You are on page 1of 70

International Finance

July 2015
Dr. Dhirendra Gautam
Ph.D., CA, CMA & CWA

Agenda
v Introduction
v Course Content
v What is Finance
v International Finance
v Domestic Finance
v Domestic Vs. International Finance
v Why International Finance

International
Finance
Me

You

Introduction

Introduction

Let Me know all of you.

Introduction

Let Me Introduce My-self

I can be reached on ceo@indiba.in or www.visitingcfo.com

International Financial
Course Content:

Foreign Exchange

International Financial Institutions

Balance of Payments (Structure and Equilibrium)

Foreign Exchange Markets

Mechanics of Foreign Exchange Markets

Economic Unions and Trade Agreements

Indias Foreign Trade Promotion and Control.

SL.No
1
2
3

Particulars
FOREIGN EXCHANGE RATES
Theories of exchange rates. Purchasing power parity theory. Demand supply and elasticities in foreign exchange rate determination. Balance of Payments theory. Historical perspective on
exchange rate. Gold Standard, Inter-war instability, Bretton Woods, Fixed exchange rates, fluctuating exchange rates.
Case for Fixed or fluctuating exchange rates. The changing nature of world money. The rise of private world money. Eurocurrencies, Eurodollars, European Currency Unit, C. R. U their
mechanics and impact. International capital - flows and shocks. International debt problem - its origin, history and status. International liquidity and SDRs.
International Financial Institutions - International Monetary Fund, World Bank, International Finance Corporation, Washington D. C., Asian Development Bank.The basics of currency
trading. Foreign exchange dealers. Clearing, hedging, speculation in foreign exchange markets. Forward exchange rate, forward against spot exchange rate. Factors causing exchange rate
fluctuations.
BALANCE OF PAYMENTS (Structure and Equilibrium)
Balance of Payments definition. Component of Balance of Payments. Current Account, Capital Account, Balance of Payments Models, Basic balance. Disequilibrium in Balance of
Payments. Measures to correct disequilibrium in Balance of Payments.
FOREIGN EXCHANGE MARKETS
Operations of foreign exchange markets. Modes and mechanism of spot and forward exchange contracts. Exchange trading and position. Syndication. Swaps. Options, Offshore banking.
International Money, Capital and Foreign Exchange Markets with reference to New York, London, Tokyo, Hong Kong and Singapore.
MECHANICS OF FOREIGN EXCHANGE MARKETS
Contracts, Credits and Documentation. Sale and Purchase Contracts. Risks in international transactions. Incoterms, their importance and their applicability. Payments under trade contracts.
Documentary credits. Types of credits. Important credit clauses. Procedure for establishing credits.
Documents in foreign trade. Financial, Commercial, transport, insurance and other documents. Arbitration and conciliation.
ECONOMIC UNIONS AND TRADE AGREEMENTS
Theory of Custom Union. Political economy of trade barriers. Protection in world trade - a historical perspective. International Trade Organization (ITO). General Agreement on tariffs and
Trade (GATT). Kennedy Round. UNCTAD. Generalised System of Preferences (GSP). Tokyo Round. New International Economic Order. Brandt Commission and economic integration.
Uruguay Round. North South divide and dialogue. European Economic Community (EEC) and integration 1992. Impact of currency blocks on world trade and exchange.
INDIA'S FOREIGN TRADE PROMOTION AND CONTROL :
India's economy in global perspective. India's external debt. Export promotion strategy and policy. Export promotion measures. Commercial Policy. Non-Resident Investments and
Accounts.
The Export-Import Bank of India- its functions, resources, organization, management and current operations.
Export Credit Guarantee Corporation (ECGC) - its function, policy, management and current operations.
Financing of foreign trade. Types of credits, guarantees, bid bonds etc. Mechanism of Operations.
Foreign exchange controls - Objectives, exchange management and controls in India. FERA/ FEMA and its important provisions. Import Export Policy and procedures.
Case Studies and Presentations

What is
Finance?

How to
earn

How to
Manage

Finance
Money Management

How to
Expend

Two Old Theories

Accounts

Finance

Recording Transactions in terms of Money


Or Recording Financial Transaction

Economics

Resource Management for both


House hold and Government
Managing BOTH,
Money and Resource

The New Subject

Managing BOTH,
Money and Resource
CFO / CEO

Finance
Management

Managing the
Finance of Any
Business

Decision
Management

Deciding About the:


Cost
Benefit and
Risk

Financial Management is Managing the Business

Business
Management

Managing the
Resource of Any
Business

International
Finance

International Finance
Meaning of International Finance:
v International Finance is an area of financial economics that deals with
monetary interactions between two or more countries.
v More Specifically:
v Foreign (Currency) exchange rates,
v International monetary systems,
v Foreign direct investment,
v International financial management including
v Political risk and foreign exchange risk inherent in managing multinational
corporations.

Domestic
Finance

Equity Holder

Financing D ecision
A & B S tarted a
Business w ith high
potential of S uccess
Not had enough
Money so they got
approach and
convince Mr. C for
initial funding

Priority
Payment
to Mr. D

Money Machine
An E- Commerce
Portal for S elling
Cosmetics Products
Online

More
Money

Loan Holder

Investing D ecision
Still Not enough
Money so they
approach Mr. D ,
But D says I w ill not
invest but I w ill
Lend Money to
your Business

Put B acks Money in B usiness

Dividend Decision

Payment
to A, B & C

Loan Holder

Equity Holder

Financing D ecision
A & B S tarted a
Business w ith high
potential of S uccess
Not had enough
Money so they got
approach and
convince Mr. C for
initial funding

Money Machine
An E- Commerce
Portal for S elling
Cosmetics Products
Online

More
Money
Dividend Decision

Investing D ecision

Still Not enough


Money so they
approach Mr. D ,
But D says I w ill not
invest but I w ill
Lend Money to
your Business
3 & 4

Priority
Payment
to Mr. D

5&6

Sources of Finance
Cost of Capital &
Capital Structure

Put B acks Money in B usiness

Capital Budgeting &


Working Capital Mgt.

Payment
to A, B & C

Dividend Policy &


Retained Earnings

Financial Management

Financial
Manage
ment

Financing
Decision

A.
B.

Cost of Capital
Capital Structure Decisions

Investing
Decision

A.
B.

Capital Budgeting
Working Capital Management

Dividend
Decision

A.
B.

Dividend Policy
B. Retained - Earnings

Why ?
International
Finance

Why International Finance


Capital investment is the single most critical factor in growing an
economy. Without investment, there is no growth, only subsistence.
For example, a farmer can barely feed himself if he has no tools. If he
has the capital to invest in a horse and plow he can feed many
people. If he has the capital to invest in a tractor he can feed many
more. Developing countries have a hard time getting their
economies to grow because they have no capital. This is why
international finance is necessary.

Domestic Vs.
International
Finance

Domestic Vs. International


Domestic companies tend to restrict their operations to the country
of origin, while multinational corporations operate in more than two
countries.
Companies expand globally for many reasons, mostly to obtain
new markets, cheaper resources and reduction in operational
costs, all of which significantly affect financial management.
These benefits also increase the risks faced by multinational
corporations.
Multinational financial management differs from domestic
financial management in majorly six essential ways.

Domestic Vs. International


Legal and Economic Structure
Coordinating and controlling worldwide operations can be
complicated by the legal and economic systems specific to each
country.
Some practices that are routine in one country may be illegal in
another. For example, paying an incentive to facilitate licensing in
one country could be considered a bribe in another.
Multinational corporations must learn how to adapt to
differences in financial methods and customs. Unlike domestic
firms, these corporations have financial obligations to foreign
countries, which complicates tax reporting.

Domestic Vs. International


Exchange Rate Risks
For a multinational, cash flows will be denominated in different currencies,
and the effects of currency devaluations must be addressed in all financial
analyses.
Unlike their domestic financial management counterparts,
multinationals are subject to exchange rates that differ based on the
prevailing inflation rate in the foreign countries where they operate.
High inflation will result in currency decline, making it difficult and
unpredictable to operate profitably.
In addition, the process of changing currencies when transferring
money between countries can be expensive and inconvenient

Domestic Vs. International


Role of Government
Although many countries encourage foreign investment by providing
incentives, the government's policy isn't the only determinant of
competition.
Financial management in a multinational corporation can be
significantly affected by high levels of corruption, inefficiency and
bureaucracy when the company has to deal with some foreign
government officials.
Unlike financial management in companies that operate domestically, a
multinational often has to deal with burdensome and unpredictable
regulations governing licensing, tariffs and taxes imposed by the host
government

Domestic Vs. International


Political Risk
Multinational corporations may have operations in countries that
experience political instability.
A change of government may come with new policies that make it
impossible to operate profitably.
For example, the new government may come up with nationalization
programs that restrict money movement from the country.
This can be a major challenge for financial management that relies on
foreign exchange to ensure the company's continued global
operations.
Such political risk is typically not experienced on the domestic financial
management front.

Domestic Vs. International


Banking Regulations
Multinational financial managers have to deal with global banking
institutions that have their own challenges.
Some banks experience liquidity problems because of prevailing
economic conditions in their countries.
Other banks in some emerging economies are heavily regulated by
their respective countries' central governments rather than by
market forces, which influences interest rates.
In addition, many multinationals find themselves operating in
countries where the banking industry is subject to the policies of
the International Monetary Fund, which many businesses consider
unfriendly to their needs.

Domestic Vs. International


Credit
Excessive debt can ruin the multinational corporation's chances of
growth and expansion in the foreign markets.
Financial management has to ensure the multinational has
ample credit for routine business-to-business operations.
If the corporation has to get part of its financing for overseas
projects from the countries where it has operations, it will be
vulnerable to lending rates dictated by the condition of the
economy in those countries.

Foreign
Exchange

Foreign Exchange
The total turnover in Forex Market apprx. US dollar 1.5 trillion per
day. Indian Market USD 1.20 BN per day.
Round the clock market starting from Sydney and Tokyo in the east
through Hong Kong, Singapore, Bahrain, London and New York.
participants are central banks , commercial banks, investment
funds, corporate, individuals and brokers.
Over the counter market

Foreign Exchange
Theories of exchange rates.
v Purchasing power parity theory (PPP)
v Demand supply and elasticity in foreign exchange rate determination.
v Balance of Payments theory.
v Historical perspective on exchange rate.
v Gold Standard,
v Inter-war instability,
v Bretton Woods,
v Fixed exchange rates,
v Fluctuating exchange rates.

Exchange Rate is a rate at which one currency


can be exchanged into another currency. In other
words it is value one currency in terms of other.
say:
US $ 1 = Rs. 65.10
This rate is the conversion rate of every US $ 1 to
Rs. 65.10

Foreign Exchange Market is a market in which


different currencies can be exchanged at a specific
rate called the foreign exchange rate".
We can understand the importance of foreign
exchange rate if we can just consider the influence
of it on the imports and exports of a country.

For example, lets assume a currency appreciation The euro against the
US dollar.
Firstly, the exports of the European Union (E.U) nations will become
expensive for the United States of America (USA), which among other
things means that E.U product will lose in terms of competitiveness.
Secondly, such a currency appreciation will be to the benefit of E.U
imports, should those be payable in US dollars. Conversely, a depreciation
of the euro against the US dollar will cause an opposite impact.
On the other hand, the rapid growth of international trade (both the import
penetration and the export ratio) during the last decades, which was mainly
due to the increase of the open economies, enhances the significance of the
foreign exchange rates.

Depreciation and Appreciation

Depreciation is a decrease in the value of a currency relative to another


currency.
A depreciated currency is less valuable (less expensive) and therefore
can be exchanged for (can buy) a smaller amount of foreign currency.
$1/1 $1.20/1 means that the dollar has depreciated relative to the
euro. It now takes $1.20 to buy one euro, so that the dollar is less
valuable.
The euro has appreciated relative to the dollar: it is now more valuable.

Depreciation and Appreciation Cont..


A depreciated currency is less valuable, and therefore it can buy
fewer foreign produced goods that are denominated in foreign
currency.
How much does a Honda cost? 3,000,000
3,000,000 x $0.0098/1 = $29,400
3,000,000 x $0.0100/1 = $30,000
A depreciated currency means that imports are more expensive and
domestically produced goods and exports are less expensive.
A depreciated currency lowers the price of exports relative to the
price of imports.

Depreciation and Appreciation Cont..


Appreciation is an increase in the value of a currency
relative to another currency.
An appreciated currency is more valuable (more expensive) and
therefore can be exchanged for (can buy) a larger amount of
foreign currency.
$1/1 $0.90/1 means that the dollar has appreciated relative
to the euro. It now takes only $0.90 to buy one euro, so that the
dollar is more valuable.
The euro has depreciated relative to the dollar: it is now less
valuable.

Depreciation and Appreciation Cont..


An appreciated currency is more valuable, and therefore it can buy
more foreign produced goods that are denominated in foreign
currency.
How much does a Honda cost? 3,000,000
3,000,000 x $0.0098/1 = $29,400
3,000,000 x $0.0090/1 = $27,000
An appreciated currency means that imports are less expensive and
domestically produced goods and exports are more expensive.
An appreciated currency raises the price of exports relative to the
price of imports.

FOREIGN EXCHANGE REGIMES

Governments have always paid very serious attention to the exchange rate of a countrys
currency, utilizing any available means at hand, in order to stabilize the desirable
range of rate.

Historically, there were periods that governments through the central banks
intervened in the foreign exchange market in order to affect the fluctuation of the
exchange rate that otherwise would be determined by market forces.

There were also periods with no intervention when the exchange rate, just like a price
was determined by supply and demand.

On 22nd July, 1944, at Bretton Woods in the United States of America, 44 countries
agreed that a broad international action was necessary to maintain an international
monetary system, which would promote foreign trade.

FOREIGN EXCHANGE REGIMES

In this respect, it established a worldwide system of fixed exchange rates between currencies.
Actually, the tool was gold, with the following quota: one ounce of gold was to be worth US
dollars 35. After the establishment of the fixed rate of exchange, all other currencies were pegged
to the US dollar at a fixed exchange rate.

The End Of the "Fixed" Dollar, by the beginning of the 1960s, the US dollar 35 = 1 oz. gold
ratio was becoming more and more difficult to sustain. Gold demand was rising and the U.S. Gold
reserves were declining.

On 15th August, 1971, President Nixon, repudiated the international obligation of the U.S. to
redeem its dollar in gold. By the end of 1974, gold had soared from $35 to $195 an ounce.

Since the collapse of the Bretton Woods agreement (February 1973), the world's currencies have
"floated" with respect to the US dollar.

Thus, the foreign exchange rate regime changed from a fixed exchange rate to a flexible or
floating exchange rate. A system in which, exchange rates are determined by supply and demand
that is called clean float or where governments through central banks intervene (buy and sell
currencies) in the markets, which is called dirty float.

VOLATILITY AND RISK (Associated with Floating Exchange Rate)

Undoubtedly, dramatic movements in the value of currencies can occur where the forces of supply
and demand freely determine the price.

Consequently, such a system increases the exchange rate risk associated with but not limited to
international transactions.

The cross-border financial activity differs from the domestic activity in respect to related risk due
to the fact that when investing in a foreign country you have to consider many other factors, such
as:

Tax system - differences related to the specific countrys system.

Political risk - a democratic country is preferable to a non-democratic one.

Government intervention - it is also preferable to deal with a country without government


intervention.

Business risk - unforeseen changes in the general economic environment.

In addition, the likely volatility in the exchange rate can drastically affect the cost, profits and
return on investments of international firms, thus, resulting in the following levels of risk:

VOLATILITY AND RISK (Associated with Floating Exchange Rate)

Additionally the volatility in the exchange rate can drastically affect the cost, profits and return on
investments of international firms, thus, resulting in the following levels of risk:

Transaction exposure is related to those activities that trade internationally.


For example, a EU company imports bicycle components from the United States with 2 months
credit. Possible US dollar depreciation will be for the benefit of the EU organization because it will
pay fewer Euros. On the contrary, if the US dollar appreciates, the company will suffer a loss, due
to the fact that it will pay more Euros. The transaction exposure (the risk of adverse movements
in the exchange rate) can be eliminated using hedging instruments. An example of this would be
forward rate contracts.
Operational exposure. Although a company may not trade globally, due to competitiveness, it
may suffer the exchange rate risk.
For example, a US bicycle producer will have a competitive advantage compared to a EU producer
of a similar type of bicycle if the euro depreciates against the US dollar. The price of the US
bicycle if converted into Euros will fall, and consequently will attract EU members to buy it.

VOLATILITY AND RISK (Associated with Floating Exchange Rate)

Translation exposure
Assuming a company that has a subsidiary outside the EU and expects profits in one years time.
Based on the current exchange rate between foreign and domestic currency, the company has
converted the amount of profits in its local currency. If the euro appreciates against the local
currency, then the amount of profits when converted into Euros will be less.

DETERMINANTS OF EXCHANGE RATE


Many theories there have been written in respect to the main determinant of future
exchange rates. Although the majority of these theories give adequate reasons in order
to explain what actually determines the rates between the currencies, we can argue that
there are many factors that may cause a currency fluctuation.
Consequently, there is little that can be alleged in respect to the theory that better
answers the question of what finally determines the exchange rates.
Here below, we will refer to the main theories regarding the determinants of the
exchange rates.

Supply and Demand

As stated earlier, the exchange rate, just like commodities, determines its price responding to the
forces of supply and demand.

Therefore, if for some reason people increase their demand (shift of the curve from D to D1) for a
specific currency, then the price will rise from A to B, provided the supply remains stable. On the
contrary, if the supply is increased (shift of the curve from S to S1), the price will decline from A to
C, provided the demand remains stable.

Any excess supply (above the equilibrium point) or excess demand (below the equilibrium point)
will increase or decrease temporarily foreign currency reserves accordingly.

Finally, such disequilibrium situations will be eliminated through the pricing, e.g. the market itself.

Therefore, if for some reason people increase their demand (shift of the curve from D to D1) for a
specific currency, then the price will rise from A to B, provided the supply remains stable.

On the contrary, if the supply is increased (shift of the curve from S to S1), the price will decline
from A to C, provided the demand remains stable

The exchange rate as a price for the demand and supply of domestic
currency

Exchange rate E

S1

er1

D1
O
Quantity of Rs.

Adjustment of the exchange rate to a shift in demand and supply

Exchange rate

S1

er1

S2

Depreciation

er2

D2
O
Quantity of Rs.

D1

Adjustment of the exchange rate to a shift in demand and supply

Exchange rate

S1

S2

Fall in demand for


exports

er1
Depreciation
er2

D2
O
Quantity of Rs.

D1

Adjustment of the exchange rate to a shift in demand and supply

Exchange rate

S1

er1

D1
O
Quantity of Rs.

Adjustment of the exchange rate to a shift in demand and supply


S3

S1

Exchange rate

er3
er1

D3
D1
O
Quantity of Rs.

Adjustment of the exchange rate to a shift in demand and supply


S3

S1

Exchange rate

er3
Appreciation
er1

D3
D1
O
Quantity of Rs.

Purchasing Power Parity (PPP)


By definition the PPP states that using a unit of a currency, let us say one euro, which is
the purchasing power that can purchase the same goods worldwide.

The theory is based on the law of one price, which argues that should a euro price of a
good be multiplied by the exchange rate ( /US$) then it will result in an equal price of
the good in US dollars.

In other words, if we assume that the exchange rate between the and US $ states at
1/1.2, then goods that cost 10 in the EU should cost US$ 12 in the United States.
Otherwise, arbitrage profits will occur.

However, it is finally the market that through supply and demand will force
accordingly the euro and US dollar prices to the equilibrium point.

Thus, the law of one price will be reinstated, as well as the purchase power parity
between the euro and US dollar.

Purchasing Power Parity (PPP)


Inflation differentials between countries will also be eliminated in terms of their effect
on the prices of the goods because the PPP will adjust to equal the ratio of their price
levels.
More specifically, as stated in their book (Lumby S. & Jones C. 1999) the currency of
the country with the higher rate of inflation will depreciate against the other countrys
currency by approximately the inflation deferential.
In conclusion, it can be argued that the theory, although it describes in a sufficient way
the determination of the exchange rates, is not of good value, mainly because of the
following two disadvantages.
Firstly, not all goods are traded internationally (for example, buildings) and
Secondly, the transportation cost should represent a small amount of the goods
worth.

The Balance of Payments (BOP) Approach

The balance of payments approach is another method that explains what the factors are
that determine the supply and demand curves of a countrys currency.

As it is known from macroeconomics, the balance of payments is a method of recording


all the international monetary transactions of a country during a specific period of time.
The transactions recorded are divided into three categories:
the current account transactions,
the capital account transactions, and

the central bank transactions.


The aforementioned categories can show a deficit or a surplus, but theoretically the
overall payments (the BOP as a whole) should be zero which rarely happens.

The Balance of Payments (BOP) Approach

As stated earlier, a currencys price depreciation or appreciation (the change in the value
of money), directly affects the volume of a countrys imports and exports and,
consequently, a likely fluctuation in the exchange rates can add to BOP discrepancies.
For example, a likely depreciation will increase the value of exports in home currency
terms (the larger the exports demand elasticity the greater the increase).
Conversely, the imports will become more expensive and their value will be reduced in
home currency (the larger the imports demand elasticity the greater the decrease).
Consequently, we can argue that unless the value of exports increases less than the value
of imports, the depreciation will improve the current account. More specifically, we can
finally assess the impact of the currencys depreciation on the current account only by
considering the price sensitivity of imports and exports.

Forward
Exchange Rate

Forward & Spot Market


The forward market facilitates the trading of forward
contracts on currencies.
A forward contract is an agreement between a corporation
and a commercial bank to exchange a specified amount of a
currency at a specified exchange rate (called the forward
rate) on a specified date in the future.
A Spot Rate is The exchange rate in foreign exchange
transactions that calls for the payment and receipt of the
foreign exchange within two business days from the date
when the transaction is agreed Upon (spot transactions).

Forward Market cont.


When MNCs anticipate future need or future
receipt of a foreign currency, they can set up
forward contracts to lock in the exchange rate.
Forward contracts are often taken by big
corporates and are not normally used by
consumers or small firms.

Forward Market cont.


As with the case of spot rates, there is a bid/ask
spread on forward rates.
Forward rates may also contain a premium or
discount.
If the forward rate exceeds the existing spot rate, it
contains a premium.
If the forward rate is less than the existing spot rate, it
contains a discount.

Forward Market cont.


annualized forward premium/discount
spot rate 360
= forward rate
spot rate
n
where n is the number of days to maturity

Example: Suppose spot rate = $1.681,


90-day forward rate = $1.677.
$1.677 $1.681 x 360 = 0.95%
$1.681
90
So, forward discount = 0.95%

Forward Market cont.


The forward premium/discount reflects the
difference between the home interest rate and
the foreign interest rate, so as to prevent
arbitrage.

Forward Market cont.


A non-deliverable forward contract (NDF) is a forward
contract whereby there is no actual exchange of
currencies. Instead, a net payment is made by one party
to the other based on the contracted rate and the market
rate on the day of settlement.
Although NDFs do not involve actual delivery, they can
effectively hedge expected foreign currency cash flows.

Exchange Risk
Hedging &
Speculation

Foreign Exchange Risks, Hedging, and Speculation


Foreign Exchange Risks Implication
Through time, a nations demand and supply curves for foreign exchange shift,
causing the spot (and the forward) rate to vary frequently. A nations demand
and supply curves for foreign exchange shift over time as a result of changes in
tastes for domestic and foreign products in the nation and abroad, different
growth and inflation rates in different nations, changes in relative rates of
interest, changing expectations, and so on.

Case Study
If U.S. tastes for EU products increase, the U.S. demand for euros increases (the
demand curve shifts up), leading to a rise in the exchange rate (i.e., a depreciation
of the dollar). On the other hand, a lower rate of inflation in the U.S. than the EU
leads to U.S. products becoming cheaper for EU residents. This tends to increase
the U.S. supply of euros ( the supply curve shifts to the right) and causes a decline
in the exchange rate (i.e., an appreciation of the dollar). Or simply the expection
of a stronger dollar may lead to an appreciation of the dollar. In short, in a
dynamic and changing world, exchange rates frequently vary, reflecting the
constant change in the numerous economic forces simultaneously at work.

Hedging
Concept
It refers to the avoidance of a foreign exchange risk (or the covering of an
open position). Differences from Covering the Foreign Exchange Risk in the
Spot Market (deposit the money for the late use of payment and receipt fore
the interest rate)
Hedging usually takes place in the forward market, where no borrowing or
tying up of funds is required.
e.g. The importer could buy euros forward for delivery (and payment) in three
months at todays three-month forward rate. If the euro is at a three forward
premium of 4% per year, the importer will have to pay $ 101,000 in three months
for the 100,000 needed to pay for the imports.

Conclusion
A foreign exchange risk can also be hedged and an open position avoided in the futures or
options markets.

e.g. Suppose that an importer knows that he or she must pay 100,000 in three months and the
three-month forward rate of the pound is FR=$1/ 1. The importer could either purchase the
100,000 forward (in which case he or she will have to pay $100,000 in three months and
receive the 100,000) or purchase an option to purchase 100,000 in three months , say at $1/
1, and pay now the premium of , say, 1 percent (or$1,000 on the $100,000 option). If in three
months the spot rate of the pound is SR=$0.98/ 1, the importer would have to pay $100,000
with the forward contract, but could let the option expire unexercised and get the 100,000 at
the cost of only$98,000 on the spot market. In that case, the $1,000 premium can be regarded
as an insurance policy and the importer will save $2,000 over the forward contract.

In a word of foreign exchange uncertainty, the ability of traders and investors to hedge
greatly facilitates the international flow of trade and investments. Without hedging there
would be smaller international capital flows, less trade and specialization in production,
and smaller benefits from trade. (e.g. MNCs)

Speculation
Concept
It refers to the acceptance of a foreign exchange risk, or open position, in the hope of
making a profit. If the speculator correctly anticipates future changes in spot rate, he or
she makes a profit; otherwise, he or she incurs a loss. As in the hedging, speculation
can take place in the spot, forward, futures, or options markets - usually in the forward
market.
Speculation in Spot Market
If a speculator believes that the spot rate of a particular foreign currency will rise, he
or she can purchase the currency now and hold it on deposit in a bank for resale later; If
the speculator is correct and the spot rate does indeed rise, he or she earns a profit on
each unit of the foreign currency equal to the spread between the previous lower spot
rate at which he or she purchased the foreign currency and the higher subsequent spot
rate at which he or she resells it. Otherwise the speculator will bear the loss.

If the speculator believes that the spot rate will fall, he or she borrows the foreign
currency for three months, immediately exchanges it for the domestic currency at the
prevailing spot rate, and deposits the domestic currency in a bank to earn interest.
In both of the preceding examples, the speculator operated in the spot market and
either had to tie up his or her own funds or had to borrow to speculate.
Speculation in the Forward Market
If the speculator believes that the spot rate of a certain foreign currency will be higher
in three months than its present three-month forward rate, the speculator purchases a
specified amount of the foreign currency forward for delivery ( and payment ) in three
months. After three months, if the speculator is correct, he or she receives delivery of
the foreign currency at the lower agree forward rate and immediately resells it at the
higher spot rate, thus realizing a profit. Otherwise, the speculator will bear the loss.

Speculation in an Option
If the speculator believes that the foreign currency will depreciate, he or she could
have purchased an option to sell a specific amount of foreign currencies in three
months. If the speculator is correct, he or she will exercise the option, buy foreign
currency in the spot market and receive the payment by exercising the option and
earns the profit. Otherwise, he or she will bear the loss.
A Long Position & A Short Position
A Long Position
When a speculator buys a foreign currency on the spot, forward, or futures market, or
buys an option to purchase a foreign currency in the expectation of reselling it at a
higher futures spot rate, he or she is said to take a long position in the currency.
A Short Position
When the speculator borrows or sells forward a foreign currency in the expectation of
buying it at a future lower price to repay the foreign exchange loan or honor the
forward sale contract or option, the speculator is said to take a short position.

Stabilizing Speculation & Destabilizing Speculation


Stabilizing Speculation
It refers to the purchase of a foreign currency when the domestic price of the foreign currency
falls or is low, in the expectation that it will soon rise, thus leading to a profit. Or it refers to the
sale of the foreign currency when the exchange rate rises or is high, in the expectation that it will
soon fall. Stabilizing speculation moderates fluctuations in exchange rates over time and
performs a useful function.
Destabilizing Speculation
It refers to the sale of a foreign currency when the exchange rate falls or is low, in the
expectation that it will fall even lower in the future, or the purchase of a foreign currency when
the exchange rate is rising or is high, in the expectation that it will rise even higher in the future.
It thus magnifies exchange rate fluctuations over time and can prove very disruptive to the
international flow of trade and investments.
Speculators are usually wealthy individuals or firms rather than banks