Introduction
An exporter without any commercial contract is completely exposed of foreign
exchange risks that arises due to the probability of an adverse change in
exchange rates. Therefore, it becomes important for the exporter to gain some
knowledge about the foreign exchange rates, quoting of exchange rates and
various factors determining the exchange rates. In this section, we have
discussed various topics related to foreign exchange rates in detail.
Spot Exchange Rate
Also known as "benchmark rates", "straightforward rates" or "outright rates",
spot rates represent the price that a buyer expects to pay for a foreign
currency in another currency. Settlement in case of spot rate is normally done
within one or two working days.
Forward Exchange Rate
The forward exchange rate refers to an exchange rate that is quoted and traded
today but for delivery and payment on a specific future date.
Method of Quoting Exchange Rates
There are two methods of quoting exchange rates:
- Direct Quotation: In this system,
variable units of home currency equivalent to a fixed unit of foreign
currency are quoted.
For example: US $ 1= Rs. 42.75
- Indirect Quotation: In this
system, variable units of foreign currency as equivalent to a fixed unit of
home currency are quoted.
For example: US $ 2.392= Rs. 100
Before 1993, banks were required to quote all the rates
on indirect basis as foreign currency equivalent to RS. 100 but after 1993 banks
are quoting rates on direct basis only.
Exchange
Rate Regime
The exchange rate regime is a method through which a country manages its
currency in respect to foreign currencies and the foreign exchange market.
- Fixed Exchange Rate
A fixed exchange rate is a type of exchange rate regime in which a
currency's value is matched to the value of another single currency or any
another measure of value, such as gold. A fixed exchange rate is also known
as pegged exchange rate. A currency that uses a fixed exchange rate is known
as a fixed currency. The opposite of a fixed exchange rate is a floating
exchange rate.
- Floating Exchange Rate
A Floating Exchange Rate is a type of exchange rate regime wherein a
currency's value is allowed to fluctuate according to the foreign exchange
market. A currency that uses a floating exchange rate is known as a floating
currency. A Floating Exchange Rate or a flexible exchange rate and is
opposite to the fixed exchange rate.
- Linked Exchange Rate
A linked exchange rate system is used to equlise the exchange rate of a
currency to another. Linked Exchange Rate system is implemented in Hong Kong
to stabilise the exchange rate between the Hong Kong dollar (HKD) and the
United States dollar (USD).
Forward Exchange Contracts
A Forward Exchange Contract is a contract between two parties (the Bank and the
customer). One party contract to sell and the other party contracts to buy, one
currency for another, at an agreed future date, at a rate of exchange which is
fixed at the time the contract is entered into.
Benefits of Forward Exchange Contract
- Contracts can be arranged to either buy or sell a
foreign currency against your domestic currency, or against another foreign
currency.
- Available in all major currencies.
- Available for any purpose such as trade, investment
or other current commitments.
- Forward exchange contracts must be completed by the
customer. A customer requiring more flexibility may wish to consider Foreign
Currency Options.
Foreign Currency Options
Foreign Currency Options is a hedging tool that gives the owner the right to buy
or sell the indicated amount of foreign currency at a specified price before a
specific date. Like forward contracts, foreign currency options also eliminate
the spot market risk for future transactions. A currency option is no different
from a stock option except that the underlying asset is foreign exchange. The
basic premises remain the same: the buyer of option has the right but no
obligation to enter into a contract with the seller. Therefore the buyer of a
currency option has the right, to his advantage, to enter into the specified
contract.
Flexible Forwards
Flexible Forward is a part of foreign exchange that has been developed as an
alternative to forward exchange contracts and currency options. The agreement
for flexible forwards is always singed between two parties (the ‘buyer’ of the
flexible forward and the 'seller' of the flexible forward) to exchange a
specified amount (the ‘face value’) of one currency for another currency at a
foreign exchange rate that is determined in accordance with the mechanisms set
out in the agreement at an agreed time and an agreed date (the ‘expiry time’ on
the ‘expiry date’). The exchange then takes place approximately two clear
business days later on the ‘delivery date’).
Currency Swap
A currency swap which is also known as cross currency swap is a foreign exchange
agreement between two countries to exchange a given amount of one currency for
another and, after a specified period of time, to give back the original amounts
swapped.
Foreign Exchange Markets
The foreign exchange markets are usually highly liquid as the world's main
international banks provide a market around-the-clock. The Bank for
International Settlements reported that global foreign exchange market turnover
daily averages in April was $650 billion in 1998 (at constant exchange rates)
and increased to $1.9 trillion in 2004 [1]. Trade in global currency markets has
soared over the past three years and is now worth more than $3.2 trillion a day.
The biggest foreign exchange trading centre is London, followed by New York and
Tokyo.
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