Tubeloom

Risks

>> Sunday, September 27, 2009

There are risks associated with any market. It means variance of the returns and the possibility that the actual return might not be in line with the expected returns. The risks associated with trading foreign currencies are: market, exchange, Interest rate, yield curve, volatility, liquidity, forced sale, counter party, credit, and country risk.

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FEDAI

Foreign Exchange Dealers Association of India) is an association of all dealers in foreign exchange which sets the ground rules for fixation of commissions and other charges and also determines the rules and regulation relating to day-to-day transactions in foreign exchange in India. The FEDAI has commonly recognised 38 currencies for dealing.

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Risk Management

The identification and acceptance or offsetting of the risks threatening the profitability or existence of an organisation. With respect to foreign exchange involves, among others, consideration of market, sovereign, country, transfer, delivery, credit, and counterparty risk.

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Market Value

Market value of a forex position at any time is the amount of the domestic currency that could be purchased at the then market rate in exchange for the amount of foreign currency to be delivered under the forex Contract.

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Marginal Risk

The risk that a customer goes bankrupt after entering into a forward contract. In such an event the issuer must close the commitment running the risk of having to pay the marginal movement on the contract.

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Margin

Collateral that the holder of a position in securities, options, Forex or futures contracts, has to deposit to cover the credit risk of his counterparty. Other definitions to MARGIN, used in other areas are:
(1) Difference between the buying and selling rates, also used to indicate the discount or premium between spot or forward.
(2) For options, the sum required as collateral from the writer of an option.
(3) For futures, a deposit made to the clearing house on establishing a futures position account. (4) The percentage reserve required by the US Federal Reserve to make an initial credit transaction.

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Forex Deal

The purchase or sale of a currency against sale or purchase of another currency. The maximum time for a deal is defined when the deal opens, the deal can be closed at any moment until the expiry date and time. A deal cannot be closed on its first 3 minutes, due to technical reasons.

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Floating Exchange Rate

When the value of a currency is decided by the market forces dictating the demand and supply of that particular currency.

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Fixed Exchange Rate

Official rate set by monetary authorities for one or more currencies. In practice, even fixed exchange rates are allowed to fluctuate between definite upper and lower bands, leading to intervention by the central bank.

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Day Trading

A Day Trading deal is a currency exchange deal which renews automatically every night at 22:00 (GMT time) starting the day the deal was made and until it ends. The deal ends in one of the following events:
1.Termination initiated by you.
2.The day trading rate has reached the Stop-Loss or Take Profit rate you predefined.
3.The deal end date.
As long as the deal is open, it is charged a renewal fee every night at 22:00 (GMT time).

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Counter Party Risks

Foreign Currency Inter-bank Exchange (FOREX) instruments are Positions (Buys and/or Sell) between the Client and its Counterparty and, unlike exchange-traded foreign exchange instruments which are, in effect, guaranteed by a clearing organization affiliated with the exchange on which the instruments are traded, are not guaranteed by a clearing organization. Thus, when the Customer purchases an OTC foreign exchange instrument, it relies on the Counterparty from which it has purchased the instrument to fulfill the contract. Failure of a Counterparty to fulfill a Position could result in losses of any prior payment made pursuant to the Positions as well as the loss of the expected benefit of the transaction.

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Broker

An agent, who executes orders to buy and sell currencies and related instruments either for a commission or on a spread. Brokers are agents working on commission and not principals or agents acting on their own account. In the foreign exchange market brokers tend to act as intermediaries between banks bringing buyers and sellers together for a commission paid by the initiator or by both parties. There are four or five major global brokers operating through subsidiaries affiliates and partners in many countries.

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Bid Price

Bid is the highest price that the seller is offering for the particular currency at the moment; the difference between the ask and the bid price is the spread. Together, the two prices constitute a quotation; the difference between the two is the spread. The bid-ask spread is stated as a percentage cost of transacting in foreign exchange.

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Foreign Exchange Risk

The risk that the exchange rate on a foreign currency will move against the position held by an investor such that the value of the investment is reduced. For example, if an investor residing in the United States purchases a bond denominated in Japanese yen, a deterioration in the rate at which the yen exchanges for dollars will reduce the investor's rate of return, since he or she must eventually exchange the yen for dollars. Also called exchange rate risk.

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Money Market

Money market is the centre for dealings mainly of a short term character in monetary assets. It embraces all the facilities of the country for the borrowing and lending of money for short terms. It transacts in short funds which are highly liquid and are known as near money. The capital market is primarily concerned with transactions in funds for relatively long term use.

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International Liquidity (Bilateral/Multilateral Methods)

For solving the availability of internationally acceptable means of payments, International Monetary Fund, Special Drawing Rights (SDR's) Scheme etc. (IMF) have been established.

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Transfer Moratoria (Bilateral/Multilateral Methods)

Under this system, the payments for the imported goods or the interest on foreign capital are not made immediately but are suspended for a predetermined period called as period of moratorium. A country adopts this method of exchange control for temporary solving its payments problems.

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Clearing Agreement (Bilateral/Multilateral Methods)

Under this system, the governments of the two countries agree to clear the accounts in home currencies through their respectives central banks.

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Multiple Exchange Rates (Unilateral Methods)

Under this system, different exchange rates are fixed for import and export of different commodities and for different countries. This system of exchange is adopted for earning maximum possible foreign exchange by increasing exports and reducing imports.

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Rationing of Foreign Exchange (Unilateral Methods)

Under this system, the government momopolizes the foreign exchange reserves. The exporters are required to surrender foreign exchange earnings at the fixed exchange rate to the central bank of the country. The importers are allotted foreign exchange rate and in fixed amount.

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Payment Agreements (Unilateral Methods)

The payment agreements are made between a debtor and a creditor country. This method of exchange control facilities the debtor country to make more and more exports to the creditor country and import less and less quantity from it. Under this system, the international transactions in foreign exchange are settled and cleared.

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Blocked Accounts (Unilateral Methods)

Blocked accounts refer to a method by which the foreigners are restricted to transfer funds to their home countries. The extreme step of freezing the bank accounts of the foreigners is taken when the government faces the acute shortage of foreign exchange say in wartime.

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Compensation Agreement (Unilateral Methods)

Compensation agreement resembles the old fashioned deal. The two countries import and export commodities from each other of equivalent value and so leave no balance requiring settlement in foreign exchange. Since no payment is made to foreign exchange, problem of foreign exchange does not arise.

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Stand Still Agreement (Unilateral Methods)

Stand still agreement aims at maintaining status quo in the relationship between two countries in terms of capital movement. If a country is under debt to another country, payments of short term debts may be suspended for a given period by entering into an agreement called the standstill agreement. The creditor country allows the debtor country to repay the debts in easy instalments or convert the short terms debts into long terms debts.

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Clearing Agreement (Unilateral Methods)

Clearing agreement may be defined as an undertaking between two or more nations to buy and sell goods and services among themselves according to specified rate of exchange. The payments are to be made by buyers in the buyer's home currency. The balance, if any, is settled among the central banks of the nations at the end of stipulated periods either by exporging gold or of an acceptable third currency, or they are allowed to accumulate for another period in which the creditor country works off the balance by additional purchases from the debtor country. The main objectives for entering into clearing agreement are to liquidate the blocked accounts, to ensure quilibrium in the balance of payments and to check the fluctuating exchange rates.

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Exchange Equalization Account (Unilateral Methods)

Exchange Equalization account is the device adopted for smoothing out temporary or short term fluctuation in the rate of exchange as a result of any abnormal movement of capital. This type of exchange control was first adopted by England in 1932. France and U.S.A. followed suit and set up Exchange Equalization Account in 1936. This fund, i.e., Exchange Equalization Account is utilized for offsetting inward or outward movements of hot money or refugee capital. It is never intended that resources of the Exchange Equalization Account should be utilized for affecting the normal rate of exchange. The object of the fund is to iron out the abnormal fluctuation in the rates of exchange by buying and selling of foreign currencies.

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Exchange Pegging (Unilateral Methods)

Exchange pegging means the act of fixing the exchange value of the currency to some chosen rate. When the exchange rate is fixed higher than the market rate (overvaluation), it is called pegging up. When the exchange rate is fixed lower than the market rate, it is called pegging down (undervaluation). The exchange pegging is a temporary measure to remove fluctuations in the foreign exchange rate.

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Meaning of Exchange Control

Broadly speaking, exchange control refers to a government's intervention in the foreign exchange market. In other words, it means restrictions on the business involving foreign exchange and its sale and purchase in the national market. It is a government domination in the foreign exchange market. In the words of Haberler, "Exchange Control is the state regulation excluding the free play of economic forces from the free play of foreign exchange market.

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Open Account

Another method for making merchandise payments is to sell on an open account. An exporter if he has full confidence in the character, capacity of the importer may sell the goods in another country on an open account, i.e., without getting any prior commitment from the banker or any other third party. Here, the exporter runs the risk of default.

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Dealers in Foreign Exchange

Foreign Exchange dealers in every country purchase and sell foreign exchange notes and coins. They purchase foreign currency from the visitors of the other countries and pay them in them in the home currency for meeting their local money requirements and sell the foreign notes and coins to the persons visiting foreign countries at the official rate.

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Traveller Cheque

A traveller cheque is an order drawn by a bank upon its own branch to pay a specified sum of money on demand to the purchaser of the cheque. The paying bank after comparing the signature of the purchaser, which he has signed at the time of the purchase of cheques, makes the payment.

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International Money Order

Money can also be remitted to a person living in foreign country by international money order. The payee receives a definite amount sent by the payer, in the currency of his own country.

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Foreign Bank Draft

The most direct and simple method of making international cash payment is to purchase a foreign bank draft. The foreign bank draft is an order drawn by a bank on its foreign branch or correspondent to pay a specific sum of money on demand to bearer or to the order of a person designated by the purchaser of the draft.

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Mail Transfer (M.T.)

When the money is not required immediately, the remittances can also be made by mail transfer (M.T.). Here the selling office of the bank sends instructions in writing by mail to the paying bank for the payment of a specified amount of money. The payment under this transfer is made by debting to the buyer's account at the selling office and crediting to the recipient's account at the paying office.

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Cable Transfer

The cable transfer or telegraphic transfer is the quickest method of making international payments. A cable transfer is a telegraphic order sent by a bank to its correspondent bank abroad to pay the specified amount to certain person from its deposit account. For example, a Pakistani importer who wants to make payment abroad can arrange for a cable transfer from his bank in Pakistan. The importer has to bear expeses of the telegraph in addition to the specified amount. The bank uses secret system of code for making international payments.

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Bill of Exchange

The bill of exchange is a most effective instrument in making international payments. A bill of exchange is an order in writing from the drawer (creditor) to the drawee (debtor) to pay the specified sum of money on demand or on some specified future date (usually three months). The creditor can discount the bill of exchange from his hanker for an amount less than its face value. The margin between the face value and the amount paid, by the bank is termed as 'bank discount'. The mechanism of foreign bill of exchange assumes that each international payment in one direction is matched by the equal payment in the opposite direction.

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Letter of Credit

"Any arrangement, however named or described, whereby a bank, acting at the request and on the instructions of a customer".
According to Pritchard, "The letter of credit is a commitment on the part of buyer's bank to pay or accept drafts drawn open it, provided such drafts do not exceed a specified amount".

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Factors Influencing The Flow Of Foreign Exchange

The main factors which influence the movement of foreign exchange from one country to another are as follows:
(1) Leads and Lags

If a country expects that a change in the rate of exchange is likely to be in its favour, there will be a movement of funds to that country. Efforts will also be made to create delay in the settlement of debts. Payments for the imports will be made before they fall due. On the other hand, if a country fears that a change in the rate of exchange is likely to be unfavourable to it, then attempts will be made to secure early payments of debt. Efforts will also be made to make payments to the creditor country before they fall due. These factors which influence the movement of foreign exchange are know as 'leads and lags'.
(2) Arbitrate
Arbitrate is a process of buying a thing in one market and selling it at the same time in another market in order to take advantage of price difference. For instance, if there arises a difference in the stock exchange rates between Pakistan and England, the businessmen can take advantage of the price difference by buying the foreign exchange or shares in the cheaper market and sell them in the dear market. They can thus make profit out of the difference in the prices of shares or foreign exchange rates.
(3) Political and Economic Conditions
If there is political instability and labour unrest in the country, the industrial growth will be adversely affected. There will be movement of foreign capital outside the country. In case the government of a country encourages private enterprise and gives liberal concessions, the growth of exports will be stimulated and the supply of foreign exchange increases.
(4) Seasonal Factors
The rate of foreign exchange is also affected by the seasonal fluctuations in the export and import of commodities. The central bank and other foreign exchange dealers try to smooth down the fluctuations in the rate of foreign exchange by purchasing foreign exchange when the exports are at its height and sell the held up foreign exchange when the imports are liberalized.

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Kinds of Foreign Exchange Transactions

The foreign exchange transactions are usually put into four categories:-
(1) Current Transactions

As regards the Current Transaction, they are further divided into two clauses: (a) Visible Trade (b) Invisible Trade. Visible trade is based on the import and export of physical goods known as merchandise. The invisible trade has no direct relation with the import and export of merchandise. It is the payment made or received from the foreigners for the shipping, banking, insurance services, received or provided to them. Interest on capital, dividend or remittance of profits, from one country to another also fall in the category of invisible trade.
(2) Capital Transactions
Capital transactions are different from financial transactions. When a country grants aids or gives long term loans or invests employing foreign exchange in another country, a capital transaction is then said to have operated.
(3) Short Term Financial Transactions
If the citizens of one country, due to political or economic reasons, transfer their foreign exchange resources to another country for a short period, it is then said to be a short term financial transaction of foreign exchange.
(4) Working Balances
The commercial banks sometimes keep their working balances in foreign money in other countries for earning higher profit or fear of devaluation in the home currency or unfavourable political conditions at home. In all such cases, the demand for and supply of foreign exchange is affected.

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Functions of the Foreign Exchange Market

There are three main functions of the foreign exchange market
(1) Transfer Function
The basic and primary function of foreign exchange market is to transfer purchasing power between countries. The transfer function is performed through T.T, M.T, Draft, Bill of Exchange, Letters of Credit, etc. The bill of exchange is the most important and effective method of transferring purchasing power between two parties located in different countries.
(2) Credit Function
Another important function of foreign exchange market is to provide credit to the importer debtor. The exports draw the bill of exchange on Importers or on their bankers. On acceptance of the bills by importer or their banker, the exporter will get the money realized on the maturity of the bills. In case the exporters are anxious to receive the payment earlier, the bills can be discounted from their bankers, or foreign exchange banks or discount houses.
(3) Hedging Function
The foreign exchange market performs the hedging function covering the risks on foreign exchange transactions. There are frequent fluctuations in exchange rates. If the rate is favourable, the exporter will gain and vice versa. In order to avoid the risk involved, the foreign exchange market provides hedges or actual claims through forward contracts in exchange against such fluctuations. The agencies of foreign currencies guarantee payment of foreign exchange at a fixed rate. The exchange agencies bear the risks of fluctuation of exchange rates.

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What is a Foreign Exchange Market

A foreign exchange market is a place in which foreign exchange transactions take place. In the words of Kindleberger, "Foreign exchange market is a place where foreign moneys are bought and sold".

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Importance of Foreign Exchange

The importance of foreign exchange is described in brief as under:-

1- Foreign exchange reserves shows the financial strength and the stage of development of the economy.

2- The acceptance of currency at a predetermined rate makes the international trade easy.

3- The foreign exchange ratio shows direct relationship between the prices of the commodities in the national and international market.

4- The foreign exchange balances of a country directly affect the rates of exchange. A hard currency nation has stability in foreign exchange rate.

5- The rising foreign exchange balances of a nation increases its credit worthless in the international capital market.

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Definition of Foreign Exchange

In the word of H.E. Evitt, "The means and methods by which rights to wealth expressed in terms of the currency of one country are converted into rights to wealth in terms of the currency of another country are known as foreign exchange".

Hartley Whither defines foreign exchange "as a mechanism by which international indebtedness is settled between one country and another.

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Meaning of Foreign Exchange

The term 'foreign exchange' is used in its narrow as well as broad sense. In the narrow sense, foreign exchange simply means the money of a foreign country. For examply, Japanee's 'Yen' is a foreign exchange to a Indian and Indian rupee is a foreign exchange to a Japanee.
In the broader sense, the word 'foreign exchange' is related to the exchange methods and mechanism through which the payments in connection with International trade are made. It covers the methods by which (1) the currency of one country is exchanged for that of another; (2) the forms in which exchanges are conducted and (3) the ratio at which they are effected.

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