Question 1

State the problems of international trade vis-à-

vis domestic trade?
The upcoming discussion will update you about the differences between domestic trade
and international trade.
International trade refers to trade between two different countries such as India and
Bangladesh or one country and the rest of the world e.g., India and Great Britain,
Germany, U.S.A., etc. The former is called bilateral trade and the latter multilateral
trade.

Domestic trade or internal trade is the trade which takes places between the different
regions of the same country e.g., the trade between Calcutta and Mumbai or Calcutta
and Chennai, etc. It is to be noted that there are some points of similarities between
these two kinds of trade.

All trade, whether domestic or international, arises from specialization. As one region of
a country brings the goods from other regions to make up the deficiencies, one country
tries to bring goods and services, in which it has deficiencies, from other countries.
Land, labor and the other resources used in production are not distributed equally
among the nations of the world. Minerals, for example, such as coal, iron and gold are
found only in certain areas. Similarly, the climatic conditions essential for the growth of
particular commodities such as cane sugar, rice and tropical fruit are found only in
certain regions of the world.

Thus, countries are dependent upon one another for supplying their deficiencies in
foods, raw materials and other products. But countries cannot buy the products they
need from each other without selling certain things in exchange. Thus, they are
dependent upon one another for markets. But there are some points of distinctions
between these two kinds of trade; these call for a separate theory for international trade.
Trading between countries differ from domestic trade.

The following points may be noted in this context:

1. Language:

Different countries have different languages. This factor can and often does act as a
barrier to trade. Traders who sell abroad may have to employ language specialists and
incur additional expenses through the necessity of having special forms, labels,
instructions, etc., printed.
2. Differences Regarding Mobility of Labor and Capital:

In the case of domestic trade there is a fair amount of mobility of labor and capital, but
the immobility of labor and, to a smaller extent, of capital is found in the case of
international trade. Labor and capital are fairly mobile within the country, but they
cannot freely move between two countries.
As Adam Smith commented, “Of all sorts of luggage, man is the most difficult to be
transported”. The differences in language/religion, custom, etc., patriotism, family ties
or simply inertia stand in the way of free movement of labor from one country to
another. The laws of a country also impose restriction on the free mobility of labor and
capital.

3. Differences in Natural and Economic Conditions:

The natural and economic conditions are, so far as international trade is concerned, not
the same in all countries. Some countries have greater natural advantages in producing
jute or tea, and some in making machines or electronic goods.
It leads to the international specialization or division of labor. International trade is
based on this international specialization. But, the natural and economic conditions do
not, so far as domestic trade is concerned, very much in the different parts of a country.

4. Differences in Banking Systems and Economic Policies:

Monetary, banking and currency systems as also economic policies of different coun-
tries also differ. International trade is governed by these differences in domestic
economic policies and regulations. But, such restrictions (except minor restrictions like
entry tax, restrictive inter-state movement of essential goods such as rice or wheat, etc.)
do not, as a rule, exist between the different regions of a country and so do not affect, in
a large measure, domestic trade.

5. Currency:

Each country has a different currency, that is a different type of money which is
acceptable only within its own frontier. In India, the currency is the rupee, in France the
franc, while in the United States it is dollar. If an Indian importer buys goods from a
French manufacturer then payment must be made in francs which have to be
purchased in the foreign exchange market.
Such a procedure is both time-consuming and cost-raising than any payment made in
the home country. Furthermore, foreign exchange rates often vary and an adverse
movement in the conversion rate may involve a trader in a loss.
6. Systems of Payment:

As far as payment is concerned there may be more delay and less certain in foreign
trade than in case of domestic trade. An exporter has to obtain payment from a debtor
who may live on the other side of the world and about whom very little is known.
The exporter will be reluctant to ship the goods without being reasonably certain of
payment, while the importer will not wish to pay without some guarantee for receipt of
the goods. In domestic trade, a manufacturer may often get cash on delivery or quick
payment from a wholesaler.

7. Distance:

The risks involved in transporting goods increase with the distance and the frequency
with which the goods are handled. Hence, there is greater chance of loss, damage or
delay when sending goods to countries abroad.

8. Customs Duties and Import Quotas:

Certain goods may be subject to heavy duties or tariffs. This often makes it almost
impossible for exports to compete in price with home products. Furthermore, exports
may be limited by quotas imposed by importing countries.

Even if exporters consider they can compete (in spite of customs duties) they have to
ensure that the correct duty is paid. Duties vary according to the way that goods are
classified and strict penalties apply to false declarations. Hence, a correct
understanding of the classifications list is absolutely essential.
Finally, exporters run the risk that duties and quotas may be changed suddenly so that
their market in a particular country may be suddenly lost, either partly or fully.

9. Competition:

At home, a manufacturer may be protected from foreign competition by duties or quotas

imposed by the government. Hence, competition may be restricted to other home
manufacturers. However, in foreign markets, the manufacturer may have to face
competition from producers in that market as also from other foreign exporters.

10. Local Conditions:

Exporters have to consider the customs and habits of the countries to which they sell
goods. For example, foreigners may like their goods in different dimensions and in
different kinds of packages from those found suitable in the home market. Similarly,
attention has to be given to various methods of trading adopted in foreign markets.
For example, at home manufacturers may leave the provision of spare parts and after-
sales service to others, but if no such facilities are available abroad importers must
themselves contact other firms to get such facilities. Thus, international trade involves
much greater risks and difficulties than domestic trade.
Conclusion:

Owing to these differences between domestic and international trade, the economists
have built-up a separate theory for international trade known as the principle of
comparative cost (advantage). It must, however, be noted that the distinction between
these two kinds of trade is not absolute but one of degrees. After all, as all kinds of
trade arise from specialization (regional or international).

Question 2
What are the salient features of the foreign
exchange market?

The following points highlight the top seven characteristics of foreign exchange market.
The characteristics are:
1. Most Liquid Market in the World
2. Most Dynamic Market in the World
3. Twenty-Four Hour Market
4. Market Transparency
5. International Network of Dealers
6. Most Widely Traded Currency is the Dollar
7. “Over-The-Counter” Market with an “Exchange-Traded” Segment.

Characteristic # 1. Most Liquid Market in the World:

Currency spot trading is the most popular FX instrument around the world, comprising
more than 1/3 of the total activity. It is estimated that spot FX trading generates about
$1.5 trillion a day in volume, making it the largest most liquid market in the world.
Compare that to futures $437.4bn and equities $191bn and you will see that foreign
exchange liquidity towers over any other market. Even though there are many
currencies all over the world, 80% of all daily transactions involve trading the G-7
currencies i.e. the “majors.”

When compared to the futures market, which is fragmented between hundreds of types
of commodities, and multiple exchanges and the equities market, with 50,000 listed
stocks (the S&P 500 being the majority), it becomes clear that the futures and equities
provides only limited liquidity when compared to currencies.
Liquidity has its advantages, the primary one being no manipulation of the market. Thin
stock and futures markets can easily be pushed up or down by specialists, market
makers, commercials, and locals. Spot FX on the other hand takes real buying/selling
by banks and institutions to move the market. Any attempted manipulation of the spot
FX market usually becomes an exercise in futility.
Among the various financial centers around the world, the largest amount of foreign
exchange trading takes place in the United Kingdom, even though that nation’s
currency—the pound sterling—is less widely traded in the market than several others.
The United Kingdom accounts for about 32 percent of the global total; the United States
ranks a distant second with about 18 per cent and Japan is third with 8 percent. Thus,
together, the three largest markets—one each in the European, Western Hemisphere,
and Asian time zones—account for about 58 percent of global trading. After these three
leaders comes Singapore with 7 percent.
The large volume of trading activity in the United Kingdom reflects London’s strong
position as an international financial center where a large number of financial institutions
are located. In the 1998 foreign exchange market turnover survey, 213 foreign
exchange dealer institutions in the United Kingdom reported trading activity to the Bank
of England, compared with 93 in the United States reporting to the Federal Reserve
Bank of New York.

In foreign exchange trading, London benefits not only from its proximity to major
Eurocurrency credit markets and other financial markets, but also from its geographical
location and time zone. In addition to being open when the numerous other financial
centers in Europe are open, London’s morning hours overlap with the late hours in a
number of Asian and Middle East markets; London’s afternoon sessions correspond to
the morning periods in the large North American market.
Thus, surveys have indicated that there is more foreign exchange trading in dollars in
London than in the United States, and more foreign exchange trading in marks than in
Germany. However, the bulk of trading in London, about 85 percent, is accounted for by
foreign-owned (non-U.K. owned) institutions, with U.K.-based dealers of North American
institutions reporting 49 percent, or three times the share of U.K.-owned institutions
there.

Characteristic # 2 Most Dynamic Market in the World:

Foreign exchange market is the most dynamic market in the world. Regardless of which
instrument you are trading – be it stocks, municipal bonds, U.S. treasuries, agricultural
futures, foreign exchange, or any of the countless others – the attributes that determine
the viability of a market as an investment opportunity remain the same.
Namely, good investment markets all possess the following characteristics- liquidity,
market transparency, low transaction costs, and fast execution. Based upon these
characteristics, the spot FX market is the perfect market to trade.

Characteristic # 3. Twenty-Four-Hour Market:

During the past quarter century, the concept of a twenty-four-hour market has become a
reality. Somewhere on the planet, financial centers are open for business, and banks
and other institutions are trading the dollar and other currencies, every hour of the day
and night, aside from possible minor gaps on weekends. In financial centers around the
world, business hours overlap; as some centers close, others open and begin to trade.
The foreign exchange market follows the sun around the earth.
The International Date Line is located in the western Pacific, and each business day
arrives first in the Asia-Pacific financial centers— first Wellington, New Zealand, then
Sydney, Australia, followed by Tokyo, Hong Kong, and Singapore. A few hours later,
while markets remain active in those Asian centers, trading begins in Bahrain and
elsewhere in the Middle East.
Later still, when it is late in the business day in Tokyo, markets in Europe open for
business. Subsequently, when it is early afternoon in Europe, trading in New York and
other U.S. centers start. Finally, completing the circle, when it is mid- or late-afternoon
in the United States, the next day has arrived in the Asia-Pacific area, the first markets
there have opened, and the process begins again.
The twenty-four-hour market means that exchange rates and market conditions can
change at any time in response to developments that can take place at any time. It also
means that traders and other market participants must be alert to the possibility that a
sharp move in an exchange rate can occur during an off hour, elsewhere in the world.

The large dealing institutions have adapted to these conditions, and have introduced
various arrangements for monitoring markets and trading on a twenty- four-hour basis.
Some keep their New York or other trading desks open twenty-four hours a day, others
pass the torch from one office to the next, and still others follow different approaches.
However, foreign exchange activity does not flow evenly. Over the course of a day,
there is a cycle characterized by periods of very heavy activity and other periods of
relatively light activity. Most of the trading takes place when the largest number of
potential counterparties is available or accessible on a global basis.
Market liquidity is of great importance to participants. Sellers want to sell when they
have access to the maximum number of potential buyers/ and buyers want to buy when
they have access to the maximum number of potential sellers.
Business is heavy when both the U.S. markets and the major European markets are
open—that is, when it is morning in New York and afternoon in London. In the New York
market, nearly two thirds of the day’s activity typically take place in the morning hours.
Activity normally becomes very slow in New York in the mid- to late afternoon, after
European markets have closed and before the Tokyo, Hong Kong, and Singapore
markets have- opened.

Given this uneven flow of business around the clock, market participants often will
respond less aggressively to an exchange rate development that occurs at a relatively
inactive time of day, and will wait to see whether the development is confirmed when
the major markets open. Some institutions pay little attention to developments in less
active markets.
Nonetheless, the twenty-four-hour market does provide a continuous “real-time” market
assessment of the ebb and flow of influences and attitudes with respect to the traded
currencies, and an opportunity for a quick judgment of unexpected events. The foreign
exchange market provides a kind of never-ending beauty contest or horse race, where
market participants can continuously adjust their bets to reflect their changing views.
Characteristic # 4 Market Transparency:

Price transparency is very high in the FX market and the evolution of online foreign
exchange trading continues to improve this, to the benefit of traders. One of the biggest
advantages of trading foreign exchange online is the ability to trade directly with the
market maker. A reputable forex broker will provide traders with streaming, executable
prices. It is important to make a distinction between indicative prices and executable
prices.
Indicative quotes are those that offer an indication of the prices in the market, and the
rate at which they are changing. Executable prices are actual prices where the market
maker is willing to buy/sell. Although online trading has reached equities and futures,
prices represent the LAST buy/sell and therefore represent indicative prices rather than
executable prices.

Furthermore, trading online directly with the market maker means traders receive a fair
price on all transactions. When trading equities or futures through a broker, traders must
request a price before dealing, allowing for brokers to check a trader’s existing position
and ‘shade’ the price (in their favor) a few pips depending on the trader’s position.
Online trading capabilities in FX also create more efficiency and market transparency by
providing real time portfolio and account tracking capability. Traders have access to real
time profit/loss on open positions and can generate reports on demand, which provide
detailed information regarding every open position, open order, margin position and
generated profit/loss per trade.

Characteristic # 5 International Network of Dealers:

The market is made up of an international network of dealers. The market consists of a

limited number of major dealer institutions that are particularly active in foreign
exchange, trading with customers and (more often) with each other. Most, but not all,
are commercial banks and investment banks. These dealer institutions are
geographically dispersed, located in numerous financial centers around the world.
Wherever located, these institutions are linked to, and in close communication with,
each other through telephones, computers, and other electronic means.
There are around 2,000 dealer institutions whose foreign exchange activities are
covered by the Bank for International Settlements’ central bank survey, and who,
essentially, make up the global foreign exchange market. A much smaller sub-set of
those institutions accounts for the bulk of trading and market-making activity. It is
estimated that there are 100- 200 market-making banks worldwide; major players are
fewer than that.

At a time when there is much talk about an integrated world economy and “the global
village,” the foreign exchange market comes closest to functioning in a truly global
fashion, linking the various foreign exchange trading centers from around the world into
a single, unified, cohesive, worldwide market.
Foreign exchange trading takes place among dealers and other market professionals in
a large number of individual financial centers— New York, Chicago, Los Angeles,
London, Tokyo, Singapore, Frankfurt, Paris, Zurich, Milan, and many, many others. But
no matter in which financial center a trade occurs, the same currencies, or rather, bank
deposits denominated in the same currencies, are being bought and sold.
A foreign exchange dealer buying dollars in one of those markets actually is buying a
dollar-denominated deposit in a bank located in the United States, or a claim of a bank
abroad on a dollar deposit in a bank located in the United States. This holds true
regardless of the location of the financial center at which the dollar deposit is
purchased. Similarly, a dealer buying Deutsche marks, no matter where the purchase is
made, actually is buying a mark deposit in a bank in Germany or a claim on a mark
deposit in a bank in Germany. And so on for other currencies.
Each nation’s market has its own infrastructure. For foreign exchange market
operations as well as for other matters, each country enforces its own laws, banking
regulations, accounting rules, and tax code, and, as noted above, it operates its own
payment and settlement systems.
Thus, even in a global foreign exchange market with currencies traded on essentially
the same terms simultaneously in many financial centers, there are different national
financial systems and infrastructures through which transactions are executed, and
within which currencies are held.
With access to all of the foreign exchange markets generally open to participants from
all countries, and with vast amounts of market information transmitted simultaneously
and almost instantly to dealers throughout the world, there is an enormous amount of
cross border foreign exchange trading among dealers as well as between dealers and
their customers.

Characteristic # 6 Most Widely Traded Currency is the Dollar:

The dollar is by far the most widely traded currency. According to the 1998 survey, the
dollar was one of the two currencies involved in an estimated 87 percent of global
foreign exchange transactions, equal to about $1.3 trillion a day. In part, the widespread
use of the dollar reflects its substantial international role as – “investment” currency in
many capital markets, “reserve” currency held by many central banks, “transaction”
currency in many international commodity markets, “invoice” currency in many
contracts, and “intervention” currency employed by monetary authorities in market
operations to influence their own exchange rates.
In addition, the widespread trading of the dollar reflects its use as a “vehicle” currency in
foreign exchange transactions, a use that reinforces, and is reinforced by, its
international role in trade and finance. For most pairs of currencies, the market practice
is to trade each of the two currencies against a common third currency as a vehicle,
rather than to trade the two currencies directly against each other. The vehicle currency
used most often is the dollar, although by the mid-1990s the Deutsche mark also had
become an important vehicle, with its use, especially in Europe, having increased
sharply during the 1980s and ’90s.
Characteristic # 7 “Over-The-Counter” Market with an “Exchange-Traded” Segment:

Until the 1970s, all foreign exchange trading in the United States (and elsewhere) was
handled “over-the-counter,” (OTC) by banks in different locations making deals via
telephone and telex. In the United States, the OTC market was then, and is now, largely
unregulated as a market.
Buying and selling foreign currencies is considered the exercise of an express banking
power. Thus, a commercial bank or Securities & brokerage firms in the United States do
not need any special authorization to trade or deal in foreign exchange.
There are no official rules or restrictions in the United States governing the hours or
conditions of trading. The trading conventions have been developed mostly by market
participants. There is no official code prescribing what constitutes good market practice.
However, the Foreign Exchange Committee, an independent body sponsored by the
Federal Reserve Bank of New York and composed of representatives from institutions
participating in the market, produces and regularly updates its report on Guidelines for
Foreign Exchange Trading. These Guidelines seek to clarify common market practices
and offer “best practice recommendations” with respect to trading activities,
relationships, and other matters.
Although the OTC market is not regulated as a market in the way that the organized
exchanges are regulated, regulatory authorities examine the foreign exchange market
activities of banks and certain other institutions participating in the OTC market.
As with other business activities in which these institutions are engaged, examiners look
at trading systems, activities, and exposure, focusing on the safety and soundness of
the institution and its activities. Examinations deal with such matters as capital
adequacy, control systems, disclosure, sound banking practice, legal compliance, and
other factors relating to the safety and soundness of the institution.
The OTC market accounts for well over 90 percent of total U.S. foreign exchange
market activity, covering both the traditional (pre-1970) products (spot, outright
forwards, and FX swaps) as well as the more recently introduced (post-1970) OTC
products (currency options and currency swaps). On the “organized exchanges,” foreign
exchange products traded are currency futures and certain currency options.
Steps are being taken internationally to help improve the risk management practices of
dealers in the foreign exchange market, and to encourage greater transparency and
disclosure.
Question 3

What do you understand by Foreign Exchange

Exposure? Explain in details three broad
categories of foreign exchange exposure.

Foreign exchange Exposure describes the risk that an investment’s value may change
due to changes in the value of two different currencies. It is also known as currency risk,
FX risk and exchange-rate risk.

Foreign exchange risk sometimes also refers to risk an investor faces when they need
to close out a long or short position in a foreign currency and do so at a loss due to
fluctuations in exchange rates.

Some types of exposure associated with foreign exchange risk include economic
exposure, translation exposure and contingent exposure.

Economic exposure, or forecast risk, refers to when a company’s market

value is impacted by currency volatility. Translation exposure refers to when foreign
exchange rates change, affecting the figures that a multinational company reports to its
shareholders. Contingent exposure refers to the risk that firms face when they bid on
projects in foreign currencies.

Types of Foreign Exchange Currency Exposure

Foreign exchange exposure is classified into three types:

#1Transaction
#2Translation
#3Economic Exposure

Transaction exposure deals with actual foreign currency transaction. Translation

exposure deals with the accounting representation and economic exposure deals with
little macro level exposure which may be true for the whole industry rather than just the
firm under concern.

Foreign exchange exposure is said to exist for a business or a firm when the value of its
future cash flows is dependent on the value of foreign currency/currencies.
TRANSLATION EXPOSURE:

This exposure is also well known as accounting exposure. It is because the exposure is
due to the translation of books of accounts into the home currency. Translation activity
is carried out on account of reporting the books to the shareholders or legal bodies. It
makes sense also as the translated financial statements show the position of the
company as on a date in its home currency.

Gains or losses arising out of translation exposure do not have more meaning over and
above the reporting requirements.

Such exposure can even get reversed in the next year translation if currency market
moves in the favorable direction. This kind of exposure does not require too much of
management attention.

TRANSACTION EXPOSURE:

The simplest kind of foreign currency exposure which anybody can easily think of is the
transaction exposure. As the name itself suggests, this exposure pertains to the
exposure due to an actual transaction taking place in business involving foreign
currency. In a business, all monetary transactions are meant for profits as its end result.
There are all the chances of that final objective getting hampered if it is a foreign
currency transaction and the currency market moves towards the unfavorable direction.
If you have bought goods from a foreign country and payables are in foreign currency to
be paid after 3 months, you may end up paying much higher on the due date as
currency value may increase. This will increase your purchase price and therefore the
overall costing of the product compelling the profit percentage to go down or even
convert to lose.

Transaction exposure normally occurs due to foreign currency debtors of sale, payment
for imported goods or services, receipt / payment of dividend, or payment towards the
EMIs of debts etc.

ECONOMIC EXPOSURE:

The impact and importance of this type of exposure are much higher compared to the
other two. Economic exposure directly impacts the value of a firm. That means, the
value of the firm is influenced by the foreign exchange.
The value of a firm is the function of operating cash flows and the assets it possesses.
The economic exposure can have bearings on assets as well as operating cash flows.
Identification and measuring of this exposure is a difficult task. Although, the asset
exposure is still measurable and visible in books but the operating exposure has links to
various factors such as competitiveness, entry barriers etc. These are quite subjective
and interpretation of different experts may be different.
These three types of foreign currency exposures are very important to understand for
an international finance manager. Analyzing the exposure to foreign exchange helps
have the right view of the firm’s business and therefore take informed decisions.

Question 4

What is a spot exchange rate? How is it different

from a forward rate? How will you calculate
forward premium or discount?

Spot exchange rate

A spot transaction is a two-day delivery transaction (except in the case of trades

between the US dollar, Canadian dollar, Turkish lira, euro and Russian ruble, which
settle the next business day), as opposed to the futures contracts, which are usually
three months. This trade represents a “direct exchange” between two currencies, has
the shortest time frame, involves cash rather than a contract, and interest is not
included in the agreed-upon transaction. Spot trading is one of the most common types
of forex trading. Often, a forex broker will charge a small fee to the client to roll-over the
expiring transaction into a new identical transaction for a continuation of the trade. This
roll-over fee is known as the "swap" fee.

Forward rate

One way to deal with the foreign exchange risk is to engage in a forward transaction. In
this transaction, money does not actually change hands until some agreed upon future
date. A buyer and seller agree on an exchange rate for any date in the future, and the
transaction occurs on that date, regardless of what the market rates are then. The
duration of the trade can be one day, a few days, months or years. Usually the date is
decided by both parties. Then the forward contract is negotiated and agreed upon by
both parties.