Foreign Exchange Management

Functions of Foreign Exchange Market

1. Transfer Function:
It is the primary function of the foreign exchange market. It facilitates the transfer
of purchasing power in terms of foreign exchange between the countries that are
involved in the transactions. Purchasing power (or buying power) is the number of
products and services that one unit of currency can purchase. The function is
performed through credit instruments like bills of exchange, bank drafts, and
telephonic transfers. Therefore, it involves sending money or foreign currencies
from one nation to another to settle their accounts.
2. Credit Function:
Just like domestic trade, foreign trade also depends on credit. The Credit Function
of the Foreign Exchange Market implies the provision of credit in terms of foreign
exchange for the export and import of goods and services. For this, bills of
exchange are generally used for making payments internationally. The duration of
Bills of Exchange is usually three months. The main purpose of credit is to help the
importer in taking possession of goods, sell them and obtain the money to pay the
bills.
3. Hedging Function:
It implies to protection against risk related to fluctuations in the foreign exchange
rate. Under this system, buyers and sellers agree to sell and buy goods on a future
date at some commonly agreed rate of exchange. The basic purpose behind
Hedging Function is to avoid losses that might be caused because of variations in
the exchange rate in the future.
https://www.geeksforgeeks.org/foreign-exchange-market-functions-and-types/

10 Factors that influence currency exchange rates:

1. Inflation
Inflation is a general rise in prices in an economy, i.e., goods, and services and is
usually expressed in percentages.
If, for example, inflation was lower in the UK, the purchasing power of the Pound
Sterling would increase relative to other currencies. UK exports become more
competitive and the demand to purchase Pound Sterling for UK goods will
increase.
2. Interest rates
There is also a strong correlation between inflation, interest rates and exchange
rates.
Governments and Central Banks have the authority to influence exchange rates by
increasing interest rates. An example of this is “Hot money”: the higher the interest
rates the more attractive the currency offer is to foreign investors.
This involves investors rapidly and frequently moving money from a currency with
lower interest rates to a country with higher interest rates, giving a quick return on
investment.
3. Government/Public debt
A country’s debt rating is also a factor that influences its currency exchange rate.
Public sector projects sometimes require large-scale deficit financing which boosts
the domestic economy.
However, foreign investors are less likely to invest in countries with large public
deficits and government debt.
Fear of a debt default can result in the selling of bonds denominated in that
currency by investors, resulting in a fall in the value of the exchange rate.
Governments may also need to print money to pay parts of a large debt, resulting in
inflation.
4. Political stability
The strength of a currency can also be influenced by the political stability of a
particular country.
Foreign investors are more attracted to invest in countries displaying a lower
propensity for political turmoil. This injection of foreign investment leads to an
appreciation of the domestic currency.
Conversely, unpredictable events leading to unstable conditions in a country mean
less foreign investment naturally leading to a depreciation in the domestic
currency.
5. Economic recession
In theory, when a country enters a recession there is normally a depreciation of its
currency. Why so?
Firstly, it is commonplace for interest rates to fall in a recession and when this
happens, we see a flow of money out of the country to countries with higher
interest rates.
If for example, Canada entered a recession and money started to flow out of the
country, its people would sell Canadian dollars to buy other currencies resulting in
a fall in the value of CAD (Canadian dollar).
It must be noted that economic and political events in other countries will also
influence how a domestic currency moves in times of recession.
For example, in a global recession, the United States may still be seen as a haven
for investors (even though it may experience high inflation and low interest rates)
keeping its currency stable or even stronger than other currencies.
6. Terms of Trade
The Terms of Trade (ToT) or Balance of Trade as it is sometimes known, is the
difference between the monetary value of a nation’s exports and imports over a
certain time period.
The terms of trade will improve if the price of a given country’s exports rises by a
greater rate than that of its imports.
A greater demand for a country’s exports means an improvement in terms of trade
resulting in rising revenues and, consequently, an increased demand for that
country’s currency. This will naturally increase the value of that currency.
7. Current account deficits
The current account deficit is closely related to the terms or balance of trade.
The current account measures imports and exports of goods and services but also
payments to foreign holders of a country’s investments, payments received from
investments abroad, and transfers such as foreign aid and remittances.
If for example, Britain, as a regular trading partner with Canada had a higher
current account deficit this could weaken the pound relative to the Canadian dollar.
 Countries therefore with lower current account deficits will tend to have stronger
currencies than those with higher deficits.
8. Confidence and speculation
Political events or changes in commodity prices may cause a currency to fall in
value. If speculators believe the Euro will fall, they will sell now for a currency
they feel will rise in value. For this reason, sentiments in the financial markets can
heavily influence foreign exchange rates.
If the markets are alerted to the possibility of an interest rate increase in the
Eurozone for example, we are more likely to see a rise in the valuation of the Euro
as a result.
If a US speculator expects the euro to appreciate over the next 5 months, he will
contract to buy euros in 5 months at a fixed exchange rate. This is known as a
forward contract and this mitigates any risk and losses caused by exchange rate
volatility.
9. Government intervention
Governments and Central Banks have the monetary authority to intervene to
stabilize a currency by formulating trade policies, printing more money, or
increasing and decreasing interest rates.
China, for example, is reluctant to allow its currency to appreciate because it will
negatively impact its exports.
The Chinese government aims to boost its exports and attract foreign investment
by keeping the yuan artificially low. As an export dependent economy, China does
so to compete with neighboring countries like Japan and South Korea.
Given China’s large trade surplus, its central bank, the Peoples Bank of China
(PBOC) absorbs large inflows of foreign capital. It purchases foreign currency
from exporters and then issues that currency in local yuan currency.
10. The stock markets
Both the stock market and foreign exchange are the most financially traded
markets on the globe. To help with price predictions, traders often look for
correlations between both markets.
 The mood of investors is buoyed when a domestic stock market rises as it is an
indicator that the country’s economy is doing well.
As a result, there is increased interest from foreign investors and the demand for
local domestic currency also increases.
When the stock market is underperforming, a lack of confidence means investors
will take their funds back to their own currencies.
1. What are the inputs are required to extra input to mnc than domestic
fund?
Multinational corporations (MNCs) are firms that operate in more than one
country. They face more complex and challenging financial decisions than
domestic firms, as they have to deal with different currencies, markets,
regulations, and risks. Therefore, they require some extra inputs for their
capital budgeting and financing decisions, such as12:
 Exchange rates: MNCs have to consider the fluctuations and uncertainties
of exchange rates, as they affect the value and risk of their foreign cash
flows and assets. They have to use appropriate methods to forecast and
hedge against exchange rate movements, such as forward contracts, options,
or swaps12.
 Inflation rates: MNCs have to account for the differences and changes in
inflation rates across countries, as they affect the purchasing power and
competitiveness of their products and services. They have to use appropriate
methods to adjust and compare the nominal cash flows and interest rates,
such as purchasing power parity or Fisher effect12.
 Tax rates: MNCs have to comply with the tax laws and regulations of
different countries, as they affect the after-tax cash flows and returns of their
investments. They have to use appropriate methods to calculate and
minimize their tax liabilities, such as transfer pricing or tax treaties 12.
 Political risks: MNCs have to assess the political stability and security of
different countries, as they affect the likelihood and severity of adverse
events that may disrupt their operations and cash flows. They have to use
appropriate methods to measure and mitigate their political risks, such as
country risk analysis or political risk insurance.
 Cultural differences: MNCs have to respect and adapt to the cultural norms
and values of different countries, as they affect the preferences and
behaviors of their customers, suppliers, employees, and regulators. They
 have to use appropriate methods to communicate and negotiate with their
stakeholders, such as cross-cultural training or joint ventures.

2.what factors could be the possible reason to make difference between

parent and subsidiary?
There are many factors that could cause differences between a parent
company and its subsidiary, such as:
 Legal and regulatory environment: The parent company and the
subsidiary may operate in different countries or jurisdictions, which have
different laws and regulations that affect their business activities, such as
taxation, accounting, labor, environmental, and trade policies. These
differences may create challenges or opportunities for the parent company
and the subsidiary, and may require them to adopt different strategies and
practices to comply with the local rules and standards.
 Market and competitive conditions: The parent company and the
subsidiary may face different levels of demand, supply, competition, and
innovation in their respective markets, which have different characteristics,
such as size, growth, structure, and profitability. These differences may
influence the pricing, production, distribution, and marketing decisions of
the parent company and the subsidiary, and may require them to adapt to the
changing customer preferences and behaviors.
 Organizational and cultural factors: The parent company and the
subsidiary may have different organizational structures, cultures, values, and
goals, which affect their internal processes, communication, coordination,
and performance. These differences may create conflicts or synergies
between the parent company and the subsidiary, and may require them to
balance the trade-offs between centralization and decentralization,
standardization and customization, and integration and differentiation.
3. Why, we do not consider remitted funds in domestic business?
Remitted funds are funds that are sent from one party to another, usually across
different countries or jurisdictions. They are often used by foreign workers to send
money to their families or home countries.
In domestic business, remitted funds are not considered as a source of income or
expense, because they do not affect the cash flow or profitability of the
business. They are simply transfers of funds between different accounts or entities,
and do not generate any value added or cost incurred for the business.
For example, if a domestic business receives a remittance from its foreign
subsidiary, it does not record it as revenue or income, because it is not a payment
for goods or services. Similarly, if a domestic business sends a remittance to its
foreign parent company, it does not record it as expense or cost, because it is not a
payment for goods or services. Remittances are treated as changes in the equity or
capital of the business, and are reflected in the balance sheet.
4. Some project is accepted by parents’ company but rejected by subsidiary
company. Why?
There could be several reasons why a project is accepted by the parent company
but rejected by the subsidiary company, such as12:
 The project may have different financial implications for the parent and the
subsidiary, depending on their cost of capital, tax rates, exchange rates, and
inflation rates. The project may be profitable for the parent but not for the
subsidiary, or vice versa.
 The project may have different strategic implications for the parent and the
subsidiary, depending on their market and competitive conditions,
organizational and cultural factors, and political risks. The project may be
aligned with the parent’s goals and vision but not with the subsidiaries, or
vice versa.
 The project may have different acceptance criteria for the parent and the
subsidiary, depending on their legal and regulatory environment, customer
satisfaction, quality standards, and social responsibility. The project may
meet the parent’s requirements and expectations but not the subsidiaries, or
vice versa.
5. Why should capital budgeting for subsidiary projects be assessed
from the parent’s perspective?
Capital budgeting for subsidiary projects should be assessed from the
parent’s perspective because the parent company is ultimately responsible
for the financing and performance of the subsidiary projects. The parent
company has to consider the impact of the subsidiary projects on its
consolidated cash flows, returns, risks, and value.
 Some of the reasons why the parent’s perspective is important are:
 The parent company may have a different cost of capital than the subsidiary,
depending on their respective capital structures, tax rates, and market
conditions. The parent company should use its own cost of capital to
evaluate the subsidiary projects, as it reflects the opportunity cost of
investing in the projects.
 The parent company may face different exchange rate and inflation rate risks
than the subsidiary, depending on the currencies and countries involved. The
parent company should use the appropriate exchange rate and inflation rate
forecasts to convert the subsidiary cash flows into its own currency, and to
adjust for the purchasing power parity and the Fisher effect.
 The parent company may have different strategic objectives and constraints
than the subsidiary, depending on their respective markets and competitive
advantages. The parent company should align the subsidiary projects with its
overall vision and mission, and ensure that they create synergies and value
for the parent company.
 The parent company may have different tax and regulatory implications than
the subsidiary, depending on the jurisdictions and policies that apply to
them. The parent company should account for the tax and regulatory effects
of the subsidiary projects on its consolidated financial statements, and
optimize its tax and regulatory strategies.
6. What is the limitation of using point estimates of exchange rates in the
capital budgeting analysis?
Using point estimates of exchange rates in the capital budgeting analysis has
the following limitation:
 It leads to a point estimate of a project’s net present value (NPV), which
does not reflect the uncertainty and variability of the future exchange rates.
It is more desirable to have a range of possible outcomes (NPVs) that could
occur under different scenarios of exchange rate movements.
 It ignores the effects of exchange rate risk on the project’s cash flows and
returns, which may affect the feasibility and profitability of the project. It is
more appropriate to adjust the project’s cash flows and discount rate for the
exchange rate risk, using techniques such as sensitivity analysis, scenario
analysis, or simulation.