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The foreign exchange market does not have a physical market place called the foreign exchange market. It is a mechanism through which one country's currency can be exchange i.e. bought or sold for the currency of another country. The foreign exchange market does not have any geographic location. The market comprises of all foreign exchange traders who are connected to each other through out the world. They deal with each other through telephones, telexes and electronic systems. The foreign exchange market operates twenty four hours a day during the business week; the only time it is silent is after the New York market closes on Friday afternoon and before the Sydney market opens on Monday morning (which would be Sunday evening New York time). In the aftermath of the Asian crisis, which curbed and restricted offshore trading in regional currencies, most derivatives markets in Asia are still in their infancy. Financial institutions trying to introduce or transplant products from mature markets to those that are lesser developed are meeting with limited success. The RBI has ushered rupee derivatives trading into the country: it has formally allowed banks and corporate to hedge against interest rate risks through the use of interest rate swaps (IRS) and forward rate agreement (FRA). According to the guidelines issued by RBI there will be no restriction on the tenure and size of the IRS and FRA entered into by banks. The IRS will also allow corporate to hedge their interest rate risks and also to provide an opportunity to swap their old high cost loans with cheaper ones. With the new guidelines in place, commercial banks, primary institutions and financial institutions can now undertake IRS and FRA as a product of their own balance sheet management and market making purposes. Initially, there was a lot of enthusiasm shown over swaps by corporates and financial institutions but now it seems to have waned. Not many deals have been reported for long. Market participants now realize that one can strike a couple of deals for the sake of
THE FOREX AND RISK MANAGEMENT
publicity, but one cannot have a sustainable interest rate market based on a single benchmark that too when it is as short as an overnight call money market. The issues of concern being the lack of a term market and domestic interest rates, particularly the overnight rate being hostage to the fortunes of the rupee in the Forex market. The swap market is expected to grow with growth in the money and forex markets.
THE FOREX AND RISK MANAGEMENT
The main idea was to know what is foreign exchange market and what are Derivatives and how corporate use these Derivatives to manage the risk that they would have faced if there were no derivatives. And how these Derivatives helps corporate to minimize the risk and survive in world.
The data for the project report was collected from diverse sources like books, Internet. The details of the books and sites visited have been mentioned in reference and bibliography. This report is a collection of secondary data.
THE FOREX AND RISK MANAGEMENT
Foreign exchange is the process of conversion of one currency into another currency. For a country its currency becomes money and legal tender. For a foreign country it becomes the value as a commodity. This commodity character can be understood when we study about ‘Exchange Rate’ mechanism. Since the commodity has a value its relation with the other currency determines the exchange value of one currency with the other. For example, the US dollar in USA is the currency in USA but for India it is just like a commodity, which has a value which varies according to demand and supply. Foreign exchange is that section of economic activity, which deals with the means, and methods by which rights to wealth expressed in terms of the currency of one country are converted into rights to wealth in terms of the current of another country. It involves the investigation of the method, which exchanges the currency of one country for that of another. Foreign exchange can also be defined as the means of payment in which currencies are converted into each other and by which international transfers are made; also the activity of transacting business in further means.
THE FOREX AND RISK MANAGEMENT
Authorised Dealers In Foreign Exchange
The Reserve Bank of India (RBI) has granted licenses to certain established firms, hotels and other organizations permitting them to deal in foreign currency notes, coins and travellers cheques subject to directions issued to them from time to time. Except for transactions involving purchase or sale of foreign currency between any person and an authorized money changer, no person, firm or company, other than an authorized dealer, is permitted to enter into transactions involving the buying, acquiring or borrowing from, or selling, transferring or lending to, or exchanging with a person not being an authorized dealer, any foreign exchange except with the general or special permission of the RBI.
Authorised Money Changer
In order to provide facilities for encashment of foreign currency to visitors from abroad, especially foreign tourists, Reserve Bank has granted licenses to certain established firms, hotels and other organizations permitting them to deal in foreign currency notes, coins and travellers cheques subject to directions issued top them from time to time. The firms and organizations generally known as ‘authorized moneychangers’ fall into two categories, namely ‘Full-fledged money-changers’ who are authorized to undertake both purchase and sale transactions with the public and ‘Restricted money-changers’ who are authorized only to purchase foreign currency notes, coins and travellers cheques, subject to the collections are surrendered by them in turn to an authorized dealer in foreign exchange/full-fledged moneychanger.
the sum total of global trade in physical goods in one year accounts for the same amount of trade as a few days in the foreign exchange market. The date on which the two currencies are exchanged is known as settlement date or value date. The relative amount of the two currencies is determined by the foreign exchange rate between those two countries. according to the Bank for International Settlements. . To put this figure in perspective. Foreign exchange market is the single largest market in the world. One counterparty buys a specified currency from the other counterparty in exchange for another currency.THE FOREX AND RISK MANAGEMENT FOREIGN EXCHANGE MARKET Foreign exchange markets allow market participants to exchange one currency for another.44 trillion is traded in the FX market each day. More than USD 1. Hence the FX market is much. much bigger than all other markets put together. which monitors the FX market activity.
In other words. international trade has necessitated exchange of currencies and this exchange of currencies had necessitated exchange rate. and a selling rate. As every sovereign nation has a distinct national currency. the exchange rate is said to be the rate at which a number of units of one currency can be exchanged for a number of another currency. The selling rate is the rate a bank will charge for currency. Like any other commodity. the price of one unit of foreign currency can be stated in terms of domestic currency. The barter trade has given way to exchange of goods and services for currencies instead of exchange for goods and services. . If US Dollar 1 = INR 48. and the flat is an average of the buying and selling rates.50. For instance. the rigors and problems of barter trade have disappeared. the price of US Dollar can be expressed in terms of Indian Rupees. it means the exchange rate of US Dollar and Indian Rupees is 1:48. the rate of exchange means the price of one currency in terms of another country’s currency.50(as on august 28’2002). Thus. With the invention of money. a flat rate. The buying rate in that which a bank will pay for foreign currency. Exchange rates are normally quoted in terms of a buying rate.THE FOREX AND RISK MANAGEMENT Exchange Rate Countries of the world have been exchanging goods and services amongst themselves from time immemorial.
The buying rate is that which a bank will pay for a foreign currency. Exchange rates are normally quoted in terms of a buying rate. .50. it means the exchange rate of US Dollars and Indian Rupees is 1: 48. the rigors and problems of barter trade have disappeared.THE FOREX AND RISK MANAGEMENT Exchange Determination and Forecasting INTRODUCTION: EXCHANGE RATE – AN OVERVIEW What is Exchange rate? Countries of the world have been exchanging goods and services amongst themselves from time immemorial. the price of one unit of foreign currency can be stated in terms of domestic company. The barter trade has given way to exchange of goods and services for currencies instead of exchange for goods and services. For instance. the rate of exchange means the price of one currency in terms of another country. the exchange rate is said to be the rate at which a number of units of one currency can be exchanged for a number of units of another currency. If US Dollar 1 = INR 48. a flat rate. international trade has necessitated exchange of currencies and this exchange of currencies necessitated exchange rate. Like any other commodity. and a selling rate. Thus. As every sovereign nation has a distinct national currency.50(as on August 28. In other words. With the invention of money. the price of US Dollar can be expressed in terms of Indian Rupees. 2002). and the flat rate is an average of the buying and the selling rates. The selling rate is the rate a bank will charge for the currency.
Flexible Exchange Rate System In a flexible exchange rate system. Foreign exchange market intervention occurs when a government buys and sells foreign exchange in an attempt to influence the exchange rate. Intervention Intervention is the buying or selling of foreign exchange by the central bank. In a system of Clean Floating Rate. Central banks intervene to buy and sell foreign currencies in attempts to influence exchange rates. The terms flexible and floating rates are used interchangeably. 2. 4. the central banks allow the exchange rate to adjust to equate the supply and demand for foreign currency. 3. The outfall of this is that the foreigners pay less for the devalued currency and the residents of the devaluing currency pay more for foreign currencies. . Devaluation Devaluation takes place when the price of foreign currencies under a fixed rate regime is increased by official action. Fixed Exchange Rate System In a fixed exchange rate system foreign central banks stand ready to buy and sell their currencies at a fixed price in terms of dollars.THE FOREX AND RISK MANAGEMENT Some Important Terms 1. Central Banks stand aside completely and allow exchange rates to be freely determined in the foreign exchange markets. Under a Managed or a Dirty floating rate.
it costs fewer domestic currencies to buy a unit of foreign currency. under floating rates. The reverse results in appreciation. Depreciation A change in price of foreign exchange under flexible exchange rates is referred to as currency depreciation or appreciation. the domestic currency is worth more. If the exchange rate falls. A currency depreciates when.THE FOREX AND RISK MANAGEMENT 5. . it becomes less expensive in terms of foreign currencies.
Under this system. at least in theory. The gold bullion standard prevailed from about 1870 until 1914. if insufficient demand for a currency lowered its market price below the parity band. The lower level of gold reserves would. the governments' role was a passive one in which they would merely permit the free flow of gold to stabilize economies and exchange rates. the international market price of a currency (the exchange rate) would fluctuate above or below parity based on the supply and demand of that currency relative to others. as a commodity. the operative system of exchange rates has evolved from a gold bullion standard to a system of floating exchange rates with several alternative systems used in between. Under this system. in turn. If excessive demand forced the market price of a currency above the parity band. the gold bullion standard acted as an automatic stabilizer. The following are some of such systems in brief Gold Bullion In modern times. . However. result in shrinkage of that country's money supply and a lower internal price level. and intermittently thereafter until 1944. unless a country maintained a reasonable trade balance over time.THE FOREX AND RISK MANAGEMENT Fixed Rate To Flexible Exchange Rate System Different countries have adopted different exchange rate systems at different times. external creditors demanded payments in gold. continuing trade deficits would drain its gold reserves. central governments defined their currencies in terms of a specific amount of gold bullion and agreed to redeem their currencies at the set rates (mint parities). With a self-balancing system such as this. the demand for the country's currency would also increase resulting in an inflow of gold reserves. external debtors found it cheaper to pay their debts in gold. Thus. Conversely. As exports increased. Lower domestic prices would eventually make the country's products more competitive in the international marketplace.
economies of almost all the countries suffered. the agreement established the International Monetary Fund (IMF) to act as the "custodian" of the system. the international trade suffered a deathblow.THE FOREX AND RISK MANAGEMENT The Gold Standard Many countries had accepted the Gold Standard as their monetary system during the last two decades of the nineteenth century. . the United States and most of its allies ratified the Bretton Woods Agreement. Gold Standard helped in maintaining the stability in exchange rates and correcting the disequilibria in their balance of payments on an automatic basis. which set up an adjustable parity exchange-rate system under which exchange rates were fixed (pegged) within narrow intervention limits (pegs) by the United States and foreign central banks buying and selling foreign currencies. Consequently. In order to correct the balance of payments disequilibrium. In addition to setting up fixed exchange parities (par values) of currencies in relationship to gold. following World War II. This system was in vogue till the outbreak of World War I. In 1944. The currencies of the countries. This agreement. the parities of currencies were fixed in terms of gold. Several efforts went futile in reviving this system and the era of Gold Standard came to an end by late 1930s. Bretton Woods System During the world wars. Under this system. fostered by a new spirit of international cooperation. could be exchanged freely and the rate varied depending upon the gold content of the currencies. many countries devalued their currencies. This was also known as the Mint Parity Theory of exchange rates. was in response to the financial chaos that had reigned before and during the war. which were on gold standards.
In early 1973. The ensuing massive United States balance-of-payments deficits led to an erosion of confidence in the dollar as a store of wealth. Despite the fact that the IMF expressed currencies in terms of gold. Incase of insufficiency of the reserve amount available with a member country. Despite this effort.25 percent). b. Naturally. The revaluation or devaluation of a currency was called for only in the case of "fundamental disequilibria" (chronic surpluses or deficits in a nation's balance of payments). along with agreement of .THE FOREX AND RISK MANAGEMENT Under this system. This was an attempt to restore monetary order by devaluing the dollar and establishing a wider parity band (plus or minus 2. This situation arose because the United States was the only country that agreed to redeem its currency for gold. the cancellation of the gold convertibility of the dollar in August 1971 by the United States. since under these conditions international liquidity (total trade financing potential) could be expanded only through larger balance-of-payments deficits on the part of the United States. the United States continued to experience balance-of-payments deficits. in practice currencies were expressed in terms of dollars. Member governments were obligated to defend the exchange rates within a narrow band of about 1 percent above or below parity (the official exchange rate). a. an additional 1 percent devaluation of the dollar. and the signing of the Smithsonian Agreement in December 1971 by the major trading nations. referred to as The Group of Ten. the Monetary Fund could draw from their quota through Special drawing Rights (SDRs) with the IMF. the dollar could not serve as both a national and an international currency. c. and the Bretton Woods Agreement became a rigid dollar standard. The Smithsonian agreement was reached wherein USA agreed to devalue its currency provided Germany and Japan revalued their currencies.
In the international economic sense.THE FOREX AND RISK MANAGEMENT several European Economic Community (EEC) member nations to let their currencies float against the dollar. major countries suspended their obligation to intervene in the market and the Bretton Wood System. was effectively buried. the tripling of oil prices by the Organization of Petroleum Exporting Countries (OPEC) during 1973 hit the foreign exchange markets like a hurricane. In addition. dealt the death knell to the Bretton Woods and Smithsonian Agreements. money has become a circular concept--defined only in terms of the price that each currency will bring in other currencies. There was a persistent increase in liquid resources available to the private sector relative to the monetary reserves held by the central banks. However. causing global inflation to raise with the tide. Money has become a commodity that is bought and sold at market prices. the circumstances under which floating exchange rates were introduced are by no means the only problem with the system.) 2. Allowing exchange rates to float in the midst of financial chaos was like setting a boat adrift in the middle of a storm--smooth sailing was next to impossible. There were constantly improving techniques permitting market participants to shift large amounts of capital rapidly from one currency to another. 3. To make matters worse. There were improving communication methods making information available instantaneously to a growing number of analysts throughout the world Thus with the uncontrollable capital flows. The lack of an official common denominator and the diminished authority of the IMF have not helped matters. (The money supply was no longer tied to a country's gold reserves and the multiplier effect allowed for this growth. with its fixed parities. . 1. three important trends developed that contributed to the problem.
exchange rate regimes and practices vary considerably across countries. Today.THE FOREX AND RISK MANAGEMENT Floating Rate System With the exit of fixed parities system. The breakdown of Bretton Woods System and the subsequent adoption of generalized floating by major industrialized countries. different countries experimented with exchange rate systems. The widespread adoption of flexible exchange rate system has made major contributions by offering many countries the easier use of an effective means of adjustment and by reducing the political biases against adjustments. . the option was left open to the developing countries to choose their own exchange rate regime in line with national preferences. which existed under the par value system.
Some of the Middle Eastern countries have adopted this system. imports. The objective is to make the home currency more stable than if a single peg was used. However. which are as follows: a) Single Currency Peg The country pegs to a major currency. c) Flexible Limited vis-à-vis Single Currency The value of the home currency is maintained within margins of the peg. b) Composite Currency Peg A currency composite is formed by taking into account the currencies of major trading partners. which is based on the degree of exchange rate flexibility that a particular regime reflects.THE FOREX AND RISK MANAGEMENT Exchange Rate Systems In Different Countries The member countries generally accept the IMF classification of exchange rate regime. The exchange rate arrangements adopted by the developing countries cover a broad spectrum. Many of the developing countries have single currency pegs. S. About one fourth of the developing countries have composite currency pegs. or total trade. . usually the U. either at the nominal or real exchange rate levels. Currency weights are generally based on trade in goods – exports. Dollar or the French franc (ExFrench colonies) with infrequent adjustment of the parity. it has been generally observed that there exists no strict relationship between a particular regime and the degree of exchange rate flexibility it faces.
The system actually operates with different levels of intervention in foreign exchange markets by the central bank. e) Managed floating The Central Bank sets the exchange rate. a combination of fixed-floating arrangement and tax-subsidy schemes for export – import trade. separate exchange rates for capital and current account transactions. . foreign exchange reserves or parallel market spreads and adjustments are not automatic. f) Independently floating Free market forces determine exchange rates. but adjusts it frequently according to certain pre-determined indicators such as the balance of payments position.THE FOREX AND RISK MANAGEMENT d) Adjusted to indicators The currency is adjusted more or less automatically to changes in selected macroeconomic indicators. It is important to note that these classifications do conceal several features of the developing country exchange rate regimes. A particular regime may be compatible with dual or multiple rates. A common indicator is the real effective exchange rate (REER) that reflects inflation adjusted change in the home currency vis-à-vis major trading partners.
inflation. and deficit financing. economic and psychological factors. During the fixed exchange rate era. Political Factors The political factors influencing exchange rates include the established monetary policy along with government action or inaction on items such as the money supply. interest rates. The inter-bank rate therefore ruled the RBI band.THE FOREX AND RISK MANAGEMENT The Evolution Of India’s Exchange Rate Regime Market in India The Rupee was historically linked with Pound Sterling. there is also the influence of the International Monetary Fund. Other political factors influencing exchange rates include the political stability of a country and its relative economic exposure (the perceived need for certain levels and types of imports).devaluation in June 1966. the intervention currency of the Reserve Bank of India (RBI) was the British Pound. such as traders. According to John E. are in turn influenced by political. and businessmen. inflationary pressures. The views of these participants. During the existence of the fixed exchange rate system. Irving Fisher. Active government intervention or manipulations. the RBI ensured maintenance of the exchange rate by selling and buying pounds against rupees at fixed rates. taxes. an . there was only one major change in the parity of the rupee. such as central bank activity in the foreign currency markets. bankers. India was a founder member of the IMF. it is the views of participants in the foreign-exchange markets that result in the daily buying and selling pressures on currencies. also have an impact. Finally. Rule. trade imbalances. Economic Factors Economic factors affecting exchange rates include hedging activities. and EuroMarket activities.
Among the factors that exert an influence on real money demand are interest rates. this theory states that the equilibrium exchange rate equals the ratio of domestic to foreign prices. developed a theory relating exchange rates to interest rates. the long-run determinants of exchange rates are the nominal quantities of monies. speculative pressures. In the short run. can take its toll on a currency's value. instead of formal models.66% error overall. Eveling's gut feeling has. Psychological Factors Psychological factors also influence exchange rates. and his method proved uncannily accurate in foreign exchange forecasting in 1998. the purchasing-power-parity theory relates exchange rates to inflationary pressures. defied convention. On the other hand. and real income growth. the only ‘trustworthy’ method of predicting exchange rates is by “gut feel”. Other economic factors influencing exchange rates are included in a theory proposed by Dombush.THE FOREX AND RISK MANAGEMENT American economist. expected inflation. the most accurate among 19 banks. vicepresident of financial markets at SG. These factors include market anticipation. and future expectations. The secret to Eveling's intuition on any currency is keeping abreast of world events. the real money demands and the relative price structure. who presented both a long-run view and a short-run view of exchange rate determinants. SG ended the Corporate Finance forecasting year with a 2. Today. from a declaration of war to a fainting political leader. states that interest rate differentials tend to reflect exchange rate expectations. is Corporate Finance's top foreign exchange forecaster for 1999. ‘Bob Eveling’. A few financial experts are of the opinion that in today’s environment. In its absolute version. Any event. known as the Fisher Effect. The relative version of the theory relates changes in the exchange rate to changes in price ratios. This proposition. exchange rates are determined by interest arbitrage together with speculation about future spot rates. most . According to Dombush. Dombush theorizes.
These influences can be grouped broadly as shown in the following diagram: Economic Political Influences on Exchange rate People . Factors Influencing Fx Rates The government to control its foreign exchange rates uses the interest rates. The three key factors affecting interest rates are: The supply and demand for money The rate of inflation Government interventions There are a number of other factors which have both long and short term influences on exchange rates which also need to be considered for a complete picture.THE FOREX AND RISK MANAGEMENT forecasters rely on an amalgam that is part economic fundamentals. part model and part judgment.
If an investor can receive a higher interest rate by lending money in a foreign currency than he can by lending money in his domestic currency. . it makes sense for that investor to lend in the foreign currency.THE FOREX AND RISK MANAGEMENT Economic Factors In this category there are four factors to be considered: • Relative interest rates • Purchasing power parity (PPP) • Economic conditions • Supply and demand for capital Relative Interest Rates Large investors can easily switch investments between different currencies so it is important for them to compare the returns from investments in different currencies to make sure they obtain the best investment performances.
In this case. usually the dollar. as the FX rate may vary over the tenor of the loan. However. every currency is in purchasing power parity. That is. translated by the FX rate of that country’s currency against a ‘base currency’. the investor will make a loss by lending in foreign currency.THE FOREX AND RISK MANAGEMENT Comparing interest rates in different currencies in this way is called comparing relative interest rates. Purchasing Power Parity (PPP) Purchasing power parity is the measure of the relative purchasing power of different currencies. currencies with higher interest rates tend to appreciate against other currencies because more investors buy the high –interest currency in order to chase the higher returns. Economic Conditions FX exchange rates are affected in the long-term by a country’s economic conditions and trends such as: • Balance of payments • Economic growth . In fact. If the equivalent amount of currency purchases exactly the same amount of goods in every country then international trade is no longer profitable. the investor is exposed to the risk that the foreign currency may be depreciate against the domestic currency by more than the difference between the two interest rates. The concept behind purchasing power parity is that if goods are cheap in one country it pays to export them to another country where they are more expensive. It is measured by the price of the same goods in different countries.
THE FOREX AND RISK MANAGEMENT • Rate of inflation • Money supply • Unemployment figures • Rates of taxation Supply and demand for capital Capital flows to a country where investors see opportunities. Japanese car and electronic manufacturers have invested in manufacturing operations in the USA and Europe to overcome tariff and quota problem. Some countries need capital and offer appropriate interest rates – others have a surplus of money and so have lower interest rates. In short-term normal business activities affect the supply and demand for capital. For example. investors do no always invest purely for high interest rate returns. Political Factors Foreign exchange rates can be affected in the long and short term by political factors such as: • The type of economic policies pursued by the government . However.
Technical Analysis .THE FOREX AND RISK MANAGEMENT • The amount of uncertainty in the political situation • The regulatory policies followed by central banks and/or other regulatory bodies • Central bank intervention in the FX market to strengthen or weaken its currency Market Sentiment Short term changes in FX rates are often a result of what market participants call market sentiment. even if the GDP figure is still good news for the economy. This is the perception traders have of the short term prospects for the movement in the currency. Often. traders will anticipate a news report or significant government announcement by buying and selling the currency before the news is actually reported. For example. the currency will probably rise in anticipation of the figures being announced. A currency will normally strengthen relative to other currencies on positive sentiment and weaken relative on other currencies on negative sentiment. Market sentiment is usually said to be ‘positive’ or ‘negative’. the currency will fall. Sentiment affects how the currency moves when the news really breaks. Traders act as news about a given economy. If the government’s GDP figure is less than the market was expecting. if the market sentiment is positive ahead of the Government’s announcements of GDP figures.
predict future market moves. Technical analysis highlights the trends in the market based on the assumption that market participants will react in the same way today as they did in the past. rather than economic fundamentals or news. This is because they believe past market moves.THE FOREX AND RISK MANAGEMENT Many market participants trade on the basis of past price movements. . This practice is called technical analysis.
one party agrees to pay to the other party cash flows equal to the interest at a predetermined fixed rate on a notional principal for a number of years. Dealing in `Exotics' or advanced interest rate swaps have not been permitted by the RBI. The most common type of interest rate swaps are the "plain vanilla" IRS. A and B. In a plain vanilla swap. This swap can be depicted diagrammatically as shown below: . while B pays a fixed 12.15% interest rate is to be compounded quarterly. 2001. these are the only kind of swaps that are allowed by the RBI in India. Here. The swap was initiated on July 1.THE FOREX AND RISK MANAGEMENT INTEREST RATE SWAPS An IRS can be defined as an exchange between two parties of interest rate obligations (payments of interest) or receipts (investment income) in the same currency on an agreed amount of notional principal for an agreed period of time.15% rate on the same principal. for a tenure of 1 year. A agrees to pay the 3 month NSE-MIBOR rate on a notional principal of Rs. An example will help understand this better: Consider a swap agreement between two parties. Moreover. In exchange. the principal is used only to calculate the interest amounts and is never exchanged. We assume that payments are to be exchanged every three months and the 12. only the difference in the interest payments is paid/received. the party receiving the fixed rate agrees to pay the other party cash flows equal to interest at a floating rate on the same notional principal for the same period of time. Currently. 100 million.
It is the . market preferences and exposure. However. Firm A wishes to borrow at floating rates and becomes the floating rate payer in the swap arrangement. So. Example: Say. BENEFITS FROM SWAPPING a) Swap for a comparative advantage Comparative advantages between two firms arise out of differences in credit rating.20% MIBOR + 1. A actually borrows fixed rate funds in the cash market. or vice versa.THE FOREX AND RISK MANAGEMENT MIBOR (3m) Party A 12.5% Party B An interest rate swap is entered to transform the nature of an existing liability or an asset. Firm A with high credit rating can borrow at a fixed rate of 12% and at a floating rate of MIBOR + 20 bps. Firm B pays 200 bps more than firm A in the fixed rate borrowing and only 120 bps more than A in the floating rate borrowing. Now. Party A B Fixed Rate Loan 12% 14% Floating Rate Loan MIBOR + 0.50% Firm A has an absolute advantage over firm B in both fixed and floating rates. firm B has a comparative advantage in borrowing floating rate funds. Another firm B with a lower credit rating can borrow at a fixed rate of 14 % and a floating rate of MIBOR + 150 bps. A swap can be used to transform a floating rate loan into a fixed rate loan.
At the same time.12% = 200 bps. because it borrows in the fixed rate segment is: 14% .15% to firm A and receive a floating rate of MIBOR as illustrated below: MIBOR (3m) Party A 12. The calculation of the gain from the swap is shown below: The gain to firm A. the net gain in the swap = 200 120 = 70 bps. Thus. which are swapped.THE FOREX AND RISK MANAGEMENT interest rate obligations on this fixed rate funds. The firms can divide this gain equally. Firm B can pay fixed at 12.15 bps . And. and thus will actually borrow from the market at the floating rate.5% Party B 12% MIBOR + 150 bps Effective cost for firm A = 12% + (MIBOR 12. both the parties will exchange their underlying interest rate exposures with each other to gain from the swap. B wishes to borrow at a fixed rate.15) = MIBOR . Then. the loss because firm B borrows in the floating rate segment is: (MIBOR + 20 bps) (MIBOR + 120 bps) = 130 bps.
e.13. Effective cost for firm B = (MIBOR + 150) + (12. 6-month MIBOR.15)) i. The firm can thus benefit by entering into an interest rate fixed for floating swap.65%) i.25 + 0.THE FOREX AND RISK MANAGEMENT This results into a net gain of ((MIBOR + 20) . The treasurer is of the view that the average MIBOR shall remain below 18. an AAA rated corporate.MIBOR) = 13. Thus.65% This results into a gain of (14% .15% . as the interest rates have come down.. The 3-month MIBOR is quoting at 10%.50 = 10. both the parties gain from entering into a swap agreement. a gain of 35 bps. .bill vs.e. 10. MIPL.(MIBOR . 3 years back had raised 4-year funds at a fixed rate of 18. b) Swap for Reducing Cost of Borrowing With the introduction of rupee derivatives.75 %. Fixed to floating 1 year swaps are trading at 50 bps over the 364 day T.. whereby it makes floating payments at MIBOR and receives fixed payments at 50 bps over a 364-day treasury yield i. A typical Indian case would be a corporate with a high fixed rate obligation. a gain of 35 bps.25%. Today a 364-day T-bill is yielding 10.5% for the next one year. the Indian corporates can attempt to reduce their cost of borrowing and thereby add value.e.5%.
10.5 .75%.75 % The risks involved for the firm are: • Default/credit risk of party B: Since the counterparty is a bank.75% MIBOR 18. The bank may also use this swap as an opportunity to hedge its own floating liability. Any rise beyond 10. This risk involves losses to the extent of the interest rate differential between fixed and floating rate payments. This will require continuous monitoring.5% MIPL MIBOR (3m) Party B The effective cost for MIPL= 18. the effective cost is = 10 + 7.75%.75%.17.50 + MIBOR .75% will raise the cost of funds for the firm.75 = 7.THE FOREX AND RISK MANAGEMENT 10. Therefore it is very essential that the firm hold a well-suggested view that MIBOR shall remain below 10. • The firm is faced with the risk that the MIBOR goes beyond 10. How does the bank benefit out of this transaction? The bank either goes for another swap to offset this obligation and in the process earn a spread. The bank may also leave this position uncovered if it is of the view that MIBOR shall rise beyond 10.75 + MIBOR At the present 3m MIBOR is 10%.75) = 0.75 = 17.75% The gain for the firm is (18. . this risk is much lower than would arise in the normal case of lending to corporates.
here we need not see the swapping process all over again. Thus. The only difference is that in Interest Rate Swaps the underlying asset is interest rate while in case of Currency Swaps the underlying asset is that specified currency. .THE FOREX AND RISK MANAGEMENT CURRENCY SWAP TRANSACTION PROCESS It may be noted that transaction-taking place in currency swaps are done in exactly the same manner as in the case of Interest Rate Swaps. It may be referred to in the Fixed Income Derivatives part of the project.
instead it changes existing cash flows. A related question is what special strategies should be followed to reduce the impact of foreign exchange risk. exchange dealers. namely. One way to minimize the long-term risk of one currency being worth more or less in the future is to offset the particular cash flow stream with an opposite flow in the same currency. All the players. etc are facing the risk. The currency swap helps to achieve this without raising new funds. banks. . A key question facing the players then is whether these exchange risks are so large as to affect their business. FIs.THE FOREX AND RISK MANAGEMENT BENEFITS OF CURRENCY SWAPS • To mange the exchange rate risk • To lower financing cost • To access restricted markets The international trade implies returns and payments in a variety of currencies whose relative values may fluctuate it involves taking foreign exchange risk.
fiis. with trading hours overlapping to make a 24 hour global market. The principal components of a deal are: • Trade date • Counterparty • Currencies • Exchange rate • Amounts • Value date • Payment instructions .THE FOREX AND RISK MANAGEMENT THE FX DEAL A foreign exchange deal may be defined as: It’s a contract wherein one party (country.fdis) Exchange with other party in the global market. Foreign Exchange Markets are OTC operating worldwide.
Back Office This is where the processing. advice and guidance from risk managers. technical analysis. query handling and cash management functions are carried out.THE FOREX AND RISK MANAGEMENT THE FX MARKETS AT WORK The Dealing Arena The range of products available in the FX market has increased dramatically over the last 30 years. support. Front Office/Dealing Room This is where OTC trading in financial markets takes place Middle Office This provides the dealers with specialist facilities. It is important to remember that dealers cannot trade without back office. confirmation. . combined with huge volumes of money that are being traded. The complex nature of these products . settlement. Dealers at banks provide these products for their clients to allow them to invest. mean banks must have three important functions set up in order to record and monitor effectively their trades. legal advisers etc. speculate or hedge. economists.
. in which banks may buy and sell currencies in wholesale amounts. Thus. and in turn both can make an impact on a country’s domestic economy. The US dollar remains the major currency in FX terms with over 90% of world trade being settled in USD.THE FOREX AND RISK MANAGEMENT WORKING OF FOREIGN EXCHANGE MARKET Banks will generally lend their customers money in any currency they demand. However. Most FX trading is carried out inter bank and is for profit. The main methods of trading FX are via: • Direct inter bank • Voice brokers • Electronic broking system Most FX dealers specialize in one or a small group of closely related currencies. In order that banks may deal quickly and efficiently in the FX market. the bulk of FX trading is not directly related to international trade or investment. Foreign exchange rates and interest rates are closely linked and affect one another. there is an inter bank market. In 1995 the USD was involved in 86% of FX transactions world-wide. A liquidly in major currency is good but some of more ‘exotic’ currencies can be thinly traded. banks regularly have to participate in the foreign exchange market to buy and sell the currencies they are lending or receiving.
Conversely. resulting in a balance of payments deficit. a weak currency makes imports expensive and dampens demand for imports. . resulting in a balance of payments surplus. A strong domestic currency makes imports cheaper and tends to stimulate demand for imports.THE FOREX AND RISK MANAGEMENT The FX rate also affects a country’s balance of payments – the net amount of inflows and outflows of money from a country in relation to trade payments.
Banks have enough financial strength and wide experience to speculate the market and banks does so. • COMMERCIAL BANKS They are most active players in the Forex market. the international trade turnover accounts for a fraction of huge amounts dealt. • They render better service by offering competitive rates to their customers engaged in international trade. The balance amount is sold or bought from the market.e.THE FOREX AND RISK MANAGEMENT The Participants In Foreign Exchange Markets • CUSTOMERS The customers who are engaged in foreign trade participate in foreign exchange markets by availing of the services of banks. As every time the foreign exchange bought and sold may not be equal banks are left with the overbought or oversold position. Nowadays. Commercial banks dealing with international transactions offer services for conversion of one currency in to another. . They have wide network of branches. in international foreign exchange markets. bought and sold. Which is popularly known as the trading in the Forex market. i. For example. Exporters require converting the dollars in to rupee and importers require converting rupee in to the dollars. The balance amount is accounted for either by financial transactions or speculation. Typically banks buy foreign exchange from exporters and sells foreign exchange to the importers of the goods. as they have to pay in dollars for the goods/services they have imported. Commercial banks have following objectives for being active in the foreign exchange markets.
Apart from this central banks deal in the foreign exchange market for the following purposes: • Exchange rate management: It is achieved by the intervention though sometimes banks have to maintain external rate of the domestic currency at a level or in a band so fixed. 1973. For this bank has to involve certain amount of switching between currencies. Generally this is achieved by the intervention of the bank. Foreign exchange business is a profitable activity and thus such banks are in a position to generate more profits for themselves. In India as per FEDAI guidelines the ADs are free to deal directly among themselves without going through .THE FOREX AND RISK MANAGEMENT • They are in a better position to manage risks arising out of exchange rate fluctuations. They can manage their integrated treasury in a more efficient manner. • Reserve management: Central bank of the country is mainly concerned with the investment of countries foreign exchange reserve in a stable proportions in range of currencies and in a range of assets in each currency. • EXCHANGE BROKERS Forex brokers play a very important role in the foreign exchange markets. • • • CENTRAL BANK In all countries central banks have been charged with the responsibility of maintaining the external value of the domestic currency. In India Reserve Bank of India has given license to the commercial banks to deal in foreign exchange under section 6 Foreign Exchange Regulation Act. However the extent to which services of Forex brokers are utilized depends on the tradition and practice prevailing at a particular Forex market center. who are called the Authorized Dealers (A Ds).
London. followed by Bahrain. Sydney. Brokers do not disclose counterparty bank's name until the buying and selling banks have concluded the deal. In this way. the brokers can locate the most competitive buying and selling prices. New York. Paris. The Forex brokers are not allowed to deal on their own account all over the world and also in India. thereafter India. The rest of trading in world Forex markets is constituted of financial transactions and speculation.THE FOREX AND RISK MANAGEMENT brokers. the day begins with Tokyo and thereafter Singapore opens. but these prices are indicative only. As we know that the Forex market is 24-hour market.5 trillion a day. If any bank wants to respond to these prices thus made available. and these prices are immediately broadcast to a large number of banks by means of hotlines / loudspeakers in the banks dealing room / contacts many dealing banks through calling assistants employed by the broking firm. In India broker's commission bas been fixed by FEDAI. Frankfurt. The international trade however constitutes hardly 5 to 7 % of this total turnover. • OVERSEAS FOREX MARKETS Today the daily global turnover is estimated to be more than US $ 1. Once the deal is struck the broker exchange the names of the bank who has bought and who has sold. • HOW EXCHANGE BROKERS WORK? Banks seeking to trade display their bid and offer rates on their respective pages of Reuters's screen. this is done by counterparty bank by clinching the deal. The brokers charge commission for the services rendered. . and back to Tokyo. On inquiry from brokers they quote firm prices on telephone.
This also adds to speculative activity. They also buy foreign currency stocks. booking. some of the big corporate are as the exchange control have been loosened. bonds and other assets without covering the foreign exchange exposure risk. and canceling forward contracts.e. With a view to make advantage of exchange rate movement in their favor they either delay covering exposures or do not cover until cash flow materialize. they have state of the art dealing rooms. and at times the same borders on speculative activity. • Governments borrow or invest in foreign securities and delay coverage of the exposure on account of such deals. take position i. Individuals like share dealings also undertake the activity of buying and selling of foreign exchange for booking short-term profits. • Banks dealing are the major speculators in the Forex markets with a view to make profit on account of favorable movement in exchange rate. Sometimes they take positions so as to take advantage of the exchange rate movement in their favor and for undertaking this activity. • Corporations' particularly Multinational Corporation and transnational corporations having business operations beyond their national frontiers and on account of their cash flows being large and in multi currencies get in to foreign exchange exposures. This also results in speculations. In India. • • Corporate entities take positions in commodities whose price are expressed in foreign currency.THE FOREX AND RISK MANAGEMENT • SPECULATORS The speculators are the major speculators in the Forex market. if they feel that rate of particular currency is likely to go up in short term. They buy that currency and sell it as soon as they are able to make quick profit. .
By the time the exchange transaction materializes i. The profitability of the export transaction can be completely wiped out by the movement in the exchange rate. Indeed exposures can arise even for companies with no income. TYPES OF EXPOSURES Financial economists distinguish between three types of currency exposures . Foreign currency exposures and the attendant risk arises whenever a business has an income or expenditure or an asset or liability in a currency other than that of the balance-sheet currency. asset or liability in a currency different from the balance-sheet currency. When there is a condition prevalent where the exchange rates become extremely volatile the exchange rate movements destabilize the cash flows of a business significantly. whereas foreign exchange exposure is what is at risk. The risk is an adverse movement of the . Such transaction exposures arise whenever a business has foreign currency denominated receipt and payment. the exchange rate moved to say Rs 20 per mark.transaction exposures. translation exposures.line of the business. and economic exposures. liabilities or operating income due to unanticipated changes in exchange rates. is the risk from foreign currency exposures. the export is effected and the mark sold for rupees.e.THE FOREX AND RISK MANAGEMENT FOREIGN EXCHANGE EXPOSURE Foreign exchange risk is related to the variability of the domestic currency values of assets. All three affect the bottom. TRANSACTION EXPOSURE Suppose that a company is exporting deutsche mark and while costing the transaction had reckoned on getting say Rs 24 per mark. Such destabilization of cash flows that affects the profitability of the business. expenditure.
Therefore the company's exposed to Japanese Yen in an indirect way. ECONOMIC EXPOSURE An economic exposure is more a managerial concept than a accounting concept. TRANSLATION EXPOSURE Translation exposure arises from the need to "translate" foreign currency assets or liabilities into the home currency for the purpose of finalizing the accounts for any given period. when the company's competitors are using Japanese imports. If at the time of finalization of the accounts the exchange rate has moved to say Rs 35 per dollar. The imported fixed asset was therefore capitalized in the books of the company for Rs 300000. A typical example of translation exposure is the treatment of foreign currency borrowings. This would be the case for example. In the ordinary course and assuming no change in the exchange rate the company would have provided depreciation on the asset valued at Rs 300000 for finalizing its accounts for the year in which the asset was purchased. Consider that a company has borrowed dollars to finance the import of capital goods worth Rs 10000. If the Yen weekends the company loses its competitiveness (vice-versa is also possible). the dollar loan has to be translated involving translation loss of Rs50000. . The book value of the asset thus becomes 350000 and consequently higher depreciation has to be provided thus reducing the net profit. The company's competitor uses the cheap imports and can have competitive edge over the company in terms of his cost cutting. A company can have an economic exposure to say Yen: Rupee rates even if it does not have any transaction or translation exposure in the Japanese currency.THE FOREX AND RISK MANAGEMENT exchange rate from the time the transaction is budgeted till the time the exposure is extinguished by sale or purchase of the foreign currency against the domestic currency. When the import materialized the exchange rate was say Rs 30 per dollar.
THE FOREX AND RISK MANAGEMENT In simple words. Broadly speaking. while translation and transaction exposures can be hedged. Under the Indian exchange control. economic exposure affects the profitability over a longer time span than transaction and even translation exposure. economic exposure to an exchange rate is the risk that a change in the rate affects the company's competitive position in the market and hence. economic exposure cannot be hedged. . indirectly the bottom-line.
. It advocated that currencies are valued for what they can buy and the currencies had no intrinsic value attached to it. Where. As per this theory if there were no trade controls. PPP is a plausible description of the trend behaviour of exchange rates. the theory maintains the following When Pf and /or P changes. However. then the balance of payments equilibrium would always be maintained. Therefore. the consumer preferences. transportation costs and the existence of trade controls was overlooked Influence of non-monetary disturbances affecting exchange rates was totally ignored.THE FOREX AND RISK MANAGEMENT Models And Theories Of Exchange Rate Purchasing Power Parity Theory(PPP) Purchasing Power Parity Theory was pronounced by Prof. Pf is the foreign price level and e is the exchange rate. especially when inflation differentials between the countries are large. Examining the real exchange rate. The theory argues that exchange rate movements primarily reflect differences in inflation rates between countries. in this theory some factors like the methods of production. This theory does hold in the case of an increase in the money stock. P is the domestic price. under this theory the exchange rate was to be determined and the sole criterion being the purchasing power of the countries. Gustav Cassel. e changes in such a way as to maintain ePf /P constant. ePf /P.
central banks cannot conduct an independent monetary policy under fixed exchange rate system. It tightens the monetary policy. It is advocated that under fixed exchange rates and perfect capital mobility.THE FOREX AND RISK MANAGEMENT The Mundell Fleming Model: Perfect Capital Mobility Robert Mundell and Marcus Fleming. Figure 1: Monetary Expansion Under Fixed Rates And Perfect Capital Mobility Extending this model to flexible exchange rate system. Any current account deficit must be . The following is represented by Figure 1 below. This intervention results in increase in home currency stocks. As a result. extended the standard IS-LM model to the open economy under perfect capital mobility. It follows that with perfect capital mobility. Under perfect capital mobility the slightest interest differential provokes infinite capital flows. The foreigners tend to buy domestic assets. appreciating the exchange rate and forcing the central bank to intervene to hold the exchange rate constant. Any attempt at independent monetary policy leads to capital flows and a need to intervene until interest rates are back in line with those in the world market. the absence of central bank intervention implies a zero balance of payments. and interest rates rise resulting in portfolio changes. the balance of payments shows huge surplus. the initial monetary contraction is reversed and the process ends when home interest rates have been pushed back to the initial level. As a result of huge capital inflow. a country cannot pursue an independent monetary policy. Interest rates cannot move out of line with those prevailing in the world market.
Here. An application of the above-described models in the real life has been discussed below based on a model developed by some experts. However when adjustments in prices are taken into consideration. Dornbush Theory on Monetary Expansion: Short and Long term effects With given prices a monetary expansion under flexible rates and perfect mobility leads to depreciation and increased income. in response to a disturbance. the output increase is transitory. Monetary expansion therefore leads in the short run to an immediate and abrupt change in relative prices and competitiveness.THE FOREX AND RISK MANAGEMENT financed by private capital inflows: a current account surplus is balanced by capital outflows. . The important feature of the adjustment process is that exchange rate and prices do not move at the same rate. When a monetary expansion pushes interest rates down. In the long un a monetary expansion leads to an exchange depreciation and to higher prices with no change in competitiveness. the exchange rate adjusts immediately but prices adjust only gradually. overshooting means that changes in monetary policy produce large changes in exchange rates. Adjustments in the exchange rate ensure that the sum of the current and capital accounts is zero. Table 2: Effects of Monetary Expansion Exchange Rate Price ePf /P Short run + 0 + Long run + + 0 Output + 0 The exchange rate overshoots its new equilibrium level when. it first moves beyond the equilibrium it ultimately will reach and then gradually returns to the long-run equilibrium position.
Moreover. the inflow of dollars from foreign investors too tends to rise. The model owes its origin to the Keynes-Mundell-Fleming (KMF) model. Hiranya Mukhopadhyay The objective of this study was to Derive a reduces form specification that will allow us to link a central bank’s direct interventions in the foreign exchange market with changes in the country’s exchange rate We would test this relationship with the Indian data to see whether indeed the magnitude of an offset is significant. r and e. . trade balances improve and hence there is an increase in the effective demand facing the economy. As e depreciates. The extent of any change in the value of foreign exchange reserves with the central bank is perfectly correlated with the amount of dollars that the bank buys and sells in the foreign exchange market. the exchange rate depreciates. dampening the initial downward pressure on account of depreciation of the exchange rate. The endogenous variables of the model are Y. Sumon Kumar Bhaumik 2. a rise in income leads to higher imports. ceteris paribus. Once the central bank purchases dollars from the foreign exchange market.THE FOREX AND RISK MANAGEMENT RBI’s Intervention in Foreign Exchange Market An Econometric Analysis By 1. At the same time. and the initial improvement in trade balance is dampened.
if there is an increase in the net purchase of dollars by the RBI. and monthly exchange rates of US Dollars (e).882539 1.36 data points have been considered.01002 MAPE Thiel’s U Simple Moving Avg MSE MAPE Double Single Brown’s Method Holt’s Method 3. indicating that the rupee will appreciate further.912831 0.566822 1. monthly data on net purchase of foreign exchange by RBI.32619 Moving Avg Exponen Smoothen 3.528195 Winter’s Method 408.513591 1.8397 22. Annexure 2 gives the data regarding the RBI intervention in Indian markets. in turn. change in e will decrease.015037 . The conclusion derived is that in response to an appreciation of the rupee vis-à-vis other currencies. In other words.950541 2.258937 1. which. expressed as rupees per dollar.327164 4. the effect of the RBI’s direct intervention in the foreign intervention in the foreign exchange market is more than offset by the impact of the intervention on the macro-economic variables.702292 4. influence capital flows and nominal exchange rates. ARIMA 0.THE FOREX AND RISK MANAGEMENT To relate to the Indian context. expressed in dollars.37715 0.
Trends in the movement of NEER from 1993 April to February 1999 are illustrated in Table 2 on the next page.THE FOREX AND RISK MANAGEMENT Forecasting NET EFFECTIVE EXCHANGE RATE (NEER) Performance over the past five years NEER is a good indicator of the exchange rate of the country. This is in effect the performance of the NEER after the implementation of the Modified Liberalized Exchange Rate Management System (Modified – LERMS) with effect from 1st March 1993. The performance of the NEER makes a good study of the effect of the policies on the exchange rate after April 1993. . It is a multi-lateral measurement of the exchange rate of the Rupee. which depends on the trade based weights of five countries.
as fixed rates are more or less kept within a narrow band by intervention of the two governments. 2.THE FOREX AND RISK MANAGEMENT Foreign Exchange Rate Forecasting Forecasting foreign exchange rates is important for treasury and forex managers as it reduces the uncertainties associated with commitments to accept or to make payments in foreign currencies with short-term and long-term investment decisions. Technical Analysis Economic Models. but the direction and magnitude of change in longer term can be forecasted with a fair degree of accuracy. . with financing decisions and with income earned in foreign currencies. Exchange rate forecasts also help to: Analyze attractiveness of foreign borrowings. Techniques of forecasting Exchange rate There are several techniques available to forecast future rates. Plan investments in foreign countries. It is also important for a forex manager to understand the intricacies and the limitations of forecasting foreign exchange rates as it helps them to utilize the alternate avenues to manage exchange rate risk. Manage exchange rate risks and plan hedging strategies. Forward rates as short-term forecasters. Though an intra-day forecast of the exchange rate is not possible. the exchange rate between two currencies could be either fluctuating or fixed. 3. Plan long-term export-import strategy. Logically. Now. These can be classified under following categories: 1. forecast for fluctuating exchange rates only would be required by treasury manager.
2. Banks act as clearing houses for both forward and spot contracts. Forward rates are sometimes used to predict future spot rates. then it is an accurate forecast indicator. If the forecasts are done accurately on an average they are called unbiased forecasts. Firms generally anticipate future spot rate: The evaluation of any forecasts can be done based on two criteria.THE FOREX AND RISK MANAGEMENT • Forward Rates as Short-term forecasters. . Unbiased Forecast Indicator: An unbiased estimator is one. which can overestimate the value as much with the same probability as it can underestimate which implies that positive errors are as much probable as negative errors. 1. Accurate Forecast Indicator: If the future values are forecasted accurately every time with minor forecast errors.
The explanation given by economists is that current exchange rates change with the unforeseeable events. A technician believes that exchange rate movements are mechanistic and are not caused by economic and political changes. Economic factors such as inflation rates. Evaluation of technical Forecasts Economists do not like technical analysis. In an efficient forex market. forecasts based on historical data do not help develop accurate forecasts. Technicians develop their own forecasts about future currency values and each technician has his individual method. The logical explanation given by economists in support of their view is that according to efficient market hypothesis. prices reflect all available information. balance of payments and political stability are ignored by pure technicians. The pure technicians believe that clues in the past movements lead them to the future. Some technicians use historical data from primary analysis and then recommend the client in an informal fashion by keeping in view the economic and political factors. charts of past exchange rate movements etc.THE FOREX AND RISK MANAGEMENT Foreign Exchange Rate Forecasting with Technical Analysis Forecasting future exchange rates with the use of past exchange rate movements is called technical analysis. The unforeseeable events occur in random fashion and hence exchange rate changes follow a random pattern. interest rates. There are many methods used by technicians such as sophisticated statistical models. as it does not obey the principles of economics. Economic research indicates that forex movements follow a pattern of random walk. Technical analysts assert that their approach works and it is very difficult to disapprove their assertions. The forecasters are called technicians. the impact of available information is already reflected in the present rates. which implies that a specific present change is unrelated to past changes and therefore a forecast is not possible. therefore. To . The evaluation of technical forecasts is difficult because it works at times.
702292 4.THE FOREX AND RISK MANAGEMENT prove the efficiency of technical forecasts.01002 Simple Moving Avg MSE MAPE Double Single Brown’s Method Holt’s Method 3. MSE and Thiel’s statistic. the different techniques and their respective MAPE.327164 4. it is necessary to prove them to be superior to other methods over a period of time. This is not possible as at a given time. These time-series techniques are technical forecasts and their accuracy can be studied by sing MAPE. using various time-series techniques.258937 1.528195 Winter’s Method 408. the technical analysis has proved to be superior. MSE and Thiel’s statistics are given.912831 0. In the tables given below.015037 .513591 1. Technical forecasts arte often used in conjunction with economic model based forecasts. which was shown in the previous chapter.566822 1. ARIMA MAPE 0.37715 Thiel’s U 0. We have made a forecast of the NEER.950541 2.32619 Moving Avg Exponen Smoothen 3.8397 22. but technical forecasts are widely used by speculators in the forex markets to book quick profits since technical forecasts emphasize on short-term exchange rates.882539 1.
The statistical models work by establishing a relationship between future exchange rates and the variables that affect future exchange rates. Usually. It also requires for a good forecast to predict the future direction and extent of government intervention. In case of three or four variables gathering historical information for a specific period for all the variables is also difficult. Any statistical model does not give fruitful results unless political factors and impact of news are quantified.THE FOREX AND RISK MANAGEMENT • Exchange rate forecasting with Economic Models The difference between technical analysis and economic forecasting is that economic forecasting is based on established and verified economic relationships such as BoP. inflation rates. The superiority of a forecasting model depends on its accuracy over market forecast. . in case of inflation rate. interest rates etc. the future exchange rate is a dependent variable as it depends on various economic indicators. If a firm develops a superior forecast it is not sufficient to gain from it. These indicators such as BOP. In any forecasting model. and interest rates are independent variables. GNP is difficult. The approach adopted is cause and effect approach. it will be advantageous to firms to keep abreast of the latest information regarding economic indicators such as BOP. Future exchange rates can be forecasted by forecasting inflation rate. interest rates. etc. For example. we know that inflation rates affect future exchange rates. There is a difference of opinion in inclusion and exclusion of variables. The accuracy of the predicted changes in the independent variables and the gathering of accurate historical data on the variables such as inflation. inflation. A firm should have enough capital to materialize the gains out of its forecast. If some forecasts are superior to others its advantage is quickly eliminated by the market forces as they act favorably towards the forecasts and brings the price to the forecasted level if it is an efficient market. inflation. as it involves more than two variables. So. a multiple regression analysis based on statistical models is done.
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