UNIT SIX:

FOREIGN EXCHANGE
Instructional Outcomes
By the end of Unit 6, students should be able to:

Define foreign exchange and exchange rate.

Distinguish between fixed and floating exchange rates.
Discuss how exchange rates are determined.
Explain rules governing currency trading
Identify errors made in the foreign exchange market
Analyze the risks involved in foreign exchange
The Foreign Exchange Market for Beginners
►The Foreign Exchange market or Forex market as it is often called is
the market in which currencies are traded.
►Currency Trading is the world’s largest market consisting of almost
trillion in daily volumes and as investors learn more and become more
interested, market continues to rapidly grow.
►All trades that take place in the foreign exchange market involve the
buying of one currency and the selling of another currency
simultaneously. This is because the value of one currency is determined
by its comparison to another currency.
►The first currency of a currency pair is called the “base currency,” while
the second currency is called the counter currency.
WHAT IS FOREIGN EXCHANGE
Foreign exchange is the mechanism by which the
currency of one country gets converted into the
currency of another country.

The conversion of currency is done by the banks

who deal in foreign exchange. These banks maintain
stocks of one currencies in the form of balances with
banks
Nature of Foreign Exchange
Volatile, affected by hedger, arbitrager, speculator.
Affected by demand and supply.
Affected by rate of interest.
Affected by balance of payment surplus and deficit.
Affected inflation rate.
Spot and forward rates are different.
Affected by the economic stability of the country.
Affected by the fiscal policy of the government.
Affected by the political condition of the country.
It can be quoted directly or indirectly
Types of Foreign Exchange Rate
Spot Rate

Forward Rate

Buying & Selling Rate

Floating Exchange Rate

Fixed Exchange Rate

Operation of Foreign Exchange Market:
Foreign exchange market operates either as:-
1. Spot Market/Spot Rate: (Current Market)-Spot market for
foreign exchange is that market which handles only spot
transaction or current transactions.
 
Principle characteristics:-
 Spot market is of daily nature. It does not trade in future
deliveries.
 Spot rate of exchange is that rate which happens to prevail at
the time when transactions are incurred.
Operation of Foreign Exchange Market:
2. Forward Market/Forward Rate: -Forward market for
foreign exchange is that market which handles such
transaction of foreign exchange as are meant for future
delivery.

Principles Characteristics:-
 It only caters to forward transaction.
 It determines forward exchange rate at which forward
transaction are to be honored.
Exchange Rate
According to Haines, “Exchange rate is the price at
which currency of a country can be exchanged for the
number of units of currency of another country.”
Exchange rate is that rate at which one unit of
currency of a country can be exchanged for the
number of units of currency of another country.
It is the price for which one currency is exchanged for
another
Factors Influencing Exchange Rate

a) Changes in interest rates.

b) Degree of speculation in foreign exchange market.
c) Inflation rate
d) Foreign investor’s confidence in domestic country.
e) Economic situation in the country
f) Political situation in the country.
g) Balance of payments position etc.

Despite all these factors, the global forex market is more stable than
stock markets; exchange rates change slowly and by small amounts.
Exchange Rate
►Fixed Exchange Rate System
Fixed rates provide greater certainty for exporters and
importers.
►Flexible Exchange Rate System
Flexibleexchange rate or floating exchange rates
change freely and are determined by trading in the
forex market. 
Direct and Indirect exchange rates
 Direct method - Under this, a given number of units of
local currency per unit of foreign currency is quoted.
Direct quotation is also called home currency quotation.

 Indirect method – Under this, a given number of

units of foreign currency per unit of local currency is
quoted. Indirect quotation is also called foreign
currency quotation
Buying and Selling rates
Exchange rates are quoted as two way quotes –
for purchase
and for sale

As with any market, the forex market is driven by supply and

demand:
If buyers exceed sellers, price will increase
If sellers outnumber buyers, price will reduce
History of Foreign Exchange
Foreign exchange history can be viewed as a series of solutions
that allowed countries to issue their own currency and

To conduct their own monetary policy while also allowing

international trade to be conducted and

By providing a means of exchanging one currency for another

according to the exchange rate between them, which was either
agreed-upon or set by the market.
Exchange rate fluctuations
 A reliable forecast or future spot rate is called study of empirical patterns of exchange
rate fluctuation. It provides essential information for an exchange rate exposure.
Retail Exchange Market
 People may need to exchange currencies in a number of
situations. for e.g.…
Fluctuations in exchange rates
 A market based exchange rate will change whenever the values
of either of the two component currencies change.
 The higher a country's interest rates, the greater will be the
demand for that currency.
Characteristics of Foreign Exchange Market
1. It has huge trading volume representing the largest asset class in the world
leading to high liquidity.
2. It makes extensive use of information technology – making it available to
everyone
3. Traders can profit from both strong and weak economies
4. Trader can place very short-term orders – which are prohibited in some other
markets
5. The market is not regulated
6. Brokerage commissions are very low or non-existent
7. It is a continuous operation: 24 hours a day except weekends.
8. Low margins of relative profit compared with other markets of fixed income
 PARTICIPANTS / DEALERS IN FOREIGN
EXCHANGE MARKET
1. Retail Clients- They deal through commercial banks and
authorized agents. They comprise people, international
investors, multinational corporations and others who need
foreign exchange.
2. Commercial Banks- Commercial banks carry out buy and
sell orders from their retail clients and of their own account.
They deal with other commercial banks and also through
foreign exchange brokers.
PARTICIPANTS / DEALERS IN FOREIGN
EXCHANGE MARKET
3. Foreign Exchange Brokers- Each foreign exchange market
center has some authorized brokers. Brokers act as
intermediaries between buyers and sellers, mainly banks.
Commercial banks prefer brokers.
4. 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.
FOREIGN EXCHANGE MARKET STRUCTURE

Market Segments
 Foreign exchange market activity takes place onshore with
many countries prohibiting onshore entities from undertaking
the operations in offshore markets for their currencies.
 Itis the central bank, or professional dealers association, which
normally issues the code of conduct. In auction markets, an
auctioneer or auction mechanism allocates foreign exchange
by matching supply and demand orders.
TYPES OF FOREIGN EXCHANGE MARKET
1. Retail Market - The retail market is a secondary price
maker. Here travelers, tourists and people who are in need of
foreign exchange for permitted small transactions, exchange
one currency for another.
2. Wholesale Market-The wholesale market is also called
interbank market. The size of transactions in this market is
very large. Dealers are highly professionals and are primary
price makers. The main participants are Commercial banks,
Business corporations and Central banks. Multinational
banks are mainly responsible for determining exchange rate.
TYPES OF FOREIGN EXCHANGE MARKET
3. Other Participants
a) Brokers- Brokers have more information and better
knowledge of market. They provide information to banks
about the prices at which there are buyers and sellers of a
pair of currencies. They act as middlemen between the price
makers
b) Price Takers - Price takers are those who buy foreign
exchange which they require and sell what they earn at the
price determined by primary price makers.
Appreciation & Depreciation of Currency
 Appreciation- An increase in the value of the domestic
currency with respect to the foreign currency.
 Importers
gain from Appreciation of Domestic currency &
loose when it depreciates.
 Depreciation- A decrease in the value of the domestic
currency with respect to the foreign currency.
 Exportersloose from appreciation and gain from
depreciation.
CURRENCY TRADING RULES

Plan your trade and trade your plan.

The trend is your friend.
Focus on capital preservation.
Know when to cut loss.
Take profit when trade is good.
Be emotionless
Do not trade based on a tip from a friend or a
broker.
Mistakes/Errors of Foreign Exchange Traders
Trading Out of Boredom or Anger
Having Unrealistic Expectations.
Taking Highly Correlated Trades.
Failing to Use a Stop.
Taking Unnecessary Risks.
Being Too Patient With Losers and Not Patient
Enough With Winners.
Foreign Exchange Risk
Foreign exchange risk is the possibility of a gain
or loss to a firm that occurs due to unanticipated
changes in the exchange rate.

The primary goal is to protect corporate profits

from the negative impact of exchange rate
fluctuations.
Foreign Exchange Traders Risk
Exposure to exchange rate movement.
Any sale or purchase of foreign currency entails
foreign exchange risk.
Foreign exchange transaction affects the net asset or
net liability position of the buyer/seller.
Carrying net assets or net liability position in any
currency gives rise to exchange risk.
Types of Exposure
Translation Exposure

Transaction Exposure

Economic Exposure
Translation Exposure
 All financial statements of a foreign subsidiary have to be
translated into the home currency for the purpose of finalizing
the accounts for any given period.
 Translationexposure is the degree to which a firm’s foreign
currency denominated financial statements are affected by the
exchange rate changes.
 The changes in the asset valuation due to fluctuations in the
exchange rate will affect the group’s assets, capital structure
ratios, profitability ratios, solvency ratios etc.
Translation Exposure
The following procedure has been followed:
 Assets & Liabilities are to be translated at the current rate,
i.e. the rate prevailing at the time of preparation of
consolidated statements.
 All revenues & expenses are to be translated at the actual
exchange rates prevailing on the date of transactions.
 Translation adjustments (gains or losses) are not be charged
to the net income of the reporting company. (They are
accumulated & reported in a separate account).
Transaction Exposure
 This exposure refers to the extent to which the future value
of firm’s domestic cash flow is affected by exchange rate
fluctuations.
 Itarises from the possibility of incurring exchange rate gains
or losses on transaction already entered into and
denominated in a foreign currency.

 The more the transactions, the more the risk.

Transaction Exposure
All transactions gains and losses should be
accounted for and included in the equity’s net
income for the reporting period.

The exposure could be interpreted either from the

standpoint of the affiliate or the parent company.
Economic Exposure
It refers to the degree to which a firm’s present value of
future cash flows can be influenced by exchange rate
fluctuations.
It is a more managerial concept than an accounting
concept.
The risk is that a variation in the rate will affect the
company’s competitive position in the market and
hence its profits.
It cannot be hedged.
“What you lack in talent can be made up with desire,
hustle and giving 110% all the time.”

Don Zimmer

Thank You For Listening