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TO ELABORATE FURTHER ON FOREIGN EXCHANGE
DETAILED DISCUSSION ON FOREIGN EXCHANGE
FOREIGN EXCHANGE EXPOSURES:
Transaction exposure
i. Occurs when a change in foreign exchange rate occurs between the time a transaction is executed and the time it is settled
ii. Thus this risk occurs whenever the cash flow is affected in a particular transaction
Translation exposure
Occurs when the assets and liabilities which are denominated in one currency are translated into another currency for inclusion in financial statement
Economic Exposure.
This is the risk of a change in the foreign exchange rate due to change in the economic condition of one country Operating exposure Sensitivity of operating income to changes in exchange rate
Foreign exchange risk management (FERM):
i. Also known as exposure management.
ii. Copes with the possibility of incurring a loss on account of a open or an unhedged position in foreign exchange.
iii. Especially important where
iv. a large proportion of a corporate earnings / expenses are in foreign exchange; or
v. where any fluctuation in the FX has the potential to disturb the corporate ability to execute a strategic plan
FORWARD CONTRACT:
It is an immediate firm and binding agreement between bank and customer to buy or sell an agreed amount of currency at a date of exchange and at a rate fixed at the time the contract is made. Forwards (unlike futures) are not traded on the exchange. Hence the only way to exit a forward contract is to cancel the forward cover. The decision to hedge would depend upon the cost of hedging (forward premia) and also the expected movement in the foreign exchange rates.In India forward contracts are available for period’s up to 12 months.
Closing out of forward contracts
When the customer cannot perform the forward exchange contract the bank will close out the contract in one of the following manner: If the customer was to sell foreign exchange forward The bank will sell foreign exchange spot and buy it forward from the customer If the customer was to buy foreign exchange forward The bank will sell foreign exchange forward and buy back the same at spot rate
Extension of forward contracts
(i) At times, due to delay in receipt or payment of foreign exchange the customer may ask the bank to extend the forward contract.
(ii) In such cases the bank will extend the forward contract at term which is favorable as compared to entering into a fresh forward contract.
(iii) In some cases the bank may close out the old contract and enter into a fresh forward contract.
Advantages / disadvantages of forward cover
Forward cover provides insurance to the taker and thereby acts as a hedge. However by taking a forward cover one cannot take advantage of upswings or favorable movements in foreign exchange rates.
Currency futures
i. Closely related to currency forwards.
ii. Popularly known as futures contracts
iii. A standardized agreement to buy or sell a pre specified amount of foreign exchange in the futures market at some specified future date.
iv. Available for most hard currencies of the world say Yen, DM, £ sterling, $.
v. Futures being standardized are dealt on an organized exchange.
CURRENCY OPTION : It is a financial instrument that provides the holder a right but not an obligation to buy or sell pre-specified amount of currency at a predetermined rate on a specified date.
There are two types of currency options: call option and put option
CALL OPTION: The right to buy a particular currency at a specified rate on a particular date or within a specified period.Such an option will be exercised only if the rate of the currency on the exercise date is higher than the option strike price.
PUT OPTION: The right to sell a particular currency at a specified rate on a particular date. or within a specified period. Such an option will be exercised only if the rate of the currency on the exercise date is lower than the option strike price.
CURRENCY SWAPS : A legal agreement between two parties to exchange the principal and interest rate obligation or receipts in different currencies. A currency swap is an agreement to exchange fixed or floating rate payments in one currency for fixed or floating payments in a second currency plus an exchange of the principal currency amount. Allows the customer to redenominate a loan from one currency to another. Redenomination done to reduce borrowing costs and also to hedge against a perceived foreign exchange fluctuation .
LEADING AND LAGGING :Sound financial management practices require that assets should be in strong currency while liability should be maintained in weak currency. Leading and lagging refers to the technique of adjusting the timing of receipts and payments.
Leading: collect the receivables from foreign debtors before
In this project various exposures like transaction exposure ,translation exposure and economic exposure are being discussed. After that foreign exchange risk management which is also known as exposure management is being discussed. After that forward contract is beng discussed. Forward contract are different from futures contract. In forward contract size and maturity is not standardized which is standardized in futures market. In forward contract liquidity is low as compared to futures. In futures currency futures was discussed in detail. After that currency swaps which two parties agree to exchange interest and principal obligation in different currencies was discussed.After that discussion was made regarding leading which refers to payment before due date and lagging which refers to payment after due date was made.Then concept of netting was discussed.After that FRA was discussed. Then discussion was made regarding interest rate caps,collars and ceilings.
28 Feb, 2018
NIMS offers a diverse and vibrant community where students can not only excel academically but also grow personally through engaging experiences and supportive networks. Help other students by share your experiences at NIMS.