Currency risk is a type of risk in international trade that arises from the
fluctuation in price of one currency against another. This is a permanent risk
that will remain as long as currencies remain the medium of exchange for
commercial transactions. Market fluctuations of relative currency values will
continue to attract the attention of the exporter, the manufacturer, the
investor, the banker, the speculator, and the policy maker alike.
While doing business in foreign currency, a contract is signed and the company
quotes a price for the goods using a reasonable exchange rate. However, economic
events may upset even the best laid plans. Therefore, the company would ideally
wish to have a strategy for dealing with exchange rate risk.
Currency hedging is technique
used to avoid the risks associated with the changing value of currency while
doing transactions in international trade. It is possible to take steps to hedge
foreign currency risk. This may be done through one
of the following options:
- Billing foreign deals in Indian Rupees: This insulates the Indian
exporter from currency fluctuations. However, this may not be acceptable to
the foreign buyer. Most of international trade transactions take place in
one of the major foreign currencies USD, Euro, Pounds Sterling, and Yen.
- Forward contract. You agree to sell a fixed amount of
foreign exchange (to convert this into your currency) at a future date,
allowing for the risk that the buyer’s payments are late.
- Options: You buy the right to have currency at an
agreed rate within an agreed period. For example, if you expect to receive
$35,000 in 3 months, time you could buy an option to convert $35,000 into
your currency in 3 months. Options can be more expensive than a forward
contract, but you don't need to compulsorily use your option.
- Foreign currency bank account and foreign currency
borrowing: These may be suitable where you have cost in the foreign currency
or in a currency whose exchange rate is related to that currency.
Forex market is one of the largest financial markets in the world, where
buyers and sellers conduct foreign exchange transactions. Its important in the
international trade can be estimated with the fact that average daily trade in
the global forex markets is over US $ 3 trillion. We
shall touch upon some important topics that affect the
risk profile of an International transaction.
Also known as "benchmark rates", "straightforward rates"or
"outright rates", spot rates is an agreement to buy or sell currency at the
current exchange rate. The globally accepted settlementcycle for
foreignexchange contracts is two days. Foreignexchange contracts are therefore
settled on the second day after the day the deal is made.
price is a fixed price at which a particular amount of a commodity, currency or
security is to be delivered on a fixed date in the future, possibly as for as a
year ahead. Traders agree to buy and sell currencies for settlement at least
three days later, at predetermined exchange rates. This type of transaction
often is used by business to reduce their exchange rate risk.
Theoretically it is possible for a forward price of a
currency to equal its spot price However, interest rates must be
considered . The interest rate can be earned by holding different
currencies usually varies, therefore forward price can be higher or
lower than (at premium or discount to ) the spot prices.
There reference rate given by RBI is based on 12 noon rates of a few
selected banks in Mumbai.
Interbank rates rates quotes the bank for buying and selling foreign
currency in the inter bank market, which works on wafer thin margins . For
inter bank transactions the quotation is up to four decimals with the
last two digits in multiples of 25.
Telegraphic transfer or in
short TT is a quick method of transfer money from one bank to another bank. TT
method of money transfer has been introduced to solve the delay problems caused
by cheques or demand drafts. In this method, money does not move physically and
order to pay is wired to an institutions’ casher to make payment to a company or
individual. A cipher code is appended to the text of the message to ensure its
integrity and authenticity during transit. The same principle applies with
Western Union and Money Gram.
The Currency rate is the rate at which the authorized dealer buys
and sells the currency notes to its customers. It depends on the TC rate
and is more than the TC rate for the person who is buying
In inter bank transactions all currencies are normally traded against the US
dollar, which becomes a frame of reference. So if one is buying with
rupees a currency X which is not normally traded, one can arrive at a
rupeeexchange rate by relating the rupee $ rate to the $X rate .
This is known as a cross rate.
When you go long on a currency, its means you bought it and are
holding it in the expectation that it will appreciate in value. By
contrast, going short means you reselling currency in the
expectation that what you are selling will depreciate in value.
Bids are the highest price that the seller is
offering for the particular currency. On the other hand, ask is the lowest price
acceptable to the buyer.Together, the two prices constitute a quotation and the
difference between the price offered by a dealer willing to sell something and
the price he is willing to pay to buy it back.
The bidask spread is amount by which the ask price exceeds the bid. This is
essentially the difference in price between the highest price thata buyer is
willing to pay for an asset and the lowest price for whicha seller is willing
to sell it.
For example, if the bid price is $20 and the ask
price is $21 then the "bidask spread" is $1.
The spread is usually rates as percentage cost of
transacting in the forex market, which is computed as follow :
Percent spread =(Ask priceBid price)/Ask price *100
The main advantage of bid and ask methods is that conditions are laid out in
advance and transactions can proceed with no further permission or authorization
from any participants. When any bid and ask pair are compatible, a transaction
occurs, in most cases automatically.
In terms of foreign exchange, buying means purchasing a certain amount of the
foreign currency at the bid or buying price against the delivery /crediting of a
second currency which is also called counter currency.
On the other hand, selling refers to a fix amount of foreign currency at the
offered or selling price against the receipt / debiting of another currency.
Forex rates or
exchange rate is the price of a country's currency in terms of another country's
currency. It specifies how much one currency is worth in terms of the other. For
example a forex rate of 123
Japanese yen (JPY, ¥) to the
United States dollar (USD, $) means that
JPY 123 is worth the same as USD 1.
currency and its interest rate is a major concern in the international trade.
Investors are easily attracted by the higher interest rates which in turns also
effects the economy of a nation and its currency value.
example, if interest rate on INR were substantially higher than the interest
rate on USD, more USD would be converted into INR and pumped into the Indian
economic system. This would result in appreciation of the INR, resulting in
lower conversion rates of USD against INR, at the time of reconversion into USD.
rate is calculated by calculating the interest rate difference between the two
currencies involved in the transactions. For example, if a client is buying a 30
days US dollar then, the difference between the spot rate and the forward rate
will be calculated as follow:
dollars are purchased on the spot market at an appropriate rate, what causes the
forward contract rate to be higher or lower is the difference in the interest
rates between India and the United States.
The interest rate earned on US dollars is less than the interest rate earned on
Indian Rupee (INR). Therefore, when the forward rates are calculated the cost of
this interest rate differential is added to the transaction through increasing
USD 100,000 X 1.5200 = INR 152,000
INR 152,000 X 1% divided by 12 months = INR 126.67
INR 152,000 + INR 126.67 = INR 152,126.67
INR 152,126.67/USD 100,000 = 1.5213
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