANING ..................................................................................... 3 3.3 NATURE OF FOREIGN EXCHANGE MARKET ...................................................................................... 3 3.4 PARTICIPANTS of FOREX MARKET ..................................................................................................... 5 3.5 SETTLEMENTS.................................................................................................................................... 7 3.5.1 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET ............................................................ 7 3.6 FACTORS AFFECTING EXCHANGE RATE............................................................................................. 8 3.7 FOREIGN EXCHANGE RISK ............................................................................................................... 11 3.7.1 Types of Risk/Exposure ............................................................................................................ 12 3.7.1.1 Transaction Exposure ........................................................................................................ 12 3.7.1.2 Economic Exposure ........................................................................................................... 12 3.7.1.3 Translation Exposure......................................................................................................... 13 3.8 HEDGING TECHNIQUES ................................................................................................................... 13 3.8.1 Definition of 'Spread' ............................................................................................................... 13 3.8.2 Strike Price ............................................................................................................................... 14 3.8.3 Hedging Techniques Types....................................................................................................... 15 3.8.3.1 INTERNAL TECHNIQUES .................................................................................................... 15 3.8.3.2 EXTERNAL TECHNIQUES .................................................................................................... 17 3.8.4 DIFFERENCE BETWEEN FORWARD AND FUTURE MARKET ...................................................... 21 Option Contract Specifications ......................................................................................................... 21 Option Class .................................................................................................................................. 21 Strike Price .................................................................................................................................... 22 Premium........................................................................................................................................ 22 Expiration Date ............................................................................................................................. 22 Option Style................................................................................................................................... 22 Underlying Asset ........................................................................................................................... 22 Contract Multiplier........................................................................................................................ 22 1 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE 3.9 FOREIGN EXCHANGE MANAGEMENT ACT (FEMA), 1999 ............................................................... 22 3.9.1 Objectives of FEMA .................................................................................................................. 23 3.9.2 Scope of FEMA ......................................................................................................................... 23 3.9.3 Highlights of FEMA ................................................................................................................... 23 3.9.4 Applicability of FEMA ............................................................................................................... 24 3.9.5 Authorities responsible for various aspect of FEMA............................................................ 26 3.9.6 Distinguish between FERA and FEMA. ..................................................................................... 26 3.10 DETERMINANTS OF EXCHANGE RATE ........................................................................................... 27 3.11 FORECASTING FOREIGN-EXCHANGE RATES .................................................................................. 40 3.11.1 Forecasting exchange rates ................................................................................................... 40 3.11.2 Exchange Rate Forecasting in Practice .................................................................................. 42 3.11.3 Forecasting in Practice ........................................................................................................... 42 3.12 IMPACT AND EFFECTS OF EXCHANGE RATE.................................................................................. 43 3.13 ROLE OF RBI IN FOREIGN EXCHANGE MARKET ............................................................................. 46 3.14 Expected Questions – 16 marks .................................................................................................... 48 2 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE 3.1 INTRODUCTION The Foreign Exchange Market (FOREX, FX, or currency market) is a global decentralized market for the trading of currencies. The main participants in this market are the larger international banks. The foreign exchange market works through financial institutions, and it operates on several levels. The foreign exchange market assists international trade and investment by enabling currency conversion. For example, it permits a business in the United States to import goods from the European Union member states, especially Eurozone members, and pay euros, even though its income is in United States dollars. It also supports direct speculation in the value of currencies, and the carry trade, speculation based on the interest rate differential between two currencies. 3.2 FOREIGN EXCHANGE MARKETS - MEANING Foreign exchange market is a market in which foreign currencies are bought and sold. Foreign exchange market is a system facilitating mechanism through which one country currencies can be exchanged for the currencies of another country.” 3.3 NATURE OF FOREIGN EXCHANGE MARKET Foreign exchange market refers to the market in which participants are able to buy, sell, exchange and speculate on currencies. Foreign exchange markets are made up of banks, commercial companies, central banks, investment management firms, hedge funds, and retail foreign exchange brokers and investors. The foreign exchange market is considered to be the largest financial market in the world. The foreign exchange market is a global, worldwide-decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies. The foreign exchange market assists international trade and investment by enabling currency conversion. For example, it permits a business in the United States to import goods from the European Union member states especially Euro zone members and pay Euros, even though its income is in United States dollars. The foreign exchange market determines the relative values of different currencies. 3 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE The foreign exchange market assists international trade and investment by enabling currency conversion. For example, it permits a business in the United States to import goods from the European Union member states especially Euro zone members and pay Euros, even though its income is in United States dollars. Foreign Exchange Market: Global market Over the counter market Around the clock market Banks are involved in 95% cases. 1-2% transactions are for actual transaction rest for speculation. Money and near money instruments are denominated in foreign currency is foreign exchange. There is no physical transfer of money it is online. A party can never be a demander of one currency without being simultaneously a supplier of another. Volatile, affected by hedger, arbitrager, speculator. Affected by demand and supply. Affected by rate of interest. Affected by balance of payment surplus and deficit. Affected inflation rate. Spot and forward rates are different. Affected by the economic stability of the country. Affected by the fiscal policy of the government. Affected by the political condition of the country. It can be quoted directly or indirectly 4 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE 3.4 PARTICIPANTS of FOREX MARKET Exchange companies and individuals Traveller s and Tourists All Scheduled Commerci al Banks Central Banks Participants of FOREX market FOREX Brokers Hedgers Arbitra gers Speculat ors MNC’s All Scheduled Commercial Banks Reserve Bank of India (RBI). - Central Banks Speculators FOREX Brokers MNC’s Arbitragers Hedgers Travellers and Tourists Exchange companies and individuals Speculators Speculators seek to profit from changes in foreign exchange rates based upon their expectations. This class of participants, actively expose themselves to currency risk by buying and selling currencies in the forward market to profit from exchange rate fluctuations. Arbitrators 5 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE This class of participants seeks to earn risk-free profits by seeking advantage of differences in the prices of currencies, in interest rates among various countries. they use forward contract to hedge risk. Hedgers:Many MNCs engage themselves in forward contract to protect the home currency values of F.C. denominated assets and liabilities on their balance sheet that are not to be realized over the life of contract. They also hedge receivables and payables. Risk Quantum Speculator Arbitrator Hedger • High risk • No risk • Low risk Structure of Foreign Exchange Market Exchange rate market has three segments: Transactions between R.B.I. and Authorized dealers (Commercial banks). Transactions among authorized dealers. Transaction among authorized dealers and customers (Retail segment). 6 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE 3.5 SETTLEMENTS Cash/Ready • Settlement made on The same day. Tom • On the next working day (tomorrow). Spot • When the exchange of currencies takes place on the second day, working day after the date of deal is called spot rate. 3.5.1 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET Two Types of Currency Markets Spot Market Forward Market • When the exchange of currencies takes place on the second day, working day after the date of deal is called spot rate. • Settlement made at some future date Spot Prices / Spot Market The spot market refers to that segment of the foreign exchange market in which sale and purchase transactions are settled within two days of the deal. i.e. when buyers and sellers of a currency settle their transaction within two days of the deal is called as spot transaction. Forward Market The forward exchange market refers to the foreign exchange deals for sale and purchase of foreign currency at some future date, normally after 90 days of the deal. 7 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE When buyers and sellers enter an agreement to buy and sell a foreign currency after 90 days of the deal at the agreed rate of exchange, it is called forward transaction. 3.6 FACTORS AFFECTING EXCHANGE RATE Introduction: Every country has its own currency that has its own individual value. Whether you are an active trader in the foreign exchange market, planning your vacation abroad or shopping an exotic product online, understanding of exchange rate is essential. The value of currency across the world differs as the Kuwaiti dinar varies from the US dollar. The fact that a country‘s financial healthiness is judged by its exchange rate, makes evident its significance. Other than factors like interest rate and inflation, exchange rate is deemed to play a pivotal role in the country’s trade activities with it being one of the most valued factors. A higher currency makes a country's exports more expensive and imports cheaper in foreign markets; a lower currency makes a country's exports cheaper and its imports more expensive in foreign markets. A higher exchange rate can be expected to lower the country's balance of trade, while a lower exchange rate would increase it. Exchange Rate: Understanding the Term Exchange rates are determined by supply and demand. For example, if there was greater demand for American goods then there would tend to be an appreciation (increase in value) of the dollar. If markets were worried about the future of the US economy, they would tend to sell dollars, leading to a fall in the value of the dollar. The exchange rate is the rate at which one country’s currency may convert into another currency. Note: Appreciation = increase in value of exchange rate Depreciation / devaluation = decrease in value of exchange rate. A country with a stronger currency will lose as its exports will be more expensive and imports will be cheaper in the foreign market. On the contrary, a country with a weaker currency will benefit from as imports will be expensive and exports cheaper. Depreciation and Appreciation of currency A decline in a currency’s value is referred to as depreciation and an increase in currency’s value is called appreciation. 8 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE If currency A can buy you more units of foreign currency, currency A has appreciated and foreign currency depreciated If currency A can buy you less units of foreign currency, currency A has depreciated and foreign currency appreciated Factors Influencing Exchange Rate – Diagrammatic Representation Political factors International Trade Stock Exchange operations Economic Expectations Balance of payment Facto rs Capital movements Exchange rate policy & Interventions strength of the economy Government Policies & measures Inflation Speculation Sentiment s International Trade Trade of goods and services between countries is the major reason for the demand and supply of foreign currencies. The value or strength or weakness of a country’s currency in terms of other currencies depends on its trade with those countries. If a country’s import is higher, the demand for foreign currency will be high. Higher demand for foreign currency means high value of foreign currency and low value of domestic currency. The current account balance (deficit or surplus) thus reflects the strength and weakness of the domestic currency. Strength of the Economy: The strength of the economy affects the demand and supply of foreign currency. If an economy is growing fast and is strong it will attract foreign currency thereby strengthening its own. On the other hand, weaknesses result in an outflow of foreign exchange. If a country is a net exporter (as were Japan and Germany), the inflow of foreign 9 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE currency far outstrips the outflow of their own currency. The result is usually a strengthening in its value. Balance of Payment: It is the total number of transactions including its exports, imports, debt, etc. that a country deals with, in comparison to other countries determining the amount it has to pay or receive. A country that is in a position to receive more than pay will have a higher value for its currency and vice versa. Government policies and measures: A country prone to political turmoil and continuous clashes will deter the investor’s confidence lowering the value of the currency. However, a country with sound financial and trade policies without giving room for uncertainties will witness a positive influence on the value of a currency directly and indirectly, as it will influence every aspect of trade including tariffs, exports and imports, etc. Sentiment: The way, market perceives our economy as an investment destination, is essential. If it confides in our policies and believes that we are on the right track, paving way for an unprecedented growth, it will express its interest by investing with the expectation of receiving lucrative returns. Hence, sentiment of the market tends to be a major determinant of a country’s exchange rate. Inflation: A country with lower inflation will have an upper-hand in the market and have a higher currency value. On the other hand, countries with high inflation will consequently witness depreciation in their currency in comparison to the currencies of their global counterparts. Interest Rates: When interest rate for a particular currency rises, it will have a consequent effect on the yields for the assets denominated in that particular currency, nudging way for an increase in demand by investors and hence, increase the value of currency. Investors generally try to seek a balance between yield returns and safety of funds. Capital Movements: Capital movements are one of the most important reasons for changes in exchange rates. Capital movements of foreign currency are usually more than connected with international trade. This occurs due to a variety of reasons – both positive and negative. When India began its economic liberalisation and invited Foreign Institutional Investors (FIIs) to purchase equity shares in Indian companies, billions of US dollars came into the country strengthening the currency. In 1996 and 1997, FIIs took several billion US dollars out of the country weakening the currency. These were capital outflows. One of the reasons popularly believed for the rupee not depreciating in the manner other South-east Asian 10 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE currencies did in 1997-98 was because the rupee was not convertible on the “capital account”. Speculation: Speculation in a currency raises or lowers the exchange rate. For instance, the foreign exchange market in India is very shallow. If a speculator enters and buys US $1 million, it will raise the value of the US dollar significantly. If a few others do so too, the price of the US dollar will rise even further against the Indian rupees. Exchange Rate Policy and Intervention: Exchange rates are also influenced, in no small measure, by expectation of change in regulations relating to exchange markets and official intervention. Official intervention can smoothen an otherwise disorderly market. As explained before, intervention is the buying or selling of foreign currency to increase or decrease its supply. Central banks often intervene to maintain stability. It has also been experienced that if the authorities attempt to half-heartedly counter the market sentiments through intervention in the market, ultimately more steep and sudden exchange rate swings can occur. Economic Expectations: Exchange rates move on economic expectations. After the 1999 budget in India there was an expectation that the rupee would fall by 7% to 9%. Since such expectations affect the external value of the rupee, all economic data – the balance of payments, export growth, inflation rates and the likes – are analysed and its likely effect on exchange rates is examined. If the economic downturn is not as bad as anticipated the rate can even appreciate Stock exchange operations Stock exchange operations in foreign securities, debentures, stocks and shares influence the demand and supply of related currencies, thus influencing their exchange rate. Political factors Political scenario of the country ultimately decides the strength of the country. Stable efficient government at the centre will encourage positive development in the country, creating investor confidence and a good image in the international market. An economy with a strong, positive image will obviously have a strong domestic currency. 3.7 FOREIGN EXCHANGE RISK 11 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE Foreign exchange risk (also known as exchange rate risk or currency risk) is a financial risk posed by an exposure to unanticipated changes in the exchange rate between two currencies. Investors and multinational businesses exporting or importing goods and services or making foreign investments throughout the global economy are faced with an exchange rate risk which can have severe financial consequences if not managed appropriately. 3.7.1 Types of Risk/Exposure Transaction exposure Operating exposure Accounting exposure 3.7.1.1 Transaction Exposure Transaction exposure is the effect of an exchange rate change on outstanding obligations, such as imports and exports. Transaction exposure involves actual cash outflows. A firm has transaction exposure whenever it has contractual cash flows (receivables and payables) whose values are subject to unanticipated changes in exchange rates due to a contract being denominated in a foreign currency. 3.7.1.2 Economic Exposure A firm has economic exposure (also known as operating exposure) to the degree that its market value is influenced by unexpected exchange rate fluctuations. Such exchange rate adjustments can severely affect the firm's market share|position with regards to its competitors, the firm's future cash flows, and ultimately the firm's value. Economic exposure can affect the present value of future cash flows. Any transaction that exposes the firm to foreign exchange risk also exposes the firm economically, but economic exposure can be 12 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE caused by other business activities and investments which may not be mere international transactions, such as future cash flows from fixed assets. A shift in exchange rates that influences the demand for a good in some country would also be an economic exposure for a firm that sells that good. 3.7.1.3 Translation Exposure Accounting or translation exposure is the effect of an exchange rate change on financial statement items. Translation exposure does not involve actual cash flows. A firm's translation exposure is the extent to which its financial reporting is affected by exchange rate movements. As all firms generally must prepare consolidated financial statements for reporting purposes, the consolidation process for multinationals entails translating foreign asset]s and liabilities or the financial statements of foreign subsidiary /subsidiaries from foreign to domestic currency. While translation exposure may not affect a firm's cash flows, it could have a significant impact on a firm's reported earnings and therefore its stock price. Translation exposure is distinguished from transaction risk as a result of income and losses from various types of risk having different accounting treatments. 3.8 HEDGING TECHNIQUES In simple language, a hedge is a technique used to reduce any substantial losses/gains suffered by an individual or an organization. A hedge is an investment position intended to offset potential losses/gains that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of over-the-counter and derivative products, and futures contracts. A risk management strategy used in limiting or offsetting probability of loss from fluctuations in the prices of commodities, currencies, or securities. In effect, hedging is a transfer of risk without buying insurance policies. 3.8.1 Definition of 'Spread' The difference between the bid and the ask price of a security or asset. 13 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE The spread for an asset is influenced by a number of factors: a) Supply or "float" (the total number of shares outstanding that are available to trade) b) Demand or interest in a stock c) Total trading activity of the stock Therefore, currencies are quoted in terms of their price in another currency. In order to express this information easily, currencies are always quoted in pairs (e.g. USD/CAD). The first currency is called the base currency and the second currency is called the counter or quote currency (base/quote). For example, if it took C$1.20 to buy US$1, the expression USD/CAD would equal 1.2/1 or 1.2. The USD would be the base currency and the CAD would be the quote or counter currency. Now that we know how currencies are quoted in the marketplace, let's look at how we can calculate their spread. Forex quotes are always provided with bid and ask prices, similar to what you see in the equity markets. The bid represents the price at which the forex market maker is willing to buy the base currency (USD in our example) in exchange for the counter currency (CAD). Conversely, the ask price is the price at which the forex market maker is willing to sell the base currency in exchange for the counter currency. Forex prices are always quoted using five numbers; so, for this example, let's say we had a USD/CAD bid price of 120.00 and an ask of 120.05. Thus, the spread would be equal to 0.05, or $0.0005. 3.8.2 Strike Price The price at which a specific derivative contract can be exercised is called as Strike price. Strike price is mostly used to describe stock and index options, in which strike prices are fixed in the contract. For call options, the strike price is where the security can be bought (up to the expiration date), while for put options the strike price is the price at which shares can be sold. The difference between the underlying security's current market price and the option's strike price represents the amount of profit per share gained upon the exercise or the sale of the option. This is true for options that are in the money; the maximum amount that can be lost is the premium paid. finance, the strike price (or exercise price) of an option is the fixed price at which the owner of the option can buy (in the case of a call), or sell (in the case of a put), the underlying security or commodity. 14 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE 3.8.3 Hedging Techniques Types Two types of Hedging techniques are 1. Internal Techniques 2. External techniques HEDGING TECHNIQUES External Techniques Internal Techniques 1. 2. 3. 4. 5. 1. Pricing Policy 2. Netting: 3. Leading and lagging 4. Shifting the manufacturing base 5. Swaps 6. Centre for re-invoicing. Forward Market Future Market Currency Options Swaps Foreign debt 3.8.3.1 INTERNAL TECHNIQUES Sometimes known as commercial or natural, these techniques are within the internal management control of the company. Pricing: Pricing of the product should be done in the currency in which the majority of the costs are incurred i.e. n the domestic currency of the main competitors, so that comparative prices are less affected by exchange rate variations. In order to manage foreign exchange risk exposure, there are two types of pricing tactics: price variation and currency of invoicing policy. One way for companies to protect themselves against exchange risk is to increase selling prices to offset the adverse effects of 15 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE exchange rate fluctuations. Selling price requires the analysis of Competitive situation, Customer credibility, Price controls and Internal delays. Matching: Setting up an equal and opposite commercial transaction when the original exposure is created—for example, using the currency receivable to buy a commodity used by the business. Borrow in the same currency as that needed to complete the asset purchase. The netting is typically used only for inter company flows arising out of groups receipts and payments. As such, it is applicable only to the operations of a multinational company rather than exporters or importers. In contrast, matching applies to both third parties as well inter-company cash flows. It can be used by the exporter/importer as well as the multinational company. It refers to the process in which a company matches its currency inflows with its currency outflows with respect to amount and timing. Receipts generated in a particular currency are used to make payments in that currency and hence, it reduces the need to hedge foreign exchange risk exposure. Hedging is required for unmatched portion of foreign currency cash flows. The aggressive company may decide to take forward cover on its currency payables and leave the currency receivables exposed to exchange risk; if forward rate looks cheaper than the expected spot rate. In matching operation, the basic requirement is a two-way cash flow in the same foreign currency. This kind of operation is referred to as natural matching. Parallel matching is another possibility. In parallel matching, gains in one foreign currency are expected to be offset by losses in another, if the movements in two currencies are parallel. In parallel matching, there is always the risk that if the exchange rates move in opposite direction to expectations, both sides of the parallel match leads to exchange losses or gains. Netting: A partial alternative to matching—a net amount is still left exposed, but the overall risk is reduced. Netting implies offsetting exposures in one currency with exposure in the same or another currency, where exchange rates are expected to move high in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure. It is of two types bilateral netting & multilateral netting. In bilateral netting, each pair of subsidiaries nets out their own positions with each other. Flows are reduced by the lower of each company’s purchases from or sales to its netting partner. Leading and lagging: Simply, either delaying payment, or settling early, in anticipation of falling or rising exchange rates. Safe, and simple to manage, but there is a reliance on the accuracy of a forecast. 16 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE It refers to the adjustment of intercompany credit terms, leading means a prepayment of a trade obligation and lagging means a delayed payment. It is basically intercompany technique whereas netting and matching are purely defensive measures. Intercompany leading and lagging is a part of risk-minimizing strategy or an aggressive strategy that maximizes expected exchange gains. Leading and lagging requires a lot of discipline on the part of participating subsidiaries. Multinational companies which make extensive use of leading and lagging may either evaluate subsidiary performance in a pre-interest basis or include interest charges and credits to overcome evaluation problem. Another important complicating factor in leading & lagging is the existence of local minority interests. If there are powerful local shareholders in the ‘losing’ subsidiary, there will be strong objections because of the added interest cost and lower profitability which results from the consequent local borrowing Government by implementing credit and exchange controls may restrict such operations. Intercompany payment discipline: Intercompany payables and receivables are real exposure and should be ranked equally for settlement with external liabilities. There is no canceling gain or loss situation within a group. When the transaction interacts with the market there will be a gain or a loss—and it will be real. 3.8.3.2 EXTERNAL TECHNIQUES External techniques involve the use of external contracts. Companies purchase or sell forward contracts, options, swaps, futures, etc. in order to protect themselves against the exchange rate risk. External techniques insure against the possibility of exchange losses which will occur from an exposed position which internal measures have not been able to eliminate. Forwards:A forward is a made-to-measure agreement between two parties to buy/sell a specified amount of a currency at a specified rate on a particular date in the future. The Depreciation of the receivable currency is hedged against by selling a currency forward. If the risk is that of a currency appreciation (if the firm has to buy that currency in future say for import), it can hedge by buying the currency forward. Futures:A futures contract is similar to the forward contract but is more liquid because it is traded in an organized exchange i.e. the futures market. 17 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE Depreciation of a currency can be hedged by selling futures and appreciation can be hedged by buying futures. Advantages of futures are that there is a central market for futures which eliminates the problem of double coincidence Options:A currency Option is a contract giving the right, not the obligation, to buy or sell a specific quantity of one foreign currency in exchange for another at a fixed price; called the Exercise Price or Strike Price. The fixed nature of the exercise price reduces the uncertainty of exchange rate changes and limits the losses of open currency positions. Options are particularly suited as a hedging tool for contingent cash flows, as is the case in bidding processes. Call Options are used if the risk is an upward trend in price (of the currency), while Put Options are used if the risk is a downward trend An option is the right, but not the obligation, to exchange a fixed amount of one currency for a fixed amount of another within, or at the end of, a predetermined period. In effect, it is a forward contract that can be walked away from, where you lose only the cost of the option, which could be 3–5% of the contract value. It therefore has the advantage of limiting the downside, as the maximum cost is known at the beginning, while leaving unlimited profit potential. These options are ideally suited to translations, where the size or existence of the exposure is uncertain, for example tender-to-contract or price list exposures. Illustration: A quantity of a commodity (or currency to pay for it) is needed in three months’ time. A dealer is willing to accept US$100 per ton to supply a predetermined quantity at US$2,000 per ton. If the price of this commodity in three months’ time is US$1,700 per ton, then the option would be thrown away, the product bought in the spot market, and the cost to the company would be US$1,800 per ton. The tender-to-contract or price list item would have been safeguarded, and the price could even be reduced by US$200 per ton if competitive conditions demanded. If the price of the commodity rose, the cost to the company would be contained. The option could be sold at a profit if the product was not needed, or the loss would in any event be limited to US$100 per ton. There are two types of option: Calls—giving the right to buy a currency; Puts—giving the right to sell a currency. Currency Options The exchange rate (known as the strike price) and the expiry date of the option are chosen by the customer at the outset. The cost (known as the premium) of the option is calculated based on these decisions and the volatility of the currency involved. Options can be exchange-traded where they exist in standardized form, or bought over the counter, where they are written to fit a customer’s particular circumstances. 18 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE There are two styles of option: American option. The buyer can exercise the option (make the exchange of currencies) at any time up to the expiry date. European option. This can be exercised on the expiry date only, and is slightly cheaper because of its lack of flexibility. Options may have a resale value, determined by the same criteria as the original cost. When the exercise price of an option is better than the current spot exchange rate, it is called “in the money”; when it is the other way round, it is “out of the money.” Swaps: A swap is a foreign currency contract whereby the buyer and seller exchange equal initial principal amounts of two different currencies at the spot rate. The buyer and seller exchange fixed or floating rate interest payments in their respective swapped currencies over the term of the contract. At maturity, the principal amount is effectively re-swapped at a predetermined exchange rate so that the parties end up with their original currencies. Swap is essentially an exchange of two – transactions. It is an important instrument for hedging for foreign exchange transactions in which two streams of payments are exchanged. Example: Deposit US $ 1 million Spot rate of DM 1.4/US$ American Company Bank Variable Interest rate Borrow 1.4 million American Company Bank Fixed rate of interest Will be re-exchanged for the principal amount DM 1.4 Million American Company Bank $ 1 million 19 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE Instruments Description Pros Cons Forwards An almost custom-made contract to buy or sell foreign-exchange in the future, at a presently specified price. Maturity and size of contract can be determined individually to almost exactly hedge the desired position. Use up bank credit lines even when two forward contracts exactly offset each other. Futures A ready-made contract to buy or sell foreign exchange in the future, at a presently specified price. Unlike forwards, futures have a few maturity dates per year. The most common contracts have maturity dates in March, June, September, or December. But, these contracts are almost continuously traded on organised exchanges. Contracts sizes are fixed. No credit lines required. Easy access for small accounts. Fairly low margin requirements. Contract’s liquidity guaranteed by the exchange on which it is traded. Margin requirements cause cash-flow uncertainty and use managerial resources. Options A contract that offers the right but not the obligation to buy or sell foreign exchange in the future, at a presently specified price. Unlike forwards and futures, options do not have to be exercised. Available on an almost custom-made basis from banks or in ready-made form on exchanges. Allow hedging of contingent exposures and taking positions while limiting downside risk and retaining upside potential for profit. Also permit trade-offs other than risk versus expected return. Since an option is like insurance coupled with an investment opportunity, its benefits are not readily observable, leading some to conclude that it is “too expensive” Swaps An agreement to exchange one currency for another at specific dates and prices. Essentially, a swap is a series of forward contracts. Versatile, allowing easy hedging of complex exposures. Documentation requirement might be extensive. Foreign Debt:-Foreign debt can be used to hedge foreign exchange exposure by taking advantage of the International Fischer Effect relationship. 20 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE 3.8.4 DIFFERENCE BETWEEN FORWARD AND FUTURE MARKET Forward contracts, on the other hand, do not have such mechanisms in place. Since forwards are only settled at the time of delivery, the profit or loss on a forward contract is only realized at the time of settlement, so the credit exposure can keep increasing. Hence, a loss resulting from a default is much greater for participants in a forward contract. Futures market Exchange traded Market and Futures contracts are highly standardized Futures contracts have clearing houses that guarantee the transactions, which drastically lowers the probability of default to almost never Futures contracts are marked-tomarket daily, which means that daily changes are settled day by day until the end of the contract. Settlement for futures contracts can occur over a range of dates. Forward Market Private agreements between two parties and are not as rigid in their stated terms and conditions. Forward contracts are private agreements, there is always a chance that a party may default on its side of the agreement. Forward contracts, settlement of the contract occurs at the end of the contract. Forward contracts, on the other hand, only possess one settlement date or at the time of delivery, so the profit or loss on a forward contract is only realized at the time of settlement. Guarantee deposit Contract with Clearing House Quotation on market Commission or brokerage Frequently employed by speculators, who bet on the direction in which an asset's price will move, they are usually closed out prior to maturity and delivery usually never happens. No guarantee deposit Contract with a bank Quotation by a bank Quoted rate (spread between buying and selling rates) Hedgers that want to eliminate the volatility of an asset's price, and delivery of the asset or cash settlement will usually take place. Option Contract Specifications The following terms are specified in an option contract. Option Class The two classes of stock options are puts and calls. Call options confers the buyer the right to buy the underlying stock while put options give him the rights to sell them. 21 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE Strike Price The strike price is the price at which the underlying asset is to be bought or sold when the option is exercised. It's relation to the market value of the underlying asset affects the moneyness of the option and is a major determinant of the option's premium. Premium In exchange for the rights conferred by the option, the option buyer have to pay the option seller a premium for carrying on the risk that comes with the obligation. The option premium depends on the strike price, volatility of the underlying, as well as the time remaining to expiration. Expiration Date Option contracts are wasting assets and all options expire after a period of time. Once the stock option expires, the right to exercise no longer exists and the stock option becomes worthless. The expiration month is specified for each option contract. The specific date on which expiration occurs depends on the type of option. For instance, stock options listed in the United States expire on the third Friday of the expiration month. Option Style An option contract can be either american style or european style. The manner in which options can be exercised also depends on the style of the option. American style options can be exercised anytime before expiration while european style options can only be exercise on expiration date itself. All of the stock options currently traded in the marketplaces are american-style options. Underlying Asset The underlying asset is the security which the option seller has the obligation to deliver to or purchase from the option holder in the event the option is exercised. In the case of stock options, the underlying asset refers to the shares of a specific company. Options are also available for other types of securities such as currencies, indices and commodities. Contract Multiplier The contract multiplier states the quantity of the underlying asset that needs to be delivered in the event the option is exercised. For stock options, each contract covers 100 shares. 3.9 FOREIGN EXCHANGE MANAGEMENT ACT (FEMA), 1999 The Foreign Exchange Management Act (FEMA), 1999 replaced the Foreign Exchange Regulation Act (FERA), 1973 which regulated the foreign exchange transactions in India and which sought to control certain aspects of the conduct of business outside the country by Indian companies and in India by foreign companies. 22 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE The FEMA, which came into effect from 1st January, 2000 extends to the whole of India and also applies to all branches, offices, and agencies outside India, owned or controlled by a person resident in India. Foreign Exchange Management Act or in short (FEMA) is an act that provides guidelines for the free flow of foreign exchange in India. It has brought a new management regime of foreign exchange consistent with the emerging frame work of the World Trade Organisation (WTO). Foreign Exchange Management Act was earlier known as FERA (Foreign Exchange Regulation Act), which has been found to be unsuccessful with the proliberalisation policies of the Government of India. FEMA is applicable in all over India and even branches, offices and agencies located outside India, if it belongs to a person who is a resident of India. 3.9.1 Objectives of FEMA 1. To facilitate external trade and payments. 2. To promote the orderly development and maintenance of foreign exchange market. 3.9.2 Scope of FEMA FEMA provides 1. Free transactions on current account subject to reasonable restrictions that may be imposed. 2. RBI controls over capital account transactions. 3. Control over realization of export proceeds. 4. Dealing in foreign exchange through authorized persons like authorized dealer/money changer / off shore banking unit. 3.9.3 Highlights of FEMA It prohibits foreign exchange dealing undertaken other than an authorised person; It also makes it clear that if any person residing in India, received any Forex payment (without there being a corresponding inward remittance from abroad) the concerned person shall be deemed to have received they payment from a nonauthorised person. 23 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE There are 7 types of current account transactions, which are totally prohibited, and therefore no transaction can be undertaken relating to them. These include transaction relating to lotteries, football pools, banned magazines and a few others. FEMA and the related rules give full freedom to Resident of India (ROI) to hold or own or transfer any foreign security or immovable property situated outside India. Similar freedom is also given to a resident who inherits such security or immovable property from an ROI. An ROI is permitted to hold shares, securities and properties acquired by him while he was a Resident or inherited such properties from a Resident. The exchange drawn can also be used for purpose other than for which it is drawn provided drawl of exchange is otherwise permitted for such purpose. Certain prescribed limits have been substantially enhanced. For instance, residence now going abroad for business purpose or for participating in conferences seminars will not need the RBI's permission to avail foreign exchange up to US$. 25,000 per trip irrespective of the period of stay, basic travel quota has been increased from the existing US$ 3,000 to US$ 5,000 per calendar year. FEMA regulations have an immense impact in international trade transactions and different modes of payments.RBI release regular notifications and circulars, outlining its clarifications and modifications related to various sections of FEMA. 3.9.4 Applicability of FEMA The Foreign Exchange Management Act, 1999 was enacted to consolidate and amend the law relating to foreign exchange with the objective of facilitating external trade and for promoting the orderly development and maintenance of foreign exchange market in India. FEMA extends to the whole of India. The Act also applies to all branches, offices and agencies outside India owned or controlled by a person resident in India, and also to any contravention committed there under outside India by any person to whom this Act is applies. 24 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE Overall Structure The overall structure of Foreign Exchange Management Act, 1999 is covered by legislations rules and regulations. These legislations, rules and regulations relating to Foreign Exchange Management Act, 1999 can be divided in to the following. 1. FEMA contains 7 chapters divided into 49 sections (Supreme Legislation) 2. 5 sets of Rules made by Ministry under section 46 of FEMA. (Delegated legislations) 3. 23 sets of regulations made by RBI under section 47 of FEMA (Subordinate Legislations). 4. Master circular issued by RBI every year. 5. Foreign Direct Investment (FDI) policy issued by Department of Industrial policy and Promotion (DIPP) time to time. 6. Notifications and circulars issued by RBI. 7. Enforcement Directorate. FEMA contains 7 chapters divided into 49 sections of which 12 sections cover operational part and the rest 37 sections deal with contraventions, penalties, adjudication, appeals, enforcement directions, etc. FEMA makes provisions for dealings in foreign exchanges. The capital account transactions will be regulated by RBI/Central Government for which necessary circulars/notifications will have to be issued under FFEMA. All chapters of FEMA divided into 49 sections. Besides the FEMA, there are 5 rules and 23 regulations under the Act which help in implementation of the act are classified here: Chapter I: Preliminary (Section 1&2) Chapter II: Regulation and Management of Foreign Exchange (Section 3-9) Chapter III: Authorized Person (Section 10-12) Chapter IV: Contraventions and Penalties (Section 13-15) Chapter V: Adjudication and Appeal (Section 16-35) Chapter VI: Directorate of Enforcement (Section 36-38) Chapter VII: Miscellaneous (Section 39-49) 25 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE 3.9.5 Authorities responsible for various aspect of FEMA 1. Enforcement Directorate: They are responsible to investigate provisions of the Act, the Central Government, have established the Directorate of Enforcement with Directors and other officers as officers of the Enforcement. 2. Adjudicating Authorities The Adjudicating Authorities will issue a notice to the person who has contravened the provisions of the Foreign Exchange Management Act, Rules, Regulations, Notificatons or any directions issued by the RBI. 3. Special Director (Appeals) Any person aggrieved by an order made by the Adjudicating authority, being an Assistant Director of Enforcement or a Deputy Director of Enforcement can prefer an appeal to the special Director (Appeals). 4. Appellate Tribunal Any person aggrieved by an order made by the adjudicating Authority, or the special director (appeals) can prefer an appeal to the Appellate Tribunal. 3.9.6 Distinguish between FERA and FEMA. FERA 1. FERA means Foreign Exchange Regulation Act. FEMA FEMA means Foreign Exchange Management Act. 2. RBI’s permission was necessary in RBI’s permission is necessary only for Section 3. respect of most of the regulations. 3. Any person who contravenes Any person who contravenes is liable to penalty but not imprisonment. Dealings with Non-residents have been substantially diluted. FERA is subject to penalty and imprisonment. 4. All transactions with Non-residents were prohibited. 26 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE 3.10 DETERMINANTS OF EXCHANGE RATE The rate of exchange in the foreign exchange market will be determined by the interaction between the demand for foreign exchange and the supply of foreign exchange. Exchange Rate Equilibrium Forces of demand and supply together determine the exchange rate Demand for foreign currency Supply of foreign currency Changes in Exchange Rates Exchange rates (e) are a function of the supply and demand for currency. An increase in the supply of a currency (US$) will decrease the exchange rate of a currency ((US$). A decrease in supply of a currency will increase the exchange rate of a currency. An increase in demand for a currency will increase the exchange rate of a currency. A decrease in demand for a currency will decrease the exchange rate of a currency. Supply of Dollars (The Demand for Rupees ) 1. Firms, households, or governments that import Indian goods into the United States or want to buy British-made goods and services. 2. U.S. citizens traveling in India. 3. Holders of dollars who want to buy Indian stocks, bonds, or other financial instruments. 4. U.S. companies that want to invest in India. 5. Speculators who anticipate a decline in the value of the dollar relative to the Indian Rupee. The Demand for Dollars (Supply of Rupees) 1. Firms, households, or governments that import U.S. goods into India or want to buy U.S.made goods and services 2. Indian citizens traveling in the United States 3. Holders of Rupees who want to buy stocks, bonds, or other financial instruments in the United States 4. Indian companies that want to invest in the United States 27 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE 5. Speculators who anticipate a rise in the value of the dollar relative to the Indian Rupee. The Equilibrium Exchange Rate When exchange rates are allowed to float, they are determined by the forces of supply and demand. An excess demand for rupees will cause the rupee to appreciate against the dollar. An excess supply of rupees will lead to a depreciate rupees against the dollar. 3.10.1 EXCHANGE RATE DETERMINANTS: • Exchange rate changes • Reactions of traders in the foreign-exchange market to changes in Relative price levels Relative productivity levels Consumer preferences for domestic or foreign goods Trade barriers Relative price levels Trade barriers Determin ants of Exchang e rate Relative productivity levels Consumer preferences for domestic or foreign goods Determinants of the dollar’s exchange rate in the long term 28 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE • Increase in the U.S. price level relative to price levels in other countries • Increase in the demand for foreign currency. • Decrease in the supply of foreign currency • Depreciation of the dollar Market fundamentals that affect the dollar’s exchange rate in the long term (a) 29 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE In the long term, the exchange rate between the dollar and the pound reflects relative price levels, relative productivity levels, preferences for domestic or foreign goods, and trade barriers. • U.S. productivity growth is faster than that of other countries • • • Increase in the supply of foreign currency Decrease in the demand for foreign currency Appreciation of the dollar 30 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE Market fundamentals that affect the dollar’s exchange rate in the long term (b) In the long term, the exchange rate between the dollar and the pound reflects relative price levels, relative productivity levels, preferences for domestic or foreign goods, and trade barriers. Determining Long-Term Exchange Rates • An increased demand for U.S. exports • Appreciation of the dollar • An increased demand for U.S. imports • Depreciation of the dollar • U.S. imposes trade barriers • Appreciation of the dollar Market fundamentals that affect the dollar’s exchange rate in the long term (c) 31 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE In the long term, the exchange rate between the dollar and the pound reflects relative price levels, relative productivity levels, preferences for domestic or foreign goods, and trade barriers. Market fundamentals that affect the dollar’s exchange rate in the long term (d) 32 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE In the long term, the exchange rate between the dollar and the pound reflects relative price levels, relative productivity levels, preferences for domestic or foreign goods, and trade barriers. Purchasing Power Parity: The Law of One Price The higher price level in India makes imports relatively less expensive. Indian citizens are likely to increase their spending on imports from US, shifting the demand for US Dollar to the right, from D0 to D1. At the same time, the U.S. people see Indian goods getting more expensive and reduce their demand for Indian goods stop imports from India. The supply of US $ Dollar shifts to the left, from S0 to S1. The result is an increase in the price of Dollar. The dollar appreciates, and the Indian rupee is worth less. Price of Rupee/US Dollar S1 S0 Rs.68/$ Rs.60/$ D1 D0 0 INR Quantity of US Dollar Relative Interest Rates If U.S. interest rates rise relative to British interest rates, British citizens holding pounds may be attracted into the U.S. securities market. To buy bonds in the United States, British buyers must exchange pounds for dollars. The supply of pounds shifts to the right, from S0 to S1. However, U.S. citizens are less likely to be interested in British securities because interest rates are higher at home. The demand 33 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE for pounds shifts to the left, from D0 to D1. The result is a depreciated pound and a stronger dollar. • • • If interest rates in U.S. > interest rates abroad • Increase in the demand for dollars • Dollar appreciation If interest rates in U.S. < interest rates abroad • Decrease in the demand for dollars • Dollar depreciation Real interest rate • Nominal interest rate minus the inflation rate 34 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE In the short term, the exchange rate between the dollar and the pound reflects relative interest rates and expected changes in the exchange rate. 35 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE 3.10.2 Determining Short-Term Exchange Rates: The Asset-Market Approach • Expected change in the exchange rate • Future expectations of an appreciation of the dollar can be self-fulfilling for today’s value of the dollar Factors affecting the dollar’s exchange rate in the short term (b) In the short term, the exchange rate between the dollar and the pound reflects relative interest rates and expected changes in the exchange rate. Other factors affecting investment flows among economies • Size of the stock of assets denominated in a particular currency in investor portfolios • Significant safe-haven effect behind some investment flows 36 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE 3.10.3 The Ups and Downs of the Dollar • • • • • • The 1980s, appreciation and then depreciation • 1979, dollar appreciation • Sharp tightening of monetary policy • Reagan administration - sizable tax cuts along with increased government spending • Peak in1985 The 1980s, appreciation and then depreciation • Second half of the 1980s, dollar depreciation • Speculators – expected dollar depreciation • Sizable currency interventions aimed at weakening an overvalued dollar • Expansionary monetary policy • Fiscal policy - to reduce the size of budget deficits The 1990s • Weakening economy, recession in 1991 • Expansionary monetary policy • Fiscal policy - increased government spending and dampened tax receipts • Dollar depreciation The 1990s • Mid-1990s, the U.S. economy was growing rapidly • Sharp increase in the pace of investment spending by business • Market acceleration in productivity growth • Strong consumer demand • Deregulation; Trade liberalization; Computer era • Declining rate of inflation • Dollar appreciation First decade of the 2000s • 2002-2004, depreciation of the dollar • Weakening of the demand for dollar-denominated assets • Recession in the U.S. in 2001 • Declining stock market • Uncertainty about corporate accounting practices • Steady decline in interest rates • Uncertainty due to the ongoing war on terrorism and the war with Iraq First decade of the 2000s • By 2005, dollar appreciation • Current and prospective strong performance of the U.S. economy • Restrictive monetary policy – higher interest rates • 2006–2007, weakening dollar • Slackening of private investment flows 37 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE • • By 2008, stronger dollar • U.S. - safe haven; economic crisis of 2007–2008 2009, weakening dollar 3.10.4 THE DETERMINANTS OF FOREIGN EXCHANGE RATES - THEORIES Purchasing Power Parity Approach • PPP is the oldest and most widely followed of the exchange rate theories • PPP is embedded within most theories of exchange rate determination • PPP calculations and forecasts have structural differences across countries and significant data challenges in estimation 38 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE Balance of Payments (Flows) Approach • Essentially BOP approach says equilibrium exchange rate is achieved when current account inflows match current account outflows • BOP transactions are widely appealing, captured, and reported • Criticism of the BOP approach is that it focuses on flows rather than stocks of money or financial assets • Relative stocks of money or financial assets do not play a role in the theory • Practitioners use BOP but academics largely dismiss it Monetary Approaches • Changes in supply and demand for money largely determine inflation which in turn alter exchange rates • Prices are flexible in both the short and long-run thus, the transmission impact is immediate • Real economic activity influences exchange rates through any alterations in demand for money • Omits a number of important factors for exchange rate determination including: • – The failure of PPP to hold in the short to medium term – Money demand appears to be relatively unstable over time – The level of economic activity and the money supply do not appear to be independent Do to these significant omissions the authors choose to ignore this approach Asset Market Approach • AKA relative price of bonds or portfolio balance approach • argues that exchange rates are determined by supply and demand for a wide variety of assets – Shifts in supply and demand alter exchange rates – Changes in monetary and fiscal policy alter expectations and thus exchange rates – Theories of currency substitution follow the same basis premises of portfolio rebalance framework • The Asset market approach assumes that whether foreigners are willing to hold claims in monetary form depends on an extensive set of investment considerations or drivers (as per the previous exhibit) • In highly developed countries, foreign investors are willing to hold securities and undertake foreign direct investment based primarily on relative real interest rates and the outlook for economic growth and profitability 39 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE 3.11 FORECASTING FOREIGN-EXCHANGE RATES 3.11.1 Forecasting exchange rates • • Is very tricky, especially in the short term Necessary for exporters, importers, investors, bankers, and foreign-exchange dealers and Consulting firms Exchange-rate forecasters • • Judgmental forecasts • Subjective or common sense models. • Require • Wide array of political and economic data • Interpretation of these data in terms of the timing, direction, and magnitude of exchange-rate changes • Projections based on a thorough examination of individual nations • Economic indicators; Political factors • Technical factors; Psychological factors Technical forecasts • Technical analysis • Use of historical exchange-rate data to estimate future values • Ignoring economic and political determinants of exchange-rate movements • “History repeats itself” Technical analysis of the Yen’s exchange value 40 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE When forecasting exchange rates, technical analysts watch for new highs and lows, broken trend lines, and patterns that are thought to predict price targets and movement. • Fundamental analysis • The opposite of technical analysis • Considerations of economic variables that are likely to affect the supply and demand of a currency • Computer-based econometric models • For individual nations • Attempt to incorporate the fundamental variables that underlie exchange-rate movements • Interest rates, balance of trade, productivity, inflation rates • Limitations of econometric models used to forecast exchange rates • Rely on predictions of key economic variables • Factors affecting exchange rates that cannot easily be quantified • Precise timing of a factor’s effect on a currency’s exchange rate may be unclear 41 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE 3.11.2 Exchange Rate Forecasting in Practice 3.11.3 Forecasting in Practice • • • Decades of theoretical and empirical studies show that exchange rates do adhere to the fundamental principles and theories outlined in the previous sections – fundamentals do apply in the long term Therefore, there is something of a fundamental equilibrium path for a currency’s value In the short term, a variety of random events, institutional frictions, and technical factors may cause currency values to deviate significantly from their long term fundamental path – this is sometimes referred to as noise 42 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE 3.12 IMPACT AND EFFECTS OF EXCHANGE RATE Exchange rate means how much one currency is worth in terms of another currency. If we can buy $ 1 with Rs. 46, the exchange rate of the two currencies would be $1 = Rs. 46. There are two types of exchange rate: Fixed and Floating. Some countries have fixed exchange rate systems while some have floating. As the name suggests, the fixed exchange rate doesn’t fluctuate because of government intervention. The floating exchange rate on the other hand keeps on changing continuously just like the stock market. Thus the government intervention is almost negligible. In India, we have a Managed Floating Exchange Rate System. This means that the Indian government intervenes only if the exchange rate seems to go out of hand by increasing or reducing the money supply as the situation demands. Rupee Appreciation & Rupee Depreciation (instead of using the word ‘currency’ we are using ‘rupee’ for the Indian context and explain the fluctuation with respect to dollar). When rupee is said to be appreciating it means that our currency is gaining strength and its value is increasing with respect to dollar. However, when rupee depreciates it means our currency is getting weaker & its value is falling with respect to dollar. You can understand it with the following example: Suppose, currently, the exchange rate is Rs. 45 = $1, 10 months later, either of the following two cases can happen Case1: The exchange rate is say Rs. 40 = $1. This means rupee has appreciated or gotten stronger by approx 11% and you would be paying less to for a dollar Case2: The exchange rate is at Rs. 50 = $1. This means rupee has depreciated or gotten weaker by approx 11% and you end up paying more for a dollar. Rupee’s appreciation or depreciation against the dollar depends on the change in demand and supply for both the currencies. If the demand for rupee is comparatively high, rupee appreciates; if low, it depreciates. What factors drive the demand for a currency?’ They are: o Interest Rate: A demand for a currency is hugely dependent on the interest rate differential between two countries. A country like India where int. rate is around 7-8% experiences greater capital inflow as investors get better return than what they might get in US. (with Interest rates of 2-3%). This results into rupee appreciation. o Inflation Rate: The demand for a country’s goods & services by the foreign buyers would be more if the inflation rate is lower in that country compared to other countries. Higher demand for goods & services would mean higher demand for that currency resulting in the 43 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE appreciation of that currency. For instance if India’s inflation rate is lower than that of Zimbabwe then the demand for our goods, services and currency would be higher than that for Zimbabwe’s. o Export-Import: If a country is exporting more than its imports from other countries, then this would mean higher demand for that currency, causing appreciation of that currency against others. o Trading in currencies in the Forex market: The exchange rate fluctuates minute by minute because of speculative trading in the Forex market. Though trading in Forex market causes fluctuations in the exchange rate, over a period the change is backed by the fundamental factors like the growth potential in the economy, interest rate differential and the inflation rate existing in different countries. In a manage floating exchange rate system like India the government purchases rupee in exchange for the foreign currency to increase money supply in the economy which leads to depreciation of the home currency. Conversely, it purchases foreign currency in exchange for rupee to reduce the money supply in the economy leading to appreciation of the home currency. Impact on economy: Exchange rate fluctuation has a significant impact on the overall economy of a country. Rupee appreciation against US dollar is an indication of the strengthening of Indian economy with respect to US economy. Impact on foreign investors: If a foreign investor invests in Indian stock market and even if its value doesn’t change in 1 year, he’ll earn profit if rupee appreciates and make a loss if it depreciates. You can understand this with an example: Suppose an FII Invests Re. 1 Cr. in the Indian stock market and at an exchange rate of $1 = Rs. 50. So, the amount invested is $200,000. Suppose, after 1 year, even if the value of investment doesn’t appreciate the foreign investor can earn a profit if the exchange rate has changed to $1 = Rs. 40 (Rupee appreciation) If the investor sells his investment and converts the currency, he would get $ 250,000. So, he would earn $ 50,000 as a profit thanks to a change in the exchange rate i.e. rupee appreciation So, a continuously appreciating rupee would lead to greater investment by the FIIs. Impact on industry/companies: Appreciation of the rupee makes imports cheaper and exports expensive. So, it can spell good news for companies who rely on import of goods like heavy machinery, technology, micro chips etc. According to reports by Associated Chambers of Commerce and Industry of India (ASSOCHAM) sectors like Petro & Petro Products, Drugs & Pharma and Engineering Goods which have import inputs of as much as 77%, 44 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE 19% and 21% respectively would stand to gain the most if rupee appreciates.They would have to pay less for the imported raw materials which would increase their profit margins. Similarly, a depreciating rupee makes EXPORTS CHEAPER AND IMPORTS EXPENSIVE So, it is welcome news for sectors like IT, Textiles, Hotel & Tourism etc. which generates revenue mainly from exporting their products or services. Rupee depreciation makes Indian goods & services cheaper for the foreign buyers thus leading to increase in demand and higher revenue generation. The foreign tourist would find it cheaper to come to India thus increasing the business of hotel, tours & travel companies. Indian IT sector is dependent on foreign clients, especially US, for more than 70% of its revenue. When an IT company gets a project from a client it pre-decides on the length of the contract and the cost of the project. The contracts with US clients are usually quoted in dollars term. So, the fluctuation in the exchange rate can bring a considerable difference in the performance of a company. Take the example of Infosys results between 2007 and 2008 to understand the impact that the fluctuation in exchange rate can have on the performance of a company. The income of Infosys, in 2008, increased by 34.1% to $ 3912 million but because of rupee appreciation of 11.2%, from Rs. 45.06 to Rs. 40, in rupee terms, its income increased only by 19%. 45 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE “Every 1% movement in the Rupee against the US Dollar has an impact of approximately 50 basis points on operating margins” – Infosys Annual Report However the IT sector does not just sit idle and let exchange rate play the spoil sport. It undertakes various measures like hedging exchange risks using forward and future contracts. This helps them in mitigating some of the loss due to exchange rate fluctuation but none the less the impact is substantial. Exchange rate is thus an important tool that can be used to analyze many key industries like IT, Textiles etc. Fluctuating exchange rate has a significant impact on the economy, industries, companies, foreign investors etc. Rupee appreciation is beneficial for industries which rely heavily on imported inputs while depreciation of rupee is good news for industries which are exporting majority of their production. RBI’s INTERVENTION AND EXCHANGE RATE MANAGEMENT:In 1939, the Exchange Control Department of RBI was set up. In order to conserve the scarce foreign exchange reserves, the Foreign Exchange Regulation Act (FERA) was passed in 1947. India adopted fixed exchange rate of IMF upto 1971, whereby the Indian Rupee external par value was fixed. In 1973, FERA was amended and it came in force on January 1st, 1974. It gave wide powers to RBI to administer exchange control mechanism properly. In 1992, RBI introduced LERMS (Liberalised Exchange Rate Management System) Under LERMS a dual exchange rate was fixed. The 1993-94 Budget made Indian Rupee fully convertible on trade account. LERMS was withdrawn. Developing countries allowed market forces to determine the exchange rate. Under flexible exchange rate system, if demand for foreign currency is more than that of its supply, foreign currency appreciates and domestic currency depreciates and vice versa. To minimise the disadvantages of flexible exchange rate, most of the developing countries including India have adopted the concept of managed Flexible Exchange Rate (MFER). Under MFER, the Central bank intervenes to bring stability in exchange rate. RBI’s intervention involves purchase of foreign currency from market or release (sale) of foreign currency in the market, to bring stability in exchange rates. 3.13 ROLE OF RBI IN FOREIGN EXCHANGE MARKET The role of RBI in the foreign exchange market is revealed by the provisions of FERA (1973). Administrative Authority The RBI is the administrative authority for exchange control in India. The RBI has been given powers to issue licences to those who are involved in foreign exchange transactions. 46 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE Authorised Dealers The RBI has appointed a number of authorised dealers. They are permitted to carry out ail transactions involving foreign exchange. The above provision is laid down in Section 3 of FERA. Issue Of Directions The 'Exchange Control Manual' contains all directions and procedures given by RBI to authorised dealers from time to time. Fixation Of Exchange Rates :The RBI has the responsibility of fixing the exchange value of home currency in terms of other currencies. This rate is known as official rate of exchange. All authorised dealers and money lenders are required to follow this rate strictly in all their foreign exchange transactions. Foreign Investments:Non-residents can make investments in India only after obtaining the necessary permission from Central Government or RBI. Great investment opportunities are provided to non-resident Indians. Foreign Travel :Indian residents can get foreign exchange released from RBI upto a specified amount for travelling abroad through proper application. Import Trade The RBI regulates import trade. Imports are permitted only against proper licenses. The items of imports that can be imported freely are specified under Open General Licence. Export Trade The RBI controls export trade. Export of gold and jewellery are allowed only with special permission from RBI. Gold. Silver. Currency Notes Etc. In recent years, the limits fixed for bringing gold, silver, currency notes etc. has been relaxed considerably. 47 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE Submission of Returns All foreign exchange transactions made by authorised dealers must be reported to RBI. This enables the RBI to have a close watch on foreign exchange dealings in India. Thus, from above points we can say that RBI is the apex bank that intervens, supervises, controls the foreign exchange markets in order to create an stable and active exchange market. 3.14 Expected Questions – 16 marks 1. 2. 3. 4. 5. Explain how Foreign Exchange rates are determined. Explain and Illustrate the Purchasing Power Parity Theory. Explain Forward, Futures and currency options and its uses. Illustrate the impact and effects of exchange rates in the foreign trade. Briefly explain the FEMA Act. 6. Explain RBI’s intervention in exchange rate management in India. (M.2011) OR “RBI is the apex body that intervenes and control foreign exchange in India”. Discuss. OR How does RBI intervene in the foreign exchange market. 48 KV INSTITUTE OF MANAGEMENT AND INFORMATION STUDIES INTERNATIONAL TRADE FINANCE http://study-material4u.blogspot.in/2012/07/chapter-19-rbis-intervention-and.html RBI INTERNVNETION http://stockshastra.moneyworks4me.com/basics-of-investing/exchange-rate-fluctuation-rupeeappreciation-impact-on-stock-markets/ - impact of exchange rate http://study-material4u.blogspot.in/2012/07/chapter-19-rbis-intervention-and.html 49