Foreign Exchange Project 5r338

FOREIGN EXCHANGE Foreign exchange, or Forex, is the conversion of one country's currency into that of another. In a free economy, a country's currency is valued according to factors of supply and demand. In other words, a currency's value can be pegged to another country's currency, such as the U.S. dollar, or even to a basket of currencies. A country's currency value also may be fixed by the country's government. However, most countries float their currencies freely against those of other countries, which keeps them in constant fluctuation. The value of any particular currency is determined by market forces based on trade, investment, tourism, and geo-political risk. Every time a tourist visits a country, for example, he or she must pay for goods and services using the currency of the host country. Therefore, a tourist must exchange the currency of his or her home country for the local currency. Currency exchange of this kind is one of the demand factors for a particular currency. Another important factor of demand occurs when a foreign company seeks to do business with a company in a specific country. Usually, the foreign company will have to pay the local company in their local currency. At other times, it may be desirable for an investor from one country to invest in another, and that investment would have to be made in the local currency as well. All of these requirements produce a need for foreign exchange and are the reasons why foreign exchange markets are so large. Foreign exchange is handled globally between banks and all transactions fall under the auspice of the Bank of International Settlements.

Foreign Exchange

International Trade

External Receipts and Payments

Import Trade

Current

Export Trade

Capital

Foreign Exchange Market The Foreign Exchange Market is a market where the buyers and sellers are involved in the sale and purchase of foreign currencies. In other words, a market where the currencies of different countries are bought and sold is called a foreign exchange market. The structure of the foreign exchange market constitutes central banks, commercial banks, brokers, exporters and importers, immigrants, investors, tourists. These are the main players of the foreign market, their position and place are shown in the figure below.

At the bottom of a pyramid are the actual buyers and sellers of the foreign currencies- exporters, importers, tourist, investors, and immigrants. They are actual s of the currencies and approach commercial banks to buy it. The commercial banks are the second most important organ of the foreign exchange market. The banks dealing in foreign exchange play a role of “market makers”, in the sense that they quote on a daily basis the foreign exchange rates for buying and selling of the foreign currencies. Also, they function as clearing houses, thereby helping in wiping out the difference between the demand for and the supply of currencies. These banks buy the currencies from the brokers and sell it to the buyers. The third layer of a pyramid constitutes the foreign exchange brokers. These brokers function as a link between the central bank and the commercial banks and also between the actual buyers and commercial banks. They are the major source of market information. These are the persons who do not themselves buy the foreign currency, but rather strike a deal between the buyer and the seller on a commission basis. The central bank of any country is the apex body in the organization of the exchange market. They work as the lender of the last resort and

the custodian of foreign exchange of the country. The central bank has the power to regulate and control the foreign exchange market so as to assure that it works in the orderly fashion. One of the major functions of the central bank is to prevent the aggressive fluctuations in the foreign exchange market, if necessary, by direct intervention. Intervention in the form of selling the currency when it is overvalued and buying it when it tends to be undervalued.

Factors that Affect Foreign Exchange Rates Foreign Exchange rate (FOREX rate) is one of the most important means through which a country’s relative level of economic health is determined. A country's foreign exchange rate provides a window to its economic stability, which is why it is constantly watched and analyzed. If you are thinking of sending or receiving money from overseas, you need to keep a keen eye on the currency exchange rates.

The exchange rate is defined as "the rate at which one country's currency may be converted into another." It may fluctuate daily with the changing market forces of supply and demand of currencies from one country to another. For these reasons; when sending or receiving money internationally, it is important to understand what determines exchange rates. This article examines some of the leading factors that influence the variations and fluctuations in exchange rates and explains the reasons behind their volatility, helping you learn the best time to send money abroad.

Inflation Rates Changes in market inflation cause changes in currency exchange rates. A country with a lower inflation rate than another's will see an appreciation in the value of its currency. The prices of goods and services increase at a slower rate where the inflation is low. A country with a consistently lower

inflation rate exhibits a rising currency value while a country with higher inflation typically sees depreciation in its currency and is usually accompanied by higher interest rates

Interest Rates Changes in interest rate affect currency value and dollar exchange rate. Forex rates, interest rates, and inflation are all correlated. Increases in interest rates cause a country's currency to appreciate because higher interest rates provide higher rates to lenders, thereby attracting more foreign capital, which causes a rise in exchange rates

Country’s Current / Balance of Payments A country’s current reflects balance of trade and earnings on foreign investment. It consists of total number of transactions including its exports, imports, debt, etc. A deficit in current due to spending more of its currency on importing products than it is earning through sale of exports causes depreciation. Balance of payments fluctuates exchange rate of its domestic currency.

Government Debt Government debt is public debt or national debt owned by the central government. A country with government debt is less likely to acquire foreign capital, leading to inflation. Foreign investors will sell their bonds in the open market if the market predicts government debt within a certain country. As a result, a decrease in the value of its exchange rate will follow.

of Trade Related to current s and balance of payments, the of trade is the ratio of export prices to import prices. A country's of trade improves if its exports prices rise at a greater rate than its imports prices. This results in higher revenue, which causes a higher demand for the country's currency and an increase in its currency's value. This results in an appreciation of exchange rate.

Political Stability & Performance A country's political state and economic performance can affect its currency strength. A country with less risk for political turmoil is more attractive to

foreign investors, as a result, drawing investment away from other countries with more political and economic stability. Increase in foreign capital, in turn, leads to an appreciation in the value of its domestic currency. A country with sound financial and trade policy does not give any room for uncertainty in value of its currency. But, a country prone to political confusions may see a depreciation in exchange rates.

Recession When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to acquire foreign capital. As a result, its currency weakens in comparison to that of other countries, therefore lowering the exchange rate.

Speculation If a country's currency value is expected to rise, investors will demand more of that currency in order to make a profit in the near future. As a result, the value of the currency will rise due to the increase in demand. With this increase in currency value comes a rise in the exchange rate as well.

All of these factors determine the foreign exchange rate fluctuations. If you send or receive money frequently, being up-to-date on these factors will help you better evaluate the optimal time for international money transfer. To avoid any potential falls in currency exchange rates, opt for a locked-in exchange rate service, which will guarantee that your currency is exchanged at the same rate despite any factors that influence an unfavorable fluctuation. For more information on transferring money abroad, learn about some important tips for sending money overseas and your rights as an overseas money sender.

Foreign Exchange Exposure Foreign Exchange Exposure refers to the risk associated with the foreign exchange rates that change frequently and can have an adverse effect on the financial transactions denominated in some foreign currency rather than the domestic currency of the company. In other words, the firm’s risk that its future cash flows get affected by the change in the value of the foreign currency, in which it has maintained its books of s (balance sheet), due to the volatility of the foreign exchange rates is termed as foreign exchange exposure. It is not only those firms who directly make the financial transactions in the foreign currency denominations faces the risk of foreign exposure, but also, the other firms who are indirectly related to the foreign currency is exposed to foreign currency risk. For example, if Indian company is competing against the products imported from China and if the Chinese yuan per Indian rupee falls, then the importers enjoy decreased cost advantage over the Indian company. This shows, that the companies not having any direct link to the forex do get affected by the change in the foreign currency.

Transaction Exposure The Transaction Exposure is a kind of foreign exchange risk involved in the international trade wherein the cross-currency transactions (multiple currencies) are involved. In other words, a risk faced by the company that while dealing in the international trade, the currency exchange rates may change before making the final settlement, is termed as a transaction exposure. If the Indian exporter has the receivable of $5,00,00, due five months hence, but in the meanwhile the dollar depreciates relative to the rupee, then the exporter will suffer the cash loss. But however, in the case of a payable of the same amount, the exporter gains if the dollar depreciates relative to the rupee. Thus, once the cross-currency contract has been agreed upon by the firms located in two different countries for the specific amount of goods and money, the contract value may change with the fluctuations in the foreign exchange rates. This risk of change in the exchange rates is called the transaction exposure.

The greater the time gap between the agreement and the final settlement, the higher is the risk associated with the change in the foreign exchange rates. However, the companies could save themselves against the transaction exposure through hedging techniques.

Operating Exposure The Operating Exposure refers to the extent to which the firm’s future cash flows gets affected due to the change in the foreign exchange rates along with the price changes. In other words, a risk that firm’s revenue will be adversely affected due to the substantial change in the exchange rate and the inflation rate is called as operating exposure. Operating Exposure, like transaction exposure, also involves the actual or potential gain or loss, but the latter is specific in nature and deals with a particular transaction of the firm, while the former deals with certain macro level exposure wherein not only the firm under concern gets affected but rather the whole industry observes the change with the change in the exchange rates and the inflation rate. Thus, with operating exposure, the entire economy is exposed to the foreign exchange risk. Since, operating exposure is much broader in nature, and relates to the entire investment of the firm so with the change in the exchange rates the overall value of the firm gets altered. The firm’s value is comprised of the operating cash flows and the total assets the firm possesses. It is quite difficult to identify operating risk, as the cash flows largely depends on the cost of firm’s inputs and the prices of its outputs which gets altered significantly with the change in the foreign exchange rates. Also, such exposure relates to the unseen challenges from the competitors, entry barriers, etc., which are subjective in nature and are interpreted differently by different experts. Thus, operating exposure influences the competitive position of the firm substantially.

Translation Exposure The Translation Exposure or ing Exposure is the risk of loss suffered when stock, revenue, assets or liabilities denominated in foreign currency changes with the movement of the foreign exchange rates. In other words, the translation exposure stems from the requirement of converting the subsidiary’s assets and liabilities (operating in another

country) denominated in foreign currency in the home currency of the parent company, at the time of preparing the consolidated profit and loss statement and the balance sheet. Thus, any change in the foreign exchange rate will have a considerable impact on the financial statements. In translating the items denominated in foreign currency in the domestic currency, an ant encounters two issues: 1. Whether the financial statement items denominated in foreign currency are converted at the current exchange rate or at the rate which was prevailing at the time the transaction occurred (historical exchange rate)? 2. Whether the profit or loss that arises from the rate adjustments be taken into the current period profit and loss statement or be postponed? If there is any change in the exchange rate over the previous ing period, then the translation of the items denominated in the foreign currency will result in foreign exchange gains or losses, except when there is a tax implication on these items. The translation exposure is concerned with the recorded profits and the balance sheet values and does not affect the overall value of the firm. Since the gains or losses suffered due to the translation of financial items has no significant impact on the stock prices of the firm. And the investors do believe that such risk can be diversified and hence does not demand any extra for it.