A PROJECT REPORT ON STUDY ON FOREIGN EXCHANGE RISK In the subject of Economics of Global Trade & Finance

SUBMITTED TO UNIVERSITY OF MUMBAI FOR SEMESTER II OF M.COM. ( BY Name of the Student Nikilesh Pillai Roll No. UNDER THE GUIDANCE OF Prof. YEAR 2012 2013 )

C E R T I F I C A T E

This is to certify that the project entitled STUDY ON FOREIGN EXCHANGE RISK. Submitted by Ms. Yogita Nath Gosavi Roll No. 217 Student of M.Com (Part-I) Banking & Finance (University of Mumbai) Semester II examination has not been submitted for any other examination and does not form a part of any other course undergone by the candidate. It is further certified that she has completed all required phases of the project. This project is original to the best of our knowledge and has been accepted for Internal Assessment.

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DECLARATION

Miss. YOGITA NATH GOSAVI the student of FIRST year of MCOM Part 1 (Banking and Finance) Semester 2 (2012-2013) hereby declares that I have completed the project on STUDY ON FOREIGN EXCHANGE RISK. The information submitted is true and original to the best of my knowledge.

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ACKNOWLEDGEMENT

I wish express my sincere acknowledgement to our principal Dr. M. R. Nair and all other who were directly or indirectly associated with the project. In the completion for this project, support and help of many is acknowledged. I would like to express my sincere appreciation to Prof P.S. IYER for her guidance, patience, Inness and wisdom with this research project, as well as all other important aspect of this project. Additional acknowledgements go to the Librarian for providing me with all the required reference books for the project. Lastly, I would like to express my sincerest appreciation towards my parents, sister and all of my extended friends for their everlasting support and encouragement.

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METHODOLOGY

PRIMARY DATA:

I collected my project informations from Books. And I also collected from my friends.

SECONDRY DATA:

I have collected my project information from internet. The websites from were I have got the information is google.com, Wikipedia, and from Investopedia website.

OBJECTIVES

To study the Functions of FOREIGN EXCHANGE in detail.

To find out new changes in the FOREIGN EXCHANGE RISK.

How it is benefited to the FOREIGN EXCHANGE MARKET.

To understand the FOREIGN EXCHANGE Environment.

To understand the Role of FOREIGN EXCHANGE RISK.

To see the future of FOREIGN EXCHANGE .

TABLE OF CONTENTS

SR NO 1 INTRODUTION

TOPICS

PAGE NO

2 DEFINITION 3 4 FOREIGN EXCHANGE MARKET NEEDS OF FOREIGN EXCHANGE

5 6 7 8 9 10 11 12 13

THE ROLE OF CURRENCY AND FOREIGN EXCHANGE MARKETS EXCHANGE RATE METHODS OF EXCHANGE CONTROL FUNCTIONS OF FOREIGN EXCHANGE MARKETS FOREIGN EXCHANGE RISK MANAGEMENT FOREIGN EXCHANGE MANAGEMENT ACT DETERMINANTS OF EXCHANGE RATES MEASUREMENT CONCLUSION

INTRODUCTION OF FOREIGN - EXCHANGE RISK

This risk usually affects businesses that export and/or import, but it can also affect investors making international investments. For example, if money must be converted to another currency to make a certain investment, then any changes in the currency exchange rate will cause that investment's value to either decrease or increase when the investment is sold and converted back into the original currency.

Definition of Foreign-Exchange Risk

The risk of an investment's value changing due to changes in currency exchange rates. The risk that an investor will have to close out a long or short position in a foreign currency at a loss due to an adverse movement in exchange rates. Also known as "currency risk" or "exchange-rate risk"

FOREIGN EXCHANGE MARKET

The foreign exchange market (forex, FX, or currency market) is a form of exchange for the global decentralized trading of international 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. EBS and Reuters' dealing 3000 are two main interbank FX trading platforms. 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 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. In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying some quantity of another currency. The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major

industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system. The foreign exchange market is unique because of the following characteristics: its huge trading volume representing the largest asset class in the world leading to high liquidity; its geographical dispersion; its continuous operation: 24 hours a day except weekends, i.e., trading from 20:15 GMT on Sunday until 22:00 GMT Friday; the variety of factors that affect exchange rates; the low margins of relative profit compared with other markets of fixed income; and the use of leverage to enhance profit and loss margins and with respect to account size. As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding currency intervention by central banks. According to the Bank for International Settlements, as of April 2010, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume as of April 2007. Some firms specializing on foreign exchange market had put the average daily turnover in excess of US$4 trillion. The $3.98 trillion break-down is as follows: $1.490 trillion in spot transactions $475 billion in outright forwards $1.765 trillion in foreign exchange swaps $43 billion currency swaps $207 billion in options and other products

NEED OF FOREIGN EXCHANGE

There was a time in human civilization that money, whether in coins or in paper, didn't exist. When you needed something, you would have to give up one of your possessions for another's. For example, if a farmer sees a travelling merchant visiting their community to sell some precious and delicate china porcelains, he would have to exchange a portion of his rice for the merchant's china. Such an agreement is called barter where one thing is exchanged for another that was believed to be of the same value. Of course, this hardly ever happens now as barter, except maybe for e-bay, as it could become a very complicated process in the large-scale. Money has become an effective tool to make businesses and ultimately, our daily lives, easy and simple. When you need a commodity or service, all you need to do is to have the right amount of money in order to have that thing you desire.

Because of globalization and with more countries opening up to the world, it is inevitable that we become more involved with each other. The young Koreans have found it important to see and travel the world with a certain fondness for the beaches in the Southeast Asia. The Americans travel all the time to France and Italy to see the latest fashion and the great landmarks. The Africans are selling their nicely-crafted home designs to the Europeans. All of these are indicative as to how we are all connected, one way or another. However, when you travel, you cannot bring your nation's money alone and expect to live on a foreign land. This is where foreign exchange becomes important to you. Each nation is represented by its own national currency. The US has the American dollar while the Japanese has the yen, just to name a few. When an American travels to Japan, he would need to exchange his dollars to yen in order to buy things in that country. This is called foreign exchange. In order for him to have a benchmark as to how many yen his dollars could buy, he would need to now the current exchange rate in local banks or money exchange. If it says 1 dollar = 101 yen, it means that his dollar is highly valued and could already buy 101 yen. If the exchange rate the following day changes and becomes 1 dollar = 100 yen, his dollar had depreciated against the yen and now could buy one yen less than the other day. A depreciation and appreciation of a currency indicates the strength of that particular currency and is always in reference to another currency. Multiple countries are also doing business with each other and this is another situation where foreign exchange becomes important. When a Filipino exporter exports his mangoes to the US, he does not get paid in pesos but in dollar equivalent. Foreign exchange is an exchange of two national currencies, in this case, the peso and the dollar. So now we have seen how foreign exchange works and how we are affected by it one way or another. It is not as complicated as how it looks like in the business papers. All you need to do is to have a clear grasp on how the exchange of money happens and you would do just fine.

THE ROLE OF CURRENCY AND FOREIGN EXCHANGE MARKETS

The role of currency is only as a tool or a means of exchanging goods. Its value is derived from the faith people have in the currency. For any currency to have a value, people must be able to accept it as a means which they will part or exchange other items for it. In itself, currency has no value. It is only how we perceive currency that gives it value. In todays world, currency is bought and sold in the international currency market or foreign exchange market for those not in the financial sector. National currencies are valued independently due to the nations central banking system which is independent from one another. However each currency in todays market, from the strongest to the weakest are all dependent and interconnected with each other for purposes of value and stability. The trading between national currencies is important in the overall value of a single countrys currency. How active the foreign exchange market also tells the story of what the financial community thinks of the global economy at that time. The foreign exchange is often the barometer for influences on the world economy as it is often the first market to react whenever there is a dip or boom in the global economy. The foreign currency market is also always open. For instance, when the currency markets open in Europe, its counterpart in Asia will be winding down to a close. As the European market closes, the American market opens and so on and so forth. This trading cycle continues throughout the day making it the most active market in the world. People are always conscious of money. Whether they are keeping track of these markets to find some money saving tips, it is something that remains at the forefront of many peoples minds. The players who are big in foreign exchange market are banks, large commercial entities hedge fund, investment firms and central banks of the nations. Hedge funds and central banks are the two biggest influences on the foreign exchange market. Although not all central banks do it, but some central banks do trade in the foreign exchange market. They do this for a multitude of reasons. Among the reasons include synchronizing the countrys interest rates in line with the other countries and to stabilize the currency of the country so that the import and export of goods can be completed in an orderly manner. Some central banks also use the foreign exchange market to control fiscal issues like inflation. On the other hand, hedge funds represent the purely commercial side of the foreign exchange market. Hedge funds trade in the market with the sole purpose of taking advantage of anomalies and market huge profits sometimes even at the expense of destabilizing a nations currency.

EXCHANGE RATE

An exchange rate is the rate at which one currency can be exchanged for another. In other words, it is the value of another country's currency compared to that of your own. If you are traveling to another country, you need to "buy" the local currency. Just like the price of any asset, the exchange rate is the price at which you can buy that currency. If you are traveling to Egypt, for example, and the exchange rate for U.S. dollars is 1:5.5 Egyptian pounds, this means that for every U.S. dollar, you can buy five and a half Egyptian pounds. Theoretically, identical assets should sell at the same price in different countries, because the exchange rate must maintain the inherent value of one currency against the other.

FIXED EXCHANGE RATES

There are two ways the price of a currency can be determined against another. A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged. If, for example, it is determined that the value of a single unit of local currency is equal to US$3, the central bank will have to ensure that it can supply the market with those dollars. In order to maintain the rate, the central bank must keep a high level of foreign reserves. This is a reserved amount of foreign currency held by the central bank that it can use to release (or absorb) extra funds into (or out of) the market. This ensures an appropriate money supply, appropriate fluctuations in the market (inflation/deflation) and ultimately, the exchange rate. The central bank can also adjust the official exchange rate when necessary.

FLOATING EXCHANGE RATES

Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed "self-correcting," as any differences in supply and demand will automatically be corrected in the market. Look at this simplified model: if demand for a currency is low, its value will decrease, thus making imported goods more expensive and stimulating demand for local goods and services. This in turn will generate more jobs, causing an auto-correction in the market. A floating exchange rate is constantly changing. In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also influence changes in the exchange rate. Sometimes, when a local currency reflects its true value against its pegged currency, a "black market (which is more reflective of actual supply and demand) may develop. A central bank will often then be forced to revalue or devalue the official rate so that the rate is in line with the unofficial one, thereby halting the activity of the black market.

METHODS OF EXCHANGE CONTROL

The various methods of exchange control may broadly be classified into two types, direct and indirect. Direct methods of exchange control include those devices which are adopted by governments to have an effective control over the exchange rate, while indirect methods are designed to regulate international movements of goods. There are many ways to introduce exchange control in an economy. These are usually classified into two groups:

(i) Direct Exchange Control and

(ii) Indirect Exchange Control. Direct Methods of Exchange Control:

In direct exchange control, certain measures are adopted which effectuate immediate direct restriction on foreign exchange from all sides - its quantum, use and allocation. In general, direct exchange control includes measures like:

(i) Intervention; (ii) Exchange restrictions; (iii) Exchange clearing agreements; (iv) Payment agreements; and (v) Gold policy.
Intervention: It refers to the government's intervention or interference in the free working of the exchange market with a view to overvalue or undervalue the country's currency in terms of foreign money. The government or its agency - the central bank - can intervene in the free market by resorting to buying and selling the home currency against foreign currency in the foreign exchange market to support or depress the exchange rate of its currency. Pegging Operations: Government intervention in the foreign exchange market takes the from of of the currency of the country to a chosen ratepegging down or pegging up of exchange. Since undervaluation or overvaluation is not the equilibrium rate, it has to be pegged. Thus, pegging means keeping a fixed exchange value of a currency; however, intervention may be practised by a government without resorting to pegging as such. Pegging operations take the form of buying and selling of the local currency by the central bank of a country in exchange for the foreign currency in the foreign exchange market, in order to maintain an exchange rate whether, it is overvalued or undervalued. Pegging up means pegging down pegging may be holding fixed overvaluation, i.e., to maintain the exchange rate at a higher level. Pegging down means holding fixed undervaluation, i.e., to maintain the exchange rate at a lower (depressed) level. In the case of pegging up, the central bank shall have to keep itself ready to buy unlimited amount of local currency in exchange for foreign currencies at a fixed rate, because overvaluation tends to increase the demand for foreign currencies by creating import surplus. In the case of pegging down, the central bank or central agency shall have to keep itself ready to sell any amount to local currency by creating export surplus. Similarly, pegging up involves holding of sufficient amount of foreign currencies while pegging down involves holding of sufficient amount of local currency by the central bank. It goes without saying that pegging up, is more difficult to maintain as it requires huge amounts of foreign currencies which is difficult to obtain. As such pegging up can be adopted only as a temporary expedient. It should be noted that intervention by a government in the foreign exchange market has the effect of neutralising the forces of demand and supply of foreign exchange. However, it is generally assumed that government intervention or pegging up and pegging down operations should be used as temporary expedients to remove fluctuations in the exchange rate. Exchange Restrictions:

Exchange restrictions refer to the policy or measures adopted by a government which restrict or compulsory reduce the flow of home currency in the foreign exchange market. Exchange restrictions may be of three types: (i) The government may centralise all trading in foreign exchange with itself or a central authority, usually the central bank; (ii) the government may prevent the exchange of local currency against foreign currencies without its permission; (iii) the government may order all foreign exchange transactions to be made through its agency. Exchange restrictions may take various forms, the most common of them being: (1) Blocked accounts, (2) Multiple exchange rates. Blocked Accounts: Under the condition of severe financial crisis, a debtor country may adopt the scheme of blocking the accounts of its creditors. In 1931, Germany, for instance, had done so in order to have exchange restrictions. Blocked accounts refer to bank deposits, securities and other assets held by foreigners in a country which denies them conversion of these into their home currency. Blocked accounts, thus, cannot be converted into the creditor country's currency. Under the blocked accounts scheme, all those who have to make payments to any foreign country will have to make them not to the foreign creditor directly but to the central bank of the country which will keep the amount in the name of the foreign creditor. This amount will not be available to the foreigners in their own currency, but can be used by them for purchase in the controlling country. Blocked accounts system has two drawbacks: (i) It reduces international trade to a minimum, and (ii) it leads to black-marketing in foreign exchange. Multiple Exchange Rates: In the early thirties, Germany had initiated the device of multiple rates, as a weapon to improve her balance of payments position. Under this system, different exchange rates are set for different classes and categories of exports and imports. Generally a low rate, i.e., low prices of foreign money in terms of domestic currency, is confined to imports of necessary items having an inelastic demand, while a high penalty rate is fixed for the imports of luxury items. In short, the multiple exchange rates system implies official price discriminatory policy in foreign exchange transactions. By simply fixing a high exchange rate for a commodity, the government can check its imports (when its elasticity of demand for import is greater than unity). Similarly, its imports can be encouraged by fixing a low exchange rate. Likewise, the export of a commodity can be encouraged by setting a high rate of exchange. Thus, the device of multiple exchange rates can be effectively used by the government for making short-term adjustments in the balance of payments, without resorting to quantitative restrictions and licensing. Indeed, multiple exchange rates amount to discriminatory export taxation and varying rates of tariffs on imports. In other words, the system of multiple exchange rates in essence is a form of discriminatory partial devaluation, because instead of devaluing the currency for the whole of foreign trade, under this system, the currency is devalued for imports and exports of goods with an elasticity greater than unity and appreciating the currency for goods with an elasticity less than unity. It is thus more effective in bringing about the desired effect on the level of trade and thereby, improve the balance of payments. Thus, the main merit of the system of multiple exchange rates is that it allows more effective control of the balance of payments. Secondly, it also contains disguised subsidies and tariffs, which may encourage or discourage trade in certain goods and affect the level of foreign trade.

Apparently, buying foreign exchange at a rate above the equilibrium rate amounts to subsidisation of exports, while selling foreign exchange at a rate above the equilibirum rate amounts to a tariff on imports. Another merit of the system is that it enables the government to yield revenue by buying foreign exchange at low prices in domestic money from exporters and then selling it at higher prices to importers. However, the system has the following drawbacks: Instead of correcting the balance of payments, it adversely affects the growth of international trade and the maximisation of world output and welfare. (ii) It puts too much arbitrary powers into the hands of the government to influence foreign trade. (iii) It creates undue complexities in calculation, due to different exchange rates for different imports and exports which may be changed from time to time, resulting in uncertainty in foreign trade. (iv) The system has a formidable administrative problem of effective control. Utmost vigilance has to be maintained against the undervaluation of export invoices and overvaluation of import invoices and care should be taken to see that exporters do not sell their proceeds of foreign exchange in the black-market and importers do make specific and proper use of the allotted foreign exchange. Further, the system is also likely to breed corruption. We may thus, conclude with Ellsworth that exchange control by the system of multiple exchange rates is only a partial solution to devaluation, and introduces uncertainties and distortions of its own. Exchange Clearing Agreements: European countries had adopted this form of exchange control in the Thirties. It was a system for the direct bilateral bartering of goods on a national scale. Under this device, two countries engaged in trade pay to their respective central banks the amounts payable to their respective foreign creditors. These central banks then use the money in offsetting the corresponding claims after fixing the value of the currencies by mutual agreement. And, importers have to deposit their payment with the central bank can use such money to pay the domestic exporters. This economises exchange needs for trade. Therefore, exchange clearing device is helpful to a country which has little or no foreign exchange reserves and which is more interested in selling than buying. However, this system is essentially one of offsetting each other's payments, and the basic assumption is that countries entering into such an agreement should try to equalise their imports and exports so that, there will be no necessity for either making or receiving payments from the other countries.

Following are the drawbacks of exchange clearing agreements: (i) There is a possibility of exploitation of an economically weaker country by a stronger country. (ii) The exchange clearing agreements involve bilateral transactions in foreign trade, which cause a diversion of normal trade pattern and endanger the promotion of world trade. (iii) This device also reduces the volume of international trade. Besides, it attempts to do away with the foreign exchange market. (iv) The scheme requires that all payments have to be centralised. Payment Agreements:

To overcome the difficulties of the problems of waiting and centralisation of payments observed in clearing agreements, the device is formed as payment agreements. Under this scheme, a creditor is paid as soon as informants. Under this scheme, a creditor is paid as soon as information is received by the central bank of the debtor country from the creditor country's central bank that its debtor has discharged his obligation and vice versa. By designing the arrangement for mutual credit facilities, thus, possibilities of delay are ruled out. Payment Agreements have the advantage that direct relation between exporters and importers are maintained. However, payment agreements suffer from two defects: (i) The agreement accounts could only be debited or credited for licensed payments. (ii) The balances in the accounts could only be used for payment from one partner to another. Gold Policy: Through a suitable gold policy, the country can bring the desired exchange control. For this, the country may resort to the manipulation of the buying and selling prices of gold which affect the exchange rate of the country's currency. In 1936, for instance, the U.K., France and U.S.A. signed the Tripartite Agreement in this regard for fixing a suitable purchase and sale price of gold. Indirect Methods of Exchange Control : Apart from the direct methods, there are several indirect methods also regulating the rates of exchange. Important ones are briefly discussed below. Changes in Interest Rates: Changes in interest rate tend to influence indirectly the foreign exchange rate. A rise in the interest rate of a country attracts liquid capital and banking funds of foreigners. It will tend to keep their funds in their own country. All this tends to increase the demand for local currency and consequently the exchange rate move in its favour. It goes without saying that, a lowering of the rate of interest will have the opposite effect. Tariffs Duties and Import Quotas: The most important indirect method is the use of tariffs and import quotas and other such quantitative restrictions on the volume of foreign trade. Import duty reduces imports and with it rise the value of home currency relative to foreign currency. Similarly, export duty restricts exports; as a result, the value of home currency falls relative to foreign currencies. In short, when import duties and quotas are imposed, the rate of exchange tends to go up in favour of the controlling country.

Export Bounties: Export bounties of subsidies increase exports. As such the external value of the currency of the subsidygiving country rises. It should be noted that import duties and export bounties are treated as indirect instruments of exchange control only if they are imposed with the object of conserving the foreign exchange. Otherwise, the fundamental aim of import duty is merely to check imports and that of export bounty is to encourage exports.

In fine, interest rates, import duty or export subsidy, each has its limitations. For instance, import duty cannot go so far as to completely restrict imports. There is also the fear of retaliation in regard to tariff policy. Similarly, the volume of subsidy depends upon the support of public fund. Likewise, manipulation of exchange rate through changes in interest rate may not be always effective. Moreover, rates of interest cannot be raised to any limit without engendering depression. Concluding Remarks: There are various forms in which the exchange control system may be devised. Each form has its own merits and demerits and each one serves a specific purpose. Therefore, the whole economic situation of foreign trade of a country must be carefully viewed while resorting to exchange control and more than one methods must be combined together. In so far as the correction of disequilibirum is concerned, it should be noted that exchange control does not basically solve the problem, it only prevents the situation from becoming worse. Moreover, exchange control is always an inhibiting factor to an expanding world trade. With its adoption the gains from international trade are reduced and channels of trade are distorted. It also checks the flow of international investments which are very essential for the planned development of world's economic resources. In normal peace times, therefore, it has hardly anything to commend. That is why; International Monetary Fund also has mentioned the removal of exchange controls as one of its major objectives.

FUNCTIONS OF FOREIGN EXCHANGE MARKETS

To detail the functions of the foreign exchange market (FOREX), we need an understanding of what a foreign currency exchange market is, what it does, why we need it, and the benefits it has on monetary systems of all participating countries. Starting with a simple explanation given by Ball, McCulloch, Frantz, Geringer, and Minor (2006 p.166), FOREX "is a place where monies can be bought, sold, or borrowed". FOREX locations are in various countries and cities, but the major FOREX locations are in London, New York, Tokyo, and Singapore (Ball et al., 2006).

As previously stated the FOREX provides a place for nations to purchase, borrow, or sell their own currency to members of other nations. So what does the FOREX do? FOREX provides the resources for countries to make payments and transfer funds across borders, and provides purchasing power from one currency to another (Cross, 1998). Cross explains that these provisions make valuations of currency available to determine one of the greatest functions of the FOREX, the exchange rate. The exchange rate, as determined by Cross (1998), is "a price determined by the number of units of one nation's currency that must be surrendered in order to acquire one unit of another nation's currency". Cross continues to explain that the exchange rate between two currencies is dependent upon official or private participants to buy and sell its currency to maintain an authorized pegged rate. The exchange rates in FOREX are set then by the market and not by governments (Ball et al., 2006), thus referred to as the floating currency exchange rate. Other approaches to determining the exchange rate like the purchasing power parity (PPP) theory which states that exchange rates in the long run will adjust to equalize the purchasing power of differing currencies (Ball et al., 2006). Therefore, products in competitive markets will sell for identical prices when valued in the same currency (Cross, 1998). The PPP relies on a portion of another approach in determining exchange rates, balance of payments (BOP). BOP approach relies on assessing foreign exchange flows and evaluating balance of payments on current and capital accounts (Cross, 1998). Even with these determinations, the biggest player in defining the exchange rates rely on supply and demand of American goods and currency. International business relies directly on the functionality of the FOREX. In addition to international business, citizens traveling to foreign nations have to a standard in which they can pay for foreign goods and services. FOREX make these situations possible. As we know, every nation has its own currency and monetary system. The FOREX makes it possible for U.S. citizens to travel to foreign nations and by goods and services in forms acceptable to foreigners (Cross, 1998). Whether the business in the foreign country accepts the dollar at a determined exchange rate or the U.S. citizen exchanges their dollars at a bank for a foreign currency, business transactions can be made. The same can be said for foreign businesses investing in American owned companies or vice versa, cross boarder purchases and investments are able to be made. The international use of currency creates many benefits to issuing countries. First, it obtains profit from minting coins, because the noninterest-bearing claims on it are expressed in its own currency and is able to do this by unexpectedly inflating its currency (Tavlas, 1998). Second, as Tavlas states, as the international use of a currency expands, loans, investments, and purchases of goods and services will increasingly be executed through the financial institutions of the issuing country". Thus, we can say that another function of FOREX is the participation in the growth of developing nations; helping to eliminate poverty and internationalize their goods and services.

FIXED EXCHANGE - RATE SYSTEM

A fixed exchange-rate system (also known as pegged exchange rate system) is a currency system in which governments try to maintain their currency value constant against one another.[1] In a fixed exchange-rate system, a countrys government decides the worth of its currency in terms of either a fixed weight of gold, a fixed amount of another currency or a basket of other currencies. The central bank of a country remains committed at all times to buy and sell its currency at a fixed price. The central bank provides foreign currency needed to finance payments imbalances.

Types Of Fixed Exchange Rate Systems

The gold standard

Under the gold standard, a countrys government declares that it will exchange its currency for a certain weight in gold. In a pure gold standard, a countrys government declares that it will freely exchange currency for actual gold at the designated exchange rate. This "rule of exchange allows anyone to go the central bank and exchange coins or currency for with pure gold or vice versa. The gold standard works on the assumption that there are no restrictions on capital movements or export of gold by private citizens across countries. Because the central bank must always be prepared to give out gold in exchange for coin and currency upon demand, it must maintain gold reserves. Thus, this system ensures that the exchange rate between currencies remains fixed. For example, under this standard, a 1 gold coin in the United Kingdom contained 113.0016 grains of pure gold, while a $1 gold coin in the United States contained 23.22 grains. The mint parity or the exchange rate was thus: R = $/ = 113.0016/23.22 = 4.87.[6] The main argument in favour of the gold standard is that it ties the world price level to the world supply of gold, thus preventing ination unless there is a gold discovery (a gold rush, for example).
Price specie flow mechanism

The automatic adjustment mechanism under the gold standard is the price specie flow mechanism, which operates so as to correct any balance of payments disequilibria and adjust to shocks or changes. This mechanism was originally introduced by Richard Cantillon and later discussed by David Hume in 1752 to refute the mercantilist doctrines and emphasize that nations could not continuously accumulate gold by exporting more than their imports. The assumptions of this mechanism are: Prices are exible All transactions take place in gold There is a xed supply of gold in the world Gold coins are minted at a xed parity in each country There are no banks and no capital ows

Adjustment under a gold standard involves the flow of gold between countries resulting in equalization of prices satisfying purchasing power parity, and/or equalization of rates of return on assets satisfying interest rate parity at the current fixed exchange rate. Under the gold

standard, each country's money supply consisted of either gold or paper currency backed by gold. Money supply would hence fall in the deficit nation and rise in the surplus nation. Consequently, internal prices would fall in the deficit nation and rise in the surplus nation, making the exports of the deficit nation more competitive than those of the surplus nations. The deficit nation's exports would be encouraged and the imports would be discouraged till the deficit in the balance of payments was eliminated.
Reserve currency standard

In a reserve currency system, the currency of another country performs the functions that gold has in a gold standard. A country fixes its own currency value to a unit of another countrys currency, generally a currency that is prominently used in international transactions or is the currency of a major trading partner. For example, suppose India decided to fix its currency to the dollar at the exchange rate E/$ = 45.0. To maintain this fixed exchange rate, the Reserve Bank of India would need to hold dollars on reserve and stand ready to exchange rupees for dollars (or dollars for rupees) on demand at the specified exchange rate. In the gold standard the central bank held gold to exchange for its own currency; with a reserve currency standard it must hold a stock of the reserve currency. Currency board arrangements are the most widespread means of fixed exchange rates. Under this, a nation rigidly pegs its currency to a foreign currency, Special drawing rights (SDR) or a basket of currencies. The central bank's role in the country's monetary policy is therefore minimal. CBAs have been operational in many nations like Hong Kong (since 1983); Argentina (1991 to 2001); Estonia (1992 to 2010); Lithuania (since 1994); Bosnia and Herzegovina (since 1997); Bulgaria (since 1997); Bermuda (since 1972); Denmark (since 1945); Brunei (since 1967) [12]

Gold exchange standard

The fixed exchange rate system set up after World War II was a gold-exchange standard, as was the system that prevailed between 1920 and the early 1930s.[13] A gold exchange standard is a mixture of a reserve currency standard and a gold standard. Its characteristics are as follows: All non-reserve countries agree to fix their exchange rates to the chosen reserve at some announced rate and hold a stock of reserve currency assets. The reserve currency country fixes its currency value to a fixed weight in gold and agrees to exchange on demand its own currency for gold with other central banks within the system, upon demand. Unlike the gold standard, the central bank of the reserve country does not exchange gold for currency with the general public, only with other central banks.
Hybrid exchange rate systems

The current state of foreign exchange markets does not allow for the rigid system of fixed exchange rates. At the same time, freely floating exchange rates expose a country to volatility in exchange rates. Hybrid exchange rate systems have evolved in order to combine the characteristics features of fixed and flexible exchange rate systems. They allow fluctuation of the exchange rates without completely exposing the currency to the flexibility of a free float.
Basket-of-currencies

Countries often have several important trading partners or are apprehensive of a particular currency being too volatile over an extended period of time. They can thus choose to peg their currency to a weighted average of several currencies (also known as a currency basket) . For example, a composite currency may be created consisting of hundred rupees, 100 Japanese yen and one U.S. dollar the country creating this composite would then need to maintain reserves in one or more of these currencies to satisfy excess demand or supply of its currency in the foreign exchange market. A popular and widely used composite currency is the SDR, which is a composite currency created by the International Monetary Fund (IMF), consisting of a fixed quantity of U.S. dollars, euros, Japanese yen, and British pounds.

Crawling pegs

In a crawling peg system a country fixes its exchange rate to another currency or basket of currencies. This fixed rate is changed from time to time at periodic intervals with a view to eliminating exchange rate volatility to some extent without imposing the constraint of a fixed rate. Crawling pegs are adjusted gradually, thus avoiding the need for interventions by the central bank (though it may still choose to do so in order to maintain the fixed rate in the event of excessive fluctuations).
Pegged within a band

A currency is said to be pegged within a band when the central bank specifies a central exchange rate with reference to a single currency, a cooperative arrangement, or a currency composite. It also specifies a percentage allowable deviation on both sides of this central rate. Depending on the band width, the central bank has discretion in carrying out its monetary policy. The band itself may be a crawling one, which implies that the central rate is adjusted periodically. Bands may be symmetrically maintained around a crawling central parity (with the band moving in the same direction as this parity does). Alternatively, the band may be allowed to widen gradually without any pre-announced central rate.
Currency boards

A currency board (also known as 'linked exchange rate system")effectively replaces the central bank through a legislation to fix the currency to that of another country. The domestic currency remains perpetually exchangeable for the reserve currency at the fixed exchange rate. As the anchor currency is now the basis for movements of the domestic currency, the interest rates and inflation in the domestic economy would be greatly influenced by those of the foreign economy to which the domestic currency is tied. The currency board needs to ensure the maintenance of adequate reserves of the anchor currency. It is a step away from officially adopting the anchor currency (termed as dollarization or euroization).
Dollarization/euroization

This is the most extreme and rigid manner of fixing exchange rates as it entails adopting the currency of another country in place of its own. The most prominent example is the eurozone, where 17 seventeen European Union (EU) member states have adopted the euro () as their common currency. Their exchange rates are effectively fixed to each other. There are similar examples of countries adopting the U.S. dollar as their domestic currency- British Virgin Islands, Caribbean Netherlands, East Timor, Ecuador, El Salvador, Marshall Islands, Federated States of Micronesia, Palau, Panama, Turks and Caicos Islands.

Advantages

A fixed exchange rate may minimize instabilities in real economic activity[14] Central banks can acquire credibility by fixing their country's currency to that of a more disciplined nation On a microeconomic level, a country with poorly developed or illiquid money markets may fix their exchange rates to provide its residents with a synthetic money market with the liquidity of the markets of the country that provides the vehicle currency A fixed exchange rate reduces volatility and fluctuations in relative prices It eliminates exchange rate risk by reducing the associated uncertainty It imposes discipline on the monetary authority International trade and investment ows between countries are facilitated Speculation in the currency markets is likely to be less destabilizing under a fixed exchange rate system than it is in a flexible one, since it does not amplify fluctuations resulting from business cycles Fixed exchange rates impose a price discipline on nations with higher inflation rates than the rest of the world, as such a nation is likely to face persistent deficits in its balance of payments and loss of reserves [6]

Disadvantages

The need for a fixed exchange rate regime is challenged by the emergence of sophisticated derivatives and financial tools in recent years, which allow rms to hedge exchange rate uctuations The announced exchange rate may not coincide with the market equilibrium exchange rate, thus leading to excess demand or excess supply The central bank needs to hold stocks of both foreign and domestic currencies at all times in order to adjust and maintain exchange rates and absorb the excess demand or supply Fixed exchange rate does not allow for automatic correction of imbalances in the nation's balance of payments since the currency cannot appreciate/depreciate as dictated by the market It fails to identify the degree of comparative advantage or disadvantage of the nation and may lead to inefficient allocation of resources throughout the world There exists the possibility of policy delays and mistakes in achieving external balance The cost of government intervention is imposed upon the foreign exchange market

FOREIGN EXCHANGE RATE RISK

When you conduct business overseas, you will have to convert currencies involved at some prevailing exchange rate. The price of one country's currency in terms of another country is called the exchange rate. When the currency of one country depreciates (drops in value), there will be a corresponding appreciation of value in another country's currency. Depreciation occurs when it takes more currency to purchase the currency of another country. Appreciation is just the opposite; the currency is able to purchase more units of the other country's currency. Since most currencies are valued according to the marketplace, there are constant changes to exchange rates. This gives rise to exchange rate risk. There are several ways to reduce exchange rate risk. Two popular approaches are hedging and netting. Hedging is where you buy or sell a forward exchange contract to cover liabilities or receivables that are denominated in a foreign currency. Forward exchange contracts offset the gains or losses associated with foreign receivables or payables. A very popular form of hedging is the Interest Rate Swap. Interest rate swaps are arrangements whereby two companies located in different countries agree to exchange or swap debt-servicing obligations. This swap helps each company avoid the risks of changes in the foreign currency exchange rates. Due to the popularity of interest rate swaps, most major international banks offer interest rate swaps for organizations concerned about foreign exchange rate risks when making interest payments. The costs charged by banks for interest rate swaps is relatively low. Another solution to foreign exchange rate risk is the use of netting. Netting is the practice of maintaining an equal level of foreign receivables against foreign payables. The net position is zero and thus exchange rate risk is avoided. If you expect the currency to depreciate in value, than you should hold a net liability position since it will take fewer units of currency to pay the foreign currency debt. If you expect the currency to appreciate in value, then you would want to have a net receivable position to take advantage of the increased purchasing power of the foreign currency. There are other vehicles for dealing with exchange rate risk, such as option hedges and other types of derivatives. However, the costs and risks associated with these types of arrangements

can be much higher than a simple approach such as the interest rate swap. If you have exchange rate exposure, then take a look at simple hedges and netting as ways of avoiding foreign exchange rate risk. When companies conduct business across borders, they must deal in foreign currencies. Companies must exchange foreign currencies for home currencies when dealing with receivables, and vice versa for payables. This is done at the current exchange rate between the two countries. Foreign exchange risk is the risk that the exchange rate will change unfavorably before the currency is exchanged. FOREIGN EXCHANGE RISK MANAGEMENT

Your business is open to risks from movements in competitors' prices, raw material prices, competitors' cost of capital, foreign exchange rates and interest rates, all of which need to be (ideally) managed. This section addresses the task of managing exposure to Foreign Exchange movements. These Risk Management Guidelines are primarily an enunciation of some good and prudent practices in exposure management. They have to be understood, and slowly internalized and customized so that they yield positive benefits to the company over time. It is imperative and advisable for the Apex Management to both be aware of these practices and approve them as a policy. Once that is done, it becomes easier for the Exposure Managers to get along efficiently with their task.

FOREIGN EXCHANGE MANAGEMENT ACT

The Foreign Exchange Management Act (FEMA) was passed in the winter session of Parliament in 1999 replacing Foreign Exchange Regulation Act. This act seeks to make offenses related to foreign exchange civil offenses. It extends to the whole of India. , which replaced Foreign Exchange Regulation Act (FERA), had become the need of the hour since FERA had become incompatible with the pro-liberalisation policies of the Government of India. has brought a new management regime of Foreign Exchange consistent with the emerging framework of the World Trade Organisation (WTO). It is another matter that the enactment of FEMA also brought with it the Prevention of Money Laundering Act 2002, which came into effect from 1 July 2005. Unlike other laws where everything is permitted unless specifically prohibited, under this act everything was prohibited unless specifically permitted. Hence the tenor and tone of the Act was very drastic. It required imprisonment even for minor offences. Under FERA a person was presumed guilty unless he proved himself innocent, whereas under other laws a person is presumed innocent unless he is proven guilty. MAIN FEATURES Activities such as payments made to any person outside India or receipts from them, along with the deals in foreign exchange and foreign security is restricted. It is FEMA that gives the central government the power to impose the restrictions.

Restrictions are imposed on people living in India who carry out transactions in foreign exchange, foreign security or who own or hold immovable property abroad.

Without general or specific permission of the Reserve Bank of India, FEMA restricts the transactions involving foreign exchange or foreign security and payments from outside the country to India the transactions should be made only through an authorised person.

Deals in foreign exchange under the current account by an authorised person can be restricted by the Central Government, based on public interest.

Although selling or drawing of foreign exchange is done through an authorised person, the RBI is empowered by this Act to subject the capital account transactions to a number of restrictions. People living in India will be permitted to carry out transactions in foreign exchange, foreign security or to own or hold immovable property abroad if the currency, security or property was owned or acquired when he/she was living outside India, or when it was inherited to him/her by someone living outside India.

Exporters are needed to furnish their export details to RBI. To ensure that the transactions are carried out properly, RBI may ask the exporters to comply to its necessary requirements.

DETERMINANTS OF EXCHANGE RATES

The following theories explain the fluctuations in exchange rates in a floating exchange rate regime (In a fixed exchange rate regime, rates are decided by its government)

International parity conditions: Relative Purchasing Power Parity, interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world.

Balance of payments model (see exchange rate): This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for continuous appreciation of dollar during 1980s and most part of 1990s in face of soaring US current account deficit.

Asset market model (see exchange rate): views currencies as an important asset class for constructing investment portfolios. Assets prices are influenced mostly by people's willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.

None of the models developed so far succeed to explain exchange rates and volatility in the longer time frames. For shorter time frames (less than a few days) algorithms can be devised to predict prices. It is understood from the above models that many macroeconomic factors affect the exchange rates and in the end currency prices are a result of dual forces of demand and supply. The world's currency markets can be viewed as a huge melting pot: in a large and everchanging mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange.

Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology.

FINANCIAL INSTRUMENTS

SPOT A spot transaction is a two-day delivery transaction (except in the case of trades between the US Dollar, Canadian Dollar, Turkish Lira, EURO and Russian Ruble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a direct exchange between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed-upon transaction. FORWARD

One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date, regardless of what the market rates are then. The duration of the trade can be one day, a few days, months or years. Usually the date is decided by both parties. Then the forward contract is negotiated and agreed upon by both parties. SWAP The most common type of forward transaction is the swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date. These are not standardized contracts and are not traded through an exchange. A deposit is often required in order to hold the position open until the transaction is completed. FUTURE Futures are standardized forward contracts and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts. OPTION A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The options market is the deepest, largest and most liquid market for options of any kind in the world. MEASUREMENT If foreign exchange markets are efficient such that purchasing power parity, interest rate parity, and the international Fisher effect hold true, a firm or investor needn't protect against foreign exchange risk due to an indifference toward international investment decisions. A deviation from one or more of the three international parity conditions generally needs to occur for an exposure to foreign exchange risk. Financial risk is most commonly measured in terms of the variance or standard deviation of a variable such as percentage returns or rates of change. In foreign exchange, a relevant factor would be the rate of change of the spot exchange rate between currencies. Variance represents exchange rate risk by the spread of exchange rates, whereas standard deviation represents exchange rate risk by the amount exchange rates deviate, on average, from the mean exchange rate in a probability distribution. A higher standard deviation would signal a greater currency risk. Economists have criticized the accuracy of standard deviation as a risk indicator for its uniform treatment of deviations, be they positive or negative, and for automatically squaring deviation values. Alternatives such as average absolute deviation and semivariance have been advanced for measuring financial risk. Value at Risk Practitioners have advanced and regulators have accepted a financial risk management technique called value at risk (VAR), which examines the tail end of a distribution of returns for changes in exchange rates to highlight the outcomes with the worst returns. Banks in Europe have been

authorized by the Bank for International Settlements to employ VAR models of their own design in establishing capital requirements for given levels of market risk. Using the VAR model helps risk managers determine the amount that could be lost on an investment portfolio over a certain period of time with a given probability of changes in exchange rates.

CONCLUSION Derivative use for hedging is only to increase due to the increased global linkages and volatile exchange rates. Firms need to look at instituting a sound risk management system and also need to formulate their hedging strategy that suits their specific firm characteristics and exposures. In India, regulation has been steadily eased and turnover and liquidity in the foreign currency derivative markets has increased, although the use is mainly in shorter maturity contracts of one year or less. Forward and option contracts are the more popular instruments. Regulators had initially only allowed certain banks to deal in this market however now corporates can also write option contracts. There are many variants of these derivatives which investment banks across the world specialize in, and as the awareness and demand for these variants increases, RBI would have to revise regulations. For now, Indian companies are actively hedging their foreign exchanges risks with forwards, currency and interest rate swaps and different types of options such as call, put, cross currency and range-barrier options. The high use of forward contracts by Indian firms also highlights the absence of a rupee futures exchange in India. However, the Dubai Gold and Commodities Exchange in June, 2007 introduced Rupee- Dollar futures that could be traded on its exchanges and had provided another route for firms to hedge on a transparent basis. There are fears that RBIs ability to control the partially convertible currency will be subdued by this introduction but this

issue is beyond the scope of this study. The partial convertibility of the Rupee will be difficult to control if many exchanges offer such instruments and that will be factor to consider for the RBI.