The Management of Foreign Exchange Risk

by Ian H. Giddy and Gunter Dufey

New York University and University of Michigan

1 OVERVIEW.

1 (a) Goals of the chapter

Exchange risk is the effect that unanticipated exchange rate changes have on the value of the
firm. This chapter explores the impact of currency fluctuations on cash flows, on assets and
liabilities, and on the real business of the firm. Three questions must be asked. First, what
exchange risk does the firm face, and what methods are available to measure currency exposure?
Second, based on the nature of the exposure and the firm's ability to forecast currencies, what
hedging or exchange risk management strategy should the firm employ? And finally, which of
the various tools and techniques of the foreign exchange market should be employed: debt and
assets; forwards and futures; and options. The chapter concludes by suggesting a framework that
can be used to match the instrument to the problem.

1 (b) What is exchange risk?

Exchange risk is simple in concept: a potential gain or loss that occurs as a result of an exchange
rate change. For example, if an individual owns a share in Hitachi, the Japanese company, he or
she will lose if the value of the yen drops.

Yet from this simple question several more arise. First, whose gain or loss? Clearly not just those
of a subsidiary, for they may be offset by positions taken elsewhere in the firm. And not just
gains or losses on current transactions, for the firm's value consists of anticipated future cash
flows as well as currently contracted ones. What counts, modern finance tells us, is shareholder
value; yet the impact of any given currency change on shareholder value is difficult to assess, so
proxies have to be used. The academic evidence linking exchange rate changes to stock prices is
weak.

Moreover the shareholder who has a diversified portfolio may find that the negative effect of
exchange rate changes on one firm is offset by gains in other firms; in other words, that exchange
risk is diversifiable. If it is, than perhaps it's a non-risk.

Finally, risk is not risk if it is anticipated. In most currencies there are futures or forward
exchange contracts whose prices give firms an indication of where the market expects currencies
to go. And these contracts offer the ability to lock in the anticipated change. So perhaps a better
concept of exchange risk is unanticipated exchange rate changes.

These and other issues justify a closer look at this area of international financial management.
2 SHOULD FIRMS MANAGE FOREIGN EXCHANGE RISK?

Many firms refrain from active management of their foreign exchange exposure, even though
they understand that exchange rate fluctuations can affect their earnings and value. They make
this decision for a number of reasons.

First, management does not understand it. They consider any use of risk management tools, such
as forwards, futures and options, as speculative. Or they argue that such financial manipulations
lie outside the firm's field of expertise. "We are in the business of manufacturing slot machines,
and we should not be gambling on currencies." Perhaps they are right to fear abuses of hedging
techniques, but refusing to use forwards and other instruments may expose the firm to substantial
speculative risks.

Second, they claim that exposure cannot be measured. They are right -- currency exposure is
complex and can seldom be gauged with precision. But as in many business situations,
imprecision should not be taken as an excuse for indecision.

Third, they say that the firm is hedged. All transactions such as imports or exports are covered,
and foreign subsidiaries finance in local currencies. This ignores the fact that the bulk of the
firm's value comes from transactions not yet completed, so that transactions hedging is a very
incomplete strategy.

Fourth, they say that the firm does not have any exchange risk because it does all its business in
dollars (or yen, or whatever the home currency is). But a moment's thought will make it evident
that even if you invoice German customers in dollars, when the mark drops your prices will have
to adjust or you'll be undercut by local competitors. So revenues are influenced by currency
changes.

Finally, they assert that the balance sheet is hedged on an accounting basis--especially when the
"functional currency" is held to be the dollar. The misleading signals that balance sheet exposure
measure can give are documented in later sections.

But is there any economic justification for a "do nothing" strategy?

Modern principles of the theory of finance suggest prima facie that the management of corporate
foreign exchange exposure may neither be an important nor a legitimate concern. It has been
argued, in the tradition of the Modigliani-Miller Theorem, that the firm cannot improve
shareholder value by financial manipulations: specifically, investors themselves can hedge
corporate exchange exposure by taking out forward contracts in accordance with their ownership
in a firm. Managers do not serve them by second-guessing what risks shareholders want to
hedge.

One counter-argument is that transaction costs are typically greater for individual investors than
firms. Yet there are deeper reasons why foreign exchange risk should be managed at the firm
level. As will be shown in the material that follows, the assessment of exposure to exchange rate
fluctuations requires detailed estimates of the susceptibility of net cash flows to unexpected
exchange rate changes (Dufey and Srinivasulu, 1983). Operating managers can make such
estimates with much more precision than shareholders who typically lack the detailed knowledge
of competition, markets, and the relevant technologies. Furthermore, in all but the most perfect
financial markets, the firm has considerable advantages over investors in obtaining relatively
inexpensive debt at home and abroad, taking maximum advantage of interest subsidies and
minimizing the effect of taxes and political risk.

Another line of reasoning suggests that foreign exchange risk management does not matter
because of certain equilibrium conditions in international markets for both financial and real
assets. These conditions include the relationship between prices of goods in different markets,
better known as Purchasing Power Parity (PPP), and between interest rates and exchange rates,
usually referred to as the International Fisher Effect (see next section).

However, deviations from PPP and IFE can persist for considerable periods of time, especially at
the level of the individual firm. The resulting variability of net cash flow is of significance as it
can subject the firm to the costs of financial distress, or even default. Modern research in finance
supports the reasoning that earnings fluctuations that threaten the firm's continued viability
absorb management and creditors' time, entail out-of-pocket costs such as legal fees, and create a
variety of operating and investment problems, including underinvestment in R&D. The same
argument supports the importance of corporate exchange risk management against the claim that
in equity markets it is only systematic risk that matters. To the extent that foreign exchange risk
represents unsystematic risk, it can, of course, be diversified away -- provided again, that
investors have the same quality of information about the firm as management -- a condition not
likely to prevail in practice.

This reasoning is buttressed by the likely effect that exchange risk has on taxes paid by the firm.
It is generally agreed that leverage shields the firm from taxes, because interest is tax deductible
whereas dividends are not. But the extent to which a firm can increase leverage is limited by the
risk and costs of bankruptcy. A riskier firm, perhaps one that does not hedge exchange risk,
cannot borrow as much. It follows that anything that reduces the probability of bankruptcy
allows the firm to take on greater leverage, and so pay less taxes for a given operating cash flow.
If foreign exchange hedging reduces taxes, shareholders benefit from hedging.

However, there is one task that the firm cannot perform for shareholders: to the extent that
individuals face unique exchange risk as a result of their different expenditure patterns, they
must themselves devise appropriate hedging strategies. Corporate management of foreign
exchange risk in the traditional sense is only able to protect expected nominal returns in the
reference currency (Eaker, 1981).

3 ECONOMIC EXPOSURE, PURCHASING POWER PARITY AND THE

INTERNATIONAL FISHER EFFECT

Exchange rates, interest rates and inflation rates are linked to one another through a classical set
of relationships which have import for the nature of corporate foreign exchange risk. These
relationships are: (1) the purchasing power parity theory, which describes the linkage between
relative inflation rates and exchange rates; (2) the international Fisher effect, which ties interest
rate differences to exchange rate expectations; and (3) the unbiased forward rate theory, which
relates the forward exchange rate to exchange rate expectations. These relationships, along with
two other key "parity" linkages, are illustrated in Figure 1.

The Purchasing Power Parity (PPP) theory can be stated in different ways, but the most
common representation links the changes in exchange rates to those in relative price indices in
two countries.

Rate of change of exchange rate = Difference in inflation rates

The relationship is derived from the basic idea that, in the absence of trade restrictions changes
in the exchange rate mirror changes in the relative price levels in the two countries. At the same
time, under conditions of free trade, prices of similar commodities cannot differ between two
countries, because arbitragers will take advantage of such situations until price differences are
eliminated. This "Law of One Price" leads logically to the idea that what is true of one
commodity should be true of the economy as a whole--the price level in two countries should be
linked through the exchange rate--and hence to the notion that exchange rate changes are tied to
inflation rate differences.

The International Fisher Effect (IFE) states that the interest rate differential will exist only if
the exchange rate is expected to change in such a way that the advantage of the higher interest
rate is offset by the loss on the foreign exchange transactions.

This International Fisher Effect can be written as follows:

The expected rate of change of the exchange rate = The interest rate differential

In practical terms the IFE implies that while an investor in a low-interest country can convert his
funds into the currency of the high-interest country and get paid a higher rate, his gain (the
interest rate differential) will be offset by his expected loss because of foreign exchange rate
changes.

The Unbiased Forward Rate Theory asserts that the forward exchange rate is the best, and an
unbiased, estimate of the expected future spot exchange rate. The theory is grounded in the
efficient markets theory, and is widely assumed and widely disputed as a precise explanation.

The "expected" rate is only an average but the theory of efficient markets tells us that it is an
unbiased expectation--that there is an equal probability of the actual rate being above or below
the expected value.

The unbiased forward rate theory can be stated simply:

The expected exchange rate = The forward exchange rate

Now we can summarize the impact of unexpected exchange rate changes on the internationally
involved firm by drawing on these parity conditions. Given sufficient time, competitive forces
and arbitrage will neutralize the impact of exchange rate changes on the returns to assets; due to
the relationship between rates of devaluation and inflation differentials, these factors will also
neutralize the impact of the changes on the value of the firm This is simply the principle of
Purchasing Power Parity and the Law of One Price operating at the level of the firm. On the
liability side, the cost of debt tends to adjust as debt is repriced at the end of the contractual
period, reflecting (revised) expected exchange rate changes. And returns on equity will also
reflect required rates of return; in a competitive market these will be influenced by expected
exchange rate changes. Finally the unbiased forward rate theory suggests that locking in the
forward exchange rate offers the same expected return as remaining exposed to the ups and
downs of the currency -- on average, it can be expected to err as much above as below the
forward rate.

In the long run, it would seem that a firm operating in this setting will not experience net
exchange losses or gains. However, because of contractual, or, more importantly, strategic
commitments, these equilibrium conditions rarely hold in the short and medium term. Therefore
the essence of foreign exchange exposure, and, significantly, its management, are made relevant
by these "temporary deviations."

4 IDENTIFYING EXPOSURE.

The first step in management of corporate foreign exchange risk is to acknowledge that such risk
does exist and that managing it is in the interest of the firm and its shareholders. The next step,
however, is much more difficult: the identification of the nature and magnitude of foreign
exchange exposure. In other words, identifying what is at risk, and in what way.

The focus here is on the exposure of nonfinancial corporations, or rather the value of their assets.
This reminder is necessary because most commonly accepted notions of foreign exchange risk
hedging deal with assets, i.e., they are pertinent to (simple) financial institutions where the bulk
of the assets consists of (paper) assets that have with contractually fixed returns, i.e., fixed
income claims, not equities. Clearly, such timece your assets in the currency in which they are
denominated" applies in general to banks and similar firms. Nonfinancial business firms, on the
other hand, have, as a rule, only a relatively small proportion of their total assets in the form of
receivables and other financial claims. Their core assets consist of inventories, equipment,
special purpose buildings and other tangible assets, often closely related to technological
capabilities that give them earnings power and thus value. Unfortunately, real assets (as
compared to paper assets) are not labelled with currency signs that make foreign exchange
exposure analysis easy. Most importantly, the location of an asset in a country is -- as we shall
see -- an all too fallible indicator of their foreign exchange exposure.

The task of gauging the impact of exchange rate changes on an enterprise begins with measuring
its exposure, that is, the amount, or value, at risk. This issue has been clouded by the fact that
financial results for an enterprise tend to be compiled by methods based on the principles of
accrual accounting. Unfortunately, this approach yields data that frequently differ from those
relevant for business decision-making, namely future cash flows and their associated risk
profiles. As a result, considerable efforts are expended -- both by decision makers as well as
students of exchange risk -- to reconcile the differences between the point-in-time effects of
exchange rate changes on an enterprise in terms of accounting data, referred to as accounting or
translation exposure, and the ongoing cash flow effects which are referred to as economic
exposure. Both concepts have their grounding in the fundamental concept of transactions
exposure. The relationship between the three concepts is illustrated in the Exhibit 2. While
exposure concepts have been aptly analyzed elsewhere in this Handbook, some basic concepts
are repeated here to make the present chapter self contained.

4 (a) Exposure in a simple transaction.

The typical illustration of transaction exposure involves an export or import contract giving rise
to a foreign currency receivable or payable. On the surface, when the exchange rate changes, the
value of this export or import transaction will be affected in terms of the domestic currency.
However, when analyzed carefully, it becomes apparent that the exchange risk results from a
financial investment (the foreign currency receivable) or a foreign currency liability (the loan
from a supplier) that is purely incidental to the underlying export or import transaction; it could
have arisen in and of itself through independent foreign borrowing and lending. Thus, what is
involved here are simply foreign currency assets and liabilities, whose value is contractually
fixed in nominal terms.

While this traditional analysis of transactions exposure is correct in a narrow, formal sense, it is
really relevant for financial institutions, only. With returns from financial assets and liabilities
being fixed in nominal terms, they can be shielded from losses with relative ease through cash
payments in advance (with appropriate discounts), through the factoring of receivables, or via the
use of forward exchange contracts, unless unexpected exchange rate changes have a systematic
effect on credit risk.8 However, the essential assets of nonfinancial firms have noncontractual
returns, i.e. revenue and cost streams from the production and sale of their goods and services
which can respond to exchange rate changes in very different ways. Consequently, they are
characterized by foreign exchange exposure very different from that of firms with contractual
returns.

MEASURES OF ACCOUNTING EXPOSURE

Monetary/
Current/
Temporal Current
Noncurrent
Nonmonetary
ASSETS
Cash C C C C
Marketable Securities
C C C C
(At Market Value)
Accounts Receivable C C C C
Inventory (At Cost) C H H C
Fixed Assets H H H C
LIABILITIES
Current Liabilities C C C C
Long Term Debt H C C C
Residual Residual Residual Residual
Equity
Adjustment Adjustment Adjustment Adjustment

Note: In the case of Income Statements, sales revenues and interest are generally translated at the
average historical exchange rate that prevailed during the period; depreciation is translated at the
appropriate historical exchange rate. Some of the general and administrative expenses as well as
cost-of-goods-sold are translated at historical exchange rates, others at current rates.

"C" = Assets and liabilities are translated at the current rate, or rate prevailing on the date of the
balance sheet.

"H" = Assets and liabilities are translated at the historical rate.

4 (b) Accounting exposure.

The concept of accounting exposure arises from the need to translate accounts that are
denominated in foreign currencies into the home currency of the reporting entity. Most
commonly the problem arises when an enterprise has foreign affiliates keeping books in the
respective local currency. For purposes of consolidation these accounts must somehow be
translated into the reporting currency of the parent company. In doing this, a decision must be
made as to the exchange rate that is to be used for the translation of the various accounts. While
income statements of foreign affiliates are typically translated at a periodic average rate, balance
sheets pose a more serious challenge.

To a certain extent this difficulty is revealed by the struggle of the accounting profession to agree
on appropriate translation rules and the treatment of the resulting gains and losses. A
comparative historical analysis of translation rules may best illustrate the issues at hand. Over
time, U.S. companies have followed essentially four types of translation methods, summarized in
Exhibit 3. These four methods differ with respect to the presumed impact of exchange rate
changes on the value of individual categories of assets and liabilities. Accordingly, each method
can be identified by the way in which it separates assets and liabilities into those that are
"exposed" and are, therefore, translated at the current rate, i.e., the rate prevailing on the date of
the balance sheet, and those whose value is deemed to remain unchanged, and which are,
therefore, translated at the historical rate.

The current/noncurrent method of translation divides assets and liabilities into current and
noncurrent categories, using maturity as the distinguishing criterion; only the former are
presumed to change in value when the local currency appreciates or depreciates vis-à-vis the
home currency. Supporting this method is the economic rationale that foreign exchange rates are
essentially fixed but subject to occasional adjustments that tend to correct themselves in time.
This assumption reflected reality to some extent, particularly with respect to industrialized
countries during the period of the Bretton Woods system. However, with subsequent changes in
the international financial environment, this translation method has become outmoded; only in a
few countries is it still being used.

Under the monetary/nonmonetary method all items explicitly defined in terms of monetary units
are translated at the current exchange rate, regardless of their maturity. Nonmonetary items in the
balance sheet, such as tangible assets, are translated at the historical exchange rate. The
underlying assumption here is that the local currency value of such assets increases (decreases)
immediately after a devaluation (revaluation) to a degree that compensates fully for the exchange
rate change. This is equivalent of what is known in economics as the Law of One Price, with
instantaneous adjustment.

A similar but more sophisticated translation approach supports the so-called temporal method.
Here, the exchange rate used to translate balance sheet items depends on the valuation method
used for a particular item in the balance sheet. Thus, if an item is carried on the balance sheet of
the affiliate at its current value, it is to be translated using the current exchange rate.
Alternatively, items carried at historical cost are to be translated at the historical exchange rate.
As a result, this method synchronizes the time dimension of valuation with the method of
translation. As long as foreign affiliates compile balance sheets under traditional historical cost
principles, the temporal method gives essentially the same results as the monetary/nonmonetary
method. However, when "current value accounting" is used, that is, when accounts are adjusted
for inflation, then the temporal method calls for the use of the current exchange rate throughout
the balance sheet.

The temporal method provided the conceptual base for the Financial Accounting Standard
Board's Standard 8 (FAS 8), which came into effect in 1976 for all U.S.-based companies and
those non-U.S. companies that had to follow U.S. accounting principles in order to raise funds in
the public markets of the United States.

The temporal method points to a more general issue: the relationship between translation and
valuation methods for accounting purposes. When methods of valuation provide results that do
not reflect economic reality, translation will fail to remedy that deficiency, but will tend to make
the distortion very apparent. To illustrate this point: companies with real estate holdings abroad
financed by local currency mortgages found that under FAS 8 their earnings were subject to
considerable translation losses and gains. This came about because the value of their assets
remained constant, as they were carried on the books at historical cost and translated at historical
exchange rates, while the value of their local currency liabilities increased or decreased with
every twitch of the exchange rate between reporting dates.

In contrast, U.S. companies whose foreign affiliates produced internationally traded goods
(minerals or oil, for example) felt very comfortable valuing their assets on a dollar basis. Indeed,
this later category of companies were the ones that did not like the transition to the current rate
method at all. Here, all assets and liabilities are translated at the exchange rate prevailing on the
reporting date. They found the underlying assumption that the value of all assets (denominated in
the local currency of the given foreign affiliate) would change in direct proportion to the
exchange rate change did not reflect the economic realities of their business.

In order to accommodate the conflicting requirements of companies in different situations and

still maintain a semblance of conformity and comparability, at the end of 1981 the Financial
Accounting Standards Board issued Standard 52, replacing Standard 8. FAS 52, as it is
commonly referred to, uses the current/current method as the basic translation rule. At the same
time it mitigates the consequences by allowing companies to move translation losses directly to a
special subaccount in the net worth section of the balance sheet, instead of adjusting current
income. This latter provision may be viewed as a mere gimmick without much substance,
providing at best a signalling function, indicating to users of accounting information that
translation gains and losses are of a nature different from items normally found in income
statements.

A more significant innovation of FAS 52 is the "functional" currency concept, which gives a
company the opportunity to identify the primary economic environment and select the
appropriate (functional) currency for each of the corporation's foreign entities. This approach
reflects the official recognition by the accounting profession that the location of an entity does
not necessarily indicate the currency relevant for a particular business. Thus FAS 52 represents
an attempt to take into account the fact that exchange rate changes affect different companies in
different ways, and that rigid and general rules treating different circumstances in the same
manner will provide misleading information.

In order to adjust to the diversity of real life FAS 52 had to become quite complex. The
following provides a brief road map to the logic of that standard.

In applying FAS 52 a company and its accountants must make two decisions in sequence. First,
they must determine the functional currency of the entity whose accounts are to be consolidated.
For all practical purposes, the choice here is between local currency and the U.S. dollar. In
essence, there are a number of specific criteria which provide guidelines for this determination.
As usual, extreme cases are relatively easily classified: a foreign affiliate engaged in retailing
local goods and services will have the local currency as its functional currency, while a "border
plant" that receives the majority of its inputs from abroad and ships the bulk of the output outside
of the host country will have the dollar as its functional currency. If the functional currency is the
dollar, foreign currency items on its balance sheet will have to be restated into dollars and any
gains and losses are moved through the income statement, just as under FAS 8. If, on the other
hand, the functional currency is determined to be the local currency, a second issue arises:
whether or not the entity operates in a high inflation environment. High inflation countries are
defined as those whose cumulative three-year inflation rate exceeds 100 percent. In that case,
essentially the same principles as in FAS 8 are followed. In the case where the cumulative
inflation rate falls short of 100 percent, the foreign affiliate's books are to be translated using the
current exchange rate for all items, and any gains or losses are to go directly as a charge or credit
to the equity accounts.
FAS 52 has a number of other fairly complex provisions regarding the treatment of hedge
contracts, the definition of transactional gains and losses, and the accounting for intercompany
transactions.

In essence, FAS 52 allows management much more flexibility to present the impact of exchange
rate variations in accordance with perceived economic reality; by the same token, it provides
greater scope for manipulation of reported earnings and it reduces comparability of financial data
for different firms.

4 (d) Critique of the Accounting Model of Exposure

Even with the increased flexibility of FAS 52, users of accounting information must be aware
that there are three system sources of error that can mislead those responsible for exchange risk
management (Adler, 1982):

1. Accounting data do not capture all commitments of the firm that give rise to exchange risk.

2. Because of the historical cost principle, accounting values of assets and liabilities do not
reflect the respective contribution to total expected net cash flow of the firm.

3. Translation rules do not distinguish between expected and unexpected exchange rate changes.

Regarding the first point, it must be recognized that normally, commitments entered into by the
firm in terms of foreign exchange, a purchase or a sales contract, for example, will not be booked
until the merchandise has been shipped. At best, such obligations are shown as contingent
liabilities. More importantly, accounting data reveals very little about the ability of the firm to
change costs, prices and markets quickly. Alternatively, the firm may be committed by strategic
decisions such as investment in plant and facilities. Such "commitments" are important criteria in
determining the existence and magnitude of exchange risk.

The second point surfaced in our discussion of the temporal method: whenever asset values
differ from market values, translation--however sophisticated--will not redress this original
shortcoming. Thus, many of the perceived problems of FAS 8 had their roots not so much in
translation, but in the fact that in an environment of inflation and exchange rate changes, the lack
of current value accounting frustrates the best translation efforts.

Finally, translation rules do not take account of the fact that exchange rate changes have two
components: (1) expected changes that are already reflected in the prices of assets and the costs
of liabilities (relative interest rates); and (2) the real goods and services, the basic rationale for
corporate foreign exchange exposure management is to shield net cash flows, and thus the value
of the enterprise, from unanticipated exchange rate changes.

This thumbnail sketch of the economic foreign exchange exposure concept has a number of
significant implications, some of which seem to be at variance with frequently used ideas in the
popular literature and apparent practices in business firms. Specifically, there are implications
regarding (1) the question of whether exchange risk originates from monetary or nonmonetary
transactions, (2) a reevaluation of traditional perspectives such as "transactions risk," and (3) the
role of forecasting exchange rates in the context of corporate foreign exchange risk management.

4 (f) Contractual versus Noncontractual Returns

An assessment of the nature of the firm's assets and liabilities and their respective cash flows
shows that some are contractual, i.e. fixed in nominal, monetary terms. Such returns, earnings
from fixed interest securities and receivables, for example, and the negative returns on various
liabilities are relatively easy to analyze with respect to exchange rate changes: when they are
denominated in terms of foreign currency, their terminal value changes directly in proportion to
the exchange rate change. Thus, with respect to financial items, the firm is concerned only about
net assets or liabilities denominated in foreign currency, to the extent that maturities (actually,
"durations" of asset classes) are matched.

What is much more difficult, however, is to gauge the impact of an exchange rate change on
assets with noncontractual returns. While conventional discussions of exchange risk focus almost
exclusively on financial assets, for trading and manufacturing firms at least, such assets are
relatively less important than others. Indeed, equipment, real estate, buildings and inventories
make the decisive contribution to the total cash flow of those firms. (Indeed companies
frequently sell financial assets to banks, factors, or "captive" finance companies in order to leave
banking to bankers and instead focus on the management of core assets!) And returns on such
assets are affected in quite complex ways by changes in exchange rates. The most essential
consideration is how the prices and costs of the firm will react in response to an unexpected
exchange rate change. For example, if prices and costs react immediately and fully to offset
exchange rate changes, the firm's cash flows are not exposed to exchange risk since they will not
be affected in terms of the base currency.

Example of the Effect of Devaluation on Inventory

Assume the French subsidiary of a U.S. corp. has an inventory destined for sale to Germany.
Exchange rates are as follows:

before devaluation 1 FF = .15 $ = .30 DM

after devaluation 1 FF = .12 $ = .20 DM

Assumed Selling price in Economic Value of

Accounting Value (FIFO) in
"pass- Germany Inventory
through"
DM FFr US$ France USA
(in percent) Before After Before After Before After Before After Before After
0 150 150 5001 7502 75 90 5003 5003 75 60
50 150 125 500 625 75 75 500 500 75 60
100 150 100 500 500 75 60 50 500 75 60
Thus, the value of noncontractual assets is not affected.

WHAT DOES THE EFFECT OF EXCHANGE RATE CHANGES ON OPERATIONAL

CASH FLOWS DEPEND ON?

1. VOLUME EFFECTS (compensate for changes in profit margins)

2. PRICING FLEXIBILITY (change in margins to offset effect of exchange rate change)

3. DIVERSIFICATION of markets for inputs and outputs

4. PRODUCTION AND SALES FLEXIBILITY (ability to shift markets and sources quickly)

Inventories may serve as a good illustration of this proposition. The value of an inventory in a
foreign subsidiary is determined not only by changes in the exchange rate, but also by a
subsequent price change of the product--to the extent that the underlying cause of this price
change is the exchange rate change. Thus, the dollar value of an inventory destined for export
may increase when the currency of the destination country appreciates, provided its local
currency prices do not decrease by the full percentage of the appreciation. Exhibit 4 provides a
numerical illustration.

The effect on the local currency price depends, in part, on competition in the market. The
behavior of foreign and local competitors, in turn, depends on capacity utilization, market share
objectives, likelihood of cost adjustments and a host of other factors. Of course, firms are not
only interested in the value change or the behavior of cash flows of a single asset, but rather in
the behavior of all cash flows. Again, price and cost adjustments need to be analyzed. For
example, a firm that requires raw materials from abroad for production will usually find its
stream of cash outlays going up when its local currency depreciates against foreign currencies.
Yet the depreciation may cause foreign suppliers to lower prices in terms of foreign currencies
for the purpose of maintaining market share.

WHAT IS ECONOMIC EXPOSURE?

PDVSA, the Venezuelan state-owned oil company, recently set up an oil refinery near
Rotterdam, The Netherlands for shipment to Germany and other continental European
countries. The firm planned to invoice its clients in ECU, the official currency unit of the
European Community. The treasurer is considering sources of long term financing. In the past
all long term finance has been provided by the parent company, but working capital required to
pay local salaries and expenses has been financed in Dutch guilders. The treasurer is not sure
whether the short term debt should be hedged, or what currency to issue long term debt in.

This is an example of a situation where the definition of exposure has a direct impact on the
firm's hedging decisions.

Translation exposure has to do with the location of the assets, which in this case would be a
totally misleading measure of the effect of exchange rate changes on the value of the unit. After
all, the oil comes from Venezuela and is shipped to Germany: its temporary resting place, be it
a refinery in Rotterdam or a tanker en route to Germany, has no import. Both provide value
added, but neither determine the currency of revenues. So financing should definitely not be
done in Dutch guilders.

Transactions exposure has to do with the currency of denomination of assets like accounts
receivable or payable. Once sales to Germany have been made and invoicing in ECU has taken
place, PDVSA-Netherlands has contractual, ECU-denominated assets that should be financed
or hedged with ECU. For future sales, however, PDVSA-Netherlands does not have exposure
to the ECU. This is because the currency of determination is the U.S. dollar.

Economic exposure is tied to the currency of determination of revenues and costs. Since the
world market price of oil is dollars, this is the effective currency in which PDVSA's future sales
to Germany are made. If the ECU rises against the dollar, PDVSA must adjust its ECU price
down to match those of competitors like Aramco. If the dollar rises against the ECU, PDVSA
can and should raise prices to keep the dollar price the same, since competitors would do
likewise. Clearly the currency of determination is influenced by the currency in which
competitors denominate prices.

4 (g) Currency of denomination versus currency of determination

One of the central concepts of modern international corporate finance is the distinction between
the currency in which cash flows are denominated and the currency that determines the size of
the cash flows. In the example in the previous section, it does not matter whether, as a matter of
business practice, the firm may contract, be invoiced in, and pay for each individual shipment in
its own local currency. If foreign exporters do not provide price concessions, the cash outflow of
the importer behaves just like a foreign currency cash flow; even though payments are made in
local currency, they occur in greater amounts. As a result, the cash flow, even while
denominated in local currency, is determined by the relative value of the foreign currency. The
functional currency concept introduced in FAS 52 is similar to the "currency of determination" --
but not exactly. The currency of determination refers to revenue and operating expense flows,
respectively; the functional currency concept pertains to an entity as a whole, and is, therefore,
less precise.

To complicate things further, the currency of recording, that is, the currency in which the
accounting records are kept, is yet another matter. For example, any debt contracted by the firm
in foreign currency will always be recorded in the currency of the country where the corporate
entity is located. However, the value of its legal obligation is established in the currency in
which the contract is denominated. An example of the importance of these distinctions may be
found in Exhibit 5.
It is possible, therefore, that a firm selling in export markets may record assets and liabilities in
its local currency and invoice periodic shipments in a foreign currency and yet, if prices in the
market are dominated by transactions in a third country, the cash flows received may behave as
if they were in that third currency. To illustrate: a Brazilian firm selling coffee to West Germany
may keep its records in cruzeiros, invoice in German marks, and have DM-denominated
receivables, and physically collect DM cash flow, only to find that its revenue stream behaves as
if it were in U.S. dollars! This occurs because DM-prices for each consecutive shipment are
adjusted to reflect world market prices which, in turn, tend to be determined in U.S. dollars. The
significance of this distinction is that the currency of denomination is (relatively) readily subject
to management discretion, through the choice of invoicing currency. Prices and cash flows,
however, are determined by competitive conditions which are beyond the immediate control of
the firm.

Yet an additional dimension of exchange risk involves the element of time. In the very short run,
virtually all local currency prices for real goods and services (although not necessarily for
financial assets) remain unchanged after an unexpected exchange rate change. However, over a
longer period of time, prices and costs move inversely to spot rate changes; the tendency is for
Purchasing Power Parity and the Law of One Price to hold.

In reality, this price adjustment process takes place over a great variety of time patterns. These
patterns depend not only on the products involved, but also on market structure, the nature of
competition, general business conditions, government policies such as price controls, and a
number of other factors. Considerable work has been done on the phenomenon of "pass-through"
of price changes caused by (unexpected) exchange rate changes. And yet, because all the factors
that determine the extent and speed of pass-through are very firm-specific and can be analyzed
only on a case-by-case basis at the level of the operating entity of the firm (or strategic business
unit), generalizations remain difficult to make. Exhibit 6 summarizes the firm-specific effects of
exchange rate changes on operating cash flows.

Conceptually, though, it is important to determine the time frame within which the firm cannot
react to (unexpected) rate changes by (1) raising prices; (2) changing markets for inputs and
outputs; and/or (3) adjusting production and sales volumes. Sometimes, at least one of these
reactions is possible within a relatively short time; at other times the firm is "locked-in" through
contractual or strategic commitments extending considerably into the future. Indeed, those firms
which are free to react instantaneously and fully to adverse (unexpected) rate changes are not
subject to exchange risk.

A further implication of the time-frame element is that exchange risk stems from the firm's
position when its cash flows are, for a significant period, exposed to (unexpected) exchange rate
changes, rather than the risk resulting from any specific international involvement. Thus,
companies engaged purely in domestic transactions but who have dominant foreign competitors
may feel the effect of exchange rate changes in their cash flows as much or even more than some
firms that are actively engaged in exports, imports, or foreign direct investment.

6 MANAGING ECONOMIC EXPOSURE

6 (a) Economic Effects of Unanticipated Exchange Rate Changes on Cash Flows .

From this analytical framework, some practical implications emerge for the assessment of
economic exposure. First of all, the firm must project its cost and revenue streams over a
planning horizon that represents the period of time during which the firm is "locked-in," or
constrained from reacting to (unexpected) exchange rate changes. It must then assess the impact
of a deviation of the actual exchange rate from the rate used in the projection of costs and
revenues.

STEPS IN MANAGING ECONOMIC EXPOSURE

1. Estimation of planning horizon as determined by reaction period.

2. Determination of expected future spot rate.

3. Estimation of expected revenue and cost streams, given the expected spot rate.

4. Estimation of effect on revenue and expense streams for unexpected exchange rate changes.

5. Choice of appropriate currency for debt denomination.

6. Estimation of necessary amount of foreign currency debt.

7. Determination of average interest period of debt.

8. Selection between direct or indirect debt denomination.

9. Decision on trade-off between arbitrage gains vs. exchange risk stemming from exposure in
markets where rates are distorted by controls.

10. Decision about "residual" risk: consider adjusting business strategy.

Subsequently, the effects on the various cash flows of the firm must be netted over product lines
and markets to account for diversification effects where gains and losses could cancel out,
wholly or in part. The remaining net loss or gain is the subject of economic exposure
management. For a multiunit, multiproduct, multinational corporation the net exposure may not
be very large at all because of the many offsetting effects.7 By contrast, enterprises that have
invested in the development of one or two major foreign markets are typically subject to
considerable fluctuations of their net cash flows, regardless of whether they invoice in their own
or in the foreign currency.

For practical purposes, three questions capture the extent of a company's foreign exchange
exposure.

1. How quickly can the firm adjust prices to offset the impact of an unexpected exchange
rate change on profit margins?

2. How quickly can the firm change sources for inputs and markets for outputs? Or,

alternatively, how diversified are a company's factor and product markets?

3. To what extent do volume changes, associated with unexpected exchange rate

changes, have an impact on the value of assets?

Normally, the executives within business firms who can supply the best estimates on these issues
tend to be those directly involved with purchasing, marketing, and production. Finance managers
who focus exclusively on credit and foreign exchange markets may easily miss the essence of
corporate foreign exchange risk.

6 (b) Financial versus operating strategies for hedging.

When operating (cash) inflows and (contractual) outflows from liabilities are affected by
exchange rate changes, the general principle of prudent exchange risk management is: any effect
on cash inflows and outflows should cancel out as much as possible. This can be achieved by
maneuvering assets, liabilities or both. When should operations -- the asset side -- be used?

We have demonstrated that exchange rate changes can have tremendous effects on operating
cash flows. Does it not therefore make sense to adjust operations to hedge against these effects?
Many companies, such as Japanese auto producers, are now seeking flexibility in production
location, in part to be able to respond to large and persistent exchange rate changes that make
production much cheaper in one location than another. Among the operating policies are the
shifting of markets for output, sources of supply, product-lines, and production facilities as a
defensive reaction to adverse exchange rate changes. Put differently, deviations from purchasing
power parity provide profit opportunities for the operations-flexible firm. This philosophy is
epitomized in the following quotation.

It has often been joked at Philips that in order to take advantage of currency movements, it would
be a good idea to put our factories aboard a supertanker, which could put down anchor wherever
exchange rates enable the company to function most efficiently...In the present currency
markets...[this] would certainly not be a suitable means of transport for taking advantage of
exchange rate movements. An aeroplane would be more in line with the requirements of the
present era.

The problem is that Philips' production could not fit into either craft. It is obvious that such
measures will be very costly, especially if undertaken over a short span of time. it follows that
operating policies are not the tools of choice for exchange risk management. Hence operating
policies which have been designed to reduce or eliminate exposure will only be undertaken as a
last resort, when less expensive options have been exhausted.
It is not surprising, therefore, that exposure management focuses not on the asset side, but
primarily on the liability side of the firm's balance sheet. Exhibit 7 provides a summary of the
steps involved in managing economic exposure. Whether and how these steps should be
implemented depends first, on the extent to which the firm wishes to rely on currency forecasting
to make hedging decisions, and second, on the range of hedging tools available and their
suitability to the task. These issues are addressed in the next two sections.

5 GUIDELINES FOR CORPORATE FORECASTING OF EXCHANGE RATES

Academics and practitioners have sought the determinants of exchange rate changes ever since
there were currencies. Many students have learned about the balance of trade and how the more a
country exports, the more demand there is for its currency, and so the stronger is its exchange
rate. In practice, the story is a lot more complex. Research in the foreign exchange markets have
come a long way since the days when international trade was thought to be the dominant factor
determining the level of the exchange rate. Monetary variables, capital flows, rational
expectations and portfolio balance are all now understood to factor into the determination of
currencies in a floating exchange rate system. Many models have been developed to explain and
to forecast exchange rates. No model has yet proved to be the definitive one, perhaps because the
structure of the worlds economies and financial markets are undergoing such rapid evolution.

Corporations nevertheless avidly seek ways to predict currencies, in order to decide when and
when not to hedge. The models they use are typically one or more of the following kinds:
political event analysis, or fundamental, or technical.

Academic students of international finance, in contrast, find strong empirical support for the role
of arbitrage in global financial markets, and for the view that exchange rates exhibit behavior
that is characteristic of other speculative asset markets. Exchange rates react quickly to news.
Rates are far more volatile than changes in underlying economic variables; they are moved by
changing expectations, and hence are difficult to forecast. In a broad sense they are "efficient,"
but tests of efficiency face inherent obstacles in testing the precise nature of this efficiency
directly.

The central "efficient market" model is the unbiased forward rate theory introduced earlier. It
says that the forward rate equals the expected future level of the spot rate. Because the forward
rate is a contractual price, it offers opportunities for speculative profits for those who correctly
assess the future spot price relative to the current forward rate. Specifically, risk neutral players
will seek to make a profit their forecast differs from the forward rate, so if there are enough such
participants the forward rate will always be bid up or down until it equals the expected future
spot. Because expectations of future spot rates are formed on the basis of presently available
information (historical data) and an interpretation of its implication for the future, they tend to be
subject to frequent and rapid revision. The actual future spot rate may therefore deviate markedly
from the expectation embodied in the present forward rate for that maturity. The actual exchange
rate may deviate from the expected by some random error.

As is indicated in Exhibit 8, in an efficient market the forecasting error will be distributed

randomly, according to some probability distribution, with a mean equal to zero. An implication
of this is that today's forecast, as represented by the forward rate, is equal to yesterday's forward
plus some random amount. In other words, the forward rate itself follows a random walk.
Another way of looking at these errors to consider them as speculative profits or losses: what you
would gain or lose of you consistently bet against the forward rate. Can they be consistently
positive or negative? A priori reasoning suggests that this should not be the case. Otherwise one
would have to explain why consistent losers do not quit the market, or why consistent winners
are not imitated by others or do not increase their volume of activity, thus causing adjustment of
the forward rate in the direction of their expectation. Barring such explanation, one would expect
that the forecast error is sometimes positive, sometimes negative, alternating in a random
fashion, driven by unexpected events in the economic and political environment.

Rigorously tested academic models have cast doubt on the pure unbiased forward rate theory of
efficiency, and demonstrated the presence of speculative profit opportunities (for example, by the
use of "filter rules"). However it is also logical to suppose that speculators will bear foreign
exchange risk only if they are compensated with a risk premium. Are the above-zero expected
returns excessive in a risk-adjusted sense? Given the small size of the bias in the forward
exchange market, and the magnitude of daily currency fluctuations, the answer is "probably not."

As a result of their finding that the foreign exchange markets are among the world's most
efficient, academics argue the exchange rate forecasting by corporations, in the sense of trying to
beat the market, plays a role only under very special circumstances. Indeed few firms are
actively decide to commit real assets in order to take currency positions. Rather, they get
involved with foreign currencies in the course of pursuing profits from the exploitation of a
competitive advantage; rather than being based on currency expectations, this advantage is based
on expertise in such areas as production, marketing, the organization of people, or other technical
resources. If someone does have special expertise in forecasting foreign exchange rates, such
skills can usually be put to use without incurring the risks and costs of committing funds to other
than purely financial assets. Most finance managers of nonfinancial enterprises concentrate on
producing and selling goods; they should find themselves acting as speculative foreign exchange
traders only because of an occasional opportunity encountered in the course of their normal
operations. Only when foreign exchange markets are systematically distorted by government
controls on financial institutions do the operations of trading and manufacturing firms provide an
opportunity to move funds and gain from purely financial transactions. Exhibit 9 offers a
flowchart of criteria for forecasting and hedging decisions.

Forecasting exchange rate changes, however, is important for planning purposes. To the extent
that all significant managerial tasks are concerned with the future, anticipated exchange rate
changes are a major input into virtually all decisions of enterprises involved in and affected by
international transactions. However, the task of forecasting foreign exchange rates for planning
and decision-making purposes, with the purpose of determining the most likely exchange rate, is
quite different from attempting to beat the market in order to derive speculative profits.

Expected exchange rate changes are revealed by market prices when rates are free to reach their
competitive levels. Organized futures or forward markets provide inexpensive information
regarding future exchange rates, using the best available data and judgment. Thus, whenever
profit-seeking, well-informed traders can take positions, forward rates, prices of future contracts,
and interest differentials for instruments of similar riskiness (but denominated in different
currencies), provide good indicators of expected exchange rates. In this fashion, an input for
corporate planning and decision-making is readily available in all currencies where there are no
effective exchange controls. The advantage of such market-based rates over "in-house" forecasts
is that they are both less expensive and more likely to be accurate. Market rates are determined
by those who tend to have the best information and track-record; incompetent market
participants lose money and are eliminated.

The nature of this market-based expected exchange rate should not lead to confusing notions
about the accuracy of prediction. In speculative markets, all decisions are made on the basis of
interpretation of past data; however, new information surfaces constantly. Therefore, market-
based forecasts rarely will come true. The actual price of a currency will either be below or
above the rate expected by the market. If the market knew which would be more likely, any
predictive bias quickly would be corrected. Any predictable, economically meaningful bias
would be corrected by the transactions of profit-seeking transactors.

Example: Hedging with a Forward Contract

Janet Fredericks, Foreign Exchange Manager at Murray Chemical, was informed that Murray
was selling 25,000 tonnes of naphtha to Canada for a total price of C$11,500,000, to be paid
upon delivery in two months' time. To protect her company, she arranged to sell 11.5 million
Canadian dollars forward to the Royal Bank of Montreal. The two month forward contract
price was US$0.8785 per Canadian dollar. Two months and two days later, Fredericks received
US$10,102,750 from RBM and paid RBM C$11,500,000, the amount received from Murray's
customer.

The importance of market-based forecasts for a determination of the foreign exchange exposure
of the firm is that of a benchmark against which the economic consequences of deviations must
be measured. This can be put in the form of a concrete question: How will the expected net cash
flow of the firm behave if the future spot exchange rate is not equal to the rate predicted by the
market when commitments are made? The nature of this kind of forecast is completely different
from trying to outguess the foreign exchange markets

7 TOOLS AND TECHNIQUES FOR THE MANAGEMENT OF FOREIGN EXCHANGE

RISK

In this section we consider the relative merits of several different tools for hedging exchange
risk, including forwards, futures, debt, swaps and options. We will use the following criteria for
contrasting the tools.

First, there are different tools that serve effectively the same purpose. Most currency
management instruments enable the firm to take a long or a short position to hedge an opposite
short or long position. Thus one can hedge a DM payment using a forward exchange contract, or
debt in DM, or futures or perhaps a currency swap. In equilibrium the cost of all will be the
same, according to the fundamental relationships of the international money market as illustrated
in Exhibit 1. They differ in details like default risk or transactions costs, or if there is some
fundamental market imperfection. indeed in an efficient market one would expect the anticipated
cost of hedging to be zero. This follows from the unbiased forward rate theory.

Second, tools differ in that they hedge different risks. In particular, symmetric hedging tools like
futures cannot easily hedge contingent cash flows: options may be better suited to the latter.

7 (a) Tools and techniques: foreign exchange forwards

Foreign exchange is, of course, the exchange of one currency for another. Trading or "dealing" in
each pair of currencies consists of two parts, the spot market, where payment (delivery) is made
right away (in practice this means usually the second business day), and the forward market.
The rate in the forward market is a price for foreign currency set at the time the transaction is
agreed to but with the actual exchange, or delivery, taking place at a specified time in the future.
While the amount of the transaction, the value date, the payments procedure, and the exchange
rate are all determined in advance, no exchange of money takes place until the actual settlement
date. This commitment to exchange currencies at a previously agreed exchange rate is usually
referred to as a forward contract.

Forward contracts are the most common means of hedging transactions in foreign currencies, as
the example in Exhibit 10 illustrates. The trouble with forward contracts, however, is that they
require future performance, and sometimes one party is unable to perform on the contract. When
that happens, the hedge disappears, sometimes at great cost to the hedger. This default risk also
means that many companies do not have access to the forward market in sufficient quantity to
fully hedge their exchange exposure. For such situations, futures may be more suitable.

7 (b) Currency futures

Outside of the interbank forward market, the best-developed market for hedging exchange rate
risk is the currency futures market. In principle, currency futures are similar to foreign
exchange forwards in that they are contracts for delivery of a certain amount of a foreign
currency at some future date and at a known price. In practice, they differ from forward contracts
in important ways.

One difference between forwards and futures is standardization. Forwards are for any amount, as
long as it's big enough to be worth the dealer's time, while futures are for standard amounts, each
contract being far smaller that the average forward transaction. Futures are also standardized in
terms of delivery date. The normal currency futures delivery dates are March, June, September
and December, while forwards are private agreements that can specify any delivery date that the
parties choose. Both of these features allow the futures contract to be tradable.

Another difference is that forwards are traded by phone and telex and are completely
independent of location or time. Futures, on the other hand, are traded in organized exchanges
such the LIFFE in London, SIMEX in Singapore and the IMM in Chicago.

But the most important feature of the futures contract is not its standardization or trading
organization but in the time pattern of the cash flows between parties to the transaction. In a
forward contract, whether it involves full delivery of the two currencies or just compensation of
the net value, the transfer of funds takes place once: at maturity. With futures, cash changes
hands every day during the life of the contract, or at least every day that has seen a change in the
price of the contract. This daily cash compensation feature largely eliminates default risk.

Thus forwards and futures serve similar purposes, and tend to have identical rates, but differ in
their applicability. Most big companies use forwards; futures tend to be used whenever credit
risk may be a problem.

7 (c) Debt instead of forwards or futures

Debt -- borrowing in the currency to which the firm is exposed or investing in interest-bearing
assets to offset a foreign currency payment -- is a widely used hedging tool that serves much the
same purpose as forward contracts. Consider an example.

In Exhibit 10, Fredericks sold Canadian dollars forwards. Alternatively she could have used the
Eurocurrency market to achieve the same objective. She would borrow Canadian dollars, which
she would then change into francs in the spot market, and hold them in a US dollar deposit for
two months. When payment in Canadian dollars was received from the customer, she would use
the proceeds to pay down the Canadian dollar debt. Such a transaction is termed a money
market hedge.

The cost of this money market hedge is the difference between the Canadian dollar interest rate
paid and the US dollar interest rate earned. According to the interest rate parity theorem, the
interest differential equals the forward exchange premium, the percentage by which the forward
rate differs from the spot exchange rate. So the cost of the money market hedge should be the
same as the forward or futures market hedge, unless the firm has some advantage in one market
or the other.

The money market hedge suits many companies because they have to borrow anyway, so it
simply is a matter of denominating the company's debt in the currency to which it is exposed.
that is logical. but if a money market hedge is to be done for its own sake, as in the example just
given, the firm ends up borrowing from one bank and lending to another, thus losing on the
spread. This is costly, so the forward hedge would probably be more advantageous except where
the firm had to borrow for ongoing purposes anyway.

7 (d) Currency options

Many companies, banks and governments have extensive experience in the use of forward
exchange contracts. With a forward contract one can lock in an exchange rate for the future.
There are a number of circumstances, however, where it may be desirable to have more
flexibility than a forward provides. For example a computer manufacturer in California may have
sales priced in U.S. dollars as well as in German marks in Europe. Depending on the relative
strength of the two currencies, revenues may be realized in either German marks or dollars. In
such a situation the use of forward or futures would be inappropriate: there's no point in hedging
something you might not have. What is called for is a foreign exchange option: the right, but not
the obligation, to exchange currency at a predetermined rate.

A foreign exchange option is a contract for future delivery of a currency in exchange for another,
where the holder of the option has the right to buy (or sell) the currency at an agreed price, the
strike or exercise price, but is not required to do so. The right to buy is a call; the right to sell, a
put. For such a right he pays a price called the option premium. The option seller receives the
premium and is obliged to make (or take) delivery at the agreed-upon price if the buyer exercises
his option. In some options, the instrument being delivered is the currency itself; in others, a
futures contract on the currency. American options permit the holder to exercise at any time
before the expiration date; European options, only on the expiration date.

Example

Steve Yamamoto of Frito-Lay had just agreed to purchase I5 million worth of potatoes from his
supplier in County Cork, Ireland. Payment of the five million punt was to be made in 245 days'
time. The dollar had recently plummeted against all the EMS currencies and Yamamoto wanted
to avoid any further rise in the cost of imports. He viewed the dollar as being extremely
instable in the current environment of economic tensions. Having decided to hedge the
payment, he had obtained dollar/punt quotes of $2.25 spot, $2.19 for 245 days forward
delivery. His view, however, was that the dollar was bound to rise in the next few months, so
he was strongly considering purchasing a call option instead of buying the punt forward. At a
strike price of $2.21, the best quote he had been able to obtain was from the Ballad Bank of
Dublin, who would charge a premium of 0.85% of the principal.

Yamamoto decided to buy the call option. In effect, he reasoned, I'm paying for downside
protection while not limiting the possible savings I could reap if the dollar does recover to a
more realistic level. In a highly volatile market where crazy currency values can be reached,
options make more sense than taking your chances in the market, and you're not locked into a
rock-bottom forward rate.

This simple example illustrates the lopsided character of options. Futures and forwards are
contracts in which two parties oblige themselves to exchange something in the future. They are
thus useful to hedge or convert known currency or interest rate exposures. An option, in contrast,
gives one party the right but not the obligation to buy or sell an asset under specified conditions
while the other party assumes an obligation to sell or buy that asset if that option is exercised.
Figure 1 illustrates the two possible outcomes of an option such as that bought by Steve
Yamamoto.

When should a company like Frito-Lay use options in preference to forwards or futures? In the
example, Yamamoto had a view on the currency's direction that differed from the forward rate.
Taken alone, this would suggest taking a position. But he also had a view on the dollar's
volatility. Options provide the only convenient means of hedging or positioning "volatility risk."
Indeed the price of an option is directly influenced by the outlook for a currency's volatility: the
more volatile, the higher the price. To Yamamoto, the price is worth paying. In other words he
thinks the true volatility is greater than that reflected in the option's price.
This example highlights one set of circumstances under which a company should consider the
use of options. A currency call or put option's value is affected by both direction and volatility
changes, and the price of such an option will be higher, the more the market's expectations (as
reflected in the forward rate) favor exercise and the greater the anticipated volatility. For
example, during the crisis in the European Monetary System of mid-1993, put options on the
French franc became very expensive for two reasons. First, high French interest rates designed to
support the franc drove the forward rate to a discount against the German mark. Second,
anticipated volatility of the DM/FF exchange rate jumped as dealers speculated on a possible
break-up of the EMS. With movements much greater than the EMS official bands possible, the
expected gain from exercising puts became much greater. It was an appropriate time for
companies with French exposure to buy puts, but the cost would exceed the expected gain unless
the corporate Treasury anticipated a greater change, or an even higher volatility, than those
reflected in the market price of options.

Finally, one can justify the limited use of options by reference to the deleterious effect of
financial distress alluded to in section 2. Unmanaged exchange rate risk can cause significant
fluctuations in the earnings and the market value of an international firm. A very large exchange
rate movement may cause special problems for a particular company, perhaps because it brings a
competitive threat from a different country. At some level, the currency change may threaten the
firm's viability, bringing the costs of bankruptcy to bear. To avert this, it may be worth buying
some low-cost options that would pay off only under unusual circumstances, ones that would
particularly hurt the firm. Out-of-the-money options may be a useful and cost-effective way to
hedge against currency risks that have very low probabilities but which, if they occur, have
disproportionately high costs to the company.

8 CONTROLLING CORPORATE TREASURY TRADING RISKS

In a corporation, there is no such thing as being perfectly hedged. Not every transaction can be
matched, for international trade and production is a complex and uncertain business. As we have
seen, even identifying the correct currency of exposure, the currency of determination, is tricky.
Flexibility is called for, and management must necessarily give some discretion, perhaps even a
lot of discretion, to the corporate treasury department or whichever unit is charged with
managing foreign exchange risks. Some companies, feeling that foreign exchange is best handled
by professionals, hire ex-bank dealers; other groom engineers or accountants. Yet however
talented and honorable are these individuals, it has become evident that some limits must be
imposed on the trading activities of the corporate treasury, for losses can get out of hand even in
the best of companies.

In 1992 a Wall Street Journal reporter found that Dell Computer Corporation, a star of the retail
PC industry, had been trading currency options with a face value that exceeded Dell's annual
international sales, and that currency losses may have been covered up. Complex options trading
was in part responsible for losses at the treasury of Allied-Lyons, the British foods group. The
$150 million lost almost brought the company to its knees, and the publicity precipitated a
management shake-out. In 1993 the oil giant Royal Dutch-Shell revealed that currency trading
losses of as much as a billion dollars had been uncovered in its Japanese subsidiary.
Clearly, performance measurement standards, accountability and limits of some form must be
part of a treasury foreign currency hedging program. Space does not permit a detailed
examination of trading control methods, but some broad principles can be stated.

First, management must elucidate the goals of exchange risk management, preferably in
operational terms rather than in platitudes such as "we hedge all foreign exchange risks."

Second, the risks of in-house trading (for that's often what it is) must be recognized. These
include losses on open positions from exchange rate changes, counterparty credit risks, and
operations risks.

Third, for all net positions taken, the firm must have an independent method of valuing, marking-
to-market, the instruments traded. This marking to market need not be included in external
reports, if the positions offset other exposures that are not marked to market, but is necessary to
avert hiding of losses. Wherever possible, marking to market should be based on external,
objective prices traded in the market.

Fourth, position limits should be made explicit rather than treated as "a problem we would rather
not discuss." Instead of hamstringing treasury with a complex set of rules, limits can take the
form of prohibiting positions that could incur a loss (or gain) beyond a certain amount, based on
sensitivity analysis. As in all these things, any attempt to cover up losses should reap severe
penalties.

Finally, counterparty risks resulting from over-the-counter forward or swap contracts should be
evaluated in precisely the same manner as is done when the firm extends credit to, say, suppliers
or customers.

In all this, the chief financial officer might well seek the assistance of an accounting or
consulting firm, and may wish to purchase software tailored to the purposes.

9 CONCLUSIONS

This chapter offers the reader an introduction to the complex subject of the measurement and
management of foreign exchange risk. We began by noting some problems with interpretation of
the concept, and entered the debate as to whether and why companies should devote active
managerial resources to something that is so difficult to define and measure.

Accountants' efforts to put an objective value on a firm involved in international business has led
many to focus on the translated balance sheet as a target for hedging exposure. As was
demonstrated, however, there are numerous realistic situations where the economic effects of
exchange rate changes differ from those predicted by the various measures of translation
exposure. In particular, we emphasized the distinctions between the currency of location, the
currency of denomination, and the currency of determination of a business.

After giving some guidelines for the management of economic exposure, the chapter addressed
the thorny question of how to approach currency forecasting. We suggested a market-based
approach to international financial planning, and cast doubt on the ability of the corporation's
treasury department to outperform the forward exchange rate.

The chapter then turned to the tools and techniques of hedging, contrasting the applications that
require forwards, futures, money market hedging, and currency options.

In Exhibit 11, we present a sketch of how a company may approach the exchange risk
management task, based on the principles laid out in this chapter.

Sorry, not all exhibits appear in this version.

SELECTED REFERENCES

Alder, Michael. "Translation Methods and Operational Foreign Exchange Risk Management,"
Chapter 6 of Göran Bergendahl, (ed.) International Financial Management, Stockholm:
Norstedts, 1982.

Aliber, Robert Z. Exchange Risk and Corporate International Finance. New York: John Wiley
and Sons, 1979.

Cornell, Bradford. "Inflation, Relative Price Changes, and Exchange Risk," Financial
Management, Autumn 1980, pp. 30-44.

Dufey, Gunter. "Corporate Finance and Exchange Rate Variations," Financial Management,
Summer 1972, pp. 51-57.

Dufey, Gunter, and Ian Giddy. "International Financial Planning: The Use of Market-Based
Forecasts," California Management Review, Fall 1978, pp. 69-81.

Dukes, R. An Empirical Investigation of the Effects of Statement of Financial Accounting

Standards No. 8 on Security Return Behavior. Stamford, Conn.: Financial Accounting Standards
Board, 1978.

Eaker, Mark R. "The Numeraire Problem and Foreign Exchange Risk," Journal of Finance, May
1981, pp. 419-427.

Feiger, George, and Bertrand Jacquillat. International Finance: Text and Cases. Boston: Allyn
& Bacon, 1981.

Giddy, Ian H. "Why It Doesn't Pay to Make a Habit of Forward Hedging," Euromoney,
December 1976, pp. 96-100.

Hekman, Christine R. "Foreign Exchange Exposure: Accounting Measures and Economic

Reality," Journal of Cash Management, February/March 1983, pp. 34-45.
Hodder, James E. "Hedging International Exposure: Capital Structure Under Flexible
Exchange Rates and Expropriation Risk," unpublished working paper, Stanford University,
November 1982.

Jacque, Laurent L. "Management of Foreign Exchange Risk: A Review Article," Journal of

International Business Studies, Spring/Summer 1981, pp. 81-101.

Lessard, Donald R. International Financial Management. Boston: Warren, Gorham and

Lamont, 1979.

Levi, Maurice. Financial Management and the International Economy. New York: McGraw Hill,
1983.

Logue, Dennis E., and George S. Oldfield. "Managing Foreign Assets When Foreign Exchange
Markets are Efficient," Financial Management, Summer 1977, pp. 16-22.

Makin, John H. "Portfolio Theory and the Problem of Foreign Exchange Risks," Journal of
Finance, May 1978, pp. 517-534.

Myers, Stewart C. "The Search for Optimal Capital Structure," in Joel Stern and Donald Chew,
eds, The Revolution in Corporate Finance, Second edition. Cambridge, Mass.: Blackwell
Publishers, 1992.

Endnotes

1. Copyright ©1992 Ian H. Giddy and Gunter Dufey. Forthcoming in: Frederick D.S. Choi, ed.,
The Handbook of International Accounting, to be published by John Wiley & Sons.

2. For a review of the literature see R. Naumann-Etienne, "A Framework for Financial
Decisions in Multinational Corporations--A Summary of Recent Research," Journal of Financial
and Quantitative Analysis, November 1974, pp. 859-874; and more recently Maurice Levi,
Financial Management and the International Economy (New York: McGraw-Hill, 1983), Ch. 13.

3. D. Snijders, "Global Company and World Financial Markets," in Financing the World
Economy in the Nineties, J.J. Sijben, ed. (Dordrecht, Netherlands: Kluwer Academic Publishers,
1989)

4. Note that when we say the forward rate follows a random walk, we mean the forward for a
given delivery date, not the rolling 3-month forward. Since the only published measure of a
forward rate for a given delivery date is the price of a futures contract, the latter serves as a
proxy to test the proposition that the forward rate should fluctuate randomly.

5. See Gunter Dufey and Ian H. Giddy, "International Financial Planning: The Use of Market-
Based Forecasts," California Management Review, XXI, 1 (Fall 1978), pp. 69-81.
 Adapted from The Handbook of International Accounting and Finance, Frederick D.S. Choi,
Editor (Wiley)

Ian H. Giddy, Professor of Finance

New York University � Stern School of Business
44 West 4th Street, New York 10012
Tel 212 998-0332 � Fax 212 995-4233

Go to Giddy's Web Portal � Contact Ian Giddy at ian.giddy@nyu.edu

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Foreign exchange market

From Wikipedia, the free encyclopedia
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"Forex" redirects here. For the football club, see FC Forex Braşov.

Foreign exchange

Exchange rates

 Currency band
 Exchange rate
 Exchange-rate regime
 Exchange-rate flexibility
 Dollarization
 Fixed exchange rate
 Floating exchange rate
 Linked exchange rate
 Managed float regime

Markets

 Foreign exchange market

 Futures exchange
 Retail foreign exchange

Assets

 Currency
 Currency future
  Non-deliverable forward
 Foreign exchange swap
 Currency swap
 Foreign-exchange option

Historical agreements

 Bretton Woods Conference

 Smithsonian Agreement
 Plaza Accord
 Louvre Accord

See also

 Bureau de change
 Hard currency

 v
 t
 e

The foreign exchange market (forex, FX, or currency market) is a form of exchange for the
global decentralized trading of international currencies. Financial centers around the world
function as anchors of trading between a wide range of different types of buyers and sellers
around the clock, with the exception of weekends. The foreign exchange market determines the
relative values of different currencies.[1]

The foreign exchange market assists international trade and investment by enabling currency
conversion. For example, it permits a business in the United States to import goods from the
European Union member states especially Eurozone members and pay Euros, even though its
income is in United States dollars. It also supports direct speculation in the value of currencies,
and the carry trade, speculation based on the interest rate differential between two currencies.[2]

In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying
a quantity of another currency. The modern foreign exchange market began forming during the
1970s after three decades of government restrictions on foreign exchange transactions (the
Bretton Woods system of monetary management established the rules for commercial and
financial relations among the world's major industrial states after World War II), when countries
gradually switched to floating exchange rates from the previous exchange rate regime, which
remained fixed as per the Bretton Woods system.

The foreign exchange market is unique because of

  its huge trading volume representing the largest asset class in the world leading to high
liquidity;
 its geographical dispersion;
 its continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT
on Sunday until 22:00 GMT Friday;
 the variety of factors that affect exchange rates;
 the low margins of relative profit compared with other markets of fixed income; and
 the use of leverage to enhance profit and loss margins and with respect to account size.

As such, it has been referred to as the market closest to the ideal of perfect competition,
notwithstanding currency intervention by central banks. According to the Bank for International
Settlements,[3] as of April 2010, average daily turnover in global foreign exchange markets is
estimated at $3.98 trillion, a growth of approximately 20% over the $3.21 trillion daily volume
as of April 2007. Some firms specializing on foreign exchange market had put the average daily
turnover in excess of US$4 trillion.[4]

The $3.98 trillion break-down is as follows:

 $1.490 trillion in spot transactions

 $475 billion in outright forwards
 $1.765 trillion in foreign exchange swaps
 $43 billion currency swaps
 $207 billion in options and other products

Contents
[hide]

 1 Market size and liquidity

 2 Market participants
o 2.1 Commercial companies
o 2.2 Central banks
o 2.3 Foreign exchange fixing
o 2.4 Hedge funds as speculators
o 2.5 Investment management firms
o 2.6 Retail foreign exchange traders
o 2.7 Non-bank foreign exchange companies
o 2.8 Money transfer/remittance companies and bureaux de change
 3 Trading characteristics
 4 Determinants of exchange rates
o 4.1 Economic factors
o 4.2 Political conditions
o 4.3 Market psychology
 5 Financial instruments
 o 5.1 Spot
o 5.2 Forward
o 5.3 Swap
o 5.4 Future
o 5.5 Option
 6 Speculation
 7 Risk aversion
 8 Carry Trade
 9 Forex Signals
 10 See also
 11 References
 12 External links

[edit] Market size and liquidity

Main foreign exchange market turnover, 1988–2007, measured in billions of USD.

The foreign exchange market is the most liquid financial market in the world. Traders include
large banks, central banks, institutional investors, currency speculators, corporations,
governments, other financial institutions, and retail investors. The average daily turnover in the
global foreign exchange and related markets is continuously growing. According to the 2010
Triennial Central Bank Survey, coordinated by the Bank for International Settlements, average
daily turnover was US$3.98 trillion in April 2010 (vs $1.7 trillion in 1998).[3] Of this $3.98
trillion, $1.5 trillion was spot transactions and $2.5 trillion was traded in outright forwards,
swaps and other derivatives.

Trading in the United Kingdom accounted for 36.7% of the total, making it by far the most
important centre for foreign exchange trading. Trading in the United States accounted for 17.9%,
and Japan accounted for 6.2%.[5]

Turnover of exchange-traded foreign exchange futures and options have grown rapidly in recent
years, reaching $166 billion in April 2010 (double the turnover recorded in April 2007).
Exchange-traded currency derivatives represent 4% of OTC foreign exchange turnover. Foreign
exchange futures contracts were introduced in 1972 at the Chicago Mercantile Exchange and are
actively traded relative to most other futures contracts.

Most developed countries permit the trading of derivative products (like futures and options on
futures) on their exchanges. All these developed countries already have fully convertible capital
accounts. Some governments of emerging economies do not allow foreign exchange derivative
products on their exchanges because they have capital controls. The use of derivatives is growing
in many emerging economies.[6] Countries such as Korea, South Africa, and India have
established currency futures exchanges, despite having some capital controls.

Top 10 currency traders [7] Foreign exchange trading increased by 20%

% of overall volume, May 2011 between April 2007 and April 2010 and has
Rank Name Market share more than doubled since 2004.[8] The increase
1 Deutsche Bank 15.64% in turnover is due to a number of factors: the
2 Barclays Capital 10.75% growing importance of foreign exchange as an
asset class, the increased trading activity of
3 UBS AG 10.59%
high-frequency traders, and the emergence of
4 Citi 8.88% retail investors as an important market
5 JPMorgan 6.43% segment. The growth of electronic execution
6 HSBC 6.26% and the diverse selection of execution venues
7 Royal Bank of Scotland 6.20% has lowered transaction costs, increased
8 Credit Suisse 4.80% market liquidity, and attracted greater
participation from many customer types. In
9 Goldman Sachs 4.13%
particular, electronic trading via online portals
10 Morgan Stanley 3.64% has made it easier for retail traders to trade in
the foreign exchange market. By 2010, retail
trading is estimated to account for up to 10% of spot turnover, or $150 billion per day (see retail
foreign exchange platform).

Foreign exchange is an over-the-counter market where brokers/dealers negotiate directly with

one another, so there is no central exchange or clearing house. The biggest geographic trading
center is the United Kingdom, primarily London, which according to TheCityUK estimates has
increased its share of global turnover in traditional transactions from 34.6% in April 2007 to
36.7% in April 2010. Due to London's dominance in the market, a particular currency's quoted
price is usually the London market price. For instance, when the International Monetary Fund
calculates the value of its special drawing rights every day, they use the London market prices at
noon that day.

[edit] Market participants

Financial markets
  Public market

 Exchange
 Securities

Bond market

 Fixed income
 Corporate bond
 Government bond
 Municipal bond
 Bond valuation
 High-yield debt

Stock market

 Stock
 Preferred stock
 Common stock
 Registered share
 Voting share
 Stock exchange

Derivatives market

 Securitization
 Hybrid security
 Credit derivative
 Futures exchange

Over-the-counter

 Spot market
  Forwards
 Swaps
 Options

Foreign exchange

 Exchange rate
 Currency

Other markets

 Money market
 Reinsurance market
 Commodity market
 Real estate market

Practical trading

 Participants
 Clearing house
 Financial regulation

Finance series

 Banks and banking

 Corporate finance
 Personal finance
 Public finance

 v
 t
 e

Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is
the interbank market, which is made up of the largest commercial banks and securities dealers.
Within the interbank market, spreads, which are the difference between the bid and ask prices,
are razor sharp and not known to players outside the inner circle. The difference between the bid
and ask prices widens (for example from 0-1 pip to 1-2 pips for a currencies such as the EUR) as
you go down the levels of access. This is due to volume. If a trader can guarantee large numbers
of transactions for large amounts, they can demand a smaller difference between the bid and ask
price, which is referred to as a better spread. The levels of access that make up the foreign
exchange market are determined by the size of the "line" (the amount of money with which they
are trading). The top-tier interbank market accounts for 53% of all transactions. From there,
smaller banks, followed by large multi-national corporations (which need to hedge risk and pay
employees in different countries), large hedge funds, and even some of the retail market makers.
According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other
institutional investors have played an increasingly important role in financial markets in general,
and in FX markets in particular, since the early 2000s.” (2004) In addition, he notes, “Hedge
funds have grown markedly over the 2001–2004 period in terms of both number and overall
size”.[9] Central banks also participate in the foreign exchange market to align currencies to their
economic needs.

[edit] Commercial companies

An important part of this market comes from the financial activities of companies seeking
foreign exchange to pay for goods or services. Commercial companies often trade fairly small
amounts compared to those of banks or speculators, and their trades often have little short term
impact on market rates. Nevertheless, trade flows are an important factor in the long-term
direction of a currency's exchange rate. Some multinational companies can have an unpredictable
impact when very large positions are covered due to exposures that are not widely known by
other market participants.

[edit] Central banks

National central banks play an important role in the foreign exchange markets. They try to
control the money supply, inflation, and/or interest rates and often have official or unofficial
target rates for their currencies. They can use their often substantial foreign exchange reserves to
stabilize the market. Nevertheless, the effectiveness of central bank "stabilizing speculation" is
doubtful because central banks do not go bankrupt if they make large losses, like other traders
would, and there is no convincing evidence that they do make a profit trading.

[edit] Foreign exchange fixing

Foreign exchange fixing is the daily monetary exchange rate fixed by the national bank of each
country. The idea is that central banks use the fixing time and exchange rate to evaluate behavior
of their currency. Fixing exchange rates reflects the real value of equilibrium in the market.
Banks, dealers and traders use fixing rates as a trend indicator.

The mere expectation or rumor of a central bank foreign exchange intervention might be enough
to stabilize a currency, but aggressive intervention might be used several times each year in
countries with a dirty float currency regime. Central banks do not always achieve their
objectives. The combined resources of the market can easily overwhelm any central bank.[10]
Several scenarios of this nature were seen in the 1992–93 European Exchange Rate Mechanism
collapse, and in more recent times in Southeast Asia.

[edit] Hedge funds as speculators

About 70% to 90%[citation needed] of the foreign exchange transactions are speculative. In other
words, the person or institution that bought or sold the currency has no plan to actually take
delivery of the currency in the end; rather, they were solely speculating on the movement of that
particular currency. Hedge funds have gained a reputation for aggressive currency speculation
since 1996. They control billions of dollars of equity and may borrow billions more, and thus
may overwhelm intervention by central banks to support almost any currency, if the economic
fundamentals are in the hedge funds' favor.

[edit] Investment management firms

Investment management firms (who typically manage large accounts on behalf of customers
such as pension funds and endowments) use the foreign exchange market to facilitate
transactions in foreign securities. For example, an investment manager bearing an international
equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign
securities purchases.

Some investment management firms also have more speculative specialist currency overlay
operations, which manage clients' currency exposures with the aim of generating profits as well
as limiting risk. While the number of this type of specialist firms is quite small, many have a
large value of assets under management), and hence can generate large trades.

[edit] Retail foreign exchange traders

Individual Retail speculative traders constitute a growing segment of this market with the advent
of retail foreign exchange platforms, both in size and importance. Currently, they participate
indirectly through brokers or banks. Retail brokers, while largely controlled and regulated in the
USA by the Commodity Futures Trading Commission and National Futures Association have in
the past been subjected to periodic Foreign exchange fraud.[11][12] To deal with the issue, in 2010
the NFA required its members that deal in the Forex markets to register as such (I.e., Forex CTA
instead of a CTA). Those NFA members that would traditionally be subject to minimum net
capital requirements, FCMs and IBs, are subject to greater minimum net capital requirements if
they deal in Forex. A number of the foreign exchange brokers operate from the UK under
Financial Services Authority regulations where foreign exchange trading using margin is part of
the wider over-the-counter derivatives trading industry that includes Contract for differences and
financial spread betting.

There are two main types of retail FX brokers offering the opportunity for speculative currency
trading: brokers and dealers or market makers. Brokers serve as an agent of the customer in the
broader FX market, by seeking the best price in the market for a retail order and dealing on
behalf of the retail customer. They charge a commission or mark-up in addition to the price
obtained in the market. Dealers or market makers, by contrast, typically act as principal in the
transaction versus the retail customer, and quote a price they are willing to deal at.

[edit] Non-bank foreign exchange companies

Non-bank foreign exchange companies offer currency exchange and international payments to
private individuals and companies. These are also known as foreign exchange brokers but are
distinct in that they do not offer speculative trading but rather currency exchange with payments
(i.e., there is usually a physical delivery of currency to a bank account).

It is estimated that in the UK, 14% of currency transfers/payments[13] are made via Foreign
Exchange Companies.[14] These companies' selling point is usually that they will offer better
exchange rates or cheaper payments than the customer's bank. These companies differ from
Money Transfer/Remittance Companies in that they generally offer higher-value services.

[edit] Money transfer/remittance companies and bureaux de change

Money transfer companies/remittance companies perform high-volume low-value transfers

generally by economic migrants back to their home country. In 2007, the Aite Group estimated
that there were $369 billion of remittances (an increase of 8% on the previous year). The four
largest markets (India, China, Mexico and the Philippines) receive $95 billion. The largest and
best known provider is Western Union with 345,000 agents globally followed by UAE
Exchange[citation needed]

Bureaux de change or currency transfer companies provide low value foreign exchange services
for travelers. These are typically located at airports and stations or at tourist locations and allow
physical notes to be exchanged from one currency to another. They access the foreign exchange
markets via banks or non bank foreign exchange companies.

[edit] Trading characteristics

Most traded currencies by value
Currency distribution of global foreign exchange market turnover[3]

ISO 4217 code % daily share

Rank Currency
(Symbol) (April 2010)
1  United States dollar USD ($) 84.9%
2  Euro EUR (€) 39.1%
3  Japanese yen JPY (¥) 19.0%
4  Pound sterling GBP (£) 12.9%
5  Australian dollar AUD ($) 7.6%

6  Swiss franc CHF (Fr) 6.4%

7  Canadian dollar CAD ($) 5.3%

8  Hong Kong dollar HKD ($) 2.4%
9  Swedish krona SEK (kr) 2.2%
 10  New Zealand dollar NZD ($) 1.6%
11  South Korean won KRW (₩) 1.5%
12  Singapore dollar SGD ($) 1.4%
13  Norwegian krone NOK (kr) 1.3%
14  Mexican peso MXN ($) 1.3%
15  Indian rupee INR ( ) 0.9%
Other 12.2%
Total[15] 200%

There is no unified or centrally cleared market for the majority of trades, and there is very little
cross-border regulation. Due to the over-the-counter (OTC) nature of currency markets, there are
rather a number of interconnected marketplaces, where different currencies instruments are
traded. This implies that there is not a single exchange rate but rather a number of different rates
(prices), depending on what bank or market maker is trading, and where it is. In practice the rates
are often very close, otherwise they could be exploited by arbitrageurs instantaneously. Due to
London's dominance in the market, a particular currency's quoted price is usually the London
market price. Major trading exchanges include EBS and Reuters, while major banks also offer
trading systems. A joint venture of the Chicago Mercantile Exchange and Reuters, called
Fxmarketspace opened in 2007 and aspired but failed to the role of a central market clearing
mechanism.[citation needed]

The main trading center is London, but New York, Tokyo, Hong Kong and Singapore are all
important centers as well. Banks throughout the world participate. Currency trading happens
continuously throughout the day; as the Asian trading session ends, the European session begins,
followed by the North American session and then back to the Asian session, excluding
weekends.

Fluctuations in exchange rates are usually caused by actual monetary flows as well as by
expectations of changes in monetary flows caused by changes in gross domestic product (GDP)
growth, inflation (purchasing power parity theory), interest rates (interest rate parity, Domestic
Fisher effect, International Fisher effect), budget and trade deficits or surpluses, large cross-
border M&A deals and other macroeconomic conditions. Major news is released publicly, often
on scheduled dates, so many people have access to the same news at the same time. However,
the large banks have an important advantage; they can see their customers' order flow.

Currencies are traded against one another. Each currency pair thus constitutes an individual
trading product and is traditionally noted XXXYYY or XXX/YYY, where XXX and YYY are
the ISO 4217 international three-letter code of the currencies involved. The first currency (XXX)
is the base currency that is quoted relative to the second currency (YYY), called the counter
currency (or quote currency). For instance, the quotation EURUSD (EUR/USD) 1.5465 is the
price of the euro expressed in US dollars, meaning 1 euro = 1.5465 dollars. The market
convention is to quote most exchange rates against the USD with the US dollar as the base
currency (e.g. USDJPY, USDCAD, USDCHF). The exceptions are the British pound (GBP),
Australian dollar (AUD), the New Zealand dollar (NZD) and the euro (EUR) where the USD is
the counter currency (e.g. GBPUSD, AUDUSD, NZDUSD, EURUSD).

The factors affecting XXX will affect both XXXYYY and XXXZZZ. This causes positive
currency correlation between XXXYYY and XXXZZZ.

On the spot market, according to the 2010 Triennial Survey, the most heavily traded bilateral
currency pairs were:

 EURUSD: 28%
 USDJPY: 14%
 GBPUSD (also called cable): 9%

and the US currency was involved in 84.9% of transactions, followed by the euro (39.1%), the
yen (19.0%), and sterling (12.9%) (see table). Volume percentages for all individual currencies
should add up to 200%, as each transaction involves two currencies.

Trading in the euro has grown considerably since the currency's creation in January 1999, and
how long the foreign exchange market will remain dollar-centered is open to debate. Until
recently, trading the euro versus a non-European currency ZZZ would have usually involved two
trades: EURUSD and USDZZZ. The exception to this is EURJPY, which is an established traded
currency pair in the interbank spot market. As the dollar's value has eroded during 2008, interest
in using the euro as reference currency for prices in commodities (such as oil), as well as a larger
component of foreign reserves by banks, has increased dramatically. Transactions in the
currencies of commodity-producing countries, such as AUD, NZD, CAD, have also increased.

[edit] Determinants of exchange rates

See also: exchange rates

The following theories explain the fluctuations in exchange rates in a floating exchange rate
regime (In a fixed exchange rate regime, rates are decided by its government):

1. International parity conditions: Relative Purchasing Power Parity, interest rate parity,
Domestic Fisher effect, International Fisher effect. Though to some extent the above
theories provide logical explanation for the fluctuations in exchange rates, yet these
theories falter as they are based on challengeable assumptions [e.g., free flow of goods,
services and capital] which seldom hold true in the real world.
2. Balance of payments model (see exchange rate): This model, however, focuses largely on
tradable goods and services, ignoring the increasing role of global capital flows. It failed
to provide any explanation for continuous appreciation of dollar during 1980s and most
part of 1990s in face of soaring US current account deficit.
 3. Asset market model (see exchange rate): views currencies as an important asset class for
constructing investment portfolios. Assets prices are influenced mostly by people's
willingness to hold the existing quantities of assets, which in turn depends on their
expectations on the future worth of these assets. The asset market model of exchange rate
determination states that “the exchange rate between two currencies represents the price
that just balances the relative supplies of, and demand for, assets denominated in those
currencies.”

None of the models developed so far succeed to explain exchange rates and volatility in the
longer time frames. For shorter time frames (less than a few days) algorithms can be devised to
predict prices. It is understood from the above models that many macroeconomic factors affect
the exchange rates and in the end currency prices are a result of dual forces of demand and
supply. The world's currency markets can be viewed as a huge melting pot: in a large and ever-
changing mix of current events, supply and demand factors are constantly shifting, and the price
of one currency in relation to another shifts accordingly. No other market encompasses (and
distills) as much of what is going on in the world at any given time as foreign exchange.

Supply and demand for any given currency, and thus its value, are not influenced by any single
element, but rather by several. These elements generally fall into three categories: economic
factors, political conditions and market psychology.

[edit] Economic factors

These include: (a) economic policy, disseminated by government agencies and central banks, (b)
economic conditions, generally revealed through economic reports, and other economic
indicators.

 Economic policy comprises government fiscal policy (budget/spending practices) and

monetary policy (the means by which a government's central bank influences the supply
and "cost" of money, which is reflected by the level of interest rates).
 Government budget deficits or surpluses: The market usually reacts negatively to
widening government budget deficits, and positively to narrowing budget deficits. The
impact is reflected in the value of a country's currency.
 Balance of trade levels and trends: The trade flow between countries illustrates the
demand for goods and services, which in turn indicates demand for a country's currency
to conduct trade. Surpluses and deficits in trade of goods and services reflect the
competitiveness of a nation's economy. For example, trade deficits may have a negative
impact on a nation's currency.
 Inflation levels and trends: Typically a currency will lose value if there is a high level of
inflation in the country or if inflation levels are perceived to be rising. This is because
inflation erodes purchasing power, thus demand, for that particular currency. However, a
currency may sometimes strengthen when inflation rises because of expectations that the
central bank will raise short-term interest rates to combat rising inflation.
 Economic growth and health: Reports such as GDP, employment levels, retail sales,
capacity utilization and others, detail the levels of a country's economic growth and
 health. Generally, the more healthy and robust a country's economy, the better its
currency will perform, and the more demand for it there will be.
 Productivity of an economy: Increasing productivity in an economy should positively
influence the value of its currency. Its effects are more prominent if the increase is in the
traded sector [1].

[edit] Political conditions

Internal, regional, and international political conditions and events can have a profound effect on
currency markets.

All exchange rates are susceptible to political instability and anticipations about the new ruling
party. Political upheaval and instability can have a negative impact on a nation's economy. For
example, destabilization of coalition governments in Pakistan and Thailand can negatively affect
the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of
a political faction that is perceived to be fiscally responsible can have the opposite effect. Also,
events in one country in a region may spur positive/negative interest in a neighboring country
and, in the process, affect its currency.

[edit] Market psychology

Market psychology and trader perceptions influence the foreign exchange market in a variety of
ways:

 Flights to quality: Unsettling international events can lead to a "flight to quality", a type
of capital flight whereby investors move their assets to a perceived "safe haven". There
will be a greater demand, thus a higher price, for currencies perceived as stronger over
their relatively weaker counterparts. The U.S. dollar, Swiss franc and gold have been
traditional safe havens during times of political or economic uncertainty.[16]
 Long-term trends: Currency markets often move in visible long-term trends. Although
currencies do not have an annual growing season like physical commodities, business
cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may
rise from economic or political trends.[17]
 "Buy the rumor, sell the fact": This market truism can apply to many currency situations.
It is the tendency for the price of a currency to reflect the impact of a particular action
before it occurs and, when the anticipated event comes to pass, react in exactly the
opposite direction. This may also be referred to as a market being "oversold" or
"overbought".[18] To buy the rumor or sell the fact can also be an example of the cognitive
bias known as anchoring, when investors focus too much on the relevance of outside
events to currency prices.
 Economic numbers: While economic numbers can certainly reflect economic policy,
some reports and numbers take on a talisman-like effect: the number itself becomes
important to market psychology and may have an immediate impact on short-term market
moves. "What to watch" can change over time. In recent years, for example, money
supply, employment, trade balance figures and inflation numbers have all taken turns in
the spotlight.
  Technical trading considerations: As in other markets, the accumulated price movements
in a currency pair such as EUR/USD can form apparent patterns that traders may attempt
to use. Many traders study price charts in order to identify such patterns.[19]

[edit] Financial instruments

[edit] Spot

Main article: Foreign exchange spot

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.

[edit] Forward

See also: Forward contract

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.

[edit] Swap

Main article: Foreign exchange swap

The most common type of forward transaction is the swap. In a swap, two parties exchange
currencies for a certain length of time and agree to reverse the transaction at a later date. These
are not standardized contracts and are not traded through an exchange. A deposit is often
required in order to hold the position open until the transaction is completed.

[edit] Future

Main article: Currency future

Futures are standardized forward contracts and are usually traded on an exchange created for this
purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive
of any interest amounts.

[edit] Option
Main article: Foreign exchange option

A foreign exchange option (commonly shortened to just FX option) is a derivative where the
owner has the right but not the obligation to exchange money denominated in one currency into
another currency at a pre-agreed exchange rate on a specified date. The options market is the
deepest, largest and most liquid market for options of any kind in the world.

[edit] Speculation
Controversy about currency speculators and their effect on currency devaluations and national
economies recurs regularly. Nevertheless, economists including Milton Friedman have argued
that speculators ultimately are a stabilizing influence on the market and perform the important
function of providing a market for hedgers and transferring risk from those people who don't
wish to bear it, to those who do.[20] Other economists such as Joseph Stiglitz consider this
argument to be based more on politics and a free market philosophy than on economics.[21]

Large hedge funds and other well capitalized "position traders" are the main professional
speculators. According to some economists, individual traders could act as "noise traders" and
have a more destabilizing role than larger and better informed actors.[22]

Currency speculation is considered a highly suspect activity in many countries.[where?] While

investment in traditional financial instruments like bonds or stocks often is considered to
contribute positively to economic growth by providing capital, currency speculation does not;
according to this view, it is simply gambling that often interferes with economic policy. For
example, in 1992, currency speculation forced the Central Bank of Sweden to raise interest rates
for a few days to 500% per annum, and later to devalue the krona.[23] Former Malaysian Prime
Minister Mahathir Mohamad is one well known proponent of this view. He blamed the
devaluation of the Malaysian ringgit in 1997 on George Soros and other speculators.

Gregory J. Millman reports on an opposing view, comparing speculators to "vigilantes" who

simply help "enforce" international agreements and anticipate the effects of basic economic
"laws" in order to profit.[24]

In this view, countries may develop unsustainable financial bubbles or otherwise mishandle their
national economies, and foreign exchange speculators made the inevitable collapse happen
sooner. A relatively quick collapse might even be preferable to continued economic mishandling,
followed by an eventual, larger, collapse. Mahathir Mohamad and other critics of speculation are
viewed as trying to deflect the blame from themselves for having caused the unsustainable
economic conditions.

[edit] Risk aversion

See also: Safe-haven currency
Fig.1 Chart showing MSCI World Index of Equities fell while the US Dollar Index rose.

Risk aversion is a kind of trading behavior exhibited by the foreign exchange market when a
potentially adverse event happens which may affect market conditions. This behavior is caused
when risk averse traders liquidate their positions in risky assets and shift the funds to less risky
assets due to uncertainty.[25]

In the context of the foreign exchange market, traders liquidate their positions in various
currencies to take up positions in safe-haven currencies, such as the US Dollar.[26] Sometimes, the
choice of a safe haven currency is more of a choice based on prevailing sentiments rather than
one of economic statistics. An example would be the Financial Crisis of 2008. The value of
equities across the world fell while the US Dollar strengthened (see Fig.1). This happened
despite the strong focus of the crisis in the USA.[27]

[edit] Carry Trade

Currency carry trade refers to the act of borrowing one currency that has a low interest rate in
order to purchase another with a higher interest rate. A large difference in rates can be highly
profitable for the trader, especially if high leverage is used. However, with all levered
investments this is a double edged sword, and large exchange rate fluctuations can suddenly
swing trades into huge losses.

[edit] Forex Signals

Forex trade alerts, often referred to as Forex Signals are trade strategies provided by either
experienced traders or market analysts. These signals which are often charged a premium fee for
can then be copied or replicated by a trader to his own live account. Forex Signal products are
packaged as either alerts delivered to a users inbox or sms, or can be installed as an Expert
Advisor to a traders MT4 trading platform.

[edit] See also

 Balance of trade
 Currency codes
 Currency strength
 Foreign currency
 Foreign exchange
autotrading
 Foreign exchange
controls
 Foreign exchange
 Money market
 Nonfarm payrolls
 Special drawing rights
 Tobin tax
 mortgage hedge  World currency
 Foreign exchange
reserves

[edit] References
1. ^ The Economist – Guide to the Financial Markets (pdf)
2. ^ Global imbalances and destabilizing speculation (2007), UNCTAD Trade and development
report 2007 (Chapter 1B).
3. ^ a b c 2010 Triennial Central Bank Survey, Bank for International Settlements.
4. ^ "What is Foreign Exchange?". Published by the International Business Times AU. Retrieved:
February 11, 2011.
5. ^ BIS Triennial Central Bank Survey, published in September 2010.
6. ^ "Derivatives in emerging markets", the Bank for International Settlements, December 13, 2010
7. ^ Source: Euromoney FX survey FX survey 2011: The Euromoney FX survey is the largest global
poll of foreign exchange service providers.'
8. ^ "The $4 trillion question: what explains FX growth since the 2007 survey?, the Bank for
International Settlements, December 13, 2010
9. ^ Gabriele Galati, Michael Melvin (December 2004). "Why has FX trading surged? Explaining
the 2004 triennial survey". Bank for International Settlements.
http://www.bis.org/publ/qtrpdf/r_qt0412f.pdf.
10. ^ Alan Greenspan, The Roots of the Mortgage Crisis: Bubbles cannot be safely defused by
monetary policy before the speculative fever breaks on its own. , the Wall Street Journal, December 12,
2007
11. ^ McKay, Peter A. (2005-07-26). "Scammers Operating on Periphery Of CFTC's Domain Lure
Little Guy With Fantastic Promises of Profits". The Wall Street Journal (Dow Jones and Company).
http://online.wsj.com/article/SB112233850336095645.html?mod=Markets-Main. Retrieved 2007-10-31.
12. ^ Egan, Jack (2005-06-19). "Check the Currency Risk. Then Multiply by 100". The New York
Times. http://www.nytimes.com/2005/06/19/business/yourmoney/19fore.html?
_r=2&adxnnl=1&oref=slogin&adxnnlx=1191337503-g1yHfewhqPWye0XtI+Eq0A&oref=slogin.
Retrieved 2007-10-30.
13. ^ The Sunday Times (UK), 16 July 2006
14. ^ The 5 largest in the UK are Travelex, Moneycorp, HiFX, World First and Currencies Direct
15. ^ The total sum is 200% because each currency trade always involves a currency pair.
16. ^ Safe haven currency
17. ^ John J. Murphy, Technical Analysis of the Financial Markets (New York Institute of Finance,
1999), pp. 343–375.
18. ^ Investopedia
19. ^ Sam Y. Cross, All About the Foreign Exchange Market in the United States, Federal Reserve
Bank of New York (1998), chapter 11, pp. 113–115.
20. ^ Michael A. S. Guth, "Profitable Destabilizing Speculation," Chapter 1 in Michael A. S. Guth,
Speculative behavior and the operation of competitive markets under uncertainty, Avebury Ashgate
Publishing, Aldorshot, England (1994), ISBN 1-85628-985-0.
21. ^ What I Learned at the World Economic Crisis Joseph Stiglitz, The New Republic, April 17,
2000, reprinted at GlobalPolicy.org
22. ^ Summers LH and Summers VP (1989) 'When financial markets work too well: a Cautious case
for a securities transaction tax' Journal of financial services
23. ^ But Don't Rush Out to Buy Kronor: Sweden's 500% Gamble - International Herald Tribune
 24. ^ Gregory J. Millman, Around the World on a Trillion Dollars a Day, Bantam Press, New York,
1995.
25. ^ "Risk Averse". Investopedia. http://www.investopedia.com/terms/r/riskaverse.asp. Retrieved
2010-02-25.
26. ^ "Global markets-US stocks rebound, dollar gains on risk aversion". Reuters. 2010-02-05.
http://www.reuters.com/article/idUSN0515775320100205. Retrieved 2010-02-27.
27. ^ Stewart, Heather (2008-04-09). "IMF says US crisis is 'largest financial shock since Great
Depression'". London: guardian.co.uk.
http://www.guardian.co.uk/business/2008/apr/09/useconomy.subprimecrisis. Retrieved 2010-02-27.

[edit] External links

Wikimedia Commons has media related to: Foreign exchange market

 A user's guide to the Triennial Central Bank Survey of foreign exchange market activity,
Bank for International Settlements
 London Foreign Exchange Committee with links (on right) to committees in NY, Tokyo,
Canada, Australia, HK, Singapore
 United States Federal Reserve daily update of exchange rates
 Bank of Canada historical (10-year) currency converter and data download
 Microstructure effects, bid-ask spreads and volatility in the spot foreign exchange market
pre and post-EMU
 OECD Exchange rate statistics (monthly averages)
 National Futures Association (2010). Trading in the Retail Off-Exchange Foreign
Currency Market. Chicago, Illinois.

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Home>News Center>Bizchina>Review & Analysis

Managing exchange rate tricky Story Tools Advertisement

By Yi Xianrong (China Business Weekly)
Updated: 2004-10-07 11:16 Font Large Medium Small

E-Mail This Story

[The author is Director of Finance Development Division, Institute
Print Friendly Format
of Finance & Banking, Chinese Academy of Social Sciences.]
Comment On This Story

Managing the exchange rate float of the renminbi is a major

challenge for the Chinese authorities.

On one hand, the fast economic growth and rapid change of the
economic fundamentals have put more pressure on authorities to Save This Story
adjust the exchange rate policy. Related Stories

On the other hand, it is not easy to deal with the contradictions China to improve RMB exchange
between the demand to adjust the rates and other policy targets. rate system

For example, the potential impact on China's exports and

employment brought by changes in the exchange rate is
unpredictable.

If the adjustment did not meet the market expectations, it would

trigger more serious speculation on the movement of the renminbi.

But if the exchange rate remains unchanged, the expectation of a

renminbi appreciation would put China's external surplus to an
even higher level and erode the external balance for the Chinese
economy. It would also threaten the independence of domestic
monetary policy and affect the internal balance.

Chinese authorities are therefore urged to balance the pros and

cons and make a rational choice on the matter.

As proven by theory and practices, when the economic

fundamentals of a country -- including technological advancement,
the depth of opening-up and international demand -- experienced
drastic changes, its foreign exchange rates should be modified
accordingly.

That means though the authorities can peg the exchange rates at a
certain level in the short term, it is unlikely to manoeuvre the
movement of the rate in the medium and long run.

Experience in some overseas countries during times of fast

economic expansion also shows that the practice of deliberately
lowering the price of the local currency and commodities not only
hurt macro economic stability in the short term, but also affected
the sustainable and balanced development of the economy in the
medium and long term.

China's authorities, also caught in a similar dilemma, should set

clear targets for the exchange rate policy.

Based on the latest development on forex rate theories and

relevant discussions, policy targets appear to be mainly focused on
three aspects: Striking the internal and external balance of the
macro economy; lowering the exposure brought by adjustments in
the exchange rates on domestic enterprises and institutions; and
finally, maintaining stability in China's import costs and export
competitiveness.

To meet the first target, the monetary authorities need to monitor

the renminbi equilibrium exchange rate, which refers to the
exchange rate level that complies with the internal and external
balance of the macro economy.

The second target requires the authorities to monitor the exchange

rate between renminbi and US dollar.

Since most of China's foreign trade and investments are

denominated in US dollars, a more stable exchange rate of
renminbi against US dollar will lessen the foreign exchange
exposure.

Regarding the third policy target, authorities should keep an eye

on the trade weighted exchange rate, or the effective exchange
rate.

The stability of such rates directly affects the stability of China's

export competitiveness and import costs.

However, different policy targets of the exchange rate scheme put

different requirements on the rate adjustment.

Then the question is how to strike a balance between the targets

and find the best solution?

In the three targets mentioned above, there are no major

contradictions between the first two targets.

For example, to reach the internal and external balance of the

macro economy does not demand very frequent adjustments of
the renminbi exchange rate against US dollar.

The equilibrium exchange rate itself is a medium-term concept. It

is impossible to keep the real effective exchange rate at the same
level with an equilibrium exchange rate. So long as the two can
keep the same pace during a certain period, like one or two years,
it can ensure the internal and external balance of the macro
economy.

Meanwhile, to minimize the exposure of exchange rate

adjustments to micro institutions, it does not require a fixed
exchange rate of renminbi against US dollar either.

Low-frequency exchange rate adjustment, every six months or a

year, can satisfy the needs of enterprises to reduce their exposure
to the exchange rate.

Therefore, to reach the first two policy targets, it is only necessary

to adapt the renminbi exchange rate against US dollar to the same
level of equilibrium exchange rate at one time and then maintain
low-frequency adjustments of the rate based on that level.

But when that is done, if the US dollar exchange rates against

Japanese yen, Euro and other major world currencies went through
big fluctuations, it would also trigger changes in the real effective
exchange rate of renminbi, which would harm the third policy
target -- the stability of China's export competitiveness and import
costs.

How, then, can that contradiction be settled?

In the near term, the phenomenon is unlikely to occur.

After a sharp appreciation of the US dollar against Euro and

Japanese yen in 2002 and 2003, there is little room for any major
fluctuation of the exchange rates of US dollar in the near term.
Then the moving range of renminbi real effective exchange rate
would be limited too.

Even if the US dollar exchange rates became unstable against the

major currencies in the world, through the low-frequency
adjustment of renminbi rate against the US dollar, the real
effective exchange rate of renminbi could still be stabilized. And
the stability of China's export competitiveness and import cost
would also be guaranteed.

Therefore, to meet all the three targets of China's exchange rate

policy, an appropriate scheme for the renminbi exchange rate
reform in the medium term is to first adjust the rate to a level
close to the equilibrium exchange rate, based upon market
expectations, expert calculation and trends of the US dollar.

The second step is to keep a low-frequency adjustment of renminbi

exchange rate in the medium term and actively promote the
construction of the domestic financial markets and forward foreign
exchange market as well as the reform on the foreign exchange
management scheme.

Finally, monetary authorities should gradually let the market forces

to decide the value of renminbi.

Meanwhile, authorities should make greater efforts to help stabilize

domestic prices and reduce restrictions on the implementation of
monetary policies brought by the exchange rate scheme.

Close

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Negotiable instrument
From Wikipedia, the free encyclopedia
Jump to: navigation, search
This article needs additional citations for verification. Please help improve this
article by adding citations to reliable sources. Unsourced material may be challenged
and removed. (January 2011)

A negotiable instrument is a document guaranteeing the payment of a specific amount of

money, either on demand, or at a set time. Negotiable instruments are often defined in
legislation. For example, according to the Section 13 of the Negotiable Instruments Act, 1881 in
India, a negotiable instrument means a promissory note, bill of exchange or cheque payable
either to order or to bearer. So, in India, there are just three types of negotiable instruments such
as promissory note, bill of exchange and cheque. Cheque also includes Demand Draft [Section
85A].

More specifically, it is a document contemplated by a contract, which (1) warrants the payment
of money, the promise of or order for conveyance of which is unconditional; (2) specifies or
describes the payee, who is designated on and memorialized by the instrument; and (3) is capable
of change through transfer by valid negotiation of the instrument.

As a negotiable instrument is a promise of a payment of money, the instrument itself can be used
by the holder in due course as a store of value; although, instruments can be transferred for
amounts in contractual exchange that are less than the instrument’s face value (known as
“discounting”). Under United States law, Article 3 of the Uniform Commercial Code as enacted
in the applicable State law governs the use of negotiable instruments, except banknotes (“Federal
Reserve Notes”, aka "paper dollars").

Contents
[hide]

 1 Negotiable instruments distinguished from other types of contracts

o 1.1 The holder in due course
 2 History
 3 Classes
o 3.1 Promissory note
o 3.2 Bill of exchange
 4 In the Commonwealth
 5 In the United States
o 5.1 Negotiation and endorsement
o 5.2 Usage
o 5.3 Exceptions
 6 See also
 7 References
  8 External links

[edit] Negotiable instruments distinguished from other types

of contracts
A negotiable instrument can serve to convey value constituting at least part of the performance
of a contract, albeit perhaps not obvious in contract formation, in terms inherent in and arising
from the requisite offer and acceptance and conveyance of consideration. The underlying
contract contemplates the right to hold the instrument as, and to negotiate the instrument to, a
holder in due course, the payment on which is at least part of the performance of the contract to
which the negotiable instrument is linked. The instrument, memorializing (1) the power to
demand payment; and, (2) the right to be paid, can move, for example, in the instance of a 'bearer
instrument', wherein the possession of the document itself attributes and ascribes the right to
payment. Certain exceptions exist, such as instances of loss or theft of the instrument, wherein
the possessor of the note may be a holder, but not necessarily a holder in due course. Negotiation
requires a valid endorsement of the negotiable instrument. The consideration constituted by a
negotiable instrument is cognizable as the value given up to acquire it (benefit) and the
consequent loss of value (detriment) to the prior holder; thus, no separate consideration is
required to support an accompanying contract assignment. The instrument itself is understood as
memorializing the right for, and power to demand, payment, and an obligation for payment
evidenced by the instrument itself with possession as a holder in due course being the touchstone
for the right to, and power to demand, payment. In some instances, the negotiable instrument can
serve as the writing memorializing a contract, thus satisfying any applicable Statute of Frauds as
to that contract.

[edit] The holder in due course

The rights of a holder in due course of a negotiable instrument are qualitatively, as matters of
law, superior to those provided by ordinary species of contracts:

 The rights to payment are not subject to set-off, and do not rely on the validity of the
underlying contract giving rise to the debt (for example if a cheque was drawn for
payment for goods delivered but defective, the drawer is still liable on the cheque)

 No notice need be given to any party liable on the instrument for transfer of the rights
under the instrument by negotiation. However, payment by the party liable to the person
previously entitled to enforce the instrument "counts" as payment on the note until
adequate notice has been received by the liable party that a different party is to receive
payments from then on. [U.C.C. §3-602(b)]

 Transfer free of equities—the holder in due course can hold better title than the party he
obtains it from (as in the instance of negotiation of the instrument from a mere holder to a
holder in due course)
Negotiation often enables the transferee to become the party to the contract through a contract
assignment (provided for explicitly or by operation of law) and to enforce the contract in the
transferee-assignee’s own name. Negotiation can be effected by endorsement and delivery (order
instruments), or by delivery alone (bearer instruments).

[edit] History
Common prototypes of bills of exchanges and promissory notes originated in China. Here, in the
8th century during the reign of the Tang Dynasty they used special instruments called feitsyan
for the safe transfer of money over long distances.[1] Later such document for money transfer
used by Arab merchants, who had used the prototypes of bills of exchange – suftadja and hawala
in 10–13th centuries, then such prototypes had used by Italian merchants in the 12th century. In
Italy in 13–15th centuries bill of exchange and promissory note obtain their main features and
further phases of its development have been associated with France (16–18th centuries, where
the endorsement had appeared) and Germany (19th century, formalization of Exchange Law). In
England (and later in the U.S.) Exchange Law was different from continental Europe because of
different legal systems.[citation needed][2]

[edit] Classes
Promissory notes and bills of exchange are two primary types of negotiable instruments.

[edit] Promissory note

A promissory note is an unconditional promise in writing made by one person to another, signed
by the maker, engaging to pay on demand to the payee, or at fixed or determinable future time,
certain in money, to order or to bearer. (see Sec.194) Bank note is frequently referred to as a
promissory note, a promissory note made by a bank and payable to bearer on demand.

[edit] Bill of exchange

A bill of exchange or "draft" is a written order by the drawer to the drawee to pay money to the
payee. A common type of bill of exchange is the cheque (check in American English), defined as
a bill of exchange drawn on a banker and payable on demand. Bills of exchange are used
primarily in international trade, and are written orders by one person to his bank to pay the bearer
a specific sum on a specific date. Prior to the advent of paper currency, bills of exchange were a
common means of exchange. They are not used as often today.
Bill of exchange, 1933

A bill of exchange is essentially an order made by one person to another to pay money to a third
person. A bill of exchange requires in its inception three parties—the drawer, the drawee, and the
payee. The person who draws the bill is called the drawer. He gives the order to pay money to
the third party. The party upon whom the bill is drawn is called the drawee. He is the person to
whom the bill is addressed and who is ordered to pay. He becomes an acceptor when he indicates
his willingness to pay the bill. The party in whose favor the bill is drawn or is payable is called
the payee. The parties need not all be distinct persons. Thus, the drawer may draw on himself
payable to his own order.

A bill of exchange may be endorsed by the payee in favour of a third party, who may in turn
endorse it to a fourth, and so on indefinitely. The "holder in due course" may claim the amount
of the bill against the drawee and all previous endorsers, regardless of any counterclaims that
may have disabled the previous payee or endorser from doing so. This is what is meant by saying
that a bill is negotiable.

In some cases a bill is marked "not negotiable" – see crossing of cheques. In that case it can still
be transferred to a third party, but the third party can have no better right than the transferor.

[edit] In the Commonwealth

In the commonwealth almost all jurisdictions have codified the law relating to negotiable
instruments in a Bills of Exchange Act, e.g. Bills of Exchange Act 1882 in the UK, Bills of
Exchange Act 1908 in New Zealand, The Negotiable Instrument Act 1881 in India and The Bills
of Exchange Act 1914 in Mauritius. The Bills of Exchange Act:

1. defines a bill of exchange as: 'an unconditional order in writing, addressed by one person
to another, signed by the person giving it, requiring the person to whom it is addressed to
pay on demand, or at a fixed or determinable future time, a sum certain in money to or to
the order of a specified person, or to bearer.
2. defines a cheque as: 'a bill of exchange drawn on a banker payable on demand'
3. defines a promissory note as: 'an unconditional promise in writing made by one person to
another, signed by the maker, engaging to pay on demand, or at a fixed or determinable
future time, a sum certain in money to or to the order of a specified person or to bearer.'

Additionally most commonwealth jurisdictions have separate Cheques Acts providing for
additional protections for bankers collecting unendorsed or irregularly endorsed cheques,
providing that cheques that are crossed and marked 'not negotiable' or similar are not
transferable, and providing for electronic presentation of cheques in inter-bank cheque clearing
systems.

The 1911 Encyclopædia Britannica Eleventh Edition has a comprehensive article on the Bill of
Exchange, detailing its history and operation, as understood at the time of its publication.
[edit] In the United States
In the United States, Article 3 and Article 4 of the Uniform Commercial Code govern the
issuance and transfer of negotiable instruments. The various State law enactments of Uniform
Commercial Code §§3-104(a) through (d) set forth the legal definition of what is and what is not
a negotiable instrument:

§ 3-104. NEGOTIABLE INSTRUMENT.

“
(a) Except as provided in subsections (c) and (d), "negotiable instrument"
means an unconditional promise or order to pay a fixed amount of money, with
or without interest or other charges described in the promise or order, if it:

(1) is payable to bearer or to order at the time it is issued or first comes into
possession of a holder;

(2) is payable on demand or at a definite time; and

(3) does not state any other undertaking or instruction by the person promising
or ordering payment to do any act in addition to the payment of money, but the
promise or order may contain

(i) an undertaking or power to give, maintain, or protect collateral to secure

payment,

(ii) an authorization or power to the holder to confess judgment or realize on or

dispose of collateral, or

(iii) a waiver of the benefit of any law intended for the advantage or protection
of an obligor.

(b) "Instrument" means a negotiable instrument.

(c) An order that meets all of the requirements of subsection (a), except
paragraph (1), and otherwise falls within the definition of "check" in subsection
(f) is a negotiable instrument and a check.

(d) A promise or order other than a check is not an instrument if, at the time it
is issued or first comes into possession of a holder, it contains a conspicuous
statement, however expressed, to the effect that the promise or order is not
negotiable or is not an instrument governed by this Article. ”
Thus, for a writing to be a negotiable instrument under Article 3,[3] the following requirements
must be met:
 1. The promise or order to pay must be unconditional;
2. The payment must be a specific sum of money, although interest may be added to the
sum;
3. The payment must be made on demand or at a definite time;
4. The instrument must not require the person promising payment to perform any act other
than paying the money specified;
5. The instrument must be payable to bearer or to order.

The latter requirement is referred to as the "words of negotiability": a writing which does not
contain the words "to the order of" (within the four corners of the instrument or in endorsement
on the note or in allonge) or indicate that it is payable to the individual holding the contract
document (analogous to the holder in due course) is not a negotiable instrument and is not
governed by Article 3, even if it appears to have all of the other features of negotiability. The
only exception is that if an instrument meets the definition of a cheque (a bill of exchange
payable on demand and drawn on a bank) and is not payable to order (i.e. if it just reads "pay
John Doe") then it is treated as a negotiable instrument.

[edit] Negotiation and endorsement

Persons other than the original obligor and obligee can become parties to a negotiable
instrument. The most common manner in which this is done is by placing one's signature on the
instrument (“endorsement”): if the person who signs does so with the intention of obtaining
payment of the instrument or acquiring or transferring rights to the instrument, the signature is
called an endorsement. There are five types of endorsements contemplated by the Code, covered
in UCC Article 3, Sections 204–206:

 An endorsement which purports to transfer the instrument to a specified person is a

special endorsement – for example, "Pay to the order of Amy";
 An endorsement by the payee or holder which does not contain any additional notation
(thus purporting to make the instrument payable to bearer) is an endorsement in blank or
blank endorsement;
 An endorsement which purports to require that the funds be applied in a certain manner
(e.g. "for deposit only", "for collection") is a restrictive endorsement; and,
 An endorsement purporting to disclaim retroactive liability is called a qualified
endorsement (through the inscription of the words "without recourse" as part of the
endorsement on the instrument or in allonge to the instrument).
 An endorsement purporting to add terms and conditions is called a conditional
endorsement – for example, "Pay to the order of Amy, if she rakes my lawn next
Thursday November 11th, 2007". The UCC states that these conditions may be
disregarded.[4]

If a note or draft is negotiated to a person who acquires the instrument

1. in good faith;
2. for value;
3. without notice of any defenses to payment,
the transferee is a holder in due course and can enforce the instrument without being subject to
defenses which the maker of the instrument would be able to assert against the original payee,
except for certain real defenses. These real defenses include (1) forgery of the instrument; (2)
fraud as to the nature of the instrument being signed; (3) alteration of the instrument; (4)
incapacity of the signer to contract; (5) infancy of the signer; (6) duress; (7) discharge in
bankruptcy; and, (8) the running of a statute of limitations as to the validity of the instrument.

The holder-in-due-course rule is a rebuttable presumption that makes the free transfer of
negotiable instruments feasible in the modern economy. A person or entity purchasing an
instrument in the ordinary course of business can reasonably expect that it will be paid when
presented to, and not subject to dishonor by, the maker, without involving itself in a dispute
between the maker and the person to whom the instrument was first issued (this can be
contrasted to the lesser rights and obligations accruing to mere holders). Article 3 of the Uniform
Commercial Code as enacted in a particular State's law contemplate real defenses available to
purported holders in due course.

The foregoing is the theory and application presuming compliance with the relevant law.
Practically, the obligor-payor on an instrument who feels he has been defrauded or otherwise
unfairly dealt with by the payee may nonetheless refuse to pay even a holder in due course,
requiring the latter to resort to litigation to recover on the instrument.

[edit] Usage

While bearer instruments are rarely created as such, a holder of commercial paper with the
holder designated as payee can change the instrument to a bearer instrument by an endorsement.
The proper holder simply signs the back of the instrument and the instrument becomes bearer
paper, although in recent years, third party checks are not being honored by most banks unless
the original payee has signed a notarized document stating such.

Alternatively, an individual or company may write a check payable to "Cash" or "Bearer" and
create a bearer instrument. Great care should be taken with the security of the instrument, as it is
legally almost as good as cash.

[edit] Exceptions

Under the Code, the following are not negotiable instruments, although the law governing
obligations with respect to such items may be similar to or derived from the law applicable to
negotiable instruments:

 Bills of lading and other documents of title, which are governed by Article 7 of the Code.
However, under admiralty law, a bill of lading may either be a negotiable or 'order' bill of
lading or a nonnegotiable or 'straight' bill of lading.
 Deeds and other documents conveying interests in real estate, although a mortgage may
secure a promissory note which is governed by Article 3
 IOUs
 Letters of credit, which are governed by Article 5 of the Code
  Securities, such as stocks and bonds, which are governed by Article 8 of the Code

[edit] See also

Wikisource has the text of the 1911 Encyclopædia Britannica article Bill of Exchange.

 Aval
 Bearer instrument
 Negotiable cow

[edit] References
1. ^ Moshenskyi, Sergii (2008). History of the Weksel. Xlibris Corporation. ISBN 978-1-4363-
0693-5. http://books.google.co.nz/books?
id=8UBDndXgNIYC&lpg=PA51&dq=feitsyan&pg=PA50#v=onepage&q=feitsyan&f=false.
2. ^ [1]
3. ^ Uniform Commercial Code - Article 3
4. ^ Article 3, Sections 206(b)

[edit] External links

 Bill of Exchange FAQ on TheBenche.com

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1911 Encyclopædia Britannica/Bill of

Exchange
From Wikisource
< 1911 Encyclopædia Britannica
Jump to: navigation, search
1911 Encyclopædia Britannica
←Billiton Bill of Rights→
Bill of Exchange
See also Negotiable instrument on Wikipedia, and our 1911 Encyclopædia Britannica disclaimer.

BILL OF EXCHANGE, a form of negotiable instrument, defined below, the history of which,
though somewhat obscure, was ably summed up by Lord Chief Justice Cockburn in his judgment
in Goodwin v. Robarts (1875), L.R. 10 Ex. pp. 346–358. Bills of exchange were probably
invented by Florentine Jews. They were well known in England in the middle ages, though there
is no reported decision on a bill of exchange before the year 1603. At first their use seems to
have been confined to foreign bills between English and foreign merchants. It was afterwards
extended to domestic bills between traders, and finally to bills of all persons, whether traders or
not. But for some time after they had come into general employment, bills were always alleged
in legal proceedings to be drawn secundum usum et consuetudinem mercatorum. The
foundations of modern English law were laid by Lord Mansfield with the aid of juries of London
merchants. No better tribunal of commerce could have been devised. Subsequent judicial
decisions have developed and systematized the principles thus laid down. Promissory notes are
of more modern origin than bills of exchange, and their validity as negotiable instruments was
doubtful until it was confirmed by a statute of Anne (1704). Cheques are the creation of the
modern system of banking.

Before 1882 the English law was to be found in 17 statutes dealing with isolated points, and
about 2600 cases scattered over some 300 volumes of reports. The Bills of Exchange Act 1882
codifies for the United Kingdom the law relating to bills of exchange, promissory notes and
cheques. One peculiar Scottish rule is preserved, but in other respects uniform rules are laid
down for England, Scotland and Ireland. After glancing briefly at the history of these
instruments, it will probably be convenient to discuss the subject in the order followed by the act,
namely, first, to treat of a bill of exchange, which is the original and typical negotiable
instrument, and then to refer to the special provisions which apply to promissory notes and
cheques. Two salient characteristics distinguish negotiable instruments from other engagements
to pay money. In the first place, the assignee of a negotiable instrument, to whom it is transferred
by indorsement or delivery according to its tenor, can sue thereon in his own name; and,
secondly, he holds it by an independent title. If he takes it in good faith and for value, he takes it
free from "all equities," that is to say, all defects of title or grounds of defence which may have
attached to it in the hands of any previous party. These characteristic privileges were conferred
by the law merchant, which is part of the common law, and are now confirmed by statute.

Definition.—By § 3 of the act a bill of exchange is defined to be "an unconditional order in

writing, addressed by one person to another, signed by the person giving it, requiring the person
to whom it is addressed to pay on demand or at a fixed or determinable future time a sum certain
in money to or to the order of a specified person, or to bearer."[1] The person who gives the order
is called the drawer. The person thereby required to pay is called the drawee. If he assents to the
order, he is then called the acceptor. An acceptance must be in writing and must be signed by the
drawee. The mere signature of the drawee is sufficient (§17). The person to whom the money is
payable is called the payee. The person to whom a bill is transferred by indorsement is called the
indorsee. The generic term "holder" includes any person in possession of a bill who holds it
either as payee, indorsee or bearer. A bill which in its origin is payable to order becomes payable
to bearer if it is indorsed in blank. If the payee is a fictitious person the bill may be treated as
payable to bearer (§ 7).

The following is a specimen of an ordinary form of a bill of exchange:—

£100 LONDON, 1st January 1901.

Three months after date pay to the order of Mr J. Jones the sum of one
hundred pounds for value received.
BROWN & Co.
To Messrs. Smith & Sons, Liverpool.

The scope of the definition given above may be realized by comparing it with the definition
given by Sir John Comyns' Digest in the early part of the 18th century:—"A bill of exchange is
when a man takes money in one country or city upon exchange, and draws a bill whereby he
directs another person in another country or city to pay so much to A, or order, for value received
of B, and subscribes it." Comyns' definition illustrates the original theory of a bill of exchange. A
bill in its origin was a device to avoid the transmission of cash from place to place to settle trade
debts. Now a bill of exchange is a substitute for money. It is immaterial whether it is payable in
the place where it is drawn or not. It is immaterial whether it is stated to be given for value
received or not, for the law itself raises a presumption that it was given for value. But though
bills are a substitute for cash payment, and though they constitute the commercial currency of the
country, they must not be confounded with money. No man is bound to take a bill in payment of
debt unless he has agreed to do so. If he does take a bill, the instrument ordinarily operates as
conditional, and not as absolute payment. If the bill is dishonoured the debt revives. Under the
laws of some continental countries, a creditor, as such, is entitled to draw on his debtor for the
amount of his debt, but in England the obligation to accept or pay a bill rests solely on actual
agreement. A bill of exchange must be an unconditional order to pay. If an instrument is made
payable on a contingency, or out of a particular fund, so that its payment is dependent on the
continued existence of that fund, it is invalid as a bill, though it may, of course, avail as an
agreement or equitable assignment. In Scotland it has long been the law that a bill may operate as
an assignment of funds in the hands of the drawee, and § 53 of the act preserves this rule.

Stamp.—Bills of exchange must be stamped, but the act of 1882 does not regulate the stamp. It
merely saves the operation of the stamp laws, which necessarily vary from time to time
according to the fluctuating needs and policy of the exchequer. Under the Stamp Act 1891, bills
payable on demand are subject to a fixed stamp duty of one penny, and by the Finance Act 1899,
a similar privilege is extended to bills expressed to be payable not more than three days after
sight or date. The stamp may be impressed or adhesive. All other bills are liable to an ad valorem
duty. Inland bills must be drawn on stamped paper, but foreign bills, of course, can be stamped
with adhesive stamps. As a matter of policy, English law does not concern itself with foreign
revenue laws. For English purposes, therefore, it is immaterial whether a bill drawn abroad is
stamped in accordance with the law of its place of origin or not. On arrival in England it has to
conform to the English stamp laws.
Maturity.—A bill of exchange is payable on demand when it is expressed to be payable on
demand, or at sight, or on presentation or when notice for payment is expressed. in calculating
the maturity of bills payable at a future time, three days, called days of grace, must be added to
the nominal due date of the bill. For instance, if a bill payable one month after sight is accepted
on the 1st of January, it is really payable on the 4th of February, and not on the 1st of February
as its tenor indicates. On the continent generally days of grace have been abolished as anomalous
and misleading. Their abolition has been proposed in England, but it has been opposed on the
ground that it would curtail the credit of small traders who are accustomed to bills drawn at
certain fixed periods of currency. When the last day of grace is a nonbusiness day some
complicated rules come into play (§ 14). Speaking generally, when the last day of grace falls on
Sunday or a common law holiday the bill is payable on the preceding day, but when it falls on a
bank holiday the bill is payable on the succeeding day. Complications arise when Sunday is
preceded by a bank holiday; and, to add to the confusion, Christmas day is a bank holiday in
Scotland, but a common law holiday in England. When the code was in committee an attempt
was made to remove these anomalies, but it was successfully resisted by the bankers on alleged
grounds of practical convenience.

Acceptance.—By the acceptance of a bill the drawee becomes the principal debtor on the
instrument and the party primarily liable to pay it. The acceptor of a bill "by accepting it engages
that he will pay it according to the tenor of his acceptance," and is precluded from denying the
drawer's right to draw or the genuineness of his signature (§ 54). The acceptance may be either
general or qualified. As a qualified acceptance is so far a disregard of the drawer's order, the
holder is not obliged to take it; and if he chooses to take it he must give notice to antecedent
parties, acting at his own risk if they dissent (§§ 19 and 44). The drawer and indorsers of a bill
are in the nature of sureties. They engage that the bill shall be duly accepted and paid according
to its tenor, and that if it is dishonoured by non-acceptance or non-payment, as the case may be,
they will compensate the holder provided that the requisite proceedings on dishonour are duly
taken. Any indorser who is compelled to pay the bill has the like remedy as the holder against
any antecedent party (§ 55). A person who is not the holder of a bill, but who backs it with his
signature, thereby incurs the liability of an indorser to a holder in due course (§ 56). An indorser
may by express term either restrict or charge his ordinary liability as stated above. Prima facie
every signature to a bill is presumed to have been given for valuable consideration. But
sometimes this is not the case. For friendship, or other reasons, a man may be willing to lend his
name and credit to another in a bill transaction. Hence arise what are called accommodation bills.
Ordinarily the acceptor gives his acceptance to accommodate the drawer. But occasionally both
drawer and acceptor sign to accommodate the payee, or even a person who is not a party to the
bill at all. The criterion of an accommodation bill is the fact that the principal debtor according to
the instrument has lent his name and is in substance a surety for some one else. The holder for
value of an accommodation bill may enforce it exactly as if it was an ordinary bill, for that is the
presumable intention of the parties. But if the bill is dishonoured the law takes cognizance of the
true relations of the parties, and many of the rules relating to principal and surety come into play.
Suppose a bill is accepted for the accommodation of the drawer. It is the drawer's duty to provide
the acceptor with funds to meet the bill at maturity, If he fails to do so, he cannot rely on the
defence that the bill was not duly presented for payment or that he did not receive due notice of
dishonour. If the holder, with notice of the real state of the facts, agrees to give time to the
drawer to pay, he may thereby discharge the acceptor.
Holder in due Course.—The holder of a bill has special rights and special duties. He is the
mercantile owner of the bill, but in order to establish his ownership he must show a mercantile
title. The bill must be negotiated to him, that is to say, it must be transferred to him according to
the forms prescribed by mercantile law. If the bill is payable to order, he must not only get
possession of the bill, but he must also obtain the indorsement of the previous holder. If the bill
is payable to bearer it is transferable by mere delivery. A bill is payable to bearer which is
expressed to be so payable, or on which the only or last indorsement is an indorsement in blank,
if a man lawfully obtains possession of a bill payable to order without the necessary indorsement,
he may obtain some common law rights in respect of it, but he is not the mercantile owner, and
he is not technically the holder or bearer. But to get the full advantages of mercantile ownership
the holder must be a "holder in due course"—that is to say, he must satisfy three business
conditions. First, he must have given value, or claim through some holder who has given value.
Secondly, when he takes the bill, it must be regular on the face of it. In particular, the bill must
not be overdue or known to be dishonoured. An overdue bill, or a bill which has been
dishonoured, is still negotiable, but in a restricted sense. The transferee cannot acquire a better
title than the party from whom he took it had (§ 36). Thirdly, he must take the bill honestly and
without notice of any defect in the title of the transferor,—as, for instance, that the bill or
acceptance had been obtained by fraud, or threats or for an illegal consideration. If he satisfies
these conditions he obtains an indefeasible title, and can enforce the bill against all parties
thereto. The act substitutes the expression "holder in due course" for the somewhat cumbrous
older expression "bona fide holder for value without notice." The statutory term has the
advantage of being positive instead of negative. The French equivalent "tiers porteur de bonne
foi" is expressive. Forgery, of course, stands on a different footing from a mere defect of title. A
forged signature, as a general rule, is a nullity. A person who claims through a forged signature
has no title himself, and cannot give a title to any one else (§ 24). Two exceptions to this general
rule require to be noted. First, a banker who in the ordinary course of business pays a demand
draft held under a forged indorsement is protected (§ 6o). Secondly, if a bill be issued with
material blanks in it, any person in possession of it has prima facie authority to fill them up, and
if the instrument when complete gets into the hands of a holder in due course the presumption
becomes absolute. As between the immediate parties the transaction may amount to forgery, but
the holder in due course is protected (§ 20).

Dishonour. —The holder of a bill has special duties which he must fulfil in order to preserve his
rights against the drawers and indorsers. They are not absolute duties; they are duties to use
reasonable diligence. When a bill is payable after sight, presentment for acceptance is necessary
in order to fix the maturity of the bill. Accordingly the bill must be presented for acceptance
within a reasonable time. When a bill is payable on demand it must be presented for payment
within a reasonable time. When it is payable at a future time it must be presented on the day that
it is due. If the bill is dishonoured the holder must notify promptly the fact of dishonour to any
drawer and indorser he wishes to charge. If, for example, the holder only gives notice of
dishonour to the last indorser, he could not sue the drawer unless the last indorser or some other
party liable has duly sent notice to the drawer. When a foreign bill is dishonoured the holder
must cause it to be protested by a notary public. The bill must be noted for protest on the day of
its dishonour. If this be duly done, the protest, i.e. the formal notarial certificate attesting the
dishonour, can be drawn up at any time as of the date of the noting. A dishonoured inland bill
may be noted, and the holder can recover the expenses of noting, but no legal consequences
attach thereto. In practice, however, noting is usually accepted as showing that a bill has been
duly presented and has been dishonoured. Sometimes the drawer or indorser has reason to expect
that the bill may be dishonoured by the drawee. In that case he may insert the name of a "referee
in case of need." But whether he does so or not, when a bill has been duly noted for protest, any
person may, with the consent of the holder, intervene for the honour of any party liable on the
bill. If the bill has been dishonoured by non-acceptance it may be "accepted for honour supra
protest." If it has been dishonoured by non-payment it may be paid supra protest. When a bill is
thus paid and the proper formalities are complied with, the person who pays becomes invested
with the rights and duties of the holder so far as regards the party for whose honour he has paid
the bill, and all parties antecedent to him (§§65 to 68).

Discharge. —Normally a bill is discharged by payment in due course, that is to say, by payment
by the drawee or acceptor to the holder at or after maturity. But it may also be discharged in
other ways, as for example by coincidence of right and liability (§ 61), voluntary renunciation (§
62), cancellation (§ 63), or material alteration (§ 64).

Conflict of Laws. —A bill of exchange is the most cosmopolitan of all contracts. It may be drawn
in one country, payable in another, and indorsed on its journey to its destination in two or three
more. The laws of all these countries may differ. Provision for this conflict of laws is made by §
72, which lays down rules for determining by what law the rights and duties of the various
parties are to be measured and regulated. Speaking broadly, these rules follow the maxim Locus
regit actum. A man must be expected to know and follow the law of the place where he conducts
his business, but no man can be expected to know the laws of every country through which a bill
may travel. For safety of transmission from country to country bills are often made out in sets.
The set usually consists of three counterparts, each part being numbered and containing a
reference to the other parts. The whole set then constitutes one bill, and the drawee must be
careful only to accept one part, otherwise if different accepted parts get into the hands of
different holders, he may be liable to pay the bill twice (§ 71). Foreign bills circulating through
different countries have given rise to many intricate questions of law. But the subject is perhaps
one of diminishing importance, as in many trades the system of "cable transfers" is superseding
the use of bills of exchange.

A cheque "is a bill of exchange drawn on a banker payable on demand" (§ 73). For the most part
the rules of law applicable to bills payable on demand apply in their entirety to
cheques.Cheques. But there are certain peculiar rules relating to the latter which arise from the
fact that the relationship of banker and customer subsists between the drawer and drawee of a
cheque. For example, when a person has an account at a bank he is, as an inference of law,
entitled to draw on it by means of cheques. A right to overdraw, can, of course, only arise from
agreement. The drawer of a cheque is not absolutely discharged by the holder's omission to
present it for payment within a reasonable time. He is only discharged to the extent of any actual
damage he may have suffered through the delay (§ 74). Apart from any question of delay, a
banker's authority to pay his customer's cheques is determined by countermand of payment or by
notice of the customer's death (§ 75). Of recent years the use of cheques has enormously
increased, and they have now become the normal machinery by which all but the smallest debts
are discharged. To guard against fraud, and to facilitate the safe transmission of cheques by post,
a system of crossing has been devised which makes crossed cheques payable only through
certain channels. The first act which gave legislative recognition to the practice of crossing was
the 19 and 20 Vict. c. 95. That act was amended in 1858, and a consolidating and amending act
was passed in 1876. The act of 1876 is now repealed, and its provisions are re-enacted with
slight modifications by §§ 76 to 82 of the Bills of Exchange Act 1883. A cheque may be crossed
either "generally" or "specially." A cheque is crossed generally by drawing across it two parallel
lines and writing between them the words "& Co." When a cheque is crossed generally it cannot
be paid over the counter. It must be presented for payment by a banker. A cheque is crossed
specially by adding the name of the banker, and then it can only be presented through that
particular banker. A cheque, whether crossed generally or specially, may further be crossed with
the words "not negotiable." A cheque crossed "not negotiable" is still transferable, but its
negotiable quality is restricted. It is put on pretty much the same footing as an overdue bill. The
person who takes it does not get, and cannot give a better title to it, than that which the person
from whom he took it had. These provisions are supplemented by provisions for the protection of
paying and collecting bankers who act in good faith and without negllgence. Suppose that a
cheque payable to bearer, which is crossed generally and with the words "not negotiable," is
stolen. The thief then gets a tradesman to cash it for him, and the tradesman gets the cheque paid
on presentment through his banker. The banker who pays and the banker who receives the
money for the tradesman are protected, but the tradesman would be liable to refund the money to
the true owner. Again, assuming payment of the cheque to have been stopped, the tradesman
could not maintain an action against the drawer.

A promissory note is defined by section 83 of the act to be an "unconditional promise in writing

made by one person to Promissory notes.another, signed by the maker, engaging to pay on
demand, or at a fixed or determinable future time, a sum certain in money to or to the order of a
specified person or to bearer." A promissory note may be made by two or more makers, and they
may be liable either jointly, or jointly and severally, according to its tenor (§ 85). For the most
part, rules of law applicable to a bill of exchange apply also to a promissory note, but they
require adaptation. A note differs from a bill in this: it is a direct promise to pay, and not an order
to pay. When it issues it bears on it the engagement of the principal debtor who is primarily
liable thereon. The formula for applying to notes the rules as to bills is that "the maker of a note
shall be deemed to correspond with the acceptoz of a bill, and the first indorser of a note shall be
deemed to correspond with the drawer of a bill payable to drawer's order" (§ 89). Rules relating
to presentment for acceptance, acceptance [sic], acceptance supra protest, and bills in a set, have
no application to a note. Moreover, when a foreign note is dishonoured it is not necessary, for
English purposes, to protest it. All promissory notes are, under the Stamp Act 1891, subject to an
ad valorem stamp duty. Inland notes must be on impressed stamp paper. Foreign notes are
stamped with adhesive stamps. For ordinary legal purposes a bank note may be regarded as a
promissory note made by a banker payable to bearer on demand. It is, however, subject to special
stamp regulations. It is not discharged by payment, but may be re-issued again and again. In the
interests of the currency the issue of bank notes is subject to various statutory restrictions. A
bank, other than the Bank of England, may not issue notes in England unless it had a lawful note
issue in 1844. On the other hand, Bank of England notes are legal tender except by the bank
itself.

In fundamental principles there is general agreement between the laws of all commercial nations
regarding negotiable Foreign laws.instruments. As Mr Justice Story, the great American lawyer,
says: "The law respecting negotiable instruments may be truly declared, in the language of
Cicero, to be in a great measure not the law of a single country only, but of the whole
commercial world. Non erit lex alia Romae, alia Athenis, alia mine alia posthac, sed et apud
omnes gentes et omni tempore, una eademque lex obtinebit" (Swift v. Tyson, 16 Peters 1). But in
matters of detail each nation has impressed its individuality on its own system. The English law
has been summarized above. Perhaps its special characteristics may be best brought out by
comparing it with the French code and noting some salient divergences. English law has been
developed gradually by judicial decision founded on trade custom. French law was codified in
the 17th century by the "Ordonnance de 1673." The existing "Code de Commerce" amplifies but
substantially adopts the provisions of the "Ordonnance." The growth of French law was thus
arrested at an early period of its development. The result is instructive. A reference to Marius'
treatise on bills of exchange, published about 1670, or Beawes' Lex Mercatoria, published about
1740, shows that the law, or rather the practice, as to bills of exchange was even then fairly well
defined. Comparing the practice of that time with the law as it now stands, it will be seen that it
has been modified in some important respects. For the most part, where English law differs from
French law, the latter is in strict accordance with the rules laid down by Beawes. The fact is that,
when Beawes wrote, the law or practice of both nations on this subject was nearly uniform. But
English law has gone on growing while French law has stood still. A bill of exchange in its
origin was an instrument by which a trade debt due in one place was transferred to another place.
This theory French law rigidly keeps in view, in England bills have developed into a paper
currency of perfect flexibility, in France a bill represents a trade transaction; in England it is
merely an instrument of credit. English law affords full play to the system of accommodation
paper; French law endeavours to stamp it out. A comparison of some of the main points of
difference between English and French law will show how the two theories work. In England it
is no longer necessary to express on a bill that value has been given for it, for the law raises a
presumption to that effect. In France the nature of the consideration must be stated, and a false
statement of value avoids the bill in the hands of all parties with notice. In England a bill may be
drawn and payable in the same place. In France the place where a bill is drawn should be so far
distant from the place where it is payable that there may be a possible rate of exchange between
the two. This so-called rule of distantia loci is said to be disregarded now in practice, but the
code is unaltered. As French lawyers put it, a bill of exchange necessarily presupposes a contract
of exchange. In England since 1765 a bill may be drawn payable to bearer, though formerly it
was otherwise. In France it must be payable to order; if it were not so it is clear that the rule
requiring the consideration to be truly stated would be a nullity. In England a bill originally
payable to order becomes payable to bearer when indorsed in blank. In France an indorsement in
blank merely operates as a procuration. An indorsement, to operate as a negotiation, must be to
order, and must state the consideration; in short, it must conform to the conditions of an original
draft, in England, if a bill is dishonoured by non-acceptance, a right of action at once accrues to
the holder. In France no cause of action arises unless the bill is again dishonoured at maturity;
the holder in the meantime is only entitled to demand security from the drawer and indorsers. In
England a sharp distinction is drawn between current and overdue bills. In France no such
distinction is drawn. In England no protest is required in the case of the dishonour of an inland
bill, notice of dishonour being sufficient. In France every dishonoured bill must be protested.
Opinions may differ whether the English or the French system is better calculated to serve sound
commerce and promote a healthy commercial morality. But an argument in favour of the English
system may be derived from the fact that as the various continental codes are from time to time
revised and re-enacted, they tend to depart from the French model and to approximate to the
English rule. The effect upon English law of its codification has yet to be proved. A common
objection to codification in England is that it deprives the law of its elastic character. But when
principles are once settled common law has very little elasticity. On the other hand no code is
final. Modern parliaments legislate very freely, and it is a much simpler task to alter statute law
than to alter common law. Moreover, legislation is cheaper than litigation. One consequence of
the codification of the English law relating to bills is clear gain. Nearly all the British colonies
have adopted the act, and where countries are so closely connected as England and her colonies,
it is an obvious advantage that their mercantile transactions should be governed by one and the
same law expressed in the same words.

The ordinary text-books on the law of bills of exchange are constantly re-edited and brought up
to date. The following among others may be consulted:—Byles, Bills of Exchange; Chalmers,
Bills of Exchange; Daniel, Law of Negotiable Instruments (United States); Nouguier, Des lettres
de change et des effets de commerce (France); Thorburn, Bills of Exchange Act 1882 (Scotland);
Story, Bills of Exchange (United States); Hodgins, Bills of Exchange Act 1890 (Canada). (M. D.
CH.)

1. ↑ This is also the definition given in the United States, by § 126 of the general act relating
to negotiable instruments, prepared by the conference of state commissioners on uniform
legislation, and it has been adopted in the leading states.

←Billiton Return to the top of the page. Bill of Rights→

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title=1911_Encyclopædia_Britannica/Bill_of_Exchange&oldid=2847936"
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AIB Tradefinance - Bill of Exchange - Online Tue, 15 May 2012

You are Here: Home > Bill of Exchange

Home Bills of Exchange

Applic
ation
Forms The function of the Bill of Exchange in International Trade:
Bill of
Excha The Bill of Exchange performs many functions in international trade including:
nge
Case
Study  Facilitates the granting of trade credit in a legal format by permitting payments on agreed
Conta future dates.
ct us  Provides formal evidence of the demand for payment from a seller to a buyer.
FAQ's  Provides the seller with access to finance by permitting them to transfer their debts to a
Fee bank or other financier by merely endorsing the Bill of Exchange to that bank or financier.
Sched  Permits the banker or financier to retain a valid legal claim on both the buyer and the
ule seller. In certain circumstances a bank or financier may have a stronger legal claim under
Glossa a Bill than the party that sold them the debt.
ry  Permits a seller to obtain greater security over the payment by enabling a bank to
Incote guarantee a drawee's acceptance (guarantee to pay on the due date) by signing or
rms endorsing the Bill. (See Guaranteed Bills of Exchange below)
Produ
 Allows a seller protect their access to the legal system in the event of problems, while
cts &
Servic
providing easier access to that legal system.
es
Useful How the Bill of Exchange is used in international trade:
Links
Site A Bill of Exchange can either be payable immediately or at some future date.
Map
Trade
with  If a Bill is payable immediately, it is usually issued payable at sight. The term "at sight"
Easter means that a buyer should pay once they have sighted the Bill, that is once the demand for
n payment has been made.
Europ  If a Bill is payable at some future date, it must facilitate the calculation of the actual due
e date. For example Bills of Exchange may be drawn payable at 60 days sight, at 60 days
Useful from Bill of Lading Date etc.
Tools
Privac
y
Banks should be used as agents for the collection of the Bill. Visit our section on Documentary
State Collections in the Products and Services or Product Diagrams area of this website for further
 ment
Terms details.
and
Condit
ions Guaranteed Bills of Exchange:

To provide greater payment security a seller may look to have a Bill of Exchange guaranteed by a
buyer's bank. A guaranteed Bill of Exchange is one drawn on and accepted by the buyer and to
which, the buyer's bank has added its guarantee that the Bill will be paid at maturity. The security
to a seller comes from a bank giving an undertaking to effect payment on a certain date regardless
of the financial standing of a buyer on that date.

· 1. Definitions of a Bill of Exchange

· 2. Legislation for Bills of Exchange
· 4. Financing options with Bills of Exchange
· 5. Advantages of Bills of Exchange
· 6. Go to Bill of Exchange Online Now

©Copyright Allied Irish Banks p.l.c. 2000

AIB Trade Finance Services is a part of Allied Irish Banks p.l.c.
Registered in Ireland: Registered Number is 024173
Allied Irish Banks p.l.c. is regulated by the Central Bank of Ireland
Registered Office:
Bankcentre
Ballsbridge
Dublin 4
Ireland

AIB Tradefinance - Bill of Exchange - Online Tue, 15 May 2012

You are Here: Home > Bill of Exchange

Hom
e
Bills of Exchange
Appli
catio What is a Bill of Exchange?
n
A Bill of Exchange is one of the key financial instruments in International Trade. The laws regulating
Bills of Exchange in different countries come under two different legal spheres of influence:

 Bills of Exchange Act (1882) - United Kingdom

 Geneva Conventions of 1930

The Bill of Exchange is defined under these systems as follows:

Bill of Exchange Act (1882) - United Kingdom

"A Bill of Exchange is an unconditional order in writing, addressed by one person to another, signed
by the person giving it, requiring the person to whom it is addressed to pay on demand or at a fixed
or determinable future time a sum certain in money to or to the order of a specified person, or to
bearer".

For a list of countries following the 'Bills of Exchange Act' (click here).

Convention providing a uniform law for Bills of Exchange and promissory notes (Geneva,
1930) The League of Nations.

Under Article 1 of the above convention a Bill of Exchange must contain:

1. The term "Bill of Exchange" inserted in the body of the instrument and expressed in the
language employed in drawing up the instrument.
2. An unconditional order to pay a determinate sum of money.
3. The name of the person who is to pay.
4. A statement of the time of payment.
5. A statement of the place where payment is to be made;
6. The name of the person to whom or to whose order payment is to be made;
7. A statement of the date and of the place where the bill is issued;
8. The signature of the person who issues the bill.

For a list of countries following the 'Geneva Conventions' (click here).

The Parties to a Bill of Exchange:

The Drawer - Is the party that issues a Bill of Exchange in an international trade transaction;
usually the seller.

The Drawee - Is the recipient of the Bill of Exchange for payment or acceptance in an international
trade transaction; usually the buyer.

The Payee - Is the party to whom the Bill is payable; usually the seller or their bankers.

· 2. Legislation for Bills of Exchange

· 3. The function of the Bill of Exchange in International Trade
· 4. Financing options with Bills of Exchange
· 5. Advantages of Bills of Exchange
Form
s
· 6. Go to Bill of Exchange Online Now
Bill
of
Exch
ange
Case
Stud
y
Cont
act
us
FAQ's
Fee
Sche
dule
Gloss
ary
Incot
erms
Prod
ucts
&
Servi
ces
Usef
ul
Links
Site
Map
Trad
e
with
Easte
rn
Euro
pe
Usef
ul
Tools
Priva
cy
State
ment
Term
s and
Condi
tions
©Copyright Allied Irish Banks p.l.c. 2000
AIB Trade Finance Services is a part of Allied Irish Banks p.l.c.
Registered in Ireland: Registered Number is 024173
Allied Irish Banks p.l.c. is regulated by the Central Bank of Ireland
Registered Office:
Bankcentre

Tue, 15 May
AIB Tradefinance - Bill of Exchange - Online 2012

You are Here: Home > Bill of Exchange

Hom
e
Bills of Exchange
Appli
catio Financing Options with Bills of Exchange
n
Form
s
The ability to negotiate or discount Bills of Exchange can be an extremely important source of
finance in international trade. The Bill of Exchange can provide easier access to financing
Bill
of because it enables the financing bank to retain a claim on all parties to the Bill. In addition
Exch parties that finance Bills of Exchange can, in certain circumstances, obtain stronger rights
ange than the party transferring the Bill to them. Bill discounting may provide access to finance
Case rates lower than the overdraft or loan rate the seller could normally obtain.
Stud
y Negotiation Facilities:
Cont
act
us The negotiation of a Bill is the transfer of the rights under a Bill from one party to another for
FAQ's value. Some banks will negotiate Bills for a customer by purchasing Bills from them for value.
Fee
For example, the bank will advance 75% of the face value of the Bill and upon receipt of the
Sche proceeds will clear the advance together with any accrued interest on the advance.
dule Negotiation facilities can be used to finance Bills payable at sight or Bills payable at a future
Gloss date even before they have been accepted. Negotiation facilities are normally granted with
ary full recourse to the seller.
Incot
erms Bills Discounting with recourse:
Prod
ucts
& Discounting of a Bill of Exchange can only occur once the Bill has a definite maturity date in
Servi the future and the buyer has accepted it. Discounting differs from negotiation in that the bank
ces will calculate the net present value of the face value of the Bill utilising a cost of funds interest
Usef rate and a margin. The net amount so calculated is then advanced to the seller. Upon receipt
ul of the proceeds from the buyer at maturity, the bank will clear its Bills discounted account.
Links This finance is provided with recourse to the seller by the bank.
Site
Map
Bills Discounting without recourse:
Trad
e
with Similar to with recourse Bills Discounting, except that the financing bank will waive its rights
Easte of recourse to the seller. This can occur when the Bill is guaranteed by another bank, or
rn where the buyer has a very strong credit standing or rating.
Euro
pe
N.B. All financing facilities will be subject to credit approval by the financing bank.
Usef
ul
Tools
· 1. Definitions of a Bill of Exchange
Priva
cy · 2. Legislation for Bills of Exchange
State
ment
· 3. The function of the Bill of Exchange in International Trade
Term
s and · 5. Advantages of Bills of Exchange
Condi
tions
· 6. Go to Bill of Exchange Online Now

©Copyright Allied Irish Banks p.l.c. 2000

AIB Trade Finance Services is a part of Allied Irish Banks p.l.c.
Registered in Ireland: Registered Number is 024173
Allied Irish Banks p.l.c. is regulated by the Central Bank of Ireland
Registered Office:
Bankcentre
Ballsbridge
Dublin 4
Ireland

Tue, 15 May
AIB Tradefinance - Bill of Exchange - Online 2012

You are Here: Home > Bill of Exchange

Home Bills of Exchange

Appli
catio
n Advantages of Bills of Exchange:
Form
s
Companies have used Bills of Exchange for hundreds of years. Their longevity is due
Bill of
to the advantages they provide in a trading transaction.
Excha
nge
Case  A Bill of Exchange facilitates the granting of trade credit to a buyer.
Study  A Bill of Exchange provides a legal acknowledgement that a debt exists.
Conta  It can provide the seller with access to financing.
ct us  It can provide easy access to the legal systems in the event of non-payment.
FAQ's
Fee Legal Protection afforded by Bills of Exchange:
Sche
dule
Gloss An advantage for a seller in using a Bill of Exchange is the capability of the Bill of
ary Exchange to provide formal documentary evidence that the demand for payment or
Incot acceptance has been made to the buyer. In addition, it may be possible to sue the
erms buyer for non-payment based solely on this documentary evidence. A seller can protect
Produ their interests by requesting that a Bill of Exchange be noted or protested for non-
cts & payment or non-acceptance. When a Bill is not paid or accepted it is said to have been
Servi "dishonoured".
ces
Usefu
Noting:
l
Links
Site A Bill is noted in order to obtain official evidence that it has been dishonoured. A Notary
Map Public re-presents the Bill to the drawee for acceptance or payment and minutes on the
Trade Bill the reason given for dishonour. Noting is often followed by a formal protest.
with
Easte
Protesting:
rn
Europ
e Protesting is a more formal process than noting and results in the production by the
Usefu Notary Public of a formal deed of protest bearing a notary's seal. This document again
l provides formal evidence of the presentation of the Bill to the drawee and the reason
Tools for dishonour. The protest is accepted by most courts in the world as evidence that a
Priva Bill has been dishonoured.
cy
State
ment · 1. Definitions of a Bill of Exchange
Term
 s and
Condi
· 2. Legislation for Bills of Exchange
tions
· 3. The function of the Bill of Exchange in International Trade
· 4. Financing options with Bills of Exchange
· 6. Go to Bill of Exchange Online Now

©Copyright Allied Irish Banks p.l.c. 2000

AIB Trade Finance Services is a part of Allied Irish Banks p.l.c.
Registered in Ireland: Registered Number is 024173
Allied Irish Banks p.l.c. is regulated by the Central Bank of Ireland
Registered Office:
Bankcentre
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Dublin 4
Ireland

AIB Tradefinance - Bill of Exchange - Online Tue, 15 May 2012

You are Here: Home > Bill of Exchange

Home Bills of Exchange

Applic
ation
Forms Legislation for Bills of Exchange:
Bill of
Excha Most countries have adopted codified laws on Bills of Exchange. The legal codes in such
nge countries have created laws that follow the rules agreed at the Geneva Conventions in order
Case to standardise the control of Bills of Exchange. The United Kingdom Bills of Exchange Act
Study
1882 is the basis for rules governing Bills of Exchange in Ireland, U.K. and Commonwealth
Conta
countries that were part of the British Empire. These countries follow a common law
ct us
framework to create and modify statutes.
FAQ's
Fee
Sched In relation to the most fundamental aspects of a Bill of Exchange the two sets of rules are
 ule
Gloss similar in that both identify the following:
ary
Incot
erms  A Bill of Exchange is an unconditional order to pay a specific amount of money.
Produ  The Bill of Exchange must state a particular time of payment.
cts &  The Bill of Exchange must contain the name of the person who is to pay.
Servic
es There are, however, certain differences between the Bills of Exchange Act (1882) and the
Useful Geneva Convention. In particular the United Kingdom Act sets out fewer formal requirements
Links
for example:
Site
Map
Trade  The term "Bill of Exchange", which is an integral part of the physical Bill according to
with the Geneva Convention, need not be written on the Bill.
Easter  Bills can be made payable to 'bearer'.
n  The place and date of issue are also not obligatory parts of the Bill.
Europ
e
Useful The United Nations Commission on International Trade Law (UNCITRAL) is at present trying
Tools to harmonise laws through the "United Nations Convention on International Bills of Exchange
Privac and International Promissory notes".
y
State
ment · 1. Definitions of a Bill of Exchange
Terms
and ·
3. The function of the Bill of Exchange in International Trade
Condi
tions · 4. Financing options with Bills of Exchange

· 5. Advantages of Bills of Exchange

· 6. Go to Bill of Exchange Online Now

©Copyright Allied Irish Banks p.l.c. 2000

AIB Trade Finance Services is a part of Allied Irish Banks p.l.c.
Registered in Ireland: Registered Number is 024173
Allied Irish Banks p.l.c. is regulated by the Central Bank of Ireland
Registered Office:
Bankcentre
Ballsbridge
Dublin 4
 Ireland

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Forfaiting
From Wikipedia, the free encyclopedia
Jump to: navigation, search
This article needs additional citations for verification. Please help improve this
article by adding citations to reliable sources. Unsourced material may be challenged
and removed. (November 2009)

In trade finance, forfaiting is a financial transaction involving the purchase of receivables from
exporters by a forfaiter. The forfaiter takes on all the risks associated with the receivables but
earns a margin.[citation needed][1] The forfaiting is a transaction involving the sale of one of the firm's
transactions. [1] Factoring is also a financial transaction involving the purchase of financial assets,
but Factoring involves the sale of any portion of a firm's receivables.[2]

Contents
[hide]

 1 Characteristics
 2 Pricing
 3 Professional association
 4 External links
 5 References

[edit] Characteristics
The characteristics of a forfaiting transaction are:

 Credit is extended to the exporter for a period ranging between 180 days to seven years.
 Minimum bill size is normally $250,000, although $500,000 is preferred.
 The payment is normally receivable in any major convertible currency.
 A letter of credit or a guarantee is made by a bank, usually in the importer's country.
 The contract can be for either goods or services.

At its simplest, the receivables should be evidenced by a promissory note, a bill of exchange, a
deferred-payment letter of credit, or a letter of guarantee.
[edit] Pricing
Three elements relate to the pricing of a forfaiting transaction:[1]

 Discount rate, the interest element, usually quoted as a margin over LIBOR.
 Days of grace, added to the actual number of days until maturity for the purpose of
covering the number of days normally experienced in the transfer of payment, applicable
to the country of risk.
 Commitment fee, applied from the date the forfaiter is committed to undertake the
financing, until the date of discounting.

The benefits to the exporter from forfaiting include eliminating political, transfer, and
commercial risks and improving cash flows. The benefit to the forfaiter is the extra margin on
the loan to the exporter.

[edit] Professional association

The International Forfaiting Association was founded in 1999 as the worldwide trade association
for the forfaiting industry with cash contribution of the VEFI (VEFI, founded in 1978 and
chaired since 2003 by Mr Sal Chiappinelli is the oldest forfaiting association of the world). Its
purpose is to develop business relationships and assist other forfaiting-related organizations.

[edit] External links

 International Forfaiting Association (IFA) home page
 Association of Forfaiters in Switzerland (VEFI) home page

[edit] References
1. ^ a b c Where are the independent and verifiable cites for this? Links?
2. ^ J. Downes, J.E. Goodman, "Dictionary of Finance & Investment Terms", Baron's
Financial Guides, 2003; and J.G.Siegel, N.Dauber & J.K.Shim, "The Vest Pocket CPA", Wiley,
2005.

Retrieved from "http://en.wikipedia.org/w/index.php?title=Forfaiting&oldid=492502128"

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Letter of credit
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After a contract is concluded between buyer and seller, buyer's bank supplies a letter of credit to
seller

Seller consigns the goods to a carrier in exchange for a bill of lading.

Seller provides bill of lading to bank in exchange for payment. Seller's bank exchanges bill of
lading for payment from buyer's bank. Buyer's bank exchanges bill of lading for payment from
the buyer.
Buyer provides bill of lading to carrier and takes delivery of goods.

A letter of credit is a document that a financial institution or similar party issues to a seller of
goods or services which provides that the issuer will pay the seller for goods or services the
seller delivers to a third-party buyer.[1] The issuer then seeks reimbursement from the buyer or
from the buyer's bank. The document serves essentially as a guarantee to the seller that it will be
paid by the issuer of the letter of credit regardless of whether the buyer ultimately fails to pay. In
this way, the risk that the buyer will fail to pay is transferred from the seller to the letter of
credit's issuer.

Letters of credit are used primarily in international trade for large transactions between a supplier
in one country and a customer in another. In such cases, the International Chamber of Commerce
Uniform Customs and Practice for Documentary Credits applies (UCP 600 being the latest
version).[2] They are also used in the land development process to ensure that approved public
facilities (streets, sidewalks, storm water ponds, etc.) will be built. The parties to a letter of credit
are the supplier, usually called the beneficiary, 'the issuing bank,' of whom the buyer is a client,
and sometimes an advising bank, of whom the beneficiary is a client. Almost all letters of credit
are irrevocable, i.e., cannot be amended or canceled without the consent of the beneficiary,
issuing bank, and confirming bank, if any. In executing a transaction, letters of credit incorporate
functions common to giros and Traveler's cheques.

Contents
[hide]

 1 Terminology
o 1.1 Origin of the term
o 1.2 Types and related terms
 2 Documents that can be presented for payment
 3 Legal principles governing documentary credits
 4 The price of letters of credit
 5 Legal basis
 6 International Trade Payment methods
  7 Risk situations in letter-of-credit transactions
 8 See also
 9 References
 10 External links

[edit] Terminology
[edit] Origin of the term

The English name “letter of credit” derives from the French word “accréditation,” a power to do
something, which in turn derives from the Latin “accreditivus,” meaning trust. This applies to
any defense relating to the underlying contract of sale. This is as long as the seller performs their
duties to an extent that meets the requirements contained in the letter of credit.[citation needed]

[edit] Types and related terms

Letters of credit (LC) deal in documents, not goods. An LC can be irrevocable or revocable. An
irrevocable LC cannot be changed unless both buyer and seller agree. With a revocable LC,
changes can be made without the consent of the beneficiary.

A sight LC means that payment is made immediately to the beneficiary/seller/exporter upon

presentation of the correct documents in the required time frame. A time or date LC will specify
when payment will be made at a future date and upon presentation of the required documents.
[citation needed]

Negotiation means the giving of value for draft(s) and/or document(s) by the bank authorized to
negotiate, viz the nominated bank. Mere examination of the documents and forwarding the same
to the letter of credit issuing bank for reimbursement, without giving of value / agreed to give,
does not constitute a negotiation.[clarification needed][citation needed]

[edit] Documents that can be presented for payment

To receive payment, an exporter or shipper must present the documents required by the letter of
credit. Typically, the payee presents a document proving the goods were sent instead of showing
the actual goods. The Original Bill of Lading (OBL) is normally the document accepted by banks
as proof that goods have been shipped. However, the list and form of documents is open to
imagination and negotiation and might contain requirements to present documents issued by a
neutral third party evidencing the quality of the goods shipped, or their place of origin or place.
Typical types of documents in such contracts might include:[citation needed]

 Financial Documents

Bill of Exchange, Co-accepted Draft

  Commercial Documents

Invoice, Packing list

 Shipping Documents

Transport Document, Insurance Certificate, Commercial, Official or Legal Documents

 Official Documents

License, Embassy legalization, Origin Certificate, Inspection Certificate, Phytosanitary

certificate

 Transport Documents

Bill of Lading (ocean or multi-modal or Charter party), Airway bill, Lorry/truck receipt,
railway receipt, CMC Other than Mate Receipt, Forwarder Cargo Receipt, Deliver
Challan...etc

 Insurance documents

Insurance policy, or Certificate but not a cover note.

[edit] Legal principles governing documentary credits

One of the primary peculiarities of the documentary credit is that the payment obligation is
abstract and independent from the underlying contract of sale or any other contract in the
transaction. Thus the bank’s obligation is defined by the terms of the credit alone, and the sale
contract is irrelevant. The defensive of the buyer arising out of the sale contract do not concern
the bank and in no way affect its liability.[3] Article 4(a) UCP states this principle clearly. Article
5 the UCP further states that banks deal with documents only, they are not concerned with the
goods (facts). Accordingly, if the documents tendered by the beneficiary, or his or her agent,
appear to be in order, then in general the bank is obliged to pay without further qualifications.

Policies behind adopting the abstraction principle are purely commercial, and reflect a party’s
expectations: first, if the responsibility for the validity of documents was thrown onto banks, they
would be burdened with investigating the underlying facts of each transaction, and would thus be
less inclined to issue documentary credits as the transaction would involve great risk and
inconvenience. Second, documents required under the credit could in certain circumstances be
different from those required under the sale transaction. This would place banks in a dilemma in
deciding which terms to follow if required to look behind the credit agreement. Third, the fact
that the basic function of the credit is to provide a seller with the certainty of payment for
documentary duties suggests that banks should honor their obligation notwithstanding allegations
of misfeasance by the buyer.[4] Finally, courts have emphasize that buyers always have a remedy
for an action upon the contract of sale, and that it would be a calamity for the business world if,
for every breach of contract between the seller and buyer, a bank were required to investigate
said breach.

The “principle of strict compliance” also aims to make the bank’s duty of effecting payment
against documents easy, efficient and quick. Hence, if the documents tendered under the credit
deviate from the language of the credit the bank is entitled to withhold payment even if the
deviation is purely terminological.[5] The general legal maxim de minimis non curat lex has no
place in the field of documentary credits.

Letter of credit also refers to FIATA documents. More strictly, in practice freight forwarders
usual present FIATA documents and the question is does FIATA documents can use like a
document for activating letter of credit. In theory, the question is not very clear, because of the
weakness in UCP 600.

[edit] The price of letters of credit

All the charges for issuance of Letter of Credit, negotiation of documents, reimbursements and
other charges like courier are to the account of applicant or as per the terms and conditions of the
Letter of credit. If the letter of credit is silent on charges, then they are to the account of the
Applicant. The description of charges and who would be bearing them would be indicated in the
field 71B in the Letter of Credit.[citation needed]

[edit] Legal basis

Although documentary credits are enforceable once communicated to the beneficiary, it is
difficult to show any consideration given by the beneficiary to the banker prior to the tender of
documents. In such transactions the undertaking by the beneficiary to deliver the goods to the
applicant is not sufficient consideration for the bank’s promise because the contract of sale is
made before the issuance of the credit, thus consideration in these circumstances is past. In
addition, the performance of an existing duty under a contract cannot be a valid consideration for
a new promise made by the bank: the delivery of the goods is consideration for enforcing the
underlying contract of sale and cannot be used, as it were, a second time to establish the
enforceability of the bank-beneficiary relation.[citation needed]

Legal writers have failed to satisfactorily reconcile the bank’s undertaking with any contractual
analysis. The theories include: the implied promise, assignment theory, the novation theory,
reliance theory, agency theories, estoppels and trust theories, anticipatory theory, and the
guarantee theory.[6] Davis, Treitel, Goode, Finkelstein and Ellinger have all accepted the view
that documentary credits should be analyzed outside the legal framework of contractual
principles, which require the presence of consideration. Accordingly, whether the documentary
credit is referred to as a promise, an undertaking, a chose in action, an engagement or a contract,
it is acceptable in English jurisprudence to treat it as contractual in nature, despite the fact that it
possesses distinctive features, which make it sui generis.
A few countries including the United States (see Article 5 of the Uniform Commercial Code)
have created statutes in relation to the operation of letters of credit. These statutes are designed to
work with the rules of practice including the UCP and the ISP98. These rules of practice are
incorporated into the transaction by agreement of the parties. The latest version of the UCP is the
UCP600 effective July 1, 2007.[7] The previous revision was the UCP500 and became effective
on 1 January 1994. Since the UCP are not laws, parties have to include them into their
arrangements as normal contractual provisions. For more information on legal issues surrounding
letters of credit, the Journal of International Commercial Law at George Mason University's
School of Law published Volume 1, Issue 1 exclusively on the topic. .

[edit] International Trade Payment methods

International Trade Payment method can be done in the following ways.

 Advance payment (most secure for seller)

Where the buyer parts with money first and waits for the seller to forward the goods

 Documentary Credit (more secure for seller as well as buyer)

Subject to ICC's UCP 600, where the bank gives an undertaking (on behalf of buyer and at the
request of applicant) to pay the shipper (beneficiary) the value of the goods shipped if certain
documents are submitted and if the stipulated terms and conditions are strictly complied with.

Here the buyer can be confident that the goods he is expecting only will be received since it will
be evidenced in the form of certain documents called for meeting the specified terms and
conditions while the supplier can be confident that if he meets the stipulations his payment for
the shipment is guaranteed by bank, who is independent of the parties to the contract.

 Documentary collection (more secure for buyer and to a certain extent to seller)

Also called "Cash Against Documents". Subject to ICC's URC 525, sight and usance, for
delivery of shipping documents against payment or acceptances of draft, where shipment
happens first, then the title documents are sent to the [collecting bank] buyer's bank by seller's
bank [remitting bank], for delivering documents against collection of payment/acceptance

 Direct payment (most secure for buyer)

Where the supplier ships the goods and waits for the buyer to remit the bill proceeds, on open
account terms.

[edit] Risk situations in letter-of-credit transactions

Fraud Risks
  The payment will be obtained for nonexistent or worthless merchandise against
presentation by the beneficiary of forged or falsified documents.
 Credit itself may be forged.

Sovereign and Regulatory Risks

 Performance of the Documentary Credit may be prevented by government action outside

the control of the parties.

Legal Risks

 Possibility that performance of a Documentary Credit may be disturbed by legal action

relating directly to the parties and their rights and obligations under the Documentary
Credit

Force Majeure and Frustration of Contract

 Performance of a contract – including an obligation under a Documentary Credit

relationship – is prevented by external factors such as natural disasters or armed conflicts

Risks to the Applicant

 Non-delivery of Goods
 Short Shipment
 Inferior Quality
 Early /Late Shipment
 Damaged in transit
 Foreign exchange
 Failure of Bank viz Issuing bank / Collecting Bank

Risks to the Issuing Bank

 Insolvency of the Applicant

 Fraud Risk, Sovereign and Regulatory Risk and Legal Risks

Risks to the Reimbursing Bank

 no obligation to reimburse the Claiming Bank unless it has issued a reimbursement

undertaking.

Risks to the Beneficiary

 Failure to Comply with Credit Conditions

 Failure of, or Delays in Payment from, the Issuing Bank
 Credit Issued by Party other than Bank
Risks to the Advising Bank

 The Advising Bank’s only obligation – if it accepts the Issuing Bank’s instructions – is to
check the apparent authenticity of the Credit and advising it to the Beneficiary

Risks to the Nominated Bank

 Nominated Bank has made a payment to the Beneficiary against documents that comply
with the terms and conditions of the Credit and is unable to obtain reimbursement from
the Issuing Bank

Risks to the Confirming Bank

 If Confirming Bank’s main risk is that, once having paid the Beneficiary, it may not be
able to obtain reimbursement from the Issuing Bank because of insolvency of the Issuing
Bank or refusal of the Issuing Bank to reimburse because of a dispute as to whether or
not payment should have been made under the Credit

Other Risks in International Trade

 A Credit risk risk from change in the credit of an opposing business.

 An Exchange risk is a risk from a change in the foreign exchange rate.
 A Force majeure risk is 1. a risk in trade incapability caused by a change in a country's
policy, and 2. a risk caused by a natural disaster.
 Other risks are mainly risks caused by a difference in law, language or culture. In these
cases, the cargo might be found late because of a dispute in import and export dealings.

[edit] See also

 Uniform Customs and Practice for Documentary Credits
 Buyer's Credit

[edit] References
1. ^ Letter of Credit explained What is a letter of credit?. LoanUniverse.com.
2. ^ Understanding and Using Letters of Credit, Part I. Credit Research Foundation.
3. ^ See Ficom S.A. v. Socialized Cadex [1980] 2 Lloyd’s Rep. 118.
4. ^ United City Merchants (Investments) Ltd v Royal Bank of Canada (The American Accord)
[1983] 1.A.C.168 at 183
5. ^ J. H. Rayner & Co., Ltd., and the Oilseeds Trading Company, Ltd. v.Ham bros Bank Limited
[1942] 73 Ll. L. Rep. 32
6. ^ For extensive analysis See Finkelstein, H. Legal Aspects of Commercial Letters of Credit, pp.
275-295
7. ^ Dominique Doise,“The 2007 Revision of the Uniform Customs and Practice for Documentary
Credits (UCP 600)”[1]
[edit] External links
 Anatomy of a Letter of Credit, showing an actual negotiated letter of credit
 Letters of Credit and How They Work
 Credit Research Foundation - Understanding & Using Letters of Credit - Part 1
 Credit Research Foundation - Understanding & Using Letters of Credit - Part 2

Retrieved from "http://en.wikipedia.org/w/index.php?title=Letter_of_credit&oldid=488435010"

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 This page was last modified on 21 April 2012 at 03:38.

 Text is available under the Creative Commons Attribution-ShareAlike License;
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