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A STUDY ON FOREIGN EXCHANGE

AND PARITY THEORY KAILASH . R . S


LEU
STUDENT
INTRODUCTION

 A foreign exchange to arise, either buying or selling has


to be with another country or foreign currency.

 The main players in the foreign exchange market are


large commercial banks, forex brokers, large
commercial and central banks.

 Any drafts, travelers’ cheques, letters of credit and bills


of exchange expressed or drawn in Indian currency
payable in foreign currency;

OBJECTIVES OF THE STUDY

 To determine the exchange rate of a currency.


 To show two types of determination of
exchange rate.
 To explore how FEDAI has categorized
exchange dealers.
 To illustrate the market mechanism and
conventions.
 To study different types of quotes.
 To understand multi-national companies
operations.
 To illustrate the accounting issues in
hyperinflation economies.

LIMITATIONS OF THE STUDY

 The study is limited to the categorization of


FEDAI rules
 The flow effect has been considered.

 The holding effect has not been shown.



FEDAI CATEGORISEATION
 Category A: these are the offices which keep
independent foreign currencies accounts
with overseas correspondent banks in their
names.

 Category B: These are the branches which do


not maintain independent foreign currency
accounts but have the powers to operate the
accounts.

 Category C: The branches which fall in neither


of the above categories a yet handle forex
business.

EXCHANGE RATE QUOTATIONS

 AMERICAN QUOTE
 EUROPEAN QUOTE

 BID AND ASK RATE

 INTERBANK QUOTE VS. MERCHANT QUOTE

 MARKET MECHANISM AND CONVENTIONS

 INVERSE QUOTES

 CROSS RATE

 DISCOUNT AND PREMIUM



BROKEN DATE FORWARD CONTRACT

 It is a kind of forward contract for a maturity


which is not a whole month or for which is a
quote is not readily available.
PURCHASING POWER PARITY
PRINCIPLE

 The basic tenet of this principle is that the


exchange between various currencies
reflects the purchasing power of these
currencies. This is based on the LAW OF ONE
PRICE.
 PxA =S (A/B)* PBX

 Where
 PxAthe price of the commodity ‘x’ in country
A.
 S (A/B) is the spot exchange rate of the two
countries’ currency.
 PBX is the price of commodity x in the country

B.
THE ABSOLUTE FORM OF PPP

 If the law of one price were to hold good for


each and every commodity, then it will
follow:
 PA = S(A/B)*PB

 Where PA and PB are the of the same basket of


goods and services in countries A and B
respectively.
 S (A/B) = PA / PB


REASONS FOR PPP NOT HOLDING GOOD

 Some of the factors which do not hold good


are:
 Constraints on movement of commodities.

 Price index constraints.

 Effect on statistical method employed



INTEREST RATE PARITY

 IRP theory proposes that the cost of money


when the adjusted for the cost foreign
exchange risk, is equal across different
countries. This is so because in the absence
of any transactions costs, taxes, and capital
controls investors and borrowers will tend to
transact in those currencies which provide
attractive prices.

 INVESTOR’S DECISION
 The currencies when converted from spot rate
to forward rate will give
 1/SF (A/B)*(1+ra ) units of A
 Investors would prefer to invest in securities
denominated in currency A rather than B. If
it is other way around the investors would
prefer to invest in currency B than A.
 (1+ra)>F (A/B)/S (A/B)*(1+rB)


REASONS FOR IRP NOT HOLDING GOOD

 Interest Rate Parity does not hold good


because of the following reasons
 Transaction cost

 Political risk

 Taxes

 Liquidity preferences

 Capital controls

MULTI NATIONAL OPERATIONS

 ACCOUNTING ISSUES
 Choice of exchange rate

 Definition exposure

 Disposition of resulting translation adjustment


 EFFECT OF THE EXCHANGE RATE
CHANGES
 Flow Effect


TRANLATION OF FINANCIAL
STATEMENTS

 Foreign currency translations (e.g., exports,


imports, & loans) which are denominated in
a currency other than a company functional
currency.
 Temporal method

 Current method


HYPERINFLATIONARY ECONOMIES

 Hyperinflationary economy as one that


experiences a cumulative 3 year inflation
rate of more than100%. Example,
Zimbabwe.

 Two solutions for accounting in
hyperinflationary economies:
 The parent currency can be the functional
currency for all operations of
hyperinflationary subsidiaries.
 The value of non-monetary assets and
liabilities are translated at the current
exchange rate.