UNIT 1

Foreign Exchange

1. Foreign Exchange and Foreign Trade

 Foreign Exchange refers to currencies of other countries. It facilitates international

trade and investments.
 Foreign Trade is the exchange of goods and services across international borders. It
includes:
o Exports (selling domestically produced goods abroad)
o Imports (buying foreign-produced goods)
 These two concepts are closely linked since foreign trade often requires payment in
foreign currency.

2. Exchange Rate

 It is the price of one currency in terms of another.

 Types:
o Spot Rate: Rate at which currency is exchanged immediately.
o Forward Rate: Agreed-upon rate for future exchange.
o Nominal vs Real Exchange Rate: Real considers inflation differences.
 Influenced by factors like inflation, interest rates, balance of payments, etc.

3. Foreign Exchange as Stock

 Views foreign exchange as a stock variable, representing the reserve of foreign

currencies held by a country's central bank.
 It reflects the country's international liquidity position.

4. Balance of Payments (BOP)

 A statement that records all economic transactions between residents of a country and
the rest of the world over a specific period.
 Two main accounts:
o Current Account (goods, services, income, transfers)
o Capital & Financial Account (investments, loans)
 A surplus/deficit in BOP influences currency value.

5. Balance of Payments Accounting

  Systematic recording and balancing of all economic transactions.
 Uses double-entry bookkeeping:
o Credit: inflows (exports, foreign investment)
o Debit: outflows (imports, domestic investment abroad)
 Ensures accurate tracking of trade and capital movements.

6. Components of Balance of Payments

 Current Account:
o Exports/imports of goods/services
o Income (investment earnings)
o Transfers (remittances, aid)
 Capital Account:
o Debt forgiveness, transfer of assets
 Financial Account:
o FDI, portfolio investment
 Official Reserve Account:
o Central bank transactions to stabilize currency
 Entries are recorded as debits and credits.

7. International Exchange Systems

 Systems that define how exchange rates are determined and managed:
o Fixed exchange rate
o Floating exchange rate
o Managed float
 Involve international cooperation (IMF, World Bank).

8. Fixed and Floating Exchange Rate System

 Fixed: Currency value tied to another (e.g., gold or USD).

 Floating: Determined by market forces.
 Managed Float: Central bank intervenes occasionally.

9. Exchange Rate System Prior to IMF

 Gold Currency Standard: Currency backed by gold coins.

 Gold Bullion Standard: Paper currency convertible into gold bullion.
 Gold Exchange Standard: Currencies convertible into a currency that was
convertible into gold.
10. Exchange Rate System under IMF

 Bretton Woods System (1944–1971):

o Fixed exchange rates with USD pegged to gold.
 Smithsonian Agreement (1971):
o Adjusted fixed rates; failed soon after.
 Flexible Exchange Rate Regime:
o Post-1973 system of floating rates determined by supply and demand.

UNIT 2

Foreign Exchange and International Finance

1. Foreign Currency Account: NOSTRO, VOSTRO, and LORO Accounts

in Foreign Transactions

Foreign currency accounts are specialized bank accounts that help banks
conduct international transactions involving different currencies. These
accounts are essential in maintaining smooth cross-border trade and payment
systems. There are three main types of such accounts:

 NOSTRO Account: This is a Latin term meaning "our account with

you." It refers to an account that a domestic bank holds in a foreign
bank, in the foreign currency. For example, if State Bank of India
(SBI) has an account in Citibank New York denominated in USD,
then from SBI's perspective, it is a NOSTRO account. These accounts
are used to facilitate international transactions like import/export
payments, remittances, and other foreign exchange dealings.

 VOSTRO Account: This is a Latin term meaning "your account with

us." It refers to an account that a foreign bank holds with a domestic
bank, in the domestic currency. For instance, if Citibank maintains an
INR account in SBI, from SBI's point of view it is a VOSTRO
account. It allows foreign banks to facilitate transactions in the
domestic market.

 LORO Account: This means "their account with them." It refers to an

account that one bank refers to, which is held by another bank in a
third bank. It is a way to describe a third-party account used for
 international transactions. For instance, if Bank of India has an
account with Citibank that SBI refers to, SBI calls it a LORO account.

These accounts are critical in facilitating inter-bank foreign exchange

settlements and are the backbone of global trade finance.

2. Current Account Convertibility

Current account convertibility allows residents of a country to make payments

in foreign currencies for goods and services without restrictions. It includes
freedom to:

 Import/export goods and services

 Remit interest and dividends
 Send money for education or travel

Key Characteristics:

 It is essential for international trade.

 Encourages foreign investment by making transactions smoother.
 Promotes integration with the global economy.

In India:
India achieved full current account convertibility in August 1994. However,
certain remittances are still regulated under the Liberalised Remittance Scheme
(LRS) and FEMA.

Benefits:

 Promotes trade and services exports

 Improves global competitiveness
 Increases transparency

Challenges:

 Can cause balance of payments volatility

 Requires robust foreign exchange reserves and macroeconomic stability

3. Capital Account Convertibility

Capital account convertibility refers to the freedom to convert local financial
assets into foreign financial assets and vice versa at market-determined
exchange rates. It involves:

 Foreign Direct Investment (FDI)

 Portfolio investment
 External borrowings and lending

Types:

 Inward Convertibility: Foreign investors investing in domestic assets.

 Outward Convertibility: Domestic investors investing in foreign assets.

In India:
India has a partially convertible capital account. There are certain controls on
how much Indian citizens can invest abroad. Corporate entities have more
liberal provisions compared to individuals.

Advantages:

 Attracts foreign capital

 Promotes financial integration
 Provides access to international financial markets

Risks:

 Volatile capital flows

 Risk of sudden capital flight
 Exchange rate fluctuations

4. Purchasing Power Parity (PPP)

Purchasing Power Parity is an economic theory that compares different

countries' currencies through a market "basket of goods" approach. It suggests
that in the absence of transaction costs and other frictions, identical goods
should have the same price globally when expressed in a common currency.

Types of PPP:

 Absolute PPP: Direct comparison of price levels.

 Relative PPP: Takes into account inflation differences over time.
Formula:
E = P1 / P2
Where E = Exchange rate
P1 = Price level in country 1
P2 = Price level in country 2

Uses:

 Determining real exchange rates

 Comparing economic productivity
 Estimating standard of living

Limitations:

 Doesn't consider non-tradable goods

 Differences in consumption patterns
 Market imperfections

UNIT 3

1. Foreign Exchange Transactions: Purchase and Sale Transactions

Foreign exchange transactions involve the exchange of one currency for another
between two parties. They are categorized as:

 Purchase Transactions: Buying foreign currency, usually for imports or

investments abroad.
 Sale Transactions: Selling foreign currency, typically arising from
exports or remittances.

Types of Forex Transactions:

 Spot Transactions: Immediate settlement (usually T+2 days)

 Forward Transactions: Settlement at a future date at a predetermined
rate
 Swap Transactions: Simultaneous spot and forward transaction

These transactions help businesses and individuals manage foreign currency

exposures and hedge risks.
2. Exchange Quotations: Direct and Indirect Quotations, Two-Way
Quotation

 Direct Quotation: Local currency per unit of foreign currency.

Example: In India, USD 1 = INR 83.20
 Indirect Quotation: Foreign currency per unit of local currency.
Example: INR 100 = USD 1.20
 Two-Way Quotation: A dealer provides both bid (buying) and ask
(selling) rates.
Example: USD/INR = 83.20/83.50

This helps in improving market transparency, enhancing liquidity, and making

forex trading efficient.

UNIT 4

Exchange Dealings

1. Forex Risk Management: Risk in Forex Dealing, Measure of Value at

Risk (VaR)

Types of Forex Risks:

 Transaction Risk: Arises due to time lag in settlement

 Translation Risk: Revaluation of foreign currency assets/liabilities
 Economic Risk: Impact on market value and competitiveness

Risk Management Tools:

 Forward contracts
 Currency options
 Futures and swaps

Value at Risk (VaR):

VaR is a statistical technique used to measure the risk of loss on a portfolio over
a defined period for a given confidence interval.

Example: A 1-day VaR of INR 10 lakhs at 95% confidence level means there is
a 5% chance the loss could exceed INR 10 lakhs in one day.

2. Settlement of Transactions: SWIFT, CHIPS, CHAPS, FedWire

  SWIFT: Secure network for financial messaging used by banks
worldwide. It doesn’t transfer funds but sends payment instructions.
 CHIPS (Clearing House Interbank Payments System): A US-based
private clearing house for large USD payments. Settles payments through
netting.
 CHAPS (Clearing House Automated Payment System): UK-based
real-time gross settlement system for GBP transactions.
 FedWire: US Federal Reserve’s electronic payment system for large
value, real-time transactions.

These systems reduce counterparty risks and ensure smooth global financial
settlements.

3. What is Exchange Dealings? Various Dealing Positions

Exchange Dealings:
The process by which banks and authorized dealers buy/sell foreign currencies.
It involves:

 Quoting exchange rates

 Executing customer orders
 Managing currency positions

Dealing Positions:

 Overbought Position: More foreign currency purchased than sold. Risk

of depreciation.
 Oversold Position: More foreign currency sold than bought. Risk of
appreciation.
 Square Position: Purchases equal sales. No exposure.

Managing dealing positions is critical for profitability and risk control in the
forex market.

UNIT 5

Exchange Risk: Exchange Exposure and Exchange Risk

1. Exchange Risk: Exchange Exposure and
Exchange Risk
✅ Exchange Risk

 The possibility of a financial loss due to unfavorable movement in exchange rates.

 Common for firms dealing in imports, exports, or international borrowing/lending.

✅ Types of Exchange Exposure (Risks)

1. Transaction Exposure – Arises from actual transactions in foreign currency.

2. Translation Exposure – Arises from converting foreign subsidiaries’ financials into
the home currency.
3. Economic Exposure – Reflects impact on a firm’s future cash flows and market
value.

2. Transaction Exposure, Managing Transaction

Exposure
✅ Transaction Exposure

 Incurred when a firm has payables/receivables in foreign currency.

 Example: An Indian exporter has receivables in USD; if USD depreciates, revenue
reduces in INR.

✅ Managing Transaction Exposure

A. Contractual Methods:

1. Forward Contracts – Lock in exchange rate now for future transactions.

2. Futures Contracts – Standardized version of forward contracts traded on exchanges.
3. Currency Options – Provides the right (not obligation) to exchange at a pre-agreed
rate.

B. Money Market Hedge:

 Involves borrowing and lending to create offsetting cash flows.

C. Natural/Internal Hedging:

 Netting, leading/lagging payments, invoice in domestic currency.

3. External Hedge
 External hedging uses financial markets to manage risk.
 It involves buying/selling instruments to cover foreign currency exposure.

✅ Tools Used:

1. Forward Contracts
2. Futures Contracts
3. Options
4. Swaps

4. Forward Contract Hedge, Money Market

Hedge, Hedging with Futures and Options
✅ Forward Contract Hedge

 Private agreement with a bank to exchange currencies at a fixed rate on a future date.
 Protects against unfavorable rate movements.

✅ Money Market Hedge

 Uses domestic and foreign money markets to lock in the value of a future currency
transaction.
 Steps involve borrowing in one currency, converting, investing, and repaying later.

✅ Hedging with Futures

 Futures are standardized forward contracts traded on exchanges.

 Useful for hedging anticipated but uncertain transactions.

✅ Hedging with Options

 Options give the right to buy/sell at a fixed price (premium must be paid).
 Useful when the firm wants to protect downside risk but retain upside potential.

5. Internal Hedge
✅ Internal Techniques (Non-market-based methods):

1. Leading and Lagging: Adjusting payment timing to take advantage of favorable

rates.
2. Netting: Offsetting receivables and payables between group companies.
3. Currency Invoicing: Asking customers to transact in your home currency.
 4. Matching: Matching inflows and outflows in the same foreign currency.

6. Translation Exposure, Methods of Translation,

Managing Translation Exposure
✅ Translation Exposure

 Occurs when foreign subsidiaries’ financials are converted to the parent company's
currency for reporting.
 Affects consolidated financial statements.

✅ Methods of Translation:

1. Current Rate Method – All assets/liabilities at current rate; equity at historical rate.
2. Temporal Method – Monetary items at current rate; non-monetary at historical rate.
3. Monetary/Non-monetary Method – Similar to temporal; separates monetary from
non-monetary items.

✅ Managing Translation Exposure:

 Currency derivatives (forwards, options)

 Balance sheet hedging
 Currency diversification

7. Economic Exposure, Managing Economic

Exposure
✅ Economic Exposure

 The risk that a firm’s future cash flows and market value will be impacted due to
unexpected exchange rate changes.
 Affects long-term competitiveness, pricing, and profitability.

✅ Managing Economic Exposure

1. Operational Strategies:
o Diversify production and sourcing across countries.
o Flexible sourcing and pricing policies.
2. Financial Strategies:
o Currency swaps
o Derivatives
o Matching cash flows
8. Interest Rate Risk
✅ Definition

 Risk arising due to fluctuations in interest rates affecting borrowing cost, investment
returns, and asset values.

✅ Types:

1. Price Risk – Rising interest rates reduce the value of fixed-income securities.
2. Reinvestment Risk – Future cash flows may be reinvested at lower rates.

✅ Managing Interest Rate Risk

 Interest Rate Swaps – Exchange fixed rate with floating rate.

 Forward Rate Agreements (FRAs) – Lock in future interest rates.
 Duration Management – Adjusting investment portfolio to reduce risk.
 Asset-Liability Matching – Match maturities of assets and liabilities.