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Basic Concept

1. Foreign Exchange Market - The Foreign exchange market is a large,


growing and liquid financial market that operates 24 hours a day. It
is not a market in the traditional sense because there is no central
trading location or exchange".
2. Exchange Rate - The value of one currency expressed in terms of
another. For example, if EUR/USD is 1.3200, 1 Euro is worth
US$1.3200.
3. Currency Pair - The two currencies that make up an exchange rate.
When one is bought, the other is sold, and vice versa.
4. Spot Market - The market for buying and selling currencies at the
current market rate.
5. Base Currency - The first currency in the pair. Also the currency your
account is denominated in.
6. Counter Currency - The second currency in the pair i.e the terms
currency.
7. Currency Pair Terminology
EUR/USD = "Euro"
USD/JPY = "Dollar Yen"
GBP/USD = "Cable" or "Sterling"
USD/CHF = "Swissy"
USD/CAD = "Dollar Canada
AUD/USD = "Aussie Dollar"
NZD/USD = "Kiwi"
8. Bid Price - The quote is displayed on the left and is the price at
which you can buy one unit of the base currency.
9. Ask Price - The quote is displayed on the right and is the price at
which you can sell one unit of the base currency.
10. Spread - The difference between the sell quote and the buy
quote or the bid and offer price.
11. Pip - The smallest price increment a currency can make. Also
known as points.
12. Direct Quote - A foreign exchange which represent a relationship
between a fixed number of units of foreign currency against
variable number of units of domestic currency.
1USD=INR 59.35 is a direct quote in India

13. Indirect Quote - A foreign exchange which represent a
relationship between a fixed number of units of domestic currency
against variable number of units of foreign currency.
1 INR = 0.0168481 USD is a direct quote in India
14. Cross Rate - The exchange rate between two currencies that are
not the official currencies of the country that the exchange was
quoted in. Cross rates usually do not involve the U.S. dollar. The
cross rate is the exchange rate between currency A and currency C
derived from actual exchange rate between currency A and
currency B and between currency B and currency
15. Two-Way Quote - A type of quote that gives both the bid and the
ask price of a security, informing would-be traders of the current
price at which they could buy or sell the security.
16. Fiat money - Any money declared by a government to be legal
tender
17. Vehicle Currency - The currency used to invoice an international
trade transaction, especially when it is not the national currency of
either the importer or the exporter.
18. Vostro Account - Account held by a foreign bank in a domestic
bank is called Vostro account. A Vostro is our account of your
money, held by us.
For example Bank A(Barclays Bank of UK) opening an account
in Bank B(ICICI Bank of India), this is Vostro account for Bank B(ICICI
Bank of India).


19. Nostro Account
Account held by a particular domestic bank in a foreign bank is
called Nostro account. A Nostro is our account of our money, held
by you.
Here in the above example given in Vostro account the same
account is a Nostro account for Bank A(Barclays Bank of UK),
20. Loro Account - An account held by a domestic bank in itself on
behalf of a foreign A Loro is our account of their money, held by
you. Loro account is a record of an account held by a second bank
on behalf of a third party
The Loro account is an account wherein a bank remits funds in
foreign currency to another bank for credit to an account of a third
bank.


Ch.1
Meaning of International Trade
International business means carrying on business activities beyond
national boundaries.
The exchange of goods and
services among individuals and businesses in multiple countries.
A specific entity, such as a multinational corporation or international
business company that engages in business among multiple countries.

Meaning of International Trade
Capital
Goods
Services
Technology
Skilled labour
Meaning of International Trade
Production of physical goods
Provision of services
Banking
Finance,
Insurance,
Construction,
Trading
Foreign investment, Foreign Direct Investment
Objectives of International Trade
Improved Sale and Profitability
Risk Diversification
Economy of Scope and Scale
Competition and Survival
Global Branding
Multinational Companies
An enterprise operating in several countries but managed from one
(home) country.
A corporation that has its facilities and other assets in at least one
country other than its home country.
Such companies have offices and/or factories in different countries.
They have a centralized head office where they co-ordinate global
management.
Features of Multinational Companies
Huge business enterprises operating in many countries.
Large resources and Potential.
Extend production, marketing and management to host countries.
Centralized ownership and control.
Multinational stock ownership.
Reasons for growth of Multinational Companies
Limited Scalability in domestic market.
Cost Advantage.
Indian Expertise.
Government Policies.
Social Environment.
Examples of Multinational Companies
Tata Motors.
Infosys.
Tata Consultancy Services.
Ranbaxy Laboratories Ltd.
Asian Paints.
Dr. Reddys Laboratories Ltd.
Bharat Forge.
Theory of Comparative Advantage
Assumptions
There are no transport costs.
Costs are constant and there are no economies of scale.
There are only two economies producing two goods.
The theory assumes that traded goods are homogeneous.
Factors of production are assumed to be perfectly mobile within a
country but no movement internationally.
There are no tariffs or other trade barriers.

Theory of Comparative Advantage
Comparative advantages and the mutually beneficiary exchanges
between countries
In one year, England requires labor of 100 men to produce cloth and
120 men to make wine.
Whereas, Portugal requires only the labor of 80 men to produce cloth
and 90 men to make wine.
The two countries must acquire their respective benefit if they
exchange production with each other on the basis of comparative
advantage.

Portugal has its comparative advantages in the wine industry while
England could be considered to be comparatively advantageous in the
cloth industry.
For the country enjoying overall advantages in the both industries,
choose one in which it is comparatively more advantageous, while for
the other country with overall disadvantages in the both industries,
choose one in which it is comparatively less disadvantageous.
A country enjoys a comparative advantage in the production of a good
when that good can be produced at a lower cost in terms of other
goods.
For the country enjoying overall advantages in the both industries,
choose one in which it is comparatively more advantageous, while for
the other country with overall disadvantages in the both industries,
choose one in which it is comparatively less disadvantageous.
Gains from Comparative Advantage
When countries specialize in producing the goods in which they have a
comparative advantage, they maximize their combined output and
allocate their resources more efficiently.
Methods of International Business
International Trade
Licensing
Franchising
Joint Ventures
Acquisitions
Foreign Subsidiaries


Ch3
Foreign Exchange Dealings

Features of Forex market
Decentralized interbank market
Online Trading
24-Hour Market
High liquidity
Lower trading costs
Geographical dispersion
Market Participants of Forex market
Banks
Financial Institutions
Central Bank
Brokers
Hedgers
Investment Management Firms
Consumers and
Travellers
Businessmen
Types of Orders
Market Order
Limit Order
Stop Order
Once Cancel the Order (OCO)
If Done Order
Chpt.5 Forex Spot and Forward
Types of Currency Markets
Spot Market
Forward Market
Types of Currency Markets
Spot Market:
- immediate transaction
- recorded by 2
nd
business day
Forward Market:- transactions take place at a specified future date
FORWARD MARKET
Definition of a Forward Contract:
An agreement between a bank and a customer to deliver a specified amount
of currency against another currency at a specified future date and at a fixed
exchange rate.

Purpose of a Forward:
Hedging:
Act of reducing exchange rate risk.
Forward Rate Quotations
Two Methods:
Outright Rate: quoted to commercial customers.
Swap Rate: quoted in the interbank market as a discount or premium.

CALCULATING THE FORWARD PREMIUM OR DISCOUNT

= F-S x 12 x 100
S n


where F = the forward rate of exchange
S = the spot rate of exchange
n = the number of months in the forward contract
Forward Contract Maturities
30-day
90-day
180-day
360-day

Forward Market Players
Forward Market Players
Arbitrageurs
Traders
Hedgers
Speculators


Arbitrageurs
A forex strategy in which a currency trader takes advantage of different
spreads offered by brokers for a particular currency pair by making trades.
Different spreads for a currency pair imply disparities between the bid and ask
prices.
Currency arbitrage involves buying and selling currency pairs from different
brokers to take advantage of this disparity.
Traders
The act of buying and selling foreign currencies.
Currency trading is most often engaged in by banks and other institutions, for
the purposes of international trade.
Individual investors may engage in currency trading as well, attempting to
benefit from variations in exchange rates of the currencies.
Hedgers
Currency hedging is the act of entering into a financial contract in order to
protect against unexpected, expected or anticipated changes in currency.
It is used by financial investors and businesses to eliminate risks they
encounter when conducting business internationally. Hedging limits the
impact of foreign exchange rate risk.
Speculators
A person who trades derivatives, commodities, bonds, equities
or currencies with a higher-than-average risk in return for a higher-than-
average profit potential.
Speculators take large risks, especially with respect to anticipating future price
movements, in the hope of making quick, large gains.

Chpt.6 Arbitrage in Forex markets
Meaning of Arbitrage
A forex strategy in which a currency trader takes advantage of different
spreads offered by brokers for a particular currency pair by making trades.
Different spreads for a currency pair imply disparities between the bid and
ask prices.
Currency arbitrage involves buying and selling currency pairs from
different brokers to take advantage of this disparity.
A trading strategy that is used by forex traders who attempt to make a
profit on the inefficiency in the pricing of currency pairs.

Types of Arbitrage
Geographical
Triangular

Geographical Arbitrage
Geographical arbitrage is possible when a banks buying price (bid price) is
higher than another banks selling price (ask price) for the same currency.
Example: Bid Ask
Bank C NZ$ $.635 $.640
Bank D NZ$ $.645 $.650
Buy NZ$ from Bank C @ $.640, and sell it to Bank D @ $.645. Profit =
$.005/NZ$.

Triangular arbitrage
Triangular arbitrage is possible when a cross exchange rate quote differs
from the rate calculated from spot rates.
Example: Bid Ask
/$ 1.60 1.61
MYR/$ 0.200 0.202
/MYR 8.1 8.2
Buy @ $1.61, convert @ MYR8.1/, then sell MYR @ $.200. Profit =
$.01/. (8.1.2=1.62)




Chpt.11 Risk and Exposure

Foreign Exchange Risk
Foreign exchange risk (also known as FX risk, exchange rate risk or
currency risk) is a financial risk that exists when a financial transaction is
denominated in a currency other than that of the base currency of the
company.
Foreign-exchange risk is the risk that an asset or investment denominated
in a foreign currency looses value as a result of unfavourable exchange
rate fluctuations between the investment's foreign currency and the
investment holder's domestic currency.

Types of Foreign Exchange Risk
Transaction risk
Position Risk
Credit Risk
Liquidity/ Mismatch risk
Operational Risk
Sovereign/ Political/ Country Risk
Cross Country Risk


Transaction risk
Transaction risk is the risk that a company will incur losses in a
transaction comprising multiple currencies due to exchange rate
movements.
The exchange rate risk associated with the time delay between entering
into a contract and settling it. The greater the time differential between
the entrance and settlement of the contract, the greater the transaction
risk, because there is more time for the two exchange rates to fluctuate.
Transaction risk creates difficulties for individuals and corporations dealing
in different currencies, as exchange rates can fluctuate significantly over a
short period of time. This volatility is usually reduced, or hedged, by
entering into currency swaps and other similar securities.


Position Risk
In investing, any trade that has been established, or entered, that has yet
to be closed with an opposing trade involves position risk.
An open position can exist following a buy (long) position, or a sell (short)
position. In either case, the position will remain open until an opposing
trade has taken place.
Probability of loss associated with a particular trading (long or short)
position due to price changes.
Any investment that has been entered into but not closed.
For example, an investor who is long 100 shares of INTC has an open
position until an order to sell those 100 shares has been placed and filled.

Credit Risk
Credit risk refers to the risk that a borrower will default on any type of
debt by failing to make required payments. The risk is primarily that of the
lender and includes lost principal and interest, disruption to cash flows,
and increased collection costs.
The risk of loss of principal or loss of a financial reward stemming from a
borrower's failure to repay a loan or otherwise meet a contractual
obligation.
Investors are compensated for assuming credit risk by way of interest
payments from the borrower or issuer of a debt obligation.

Liquidity/ Mismatch risk
Liquidity risk is the risk that a given security or asset cannot be traded
quickly enough in the market to prevent a loss (or make the required
profit).
A category of risk that refers to the possibility that a swap dealer will be
unable to find a suitable counterparty for a swap transaction for which it is
acting as an intermediary.

Operational Risk
Operational risk is defined as the risk of loss resulting from inadequate or
failed processes, people and systems or from external events.
A form of risk that summarizes the risks a company or firm undertakes
when it attempts to operate within a given field or industry.
It is the risk remaining after determining financing and systematic risk, and
includes risks resulting from breakdowns in internal procedures, people
and systems.

Sovereign / Political/ Country Risk
The risk that a government will either default on its obligations or will
impose regulations restricting the ability of issuers in that country to meet
their obligations, such as foreign currency restrictions.
The risk that a foreign central bank will alter its foreign-exchange
regulations thereby significantly reducing or completely nulling the value
of foreign-exchange contracts.
The risk that an investment's returns could suffer as a result of political
changes or instability in a country.
Instability affecting investment returns could stem from a change in
government, legislative bodies, other foreign policy makers, or military
control.

Cross Country Risk
A collection of risks associated with investing in a foreign country.
These risks include political risk, exchange rate risk, economic risk,
sovereign risk and transfer risk, which is the risk of capital being locked up
or frozen by government action.
Country risk varies from one country to the next. Some countries have
high enough risk to discourage much foreign investment.

Foreign Exchange Exposure
Foreign exchange exposure is the possibility that a firm will gain or
lose because of changes in exchange rates.
Foreign exchange risk is the risk of loss due to changes in the
relative value of world currencies.
There are three types of Foreign Exchange Exposures:
A Translation Exposure
B Economic Exposure
C Transaction Exposure

Types of foreign exchange exposure
Transaction Exposure measures changes in the value of outstanding
financial obligations due to exchange rate changes.
Translation Exposure also called Accounting Exposure, is the changes in
owners equity because of the need to translate financial statements of
foreign subsidiaries into a single reporting currency for consolidated
financial statements.
Economic Exposure also called Operating Exposure, measures the
change in the present value of the firm resulting from any change in
expected future operating cash flows caused by an unexpected change in
exchange rates.



Conceptual Comparison of Foreign Exchange
Exposure


Transaction Exposure
Transaction exposure measures changes in the value of
outstanding financial obligations incurred prior to a change
in exchange rates but not due to be settled until after the
exchange rates change.
Thus, this type of exposure deals with changes in cash flows
the result from existing contractual obligations.
Transactions exposure results from particular transactions
such as an export where a known cash flow in a given
currency will take place at a certain date

Transaction Exposure
Transactions exposure arises when a company must pay
or receive a foreign currency at an unknown future
exchange rate
It is contractual
It affects the income statement
It can often be hedged directly using forwards, futures or
currency options.
Translation Exposure
Translation exposure, also called Accounting exposure, is the
potential for changes in owners equity to occur because of
the need to translate foreign currency financial
statements of foreign subsidiaries into a single reporting
currency to prepare worldwide consolidated financial
statements.
Results from the need of a global firm to consolidated its
financial statements to include results from foreign
operations.
o Consolidation involves translating subsidiary financial
statements from local currencies (in the foreign
markets where the firm is located) to the home
currency of the firm (i.e., the parent).
o Consolidation can result in either translation gains or
translation losses.
Translation Exposure
Translation or accounting exposure results from the way
accounting conventions dictate that a companys foreign
assets and liabilities should be booked.



Economic Exposure
Economic Exposure, also called Operating Exposure,
measures the change in the present value of the firm
resulting from any change in future operating cash flows
of the firm caused by an unexpected change in exchange
rates.
This is a long term foreign exchange exposure resulting
from a previous FDI location decision.
Over time, the firm will acquire foreign currency
denominated assets and liabilities in the foreign country.
The firm will also have operating income and operating
costs in the foreign country.
Economic exposure impacts the firm through contracts
and transactions which have yet to occur, but will, in the
future, because of the firms location.
Economic exposure can have impacts on a global firms
competitive position and on the market value of that firm.


Economic Exposure
o Change in the economic value of the firm resulting from
unanticipated exchange rate changes.
Booked vs. anticipated transactions
Expected vs. unexpected changes; the "cost of hedging"
Exposure and the parity assumptions: "We are not exposed
in the long run"
Currency of denomination vs currency of determination;