Forex Market and Risk Management

A Report on

“FOREIGN EXCHANGE MARKET AND RISK

MANAGEMENT”

A project report submitted

In partial fulfilment for the award

Of the degree

BACHELOR OF BUSINESS ADMINISTRATION

(BBA)

Submitted by:

NITIN YADAV. T

18IABBA102

2018-2021

Under the guidance of

MR. MOHAMMED AHMED

Assistant Professor

Department of Business Administration

Affiliated to Bangalore North

University

Hennur Main road, Bengalore-43

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Forex Market and Risk Management

DECLARATION

I hereby declare that the project entitled “A STUDY ON FOREIGN

EXCHANGE AND RISK MANAGEMENT” submitted by me in partial
fulfilment of the requirement for the degree in BACHEKOR OF BUSINESS
ADMINISTRATION to INDIAN ACADEMY DEGREE is my own and is not
submitted for the award of any other degree, diploma, fellowship or any other
similar title or prize.

NITIN YADAV. T

(18IABBA102)

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Forex Market and Risk Management

ACKNOWLEDGEMENT

In the light of completion of this project, I would first and foremost thank the almighty for
giving me strength and knowledge. And my beloved parents for their inevitable support love
and faith in me.

I remain deeply indebted to one and all in Indian Academy Degree College-Autonomous for
helping me in accomplishing this project. I would like to take this opportunity to include their
names in this list as a token of indebtedness to them.

I express my gratitude to our respected principal DR. E. JEROME XAVIER for his
encouragement extended at various stages of this project. His feedback and motivation had
immense value and made this project possible.

My deepest gratitude to Mr Mohammed Ahmed, faculty member Department of Business

Administration, for his guidance and support at various stages during the project, without
which the project would not been in its present form.

Last but not the least; the work would seem incomplete without acknowledging the
contribution of my friends. I express my whole hearted thanks to all my classmates who have
co-operated with me immensely during the project directly or indirectly onwards its
completion.

NITIN YADAV.T

18IABBA102

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Forex Market and Risk Management

CHAPTER 1
INTRODUCTION

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Forex Market and Risk Management

 Part A

Background and Overview

The foreign exchange market (Forex, FX, or currency market) is a global decentralized or
over-the-counter (OTC) market for the trading of currencies.

This market determines foreign exchange rates for every currency. It includes all aspects of
buying, selling and exchanging currencies at current or determined prices. In terms of trading
volume, it is by far the largest market in the world, followed by the credit market.

The main participant in this market are the larger International banks.

Financial centres around the world function as anchors of trading between a wide range of
multiple types of buyers and sellers around the clock, with the exception of weekends.

Since currencies are always traded in pairs, the foreign exchange market does not set a
currency's absolute value but rather determines its relative value by setting the market price
of one currency if paid for with another.

Ex: US$1 is worth X CAD, or CHF, or JPY, etc.

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

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Forex Market and Risk Management

In a typical foreign exchange transaction, a party purchases some quantity of one currency by
paying with some quantity of another currency.

The foreign exchange market is unique because of the following characteristics:

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 for weekends, i.e., trading from
22:00 GMT on Sunday (Sydney) until 22:00 GMT Friday (New York);
 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, the Triennial Central Bank Survey of
Foreign Exchange and OTC Derivatives Markets Activity show that trading in foreign
exchange markets averaged $6.6 trillion per day in April 2019.

MARKET SIZE AND LIQUIDITY

The foreign exchange market is the most liquid financial market in the world. Traders include
governments and central banks, commercial banks, other institutional investors and financial
institutions, currency speculators, other commercial corporations, and individuals.

According to the 2019 Triennial Central Bank Survey, coordinated by the Bank for
International Settlements, average daily turnover was $6.6 trillion in April 2019 (compared to
$1.9 trillion in 2004). Of this $6.6 trillion, $2 trillion was spot transactions and $4.6 trillion
was traded in outright forwards, swaps, and other derivatives.

Foreign exchange is traded in 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 centre is the United Kingdom, primarily London. In April 2019, trading in
the United Kingdom accounted for 43.1% of the total, making it by far the most important
centre for foreign exchange trading in the world. Owing to London's dominance in the

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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. Trading in the United States
accounted for 16.5%, Singapore and Hong Kong account for 7.6% and Japan accounted for
4.5%.

Turnover of exchange-traded foreign exchange futures and options was growing rapidly in
2004-2013, reaching $145 billion in April 2013 (double the turnover recorded in April
2007).As of April 2019, exchange-traded currency derivatives represent 2% of OTC foreign
exchange turnover. Foreign exchange futures contracts were introduced in 1972 at the
Chicago Mercantile Exchange and are traded more than to most other futures contracts.

Most developed countries permit the trading of derivative products (such as futures and
options on futures) on their exchanges. All these developed countries already have fully
convertible capital accounts. Some governments of emerging markets 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. Countries such as South Korea,
South Africa, and India have established currency futures exchanges, despite having some
capital controls.

Foreign exchange trading increased by 20% between April 2007 and April 2010 and has
more than doubled since 2004.The increase in turnover is due to a number of factors: the
growing importance of foreign exchange as an asset class, the increased trading activity of
high-frequency traders, and the emergence of retail investors as an important market segment.

Market participants

Top 10 currency traders

% of overall volume, June 2020

Market
Rank Name
share

1 JP Morgan 10.78 %

2 UBS 8.13 %

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3 XTX Markets 7.58 %

4 Deutsche Bank 7.38 %

5 Citi 5.50 %

6 HSBC 5.33 %

7 Jump Trading 5.23 %

8 Goldman Sachs 4.62 %

9 State Street Corporation 4.61 %

Bank of America Merrill

10 4.50 %
Lynch

Unlike a stock market, the foreign exchange market is divided into levels of access. At the
top is the interbank foreign exchange market, which is made up of the largest commercial
banks and securities dealers. Within the interbank market, spreads, which are the difference
between the bids 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 to 1 pip to
1–2 pips for 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 51% 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

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size”. Central banks also participate in the foreign exchange market to align currencies to
their economic needs.

Commercial companies

An important part of the foreign exchange 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 a 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
corporations (MNCs) can have an unpredictable impact when very large positions are
covered due to exposures that are not widely known by other market participants.

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 as
other traders would. There is also no convincing evidence that they actually make a profit
from trading.

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
the behaviour of their currency. Fixing exchange rates reflect the real value of equilibrium in
the market. Banks, dealers, and traders use fixing rates as a market trend indicator.

The mere expectation or rumour of a central bank foreign exchange intervention might be
enough to stabilize the currency. However, 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. Several scenarios of this nature were seen in the 1992–93 European Exchange
Rate Mechanism collapse, and in more recent times in Asia.

Investment management firms

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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 can, therefore, generate large trades.

Retail foreign exchange traders

Individual retail speculative traders constitute a growing segment of this market. Currently,
they participate indirectly through brokers or banks. Retail brokers, while largely controlled
and regulated in the US by the Commodity Futures Trading Commission and National
Futures Association, have previously been subjected to periodic foreign exchange fraud. 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 contracts for difference 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 principals in the transaction versus the retail customer, and quote a price they are
willing to deal at.

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"

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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 are made via Foreign
Exchange Companies. 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.
The volume of transactions done through Foreign Exchange Companies in India amounts to
about US$2 billion per day This does not compete favourably with any well-developed
foreign exchange market of international repute, but with the entry of online Foreign
Exchange Companies the market is steadily growing. Around 25% of currency
transfers/payments in India are made via non-bank Foreign Exchange Companies. Most of
these companies use the USP of better exchange rates than the banks. They are regulated by
FEDAI and any transaction in foreign Exchange is governed by the Foreign Exchange
Management Act, 1999 (FEMA).

TRADING CHARACTERISTICS
Most traded currencies by value
Currency distribution of global foreign exchange market turnover

ISO % of daily trades

Rank Currency 4217 code (bought or sold)
(symbol) (April 2019)

United States
1 USD (US$) 88.3%
dollar

2 Euro EUR (€) 32.3%

3 Japanese yen JPY (¥) 16.8%

4 Pound sterling GBP (£) 12.8%

5 Australian dollar AUD (A$) 6.8%

6 Canadian dollar CAD (C$) 5.0%

7 Swiss franc CHF (CHF) 5.0%

8 Renminbi CNY (元 / ¥) 4.3%

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9 Hong Kong dollar HKD (HK$) 3.5%

New Zealand
10 NZD (NZ$) 2.1%
dollar

11 Swedish krona SEK (kr) 2.0%

12 South Korean won KRW (₩) 2.0%

13 Singapore dollar SGD (S$) 1.8%

14 Norwegian krone NOK (kr) 1.8%

15 Mexican peso MXN ($) 1.7%

16 Indian rupee INR (₹) 1.7%

17 Russian ruble RUB (₽) 1.1%

18 South African rand ZAR (R) 1.1%

19 Turkish lira TRY (₺) 1.1%

20 Brazilian real BRL (R$) 1.1%

21 New Taiwan dollar TWD (NT$) 0.9%

22 Danish krone DKK (kr) 0.6%

23 Polish złoty PLN (zł) 0.6%

24 Thai baht THB (฿) 0.5%

25 Indonesian rupiah IDR (Rp) 0.4%

26 Hungarian forint HUF (Ft) 0.4%

27 Czech koruna CZK (Kč) 0.4%

28 Israeli new shekel ILS (₪) 0.3%

29 Chilean peso CLP (CLP$) 0.3%

30 Philippine peso PHP (₱) 0.3%

31 UAE dirham AED ( ‫إ‬.‫)د‬ 0.2%

32 Colombian peso COP (COL$) 0.2%

33 Saudi riyal SAR ( ‫)﷼‬ 0.2%

34 Malaysian ringgit MYR (RM) 0.1%

35 Romanian leu RON (L) 0.1%

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Other 2.2%

Total 200.0%

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 quite close due to arbitrage. Due to London's dominance
in the market, a particular currency's quoted price is usually the London market price. Major
trading exchanges include Electronic Broking Services (EBS) and Thomson Reuters Dealing,
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.

The main trading centres are London and New York City, though Tokyo, Hong Kong, and
Singapore are all important centres 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.

Fluctuations in exchange rates are usually caused by actual monetary flows as well as by
expectations of changes in monetary flows. These are caused by changes in gross domestic
product (GDP) growth, inflation (purchasing power parity theory), interest rates (interest rate
parity, Domestic Fisher effect, and 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, large banks have an important advantage; they can see their
customers' order flow.

Currencies are traded against one another in pairs. 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

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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 a positive
currency correlation between XXXYYY and XXXZZZ.

On the spot market, according to the 2019 Triennial Survey, the most heavily traded bilateral
currency pairs were:

 EURUSD: 24.0%
 USDJPY: 13.2%
 GBPUSD (also called cable): 9.6%

The U.S. currency was involved in 88.3% of transactions, followed by the euro (32.3%), the
yen (16.8%), and sterling (12.8%) 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.

DETERMINANTS OF EXCHANGE RATES

In a fixed exchange rate regime, exchange rates are decided by the government, while a
number of theories have been proposed to explain (and predict) the fluctuations in exchange
rates in a floating exchange rate regime, including:

 International parity conditions: Relative purchasing power parity, interest rate parity,
Domestic Fisher effect, International Fisher effect. To some extent the above theories
provide logical explanation for the fluctuations in exchange rates, yet these theories

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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.

 Balance of payments model: 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 the continuous appreciation of the US dollar during the 1980s and
most of the 1990s, despite the soaring US current account deficit.

 Asset market model: views currencies as an important asset class for constructing
investment portfolios. Asset 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 supply and demand. 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 distils) 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.

Economic factors

Economic factors include:

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(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.

POLITICAL CONDITIONS

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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 neighbouring country and, in the process, affect its currency.

Market psychology

 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 US dollar, Swiss franc
and gold have been traditional safe havens during times of political or economic
uncertainty.

 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.

 "Buy the rumour, 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". To buy the rumour 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,

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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.

FINANCIAL INSTRUMENTS

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. Spot
trading is one of the most common types of forex trading. Often, a forex broker will charge a
small fee to the client to roll-over the expiring transaction into a new identical transaction for
a continuation of the trade. This roll-over fee is known as the "swap" fee.

Forward

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.

Non-deliverable forward (NDF)

Forex banks, ECNs, and prime brokers offer NDF contracts, which are derivatives that have
no real deliver-ability. NDFs are popular for currencies with restrictions such as the
Argentinian peso. In fact, a forex hedger can only hedge such risks with NDFs, as currencies
such as the Argentinian peso cannot be traded on open markets like major currencies.

Forward

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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.

Non-deliverable forward (NDF)

Forex banks, ECNs, and prime brokers offer NDF contracts, which are derivatives that have
no real deliver-ability. NDFs are popular for currencies with restrictions such as the
Argentinian peso. In fact, a forex hedger can only hedge such risks with NDFs, as currencies
such as the Argentinian peso cannot be traded on open markets like major currencies.

Swap

The most common type of forward transaction is the foreign exchange 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.

Futures

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.

Currency futures contracts are contracts specifying a standard volume of a particular currency
to be exchanged on a specific settlement date. Thus the currency futures contracts are similar
to forward contracts in terms of their obligation, but differ from forward contracts in the way
they are traded. In addition, Futures are daily settled removing credit risk that exist in
Forwards. They are commonly used by MNCs to hedge their currency positions. In addition
they are traded by speculators who hope to capitalize on their expectations of exchange rate
movements.

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

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into another currency at a pre-agreed exchange rate on a specified date. The FX options
market is the deepest, largest and most liquid market for options of any kind in the world.

Speculation

Controversy about currency speculators and their effect on currency devaluations and
national economies recurs regularly. Economists, such as Milton Friedman, have argued that
speculators ultimately are a stabilizing influence on the market, and that stabilizing
speculation performs 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. Other
economists, such as Joseph Stieglitz, consider this argument to be based more on politics and
a free market philosophy than on economics.

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.

Currency speculation is considered a highly suspect activity in many countries. 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 Sweden's central bank, the Riksbank, to raise
interest rates for a few days to 500% per annum, and later to devalue the krona. Mahathir
Mohamed, one of the former Prime Ministers of Malaysia, 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 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.[83] In this view, countries may develop unsustainable economic
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 Mohamed and other critics of speculation are viewed as trying to deflect the blame
from themselves for having caused the unsustainable economic conditions.

Risk aversion

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The MSCI World Index of Equities fell while the US dollar index rose

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

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. 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 US.

 Part B
1.2 Nature of foreign exchange risk management

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Understanding the nature of foreign exchange risk management entails knowing the answers
to the following questions: What is risk management? Why does it exist? What are the
concepts used in its management? And what are the processes involved in its management?
These are the questions addressed in this chapter which explains the nature of foreign
exchange management and how it is being practiced in the western region of Melbourne.

1.2.1 CONCEPTS OF EXPOSURE

Shapiro, A. C. (1992) gave the concept of exposure as the degree to which a company is
affected by exchange rate changes. Foreign exchange exposures are classified in the
Literature into three types via:

1 Accounting or Translation exposure;

2 Transaction or Conversion exposure; and

3 Economic exposure.

It will be appropriate here to give a brief description of each of the exposures.

Accounting or Translation exposure.

Translation exposure exists when a company that has a subsidiary in another currency has to
consolidate its financial statements. Consolidation means translating the subsidiary financial
statements prepared in its local currency into the parent company's currency of operation. This
concept is supported by the description given by Shapiro (1992) that translation exposure
arises from the need for purposes of reporting, and consolidation, converting financial
statements of foreign operations from local currencies (LC) involved into the home currency
(HC) of the parent company. This means that if the exchange rate changes between the
previous reporting date and the current reporting date, then translation gain or loss will be
incurred by the parent company. In actual fact the gain or loss does not involve any cash-
flow, it is only a paper concept which does not add value to the company.

Transaction or Conversion exposure.

When a firm has a foreign currency-denominated payable or receivable, investment or loan, a

change in the value of that foreign currency we alter the amount of local currency to be paid
or received (Srinivasulu, 1983). This type of exposure involves cash-flows because at

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maturity (or future date) if the foreign currency appreciates, the firm will gain or lose in
respect of receivables/payables while at depreciation of the foreign currency, the reverse
occurs. This exposure is measured on a currency by currency basis and thus equals the
difference between the cash inflows and cash outflows. This is different from the economic
exposure because it only affects specific transactions while economic exposure affects all the
transactions in total.

Economic exposure

This is a much broader concept than the transaction exposure because it focuses on the effect
of exchange rate changes on the competitiveness of the company, that is, the impact on the
company's cash-flows.

It is a generally accepted fact in economics that devaluation of a local currency might be used
to encourage exporters to be competitive internationally. This is because devaluation of a
currency can be used by government in a managed foreign exchange system to encourage
exporters while discharging their responsibility for managing the foreign exchange rate. On
the other hand depreciation of a currency is the result of freely floating exchange rate system
as a result of the operation of market forces. The effect of depreciation is to make exporters
more competitive against importers. Therefore any exchange rate movement has the potential
to affect the firm's cost of inputs or price of outputs or both and thus the relative
competitiveness of firms. This type of effect is the essence of economic exposure. It could be
argued that both transaction and economic exposure concepts are the same as both will
influence cash flow but there is a difference between the two. In transaction exposure, it is
only the future value of the converted local currency that is unknown due to the unknown
future exchange rate but the foreign currency cash flow is known in advance. As for the
economic exposure, since the exchange rate affects costs, prices, and sales volume, both the
foreign currency cash flow and the local currency equivalent are not known. In short,
economic exposure affects the value of the firm.

1.2.2 DEFINITION OF RISK

As discussed earlier in the introductory chapter, this study is based on the concept of
exposure to foreign exchange risk management. The definition of risk is also based on such a
concept. Shapiro (1992) defined foreign exchange risk as the "variability in the firm's value
that is caused by uncertain exchange rate changes". Glaum (1990) defines foreign exchange

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risk as the "probability of changes, for better or worse, in the home currency value of an
asset, liability, or cash-flow stream caused by unexpected future exchange rate changes." This
definition is based on certain assumptions that:

1. The company is managed on behalf of its owners who are interested in wealth
Increases in their home currency.
2. Only unexpected future exchange rate changes gives rise to exchange risk.
3. Exchange risk is not confined to firms with foreign transactions alone but also
domestic oriented firms as well.

It is an accepted fact in the finance literature that the overall objective of a company is to
maximise shareholders wealth (Van Home et al 1990 p. 12). All other subsidiary Objectives
(including risk management objectives) and policies of the company are directed towards
achieving the overall objective. Maximizing shareholder's wealth means increasing the value
of the firm, therefore the assumptions in the definition of foreign exchange risk by Glaum
that the value of the firm is the most important seems appropriate.

The above definitions of risk are all based on an economic exposure concept. This concept is
in agreement with the author's view because it is the value of the firm which is of utmost
importance to the shareholders. Therefore to maximise the value of the firm, managing the
inherent foreign exchange risk should focus on risk based on economic exposure.

1.2.3 NATURE OF RISK MANAGEMENT

Darke and Klar (1990) give a broad definition of risk management as "the ability to identify,
measure, and assess limits to acceptable financial risk which an organisation may, at a
reasonable cost, defray or reduce, using financial instruments available in the market". From
this definition one could ask which one of the exposures is to be managed, but previous
studies (such as Collier and Davis 1985, and Belk and Glaum 1990) have shown that there
are divergences in practice as to the type of exposure being managed. Belk and Glaum's
(1990) findings supported the use of accounting exposure to foreign exchange risk
management in their survey in which 13 out of 16 respondents of multinational companies
expressed the importance of accounting exposure management. Other studies show that
transaction exposure management is the centre piece of foreign exchange risk management of
some multinational companies (Belk and Glaum 1990; Collier and Davis 1985). Recent
studies have shown that companies are now using the economic exposure concept in their

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foreign exchange risk management (Belk and Glaum 1990; Flood and Lessard 1986; Shapiro
1989). The economic exposure concept is generally accepted amongst academics as being the
most important foreign exchange exposure concept and the most appropriate for use in
exchange risk management (Glaum 1990).

1.2.4 RISK MANAGEMENT CONCEPTUAL FRAMEWORK

Risk management usually involves a series of steps to be followed in the process.

Cornell and Shapiro (1983) developed the risk management concept into three stages:

1. Determining what is at risk which requires the appropriate definition of foreign

exchange risk
2. Identifying the objectives of risk management and
3. Designing the phonies to achieve the objectives.

Darke and Klar (1990) gave their conceptual framework of exposure management as

Follows:

1. Identifying the exposure risks

2. Quantifying the impact of the risk
3. Establishment of policies and objectives towards the management of those risks
4. Implementing the risk management programmes.

Similarly, Holland (1986) gave his own framework as follows:

1. Defining the nature of the exposure

2. Collecting information on the exposure
3. Forecasting the path of expected exchange rates changes
4. Identifying deviations and responding to the exposure and
5. Evaluating this response relative to the goals of exposure management.

Furthermore, Shapiro (1992) enumerated his own concept as

1. Measurement of exposure and

2. Managing the exposure.

Shapiro's concept of measurement encompasses the first two steps of Darke and JClar which
is also similar to the first three steps of Holland. The concept of managing is similar to the
other steps in Darke and Klar as well as those of Holland's.

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It is clear from the above that risk management is not a simple process, therefore it must not
be left as the responsibility of the treasurer alone but it should involve all the senior
management team and should be included in the strategic policies of the firm. Glaum (1990)
had argued the case for the strategic management of foreign exchange rate risks. He said that
risk management should be approached from the economic exposure concept because the
following reasons:

1. Economic exposure concept is a dynamic, decision-making orientated concept;

2. It takes a long term approach seeing the firm as an on-going concern;
3. All cash-flows are affected by exchange rate changes; and
4. Exchange risk affects all parts of the company and thus is not solely a financial
phenomenon.

All the above point to the fact that foreign exchange risk is a strategic problem and it needs a
strategic management approach. The constituents of each step of the process is hereby given
based on the conceptual framework of Darke and Klar with an additional Step for evaluation.

1.2.5 IDENTIFYING EXPOSURE RISK

This involves examining the operations of the company to see if it is exposed to foreign
exchange risk. As discussed earlier, exposure exists either when a firm has any of it's assets,
liabilities or cash-flows denominated in foreign currencies or if it has a foreign competitor.
This is because any firm that has a foreign competitor is exposed to movements in exchange
rates between its own local currency and that of it's foreign competitor's local currency. If the
exchange rate movement is not favourable to the domestic producer, it may lose sales
revenue in foreign currency denominated costs as well as revenues and/or market share but if
favourable, it may gain. Depending on the objectives and policies of the firm, one can
determine whether the firm is exposed to accounting, transaction or economic exposures.

1.2.6 QUANTIFYING THE IMPACT OF RISK

Quantification of the risk involves forecasting exchange rate changes and their impact on the
operations of the firm. The extent of the impact can only be known after establishing the kind
of exposure the firm faces as discussed in the last paragraph. Forecasting the exchange rate

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Forex Market and Risk Management

movement is the most difficult aspect but firms can collect information on expected rates
from sources outside the firm (banks, consultants, foreign exchange dealers, etc) and compute
a scenario of events in respect of their impact on the firm's value if they lack the resources to
prepare their own forecasts internally.

1.2.7 ESTABLISHING OBJECTIVES AND POLICIES

Establishment of objectives and policies towards the management of exposure is a task to be

done by the Board of Directors, since this will be directed towards the firm's overall strategic
interest. This step will provide the strategy to be used by the treasurer or anybody responsible
for the operational management of the foreign exchange exposures. The operational tactics
will also be enumerated as well as the procedures for the evaluation of performance. The
strategy typically falls into three types via: full coverage, partial or selective coverage, and no
coverage. The limitations and the constraints in the procedures should be enumerated so that
the treasurer will not be penalized for any adverse impact over which he/she has no control.

1.2.8 IMPLEMENTING THE PROGRAMMES

Implementing the risk management programmes consists of using techniques to manage the
exposure. The instruments used in hedging techniques are either obtained from the banks or
from the exchange houses. Some large companies and multinational corporations do have in-
built instruments. The type of instruments to be used, where, and when to be purchased, as
well as the time to hedge will be enumerated in the guidelines as spelt out in the policies of
the firm established above.

1.2.9 EVALUATING PERFORMANCE

Evaluating the performance consists of measuring the performance of the technique used in
the management of the exposure and comparing it with the benchmark established in the
guidelines. This evaluation will also reflect the judgement and/or performance of the
treasurer or anybody responsible for the operational management of the foreign exchange
risk. Allan et al (1990) explained that there are three extreme benchmarks used to assess the
management of a foreign exchange exposure: do nothing, cover everything, and perfect
foresight. The benchmark to be used will influence the type of strategy to be used in

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Forex Market and Risk Management

managing the exchange risk. This is to align the performance assessment with the strategy
being used. Therefore if the evaluation benchmark is do nothing, then a do nothing strategy
will be put in place in the guidelines. Likewise a cover everything benchmark will be used for
full hedging strategy while the perfect foresight benchmark will be used for the selective
hedging strategy. Once the benchmark has been established, then the instruments to be used
to achieve the firm's objectives will be identified. These instruments are available in the
markets or over the counter and according to Allan et al (1990), the instruments can be
purchased in one market or in any combination of markets.

1.2.10 HEDGING TECHNIQUE AND INSTRUMENTS

In as much as there are various techniques used in foreign exchange risk management, there
are also various instruments used for these techniques. Hedging is one of the techniques used
in risk management. This section focuses on hedging techniques and appropriate instruments
for hedging. Darke and Klar (1991) described hedging as the process of reducing outstanding
portfolio or business risk (exposure reduction) via new techniques, technologies, or products,
or by altering the way business operates. This means taking an offsetting position in order to
cover the original open position. In terms of currency it means taking an offsetting currency
position so that whatever is lost or gained in the original currency position is offset exactly by
a corresponding gain or loss in the hedged currency. There are three strategies in hedging
techniques:

1. Full coverage in which case all the exposure in the original position is covered.
2. Selection or partial hedging involves covering a fixed proportion or certain part of the
total exposure.
3. No hedge involves a do-nothing approach in which the total exposure is left open.

The strategy to be used by a firm will be specified in the guidelines depending on the
objectives and policies of the firm. The instrument (henceforth will be referred to in this
paper as products) used for hedging had been classified by Batten et al (1992) into two
groups via physical products and synthetic products. The group classified as physical
products are spot, forward sales, short dated swaps and long dated swaps (more than six

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months). The synthetic products are futures, options, currency-swaps, forward rate agreement
(FRA's), caps, collars and floors. These products are known in the financial markets as
financial derivatives because they are derived from the financial products and their price is
linked to the price of the underlying financial product. Batten et al's (1992) classification of
these products will be used in this study. The glossary contains a brief description of these
products.

Various studies on foreign exchange risk management have shown that firms do manage their
exposure either actively, passively or as a hybrid of both (Batten et al 1992, Teoh and Er
1988, Collier et al 1990, Glaum and Belk 1990, CoUier and Davis 1985). These results claim
that risk management is necessary although some held the view that risk management was not
necessary as it was time wasting. Dufey and Srinivasulu (1983) debated the case for and
against foreign exchange risk management by examining extensively the reasons given by the
firms. They concluded that inferring on a limited range of essentially empirical propositions
identified, there is a case for foreign exchange risk management. Similarly, Eckl and
Robinson (1990) supported the case for foreign exchange risk management by companies. In
their conclusion they were concerned with how profitable a hedging transaction can be. They
suggested that since profitable hedging implies beating the market, which does not always
occur, then the best a company can do on average is to break-even in their hedging activities.

CONCLUSION

This chapter has explained the meaning of foreign exchange risk, how it exists and the
different concepts of exposure used in its management. It also indicates the processes
involved as well as the techniques and some of the products available for foreign exchange
risk management.

The conclusion derived from this chapter is that foreign exchange risk management is
necessary for all firms and not only exporting companies. In order to prevent or minimise the
loss caused by unfavourable exchange rate movements, companies can hedge their exposures
as well as actively managing their foreign exchange risk. The review of the literature
supporting the contention that there is concern by companies regarding foreign exchange risk
management, is the focus of next chapter.

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CHAPTER II

RESEARCH DESIGN

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Research design is the framework of research methods and techniques chosen by a

researcher. The design allows researchers to hone in on research methods that are suitable for
the subject matter and set up their studies up for success.

The design of a research topic explains the type of research

(experimental, survey, correlational, semi-experimental, review) and also its sub-type
(experimental design, research problem, and descriptive case-study).

There are three main types of research design: Data collection, measurement, and analysis.

The type of research problem an organization is facing will determine the research design and
not vice-versa. The design phase of a study determines which tools to use and how they are
used.

An impactful research design usually creates a minimum bias in data and increases trust in
the accuracy of collected data. A design that produces the least margin of error in
experimental research is generally considered the desired outcome. The essential elements of
the research design are:

1. Accurate purpose statement

2. Techniques to be implemented for collecting and analyzing research

3. The method applied for analyzing collected details

4. Type of research methodology

5. Probable objections for research

6. Settings for the research study

7. Timeline

8. Measurement of analysis

The tools used to measure volatility and analyse it include statistical tools, econometric tools
and descriptive analysis. Statistical tools included in descriptive summary statistics for the

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time series data include, mean, mode, median skewness and kurtosis is used to basic of
movements of exchange rates of Euro-INR, GBP-INR, USD-INR, JPY-INR.

Objectives of the study

1. To understand the forms and dynamics of foreign exchange rates in the Indian forex
markets.
2. To study and understand trends in foreign currency valuations – INR versus Euro,
Great Britain Pound Sterling(GBP), US Dollar(USD), Japanese Yen(Yen/JYP)
fluctuation.
3. To study reasons of volatility in Indian foreign exchange markets.
4. To study the measurement and analysis of forex volatility and its transmission.
5. To model the foreign exchange rate volatility.

Type and source of data

Type of data

Secondary data had been used. It is time series daily data of Euro-GBR

Proper research design sets your study up for success. Successful research studies provide
insights that are accurate and unbiased. You’ll need to create a survey that meets all of the
main characteristics of a design. There are four key characteristics of research design:

Neutrality: When you set up your study, you may have to make assumptions about the data
you expect to collect. The results projected in the research design should be free from bias
and neutral. Understand opinions about the final evaluated scores and conclusions from
multiple individuals and consider those who agree with the derived results.

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Reliability: With regularly conducted research, the researcher involved expects similar
results every time. Your design should indicate how to form research questions to ensure the
standard of results. You’ll only be able to reach the expected results if your design is reliable.

Validity: There are multiple measuring tools available. However, the only correct measuring
tools are those which help a researcher in gauging results according to the objective of the
research. The questionnaire developed from this design will then be valid.

Generalization: The outcome of your design should apply to a population and not just a
restricted sample. A generalized design implies that your survey can be conducted on any
part of a population with similar accuracy.

The above factors affect the way respondents answer the research questions and so all the
above characteristics should be balanced in a good design.

A researcher must have a clear understanding of the various types of research design to select
which model to implement for a study. Like research itself, the design of your study can be
broadly classified into quantitative and qualitative.

 Qualitative research design: Qualitative research determines relationships between

collected data and observations based on mathematical calculations. Theories related
to a naturally existing phenomenon can be proved or disproved using statistical
methods. Researchers rely on qualitative research design methods that conclude
“why” a particular theory exists along with “what” respondents have to say about it.
 Quantitative research design: Quantitative research is for cases where statistical
conclusions to collect actionable insights are essential. Numbers provide a better
perspective to make critical business decisions. Quantitative research design methods
are necessary for the growth of any organization. Insights drawn from hard numerical
data and analysis prove to be highly effective when making decisions related to the
future of the business.

You can further break down the types of research design into five categories:

1. Descriptive research design: In a descriptive design, a researcher is solely interested in

describing the situation or case under their research study. It is a theory-based design method
which is created by gathering, analyzing, and presenting collected data. This allows a
researcher to provide insights into the why and how of research. Descriptive design helps

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others better understand the need for the research. If the problem statement is not clear, you
can conduct exploratory research.

2. Experimental research design: Experimental research design establishes a relationship

between the cause and effect of a situation. It is a causal design where one observes the
impact caused by the independent variable on the dependent variable. For example, one
monitors the influence of an independent variable such as a price on a dependent variable
such as customer satisfaction or brand loyalty. It is a highly practical research design method
as it contributes to solving a problem at hand. The independent variables are manipulated to
monitor the change it has on the dependent variable. It is often used in social sciences to
observe human behaviour by analyzing two groups. Researchers can have participants change
their actions and study how the people around them react to gain a better understanding of
social psychology.

3. Correlational research design: Correlational research is a non-experimental

research design technique that helps researchers establish a relationship between two closely
connected variables. This type of research requires two different groups. There is no
assumption while evaluating a relationship between two different variables, and statistical
analysis techniques calculate the relationship between them.

A correlation coefficient determines the correlation between two variables, whose value
ranges between -1 and +1. If the correlation coefficient is towards +1, it indicates a positive
relationship between the variables and -1 means a negative relationship between the two
variables.

4. Diagnostic research design: In diagnostic design, the researcher is looking to evaluate the
underlying cause of a specific topic or phenomenon. This method helps one learn more about
the factors that create troublesome situations.

This design has three parts of the research:

· Inception of the issue

· Diagnosis of the issue

· Solution for the issue

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CHAPTER III
REVIEW OF LITERATURE

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HISTORICAL
BACKGROUND
HISTORICAL BACKGROUND
The creation of the gold standard monetary system in 1875 is one of the most important
events in the history of the FOREX market. Before the gold standard was created, countries
would commonly use gold and silver as method of international payment. The main
issue with using gold and silver for payment is that the value of these metals is greatly
affected by global supply and demand.

For example, the discovery of a new gold mine would drive gold prices down. The basic idea
behind the gold standard was that governments guaranteed the conversion of currency into a
specific amount of gold, and vice versa. In other words, a currency was backed by gold.
Obviously, governments needed a fairly substantial gold reserve in order to meet the demand
for currency exchanges.

During the late nineteenth century, all of the major economic countries had pegged an
amount of currency to an ounce of gold. Over time, the difference in price of an ounce of
gold between two currencies became the exchange rate for those two currencies. This
represented the first official means of currency exchange in history.

The gold standard eventually broke down during the beginning of World War I. Due to the
political tension with Germany, the major European powers felt a need to complete
large military projects, so they began printing more money to help pay for these projects.
The financial burden of these projects was so substantial that there was not enough gold
at the time to exchange for all the extra currency that the governments were printing off.
Although the gold standard would make a small comeback during the years between
the wars, most countries had dropped it again by the onset of World War II. However,
gold never stopped being the ultimate form of monetary value.

Bretton Woods System

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Before the end of World War II, the Allied nations felt the need to set up a
monetary system in order to fill the void that was left when the gold standard system was
abandoned. In July 1944, more than 700 representatives from the Allies met in Bretton
Woods, New Hampshire, to deliberate over what would be called the Bretton Woods
system of international monetary management.

To simplify, Bretton Woods led to the formation of the following:

 A method of fixed exchange rates;

 The U.S. dollar replacing the gold standard to become a primary reserve
currency;
 The creation of three international agencies to oversee economic activity: the

International Monetary Fund (IMF), International Bank for Reconstruction and Development,
and the General Agreement on Tariffs and Trade (GATT).

The main feature of Bretton Woods was that the U.S. dollar replaced gold as the main
standard of convertibility for the world's currencies. Furthermore, the U.S. dollar became the
only currency in the world that would be backed by gold. (This turned out to be the primary
reason why Bretton Woods eventually failed.) Over the next 25 or so years, the system ran
into a number of problems. By the early 1970s, U.S. Gold reserves were so low that the U.S.
Treasury did not have enough gold to cover all the U.S. dollars that foreign central banks had
in reserve.

Finally, on August 15, 1971, U.S. President Richard Nixon closed the gold window,
essentially refusing to exchange U.S. dollars for gold. This event marked the end of Bretton
Woods. Even though Bretton Woods didn't last, it left an important legacy that still has a
significant effect today. This legacy exists in the form of the three international agencies
created in the 1940s: the International Monetary Fund, the International Bank for
Reconstruction and Development (now part of the World Bank) and the General Agreement
on Tariffs and Trade (GATT), which led to the World Trade Organization (Investopedia
2017).

FOREIGN EXCHANGE-REGULATIONS

 FERA-Foreign Exchange Regulation Act, 1973 – Draconian

 FEMA-Foreign Exchange Management Act, 1999 - Liberalized

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 PMLA-Prevention of Money Laundering Act, 2002 - in force w.e.f. July 01, 2005 –
amended in Feb. 2009.

The Facilities and Principles for Regulating Fluctuation

The classic formula for determining domestic price levels postulates that the price level is
equal to the velocity of money multiplied by the money supply. Referencing college texts
such as the famous 1948 book Economics by Paul Samuelson:

P=MV
Price =Money Supply * Transaction Velocity
More money in circulation chasing the same number of goods at an increasing velocity leads
to inflation (a rising price level).

PROMOTIONAL STRATERGIES

A successful product or service means nothing unless the benefit of such a service can be
communicated clearly to the target market. An organizations promotional strategy can consist
of:

 Advertising: Is any non-personal paid form of communication using any form of mass
media?

 Sales promotion: Commonly used to obtain an increase in sales short term. Could involve
using money off coupons or special offers.

 Personal selling: Selling a product service one to one.

 Direct Mail: Is the sending of publicity material to a named person within an organization.
Linking Seller and Buyer

The seller’s four Ps

1) Product
2) Price
3) Place
4) Promotion

The buyer’s four Cs

1) Customer benefit
2) Customer cost
3) Convenience
4) Communication

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Key Factors to Consider

1) Reach Your Target Market

• Clearly define and understand your target audience

• Get in the customer state of mind

• How does this audience make purchasing decisions?

• What methods would be most effective in reaching this target audience? Consider these
groups when developing promotions

• Influencer – a person’s whose view or advice influences the buying decision

• Buyer – a person who makes the purchase transaction

• User – a person who uses the product/service.

2) Meet Your Goals and Objectives

Create promotion strategies (and associated budget) based on…

• Your goal/objectives

• Expected sales

• Costs of marketing activities

Economic interactions play a ubiquitous role in the world economy. Individuals and
organizations interact to find the right party with which to exchange; to arrange, manage and
integrate the activities associated with this exchange; and to monitor performance. These
interactions occur within firms, between firms, and all the way through markets to the end
consumer. They take many everyday forms – management meetings, conferences, phone
conversations, sales calls, problem solving, reports, memos – but their underlying economic
purpose is always to enable the exchange of goods, services, or ideas. Given the ubiquitous
nature of interactions, it is hardly surprising that they are important determinants of how
firms and industries are structured, and how customers behave. There is a balance to be
struck between the transformation costs of production and delivery, and the interaction costs
of arranging and coordinating exchanges.

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In order to develop relationships with customers that result in repeat business, referrals,
profitable relationships and high life-time value, the following statements must be core to
customer facing activities and processes:

• Every interaction with customers (or lack of interaction) tells customers how much they are
truly valued.

• These interactions are moments of truth are when a customer learns if promises made to
them (the brand) will be honoured or not.

• In order to create great experiences for customers, companies must know what they want
customers to feel, think and do at every stage of the relationship.

• The most unsatisfied customers can be a company’s greatest resource for innovation.
Customer engagement failures must be pursued aggressively to find out how to create great
experiences and value WITH – not for –customers.

• Business Processes must enable Brand Promises to be realized as Customer Experiences.

Moments of truth, when repeatedly resulting in positive outcomes and experiences, lead to
customer loyalty. But what is customer loyalty? Is it repeat purchases by a customer? Is it a
customer who gives a vendor a second chance if the vendor falls short on delivering the
appropriate experience? Is it a customer who refers others to a vendor?

REASONS FOR CHOOSING THE TOPIC

 Define promotion and fit in marketing.

 Clearly define and understand your target audience

 Get in the customer state of mind

 How does this audience make purchasing decisions?

 What methods would be most effective in reaching this target audience?

 To understand the competitors strategy

STATEMENT OF THE PROBLEM

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1) Some of my findings are, subjective in nature so it was difficult to verify those

findings and apply statistical tools on those findings.
2) This report may not be useful for a long period of time because market situation and
consumer behaviour is dynamic in nature.
3) Clients reluctant towards any survey or any questions relating any feedback
4) Not for domestic firms, restricted to international dealing firms.
5) Due to financial year end, appointment issues, created imbalance.

There are various studies on foreign exchange risk management theory and practice. The
academic research on risk management theory deals with the relevancy or not of foreign
exchange risk management and what firms should do to effectively manage their exposure
(Shapiro and Rutenbergl976, Logue and Oldfield 1977, Sirinivasulu 1983). The second type
of study provides empirical evidence on how firms actually manage their exposures in
practice (Collier and Davis 1985; Belk and Glaum 1990; Teoh and Er 1988). Batten et al
(1992) extended the research by providing evidence on the synthetic products being used by
firms to manage their foreign exchange exposures. To investigate the studies that have been
conducted on foreign exchange risk management practice generally and the use of synthetic
products to manage foreign exchange risk management in practice, this review of the
literature is divided into eight sections. Section one reviews the study done by Collier and
Davis (1985). Section two focuses on the study of Soenen and Aggarwal (1989). Section
three deals with the study done by Belk and Glaum (1990). Section four treats the work of
Teoh and Er (1988). Section five looks at the survey conducted by Batten et al (1992). The
research hypotheses are developed and presented in section six, while section seven gives the
tabular summary of all the literature reviewed. Section eight concludes the chapter.

COLLIER AND DAVIS STUDY

Collier and Davis (1985) conducted a study on the management of currency risk by UK
multinational companies. The study focussed on the relationship between organisational
structure and currency risk management practices. The sample was based on the Financial
Times Top 200 corporations with the use of questionnaires and follow-up 17 interviews.
There were 87 responses giving a response rate of 43.5 per cent and the results showed that
there is a relationship between organisational control (i.e degree of centralisation) and
currency risk management. It also showed that there is a relationship between the

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centralisation or decentralisation policy and risk management. That is, the more centralised
the organisational control, the greater the emphasis on the management of foreign exchange
exposure. Likewise, the results indicated that a centralised structure is associated with active
currency management. The study further found that there is no relationship between the
degree of risk of a firm and the organisational structure of risk management.

3.3 SOENEN AND AGGARWAL STUDY

Soenen and Aggarwal (1989) conducted a study on corporate practices in cash and foreign
exchange management in three countries of Western Europe. The study was conducted by the
use of questionnaires sent to companies in manufacturing, trading and service industries. A
sample of 750 companies were used (200 in United Kingdom, 250 in Netherlands, and 300 in
Belgium) while 259 companies responded giving a response rate of 30.5 per cent. The study
dealt with several issues which are of major concern to this present study. The issues covered
are policy and responsibility, degree of centralisation, foreign exchange forecasting, hedging
exposures, conflicts between departments and computerisation of foreign exchange
management Based on the above issues, the result of Soenen and Aggarwal's study are as
follows:

3.3.1 Policy and Responsibility:

The results showed that the responsibility for foreign exchange management rested on the
most senior executives of the company (V.P/Director of finance, treasurer, and controller)
across the sample. With the help of the comments of the respondents, it was found that the
responsibility of V.P Finance in respect of operational aspects is likely to occur in smaller
companies. From the results it could be adduced that there is a relationship between the
company size and responsibilities of company executives. The study suggested further that
though there are guidelines for exchange risk management, they cannot be regarded as formal
policies for the company. This present study tries to ascertain the relationship between
company size and executive responsibilities by not restricting the focus to large firms as in
the Soenen and Aggarwal's study. The same approach is used for ascertaining the presence or
lack of formal policies for foreign exchange risk management

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3.3.2 Centralisation and Decentralisation:

Soenen and Aggarwal also found that foreign exchange management operations are
centralised at headquarters. This result is similar to the result of Collier and Davis (1985) who
concluded that the more centralised the structure the greater the willingness to manage
foreign exchange exposure in terms of active or passive management.

3.3.3 Foreign Exchange Forecasting:

In this aspect the results from Soenen and Aggarwal indicated that the main sources of
information used for foreign exchange forecasting are obtained from banks and financial
publications. While some use an intuitive approach, others modify information obtained from
outside sources based on their experiences to suit their own purpose. The study did not
indicate why most of the companies relied on outside information for their exchange rate
forecasting. With the size and resources available to multinational corporations, one is
tempted to ask the question why they cannot have their own in-built system to generate the
information needed for exchange rate forecasting. In answering this question, it may be
suggested that cost could be a contributing factor whereby the cost of obtaining information
from outside might be less than the cost of generating it from inside.

Lending support to this, the literature has shown that with the sophistication in the technology
and communication industry, the cost of obtaining information from the financial markets has
been considerably reduced. Therefore when investigating the sources of information available
to small firms for foreign exchange forecasting, it could as well be assumed that their source
of information will be mainly from banks and financial publications. The forecasting horizon
of the sample was found to be between 0 and 12 months. According to Soenen and Aggarwal
this shows that the companies are risk averse, else it is assumed that if they are not risk
averse, they should have a longer time horizon than twelve months. Glaum claimed that risk
management should be strategic in nature and since strategic management is always based on
a long term approach, then the forecasting horizon should also be commensurate with the
nature of strategic management. No explanation was given for this short term approach by the
companies. The indicators used by most companies in exchange rate forecasting are mainly
Interest rate differentials, and Inflation, while the use of a combination of indicators are also
indicated. The use of these indicators might be related to the various theories in the Iterator
and finance texts which supported their usage (Shapiro 1992).

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3.3.4 Hedging exposures:

The results showed that most companies concentrate on managing transaction exposures
either separately or in combination with the translation exposures. This is similar to the result
of Belk and Glaum (1990) which found that though most companies have the management of
transaction exposures as the centre-piece of their foreign exchange risk management, they
still hedge their translation exposures as well. With the degree of exposures being hedged, it
shows that most companies are risk averse; therefore they try to minimise their loss in foreign
exchange by hedging rather than making profits from speculation in foreign exchange. The
most common strategy being used for hedging by the companies in the study was selective
hedging, followed by fully hedged and then no hedge. The rationale for the selective hedging
strategy is that the cost of full coverage of exposures is more than the benefits to be derived
from it. Another reason is that some companies are risk averse but still want to enjoy benefits
from any rally in exchange rate movements. The bottom line is that the strategy being used
by any company is dependent on the company policies. Furthermore, Soenen and Aggarwal
indicated that most firms used a combination of methods for hedging their exposures. The
most widely used methods were forward contracts, and currency invoicing, while the others
were International money market transactions and leading and lagging. However, all had
significant differences in their usage.

3.3.5 Conflicts with other departments:

The results showed that when decisions are made on foreign exchange risk management,
conflicts do occur between purchasing, sales, and finance departments. The reason adduced
for this is that risk management procedures are left to be the sole responsibility of one
department - treasury. In order to resolve this conflict, it is advisable to apply the strategic
approach to the foreign exchange risk management using the economic exposure concept.
This approach supports the recommendation of Glaum (1990).

3.3.6 Computerisation of foreign exchange management:

The Soenen and Aggarwal (1989) study found that most companies do not use computers in
their foreign exchange risk management, but have experts for data processing only. The
reason given for not using computers ranges from: not cost justifiable, not considered
suitable, to not yet being evaluated as to the cost-benefit analysis. This result can be assumed
to be applicable to small companies due to their size, resources available and probably the
volume of their International transactions.

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3.4 BELK AND GLAUM STUDY

Belk and Glaum (1990) reported on their study of U.K multinationals as regards risk
management practices. The study focussed on the following issues: the concept of exposures
being used in foreign exchange risk management, the organisational structure of risk
management, and the objectives of foreign exchange risk management. Though the study was
on a sample of 17 industrial companies with a significant degree of International
involvement, the total population and basis for sample selection were not given. Personal
interviews were used for the study based on pre-determined open-ended questions. The
results provided evidence that the majority of firms do manage both translation and
transaction exposures to a great extent, but the degree of management varies between the
companies. There was little or no use of the economic exposure concept by the companies
which is in contrast to the various views being expressed in the literature that supports the
concept. The reasons given for the flaw are the complex nature of the topic and the
respondent's use of transaction exposure concept for economic exposure concept. The
majority of the companies used hedging techniques to manage their exposures with various
strategies ranging from no hedge to full cover.

Furthermore, all of the companies used financial products for hedging their exchange risk. In
the area of organisational structure, Belk and Glaum found that many companies centralised
their exposure management but to varying degrees. Nine of the companies had a high degree
of centralisation in which the decision making and implementation were at the headquarters.
Seven companies had a low degree of centralisation whereby the decision-making was being
made at the regional or subsidiary level, while the implementation was being done at the
headquarters. Only one company was observed to be completely decentralised whereby both
decision-making and implementation were done at the subsidiary level. The study observed
further that treasury departments were being run as either profit centres or service (negative
cost) centres. Two firms operated the treasury as a profit centre, while nine companies
operated it as a service centre, though the department was expected to contribute to the
company profits. Sixteen of the 17 respondents indicated their objectives of risk management
out of which 12 said they were risk averse and the remaining four were classified as risk
taking. This is similar to other results in the literature (Teoh and Er 1988) that most firms are
risk averse, therefore they hedge most if not all their exposures.

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3.5 TEOH AND ER STUDY

Teoh and Er (1988) investigated the effect of floating the Australian dollar on foreign
exchange risk management practices in Australia. ANOVA and CHI-SQUARE tests were
used to find out the main and interaction effects amongst the variables. The independent
variables identified by the study are company specific such as: ownership structure, company
activity, sales turnover, and intemational involvement. Investigating the foreign exchange
risk management practices, the following aspects were examined: extent of resources
channelled to the risk management function, risk management objectives, organisational
structure, exchange rate forecasting and hedging policy and strategy. The survey method was
used by sending a mail questionnaire to 460 companies of which 132 responded given a
response rate of approximately 31 per cent. The result of this study showed that companies
with substantial involvement in International activities were more likely to set up a formal
organisational structure for their risk management. It was observed that the structure is highly
centralised with decision-making at the headquarters for companies with subsidiaries and at
the top-level management for single companies. The reasons given for the high degree of
centralisation are lack of experience at the operating level, and severity of fluctuations in
exchange rates, demanding as a result, and senior management attention. This indicates that
risk management is considered to be the concern of top management, and thus should be
managed strategically. As regards the risk management objectives, the result was that the
company objective should be the elimination of exchange losses arising from translation,
transaction, and economic exposures. This is synonymous to the risk averse objective
expressed in the Iterator. In respect of exchange rate forecasting, it was discovered that large
companies used information from banks while small companies used an intuitive approach to
forecasting. At the same time some companies used mathematical models for forecasting.
Furthermore, large companies were found to be more likely to have established hedging
policies than the smaller ones which shows that size is an important factor in determining
foreign exchange risk management. The observations of Teoh and Er also revealed that
forward contracts are the most widely used hedging technique.

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3.6 BATTEN, MELLOR, WAN, AND SYME STUDY

Batten et al (1992) conducted a survey on foreign exchange risk management practices and
the product usage of large Australian firms. The study analysed the characteristics of a firm
that had a major impact on foreign exchange risk management practices by the firm. The firm
characteristics identified are industry grouping, sales turnover, international involvement, and
ownership structure (sub-divided into foreign, Australian, private, public). The risk
management practice variables identified are the use of physical and synthetic products,
degree of centralisation, usage of short and long term funding techniques, and the use of
technology in the measurement and management of foreign exchange risk. Questionnaires
were sent to a sample of 500 firms with a response from 94 firms of which 72 were found
usable for the study with a response rate of 14.4 percent. Chi-square test was used to ascertain
the relationship between the firm variables and the risk management variables. The
descriptive analysis showed that the majority of the firms used the transaction exposure
concept in managing their exchange risk (61% of the sample) followed by the use of an
economic concept (17%) with only 8% using the translation concept. This is similar to the
results of Soenen and Aggarwal (1989), Glaum (1990), Collier et al (1990). The only
exception is the result of Belk and Glaum (1990) which stated that multinational corporations
in U.K do manage both translation and transaction exposures. Batten et al further observed
that most companies use both synthetic and physical products in their foreign exchange
activities with forward contracts as the main physical product being used (similar to findings
by Teoh and Er 1988, Soenen and Aggarwal 1989) followed by spot contracts. The most
widely used synthetic product is the foreign currency options followed by currency swaps.

As regards the risk management strategy, it was observed by Batten et al (1990) that almost
all the companies covered their exposures but to varying degrees. A fully hedged 24 strategy
was used by 21 firms (approximately 30.4%), 22 firms (approximately 31.9%) actively traded
their positions and the remaining 26 firms (approximately 37.7%) were assumed to be using
selective hedging. This result provides evidence as well as supporting other findings that
companies are risk averse. Surprisingly, the result on the use of computers in risk
management pointed out that companies do largely use PC based systems followed by the use
of the combination of both PC based and mainframe systems. This is in contrast to the
observation of Soenen and Aggarwal (1989) that most companies do not use computers in
their foreign exchange risk management. The difference might be attributed to the location of
the study and/or the degree of advancement in technology in Australia between 1989 and

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1992. In analysing the firm variables that have the major impact on management practices, it
was discovered that the size of the firm measured by foreign exchange turnover had the most
impact. The impact is mainly in the use of computers in risk management, the use of both
physical and synthetic products, and the funding (both short and long term) activities of the
firm.

3.7 RESEARCH HYPOTHESES

All the above diagnoses were conducted using multinational corporations and big companies.
In most of the studies, it has been shown that size of the firm has a great impact on risk
management practices. Since the big companies are not the only participants exposed to
foreign exchange risk, a decision was made to replicate or conduct a similar study using
smaller-sized firms with International involvement. The foregoing discussion will be used as
a conceptual framework for this study. In investigating the foreign exchange risk
management practices in both large and small firms, two hypotheses were developed and
tested based on the findings of the previous studies.

The first null hypothesis was developed to test the impact of size on foreign exchange risk
management practices and is stated as:

'Risk management practices are not dependent on the size of the firm’

The next investigation involves testing the impact of size on the use of synthetic products in
foreign exchange risk management. The null hypothesis is stated thus:

'The use of synthetic products in foreign exchange risk management is not dependent on the
size of the firm'

To test these hypotheses, the following identified firm specific variables similar to those
identified by Teoh and Er (1988) are used

1. Ownership

2. Turnover

3. Extent of International Involvement

The principal activity was selected based on the result of Batten at al (1992) which found that
companies in the manufacturing industry are the largest foreign exchange users. Therefore,

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the sample for this study was selected from the manufacturing industry. The following
variables are identified for the risk management practices based on the related studies
reviewed above.

Policy and responsibility;

Degree of centralisation;

Foreign exchange forecasting;

Risk management objectives;

Hedging strategy and policies; and

Computerisation of foreign exchange risk management.

In total the study will provide evidence on the foreign exchange risk management practices
by small firms based on the concepts they use, the objectives they follow and the organization
of the management function.

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CHAPTER IV
ANALYSIS AND INTERPRETATION

An Exchange Rate is Just a Price

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The foreign exchange (FX or FOREX) market is the market where exchange rates are
determined. Exchange rates are the mechanisms by which world currencies are tied together
in the global marketplace, providing the price of one currency in terms of another.

An exchange rate is a price, specifically the relative price of two currencies.

For example, the U.S. dollar/Mexican peso exchange rate is the price of a peso expressed in
U.S. dollars. On March 23, 2015, this exchange rate was USD 1.0945 per EUR, or, in market
notation, 1.0945 USD/EUR.

 The Price of Milk and the Price of Foreign Currency An exchange rate is another price in
the economy. Let’s compare an exchange rate to the price of milk. Suppose that the price of a
gallon of milk is USD 2.50, or 2.50 USD/milk, using the above exchange rate market
notation.

When we price milk, the denominator refers to one unit of the good that it is being bought –a
gallon of milk. When we price exchange rates, the denominator refers specifically to one unit
of a currency. Therefore, think of the currency in the denominator as the currency you are
buying.

 The exchange rate is just a price, but it is an important one: St plays a very important role
in the economy since it directly influences imports, exports, & cross-border investments. It
has an indirect effect on other economic variables, such as the domestic price level, Pd, and
real wages. For example: when St increases, foreign imports become more expensive in USD.
Then, the domestic price level Pd increases and, thus, real wages decrease (through a
reduction in purchasing power). Also, when St increases, USD-denominated goods and assets
are more affordable to foreigners. Foreigners buy more goods and assets in the U.S. (exports,
real estate, bonds, companies, etc.). These factors drive aggregate demand up and, thus, GDP
increases.

1. A.1 Equilibrium Exchange Rates and Foreign Exchange Risk

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Like in any other market, demand and supply determine the price of a currency. At any point
in time, in a given country, the exchange rate is determined by the interaction of the demand
for foreign currency and the corresponding supply of foreign currency. Thus, the exchange
rate is an equilibrium price (St E) determined by supply and demand considerations, as
shown by Exhibit I.1.

What are the determinants of currency supply and demand in the foreign exchange market?
The supply of foreign currency derives from foreign residents purchasing domestic goods and
services –i.e. domestic export--, foreign investors purchasing domestic assets, and foreign
tourists traveling to the domestic country. These foreign residents need domestic currency to
pay for their domestic purchases. Thus, the foreign residents buy the domestic currency with
foreign currency in the foreign exchange market. Similarly, the demand for foreign currency
derives from domestic residents purchasing foreign goods and services –i.e. domestic
imports--, domestic investors purchasing foreign assets, and domestic tourists traveling
abroad.

Over time, the many variables that affect foreign trade, international investments and
international tourism will change, forcing exchange rates to adjust to new equilibrium levels.
For example, suppose interest rates in the domestic country increase, ceteris paribus, relative
to interest rates in the foreign country. The domestic demand for foreign bonds will decrease,
reducing the demand for foreign currency in the foreign exchange rate. The foreign demand
for domestic bonds will increase, increasing the supply of foreign currency in the foreign

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exchange rate. As a result of these movements of the supply and the demand curves in the
foreign exchange market, the price of the foreign currency in terms of domestic currency will
decrease. Exhibit I.2 shows the effect of these changes in the equilibrium exchange rate.

Changes in exchange rates are usually measured by percentage changes or returns. The
currency return from time t to T, st,T, is given by:

St,T = (ST/St) - 1,

Where St represents the exchange rate in terms of number of units of domestic currency for
one unit of the foreign currency (the spot rate).

Risk arises every time actual outcomes can differ from expected outcomes. Assets and
liabilities are exposed to financial price risk when their actual values may differ from
expected values. In foreign exchange markets, we are in the presence of foreign exchange
risk (currency risk) when the actual exchange rate is different from the expected exchange
rate. That is, if there is foreign exchange risk, st,T cannot be predicted perfectly at time t. In
statistical terms, we can think of st,T as a random variable.

II. Currency Markets

2. Organization

The foreign exchange market is the generic term for the worldwide institutions that exist to
exchange or trade the currencies of different countries. It is loosely organized in two tiers: the

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retail tier and the wholesale tier. The retail tier is where the small agents buy and sell foreign
exchange. The wholesale tier is an informal, geographically dispersed, network of about
2,000 banks and currency brokerage firms that deal with each other and with large
corporations. The foreign exchange market is open 24 hours a day, split over three time
zones. Foreign exchange trading begins each day in Sydney, and moves around the world as
the business day begins in each financial center, first to Tokyo, London and New York.
Computer screens, around the world, continuously show exchange rate prices. A trader enters
a price for the USD/CHF exchange rate on her machine, and can then receive messages from
anywhere in the world from people willing to meet that price. It does not matter to her
whether the counterparties are sitting in London, Singapore, or, in theory, Buenos Aires. The
foreign exchange market has no physical venue where traders meet to deal in currencies.
When the financial press and economic textbooks talk about the foreign exchange market
they refer to the wholesale tier. In this chapter we will follow this convention.

Currency markets are the largest of all financial markets in the world. A typical transaction in
USD is about 10 million ("ten dollars," in dealer slang). In the last triennial survey conducted
by the Bank of International Settlements (BIS) in April 2019, it was estimated that the
average daily volume of trading on the foreign exchange market -spot, forward, and swap-
was close to USD 6.6 trillion –a 29% increase, compared to April 2013, see Exhibit I.1
below. The daily average volume is about ten times the daily volume of all the world’s equity
markets and sixty times the U.S. daily GDP. The exchange market's daily turnover is also
equal to 40% of the combined reserves of all central banks of IMF member states.

In April 2019, the major markets were London, with 43% of the daily volume, New York
(17%), Singapore (7%), Hong Kong (8%), and Tokyo (6%). Zurich, Frankfurt, Paris, and
Amsterdam are small players. The top traded currency was the USD, which was involved in
88% of transactions. It was followed by the EUR (30%), and the JPY (16%)). The USD/EUR
was by far the most traded currency pair in 2019 and captured 23% of global turnover,
followed by USD/JPY with 18% and USD/GBP with 9%. Trading in local currencies in
emerging markets captured about 23% of foreign exchange activity in 2019.

Given the international nature of the market, the majority (57%) of all foreign exchange
transactions involves cross-border counterparties. This highlights one of the main concerns in
the foreign exchange market: counterparty risk. A good settlement and clearing system is
clearly needed.

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2.A.1 Settlement of transactions

At the wholesale tier, no real money changes hands. There are no messengers flying around
the world with bags full of cash. All transactions are done electronically using an
international clearing system. SWIFT (Society for Worldwide Interbank Financial
Telecommunication). Operates the primary clearing system for international transactions. The
headquarters of SWIFT is located in Brussels, Belgium. SWIFT has global routing computers
located in Brussels, Amsterdam, and Culpeper, Virginia, USA. The electronic transfer system
works in a very simple way. Two banks involved in a foreign currency transaction will
simply transfer bank deposits through SWIFT to settle a transaction.

Example I.1: Suppose Banco del Suquía, one of the largest Argentine private banks, sells
Swiss francs (CHF) to Malayan Banking Berhard, the biggest Malayan private bank, for
Japanese yens (JPY). A transfer of bank deposits will settle this transaction. Banco del Suquía
will turn over to Malayan Banking Berhard a CHF deposit at a bank in Switzerland, while
Malayan Banking Berhard will turn over to Banco del Suquía a JPY deposit at a bank in
Japan. The SWIFT messaging system will handle confirmation of trade details and payment
instructions to the banks in Switzerland and Japan. Banco del Suquía will have a bank
account in I.5 Japan, in which it holds JPY, and Malayan Banking Berhard will have a bank
account in Switzerland, in which it holds CHF. ¶

The foreign accounts used to settle international payments can be held by foreign branches of
the same bank, or in an account with a correspondent bank. A correspondent bank
relationship is established when two banks maintain a correspondent bank account with one
another. The majority of the large banks in the world have a correspondent relationship with
other banks in all the major financial centers in which they do not have their own banking
operation. For example, a large bank in Tokyo will have a correspondent bank account in a
Malayan bank, and the Malayan bank will maintain one with the Tokyo bank. The
correspondent accounts are also called nostro accounts, or due from accounts. They work like
current (checking) accounts.

The foreign exchange market is largely an unregulated market. Only exchange-traded

derivative contracts are subject to formal regulation. The U.S. banks participating in the spot
market are supervised by the Federal Reserve System and must report their foreign exchange
position on a periodic basis.

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2.A.2 Activities

Speculation is the activity that leaves a currency position open to the risks of currency
movements. Speculators take a position to "speculate" the direction of exchange rates. A
speculator takes on a foreign exchange position on the expectation of a favourable currency
rate change. That is, a speculator does not take any other position to reduce or cover the risk
of this open position.

Hedging is a way to transfer part of the foreign exchange risk inherent in all transactions,
such as an export or an import, which involves two currencies. That is, by contrast to
speculation, hedging is the activity of covering an open position. A hedger makes a
transaction in the foreign exchange market to cover the currency risk of another position.
Arbitrage refers to the process by which banks, firms or individuals attempt to make a risk-
profit by taking advantage of discrepancies among prices prevailing simultaneously in
different markets. The simplest form of arbitrage in the foreign exchange market is spatial
arbitrage, which takes advantage of the geographically dispersed nature of the market. For
example, a spatial arbitrageur will attempt to buy GBP at 1.61 USD/GBP in London and sell
GBP at 1.615 USD/GBP in New York. Triangular arbitrage takes advantage of pricing
mistakes between three currencies. As we will see below, cross-rates are determined by
triangular arbitrage. Covered interest arbitrage takes advantage of a misalignment of spot and
forward rates, and domestic and foreign interest rates.

2.A.3 Players and Dealing in Foreign Exchange Markets

The players in the foreign exchange markets are speculators, corporations, commercial banks,
currency brokers, and central banks. Corporations enter into the market primarily as hedgers;
however, corporations might also speculate. Central banks tend to be speculators, that is, they
enter into the market without covering their positions. Commercial banks and currency
brokers primarily act as intermediaries, however, at different times, they might be also
speculators, arbitrageurs, and hedgers. All the parties in the foreign exchange market
communicate through traders or dealers. Commercial banks account for the largest proportion
of total trading volume. In 2019, the BIS reported that over 90% of all foreign exchange
trading was either interbank (39%) or with other financial institutions including hedge funds,
mutual funds, investment houses and securities firms (53%). Only 9% of the trading was
done between banks and non-financial customers, for example big corporations. The high

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volume of interbank trading is partially explained by the geographically dispersed nature of

the market and the price discovering process.

2.A.3.i Dealers, Market Makers and Brokers

A dealer's main responsibility is to make money without compromising the reputation of his
or her employer. To this end, they take positions, that is, buy and sell securities using their
employer's capital. At the end of the day, a dealer should have the book squared –i.e., all
positions closed.

Many dealers act as market makers. Therefore, they are obliged to provide bids and offers to
both competitors and clients upon request. That is, any interested parties can ask market
makers for a two-way quote, a bid and an ask quote. Once given, the quote is binding, that is,
the market maker will buy foreign exchange at the bid quote and sell at the ask quote. The
difference between the bid and the ask is the spread. Market makers make a profit from the
bid-ask spread. Bid-ask spreads are close to .03%, which are significantly lower than spreads
in any other financial market with the exception of the Treasury bill market. The arithmetic
average of the bid rate and the ask rate is called the mid rate. Market makers profit from the
high volume in the foreign exchange market.

Another channel for dealing is through a broker. For example, a Bertoni Bank dealer contacts
a broker offering to buy, say, JPY 500 million. The broker provides two prices: a bid and an
ask, without revealing the name of the counterparty. If Bertoni Bank accepts the ask, then the
broker will reveal the name of the counterparty so the electronic settlement of the transaction
can be performed. If the broker cannot provide immediately a price, the broker will shop
around and see if there are any sellers for this volume. Brokers make a profit from a fixed
commission paid by both parties. Instead of going to a broker, Bertoni Bank can contact
another bank and try to purchase directly from the other bank. This transaction is an interbank
or direct dealing transaction. Direct dealing saves the commission charged by the broker.
Direct dealing also reveals information about the position of other parties. Discovering other
dealers' prices help dealers to determine the position of the market and then establish their
prices.

A study by Richard Lyons, published in the Journal of Financial Economics, in 1995,

analyzes the transactions of an interbank spot trader over a five-day period. This trader
completed 267 transactions per day, that is, one transaction every 67 seconds. The average

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daily volume traded by this trader was USD 1.2 billion. The majority of the transactions were
direct deals; however, this trader tended to use brokers for larger than average transactions. In
this study, Richard Lyons reports that the median spread between the bid and ask prices was
DEM .0003, which represented less than 0.02 percent of the spot rate.

2.A.3.ii Electronic Trading

In 1992 Reuters introduced an automated, electronic brokerage system, Reuters Dealing

2000-2. The Reuters system allows dealers to enter their live prices. Prices appear on a screen
as anonymous live quotations. Traders from around the world can hit a price from their
terminals, then Reuters 2000 checks for mutual credit availability between the two
counterparties and completes the transaction with ticket writing and confirmations.

Since the introduction of Reuters 2000, other competing systems were developed. Very
quickly, two competitors appeared: MINEX, developed by Japanese banks and Dow Jones
Telerate, and Electronic Brokering Service (EBS), developed by Quotron and a consortium of
U.S. and European banks.

Electronic trading offers greater transparency compared to the traditional means of dealing
described above. Spot foreign exchange markets have been traditionally opaque, given the
difficulty of disseminating information in the absence of centralized exchanges. Before the
introduction of electronic trading, dealers –like the dealer studied by Lyons- had to enter into
a number of transactions just to obtain information on prices available in the market. Traders
using an electronic brokerage system are able to know instantly the best price available in the
market.

Electronic trading platforms gained market share almost overnight. The share of electronic
trading went from 2% in 1993 to almost 20% in 2001. In the last BIS survey, in 2019, the
share of electronic trading in the spot foreign exchange market was 56%. For certain market
segments, such as those involving the major currencies, electronic brokers reportedly covered
90% of the interbank market. The bid-ask spreads for the major currencies have fallen to
about two to three hundredths of a US cent.

Today, the electronic FX trading market is very competitive, with many well-established
trading venues. The main electronic platforms are EBS, Thompson Reuters and Bloomberg.
Other venues are FX Connect, Currenex, and 360T. The big banks (Barclays, Citi, UBS) use
their own platforms, single-bank platforms, to internalize volume.

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2.B The Products of the Foreign Exchange Market

2.B.1 The Spot Market

The spot market is the exchange market for payment and delivery today. In practice, "today"
means today only in the retailer tier. Currencies traded in the wholesale tier spot market have
customary settlement in two business days.

In the interbank market, dealers quote the bid and the ask, willing to either buy or sell up to
USD 10 million at the quoted prices. These spot quotations are good for a few seconds. If a
trade is not done immediately over the phone or the computer, the quotes are likely to change
over the next seconds. Traders use a particular system when quoting exchange rates. For
example, the EUR/USD bid-ask quotes: 1.2397-1.2398. The "1.23" is called the big figure,
and it is assumed that all traders I.8 know it. The last two digits are referred as the small
figure. Thus, it is clear for traders the meaning of a telephone quote of "97-98." The
difference between the bid and the ask is called the bid-ask spreads. Spreads are very thin in
the FX market. For actively traded pairs, usually no more 3 pips – i.e., 0.0003.

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Example I.2: A bid/ask quote of EUR/USD: 1.2397/1.2398 (spread: one pip). See screenshot
from electronic trading platform EBS below:

Take the EUR/USD quote. The first number in black, 1.23, represents the “big figure” –i.e.,
the first digits of the quote. The big numbers in yellow, within the green/blue squares,
represent the last digits of the quote to form 1.2397-1.2398. The number in black by the ask
(“offer”) 98 (11) represents an irregular amount (say USD 11 million); if no number is by the
bid/ask quote, then the “usual” amount is in play (say, USD 10 million, usually set by the
exchange and may differ by currency). These irregular amounts have a better price quote than
the regular amounts. The best regular quotes are on the sides 97 & 99. ¶

In 2016, the BIS estimated that the daily volume of spot contracts was USD 1.652 trillion
(33% of total turnover). Again, the majority of the spot trading is done between financial
institutions. Only 19% of the daily spot transactions involved non-financial customers. The
high volume of interbank trading is partially explained by the geographically dispersed nature
of the market. Dealers trade with one another to take and lay off risks, and to discover
transaction prices. Discovering other dealers' prices help dealers to determine the position of
the market and then establish their prices.

2.B.1.i Direct and Indirect Quotations

An exchange of currencies involves two currencies, either of which may arbitrarily be

thought as the currency being bought. That is, either currency may be placed in the
denominator of an exchange rate quotation. When exchange rates are quoted in terms of the
number of units of domestic currency per unit of foreign currency, the quote is referred to as
direct quotation. On the other hand, when exchange rates are quoted in terms of the number
of foreign currency units per unit of domestic currency, the quote is referred to as indirect
quotation.

The indirect quotation is the reciprocal of the corresponding direct quotation.

Most currencies are quoted in terms of units of currency that one USD will buy. This quote is
called "European" quote. Exceptions are the "Anglo Saxon" currencies (British Pound (GBP),
Irish punt (IEP), Australian dollar (AUD), the New Zealand dollar (NZD)), and the EUR.
This second type of quote is also called "American quote."

Example I.3: Quotations.

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(A) Indirect quotation: JPY/USD (European quote). Suppose a U.S. tourist wishes to buy JPY
at Los Angeles International Airport. A quote of JPY 110.34- 111.09 means the dealer is
willing to buy one USD for JPY 110.34 (bid) and sell one USD for JPY 111.09 (ask). For
each USD that the dealer buys and sells, she makes a profit of JPY .75.

(B) Direct quotation: USD/JPY (American quote). If the dealer at Los Angeles International
Airport uses direct quotations, the bid-ask quote will be USD .009002-.009063 per one JPY.

¶ It is easy to generate indirect quotes from direct quotes. And viceversa. As Example I.3
illustrates:

S(direct)bid = 1/S(indirect)ask,

S(direct)ask = 1/S(indirect)bid.

The discussion about exchange rate movements sometimes is confusing because some
comments refer to direct quotations while other comments refer to indirect quotations. Direct
quotations are the usual way prices are quoted in an economy. For example, a gallon of milk
is quoted in terms of units of the domestic currency. Thus, unless stated otherwise, we will
use direct quotations. That is, the domestic currency will always be in the numerator while
the foreign currency will always be in the denominator.

In the foreign exchange market, banks act as market makers. They realize their profits from
the bid-ask spread. Market makers will try to pass the exposure from one transaction to
another client. For example, a bank that buys JPY from a client will try to cover its exposure
by selling JPY to another client. Sometimes, a bank that expects the JPY to appreciate over
the next hours may decide to speculate, that is, wait before selling JPY to another client.
During the day, bank dealers manage their exposure in a way that is consistent with their
short-term view on each currency. Toward the end of the day, bank dealers will try to square
the banks' position. A dealer who accumulates too large an inventory of JPY could induce
clients to buy them by slightly lowering the price. Thus, because quoted prices reflect
inventory positions, it is advisable to check with several banks before deciding to enter into a
transaction.

2.B.1.ii Cross-rates

The direct/indirect quote system is related to the domestic currency. The European/American
quote system involves the USD. But if a Malayan trader calls a Hong Kong bank and asks for

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the JPY/CHF quote, the Hong Kong bank will quote a rate that does not fit under either quote
system. The Hong Kong bank will quote a cross rate. Most currencies are quoted against the
USD, so that I.10 cross-rates are calculated from USD quotations. For example, the JPY/GBP
is calculated using the USD/JPY and USD/GBP rates. This usually implies a larger bid-ask
spread on cross exchange rates. The cross-rates are calculated in such a way that arbitrageurs
cannot take advantage of the quoted prices. Otherwise, triangular arbitrage strategies would
be possible and banks would soon notice imbalances in their buy/sell orders.

Example I.4: Suppose Housemann Bank gives the following quotes: St = .0104-.0108
USD/JPY, and St= 1.5670-1.5675 USD/GBP. Housemann Bank wants to calculate the
JPY/GBP cross-rates. The JPY/GBP bid rate is the price at which Housemann Bank is willing
to buy GBP against JPY, i.e., the number of JPY units it is willing to pay for one GBP. This
transaction (buy GBP-sell JPY) is equivalent to selling JPY to buy one USD -at Housemann's
bid rate of (1/.0108) JPY/USD- and then reselling that USD to buy GBP -at Housemann's bid
rate of 1.5670 USD/GBP. Formally, the transaction is as follows:

Sbid,JPY/GBP= Sbid,JPY/USD x Sbid,USD/GBP= [(1/.0108) JPY/USD]x[(1.5670)

USD/GBP] = 145.0926 JPY/GBP.

That is, Housemann Bank will never set the JPY/GBP bid rate below 145.0926 JPY/GBP.
Using a similar argument, Housemann Bank will set the ask JPY/GBP rate (sell GBP-buy
JPY) using the following formula:

Sask,JPY/GBP = Sask,JPY/USDxSask,USD/GBP= [(1/.0104) JPY/USD]x[(1.5675)

USD/GBP] = 150.7211 JPY/GBP.¶

Example I.5: A Triangular Arbitrage Opportunity

Consider, again, Example I.4. Suppose, now, that a Housemann Bank trader observes the
following exchange rate quote: Sask,JPY/GBP = 143.00 JPY/GBP. We can see that the JPY
is overvalued in terms of GBP, since it is below the arbitrage-free bid rate of 145.0926
JPY/GBP. The trader automatically starts a triangular arbitrage strategy:

(1) Borrow USD 1 M

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(2) Sell USD 1,000,000 at the rate .0108 USD/JPY. Then, the trader buys JPY 92,592,592.59.
(3) Sell JPY 92,592,592.59 at the rate of 143.00 JPY/GBP. The trader buys GBP 647,500.65.
(4) Sell GBP 647,500.65 at the rate 1.5670 USD/GBP. The trader buys USD 1,014,633.51.
(5) Return USD loan, keep profits.

This operation makes a profit of USD 14,633.51 (or 1.46% per USD borrowed). The
Housemann trader will try to repeat this operation as many times as possible. After several
operations, banks will adjusts the quotes to eliminate arbitrage.

Note: For the strategy (1)-(5) to be considered arbitrage, steps (1)-(5) should be done
simultaneously. ¶

2.B.2 The Forward Market

Forward currency markets have a very old history. In the medieval European fairs, traders
routinely wrote forward currency contracts. A forward transaction is simple. It is similar to a
spot transaction, but the settlement date is deferred much further into the future. No cash
moves on either side until that settlement date. That is, the forward currency market involves
contracting today for the future purchase or sale of foreign currency. Forward currency
transactions are indicated on dealing room screens for intervals of one, two, three and twelve
month settlements. Most bankers today quote rates up to ten years forward for the most
traded currencies. Forward contracts are tailor-made to meet the needs of bank customers.
Therefore, if one customer wants a 63-day forward contract a bank will offer it. Nonstandard
contracts, however, can be more expensive.

Forward quotes are given by "forward points." The points corresponding to a 180-day
forward GBP might be quoted as .0100-.0108. These points can also be quoted as 8-100. The
first number represents the points to be added to the second number to form the ask small
figure, while the second number represents the small figure to be added to the bid's big

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figure. These points are added from the spot bid-ask spread to obtain the forward price if the
first number in the forward point "pair" is smaller than the second number. The forward
points are subtracted from the spot bid-ask spread to obtain the forward price, if the first
number is higher than the second number. The combination of the forward points and the spot
bid-ask rate is called the "outright price."

Example I.6: Suppose St=1.5670-1.5677 USD/GBP. We want to calculate the outright price.
(A) Addition

The 180-days forward points are .0100-.0108 (8-100), then Ft,180 = 1.5770-1.5785
USD/GBP.

(B) Subtraction

The 180-days forward points are .0072-.0068 (68-4), then Ft,180 = 1.5602-1.5605 USD/GBP.

¶ Forward contracts allow firms and investors to transfer the risk inherent in every
international transaction. Suppose a U.S. investor holds British bonds worth GBP 1,000,000.
This investor believes the GBP will depreciate against the USD, in the next 90 days. This
U.S. investor can buy a 90-day GBP forward contract to transfer the currency risk of her
British bond position.

A forward transaction can be classified into two classes: outright and swap. An outright
forward transaction is an uncovered speculative position in a currency, even though it might
be part of a currency hedge to the other side of the transaction. A foreign exchange swap
transaction helps to reduce the exposure in a forward trade. A swap transaction is the
simultaneous sale (or purchase) of spot foreign exchange against a forward purchase (or sale)
of approximately an equal amount of the foreign currency.

In 2016, the daily volume of outright forward contracts amounted to USD 700 billion, or 14%
of the total volume of the foreign exchange market. Unlike the spot market, 35% of
transactions involved a non-financial customer. These non-financial customers typically use
forward contracts to manage currency risk. Forward contracts tend to have very short
maturities: 40% of the contracts had a maturity of up to 7 days. Less than 5% of the forward
contracts had a maturity of over one year.

I.12 2.B.2.i Forward Premium and Forward Discount

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A foreign currency is said to be a premium currency if its interest rate is lower than the
domestic currency. On the other hand, a foreign currency is said to be a discount currency if
its interest rate is higher than the domestic currency. Forwards will exceed the spot for a
premium currency and will be less than the spot for a discount currency. For example, on
November 9, 1994 (see Example I.8 below), the (forward) British pound was a discount
currency. That is, the British pound is cheaper in the forward market.

It is common to express the premium and discount of a forward rate as an annualized

percentage deviation from the spot rate. When annualized, the forward premium is compared
to the interest rate differential between two currencies. The forward premium, p, is calculated
as follows:

p = [(Ft,T - St)/St] x (360/T).

Note that p could be a premium (if p > 0), or a discount (if p < 0).

Example I.7: Using the information from Example I.8 below, we obtain the 180-day
USD/GBP forward rate and the spot rate. The 180-day forward rate is 1.6167 USD/GBP,
while the spot rate is 1.62 USD/GBP. The forward premium is:

p = [(1.6167 - 1.62)/1.62] x (360/180) = -.0041.

The 180-day forward premium is -.41%. That is, the GBP is trading at a .41% discount for
delivery in 180 days. ¶

2.B.3 The Foreign Exchange Swap Market

As mentioned above, in a foreign exchange swap transaction, a trader can simultaneously sell
currency for spot delivery and buy that currency for forward delivery. A foreign exchange
swap involves two transactions. For example, a sale of GBP is a purchase of USD and a
purchase of GBP is a sale of USD. A foreign exchange swap can be described as a
simultaneous borrowing of one currency and lending of another currency.

Swaps are typically used to reduce exposure to the short-term risk of currency rate changes.
For example, a U.S. trader wants to invest in 7-day GBP certificates of deposit (CDs). Then,
the U.S. trader buys GBP spot, uses the funds to purchase the short-term GBP CDs, and sells
GBP forward. The sale of GBP forward protects the U.S. trader from an appreciation of the

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USD against the GBP, during the life of the GBP CD. Traders also use foreign exchange
swaps to change the maturity structure of their overall currency position.

The foreign exchange swap market is the segment of the foreign exchange rate market with
the highest daily volume. In 2016, the BIS reported that currency swap transactions
accounted for USD 2.378 billion out of the USD 5.1 trillion daily foreign exchange market
turnover (47%). I.13 Foreign exchange swaps are usually very short-term contracts. The
majority of them (70%) have a maturity of less than one week.

 FX Swaps and Currency Swaps: Not the Same Thing The foreign exchange swaps should
not be confused with the currency swaps to be discussed in Chapter XIV.

 2.B.4 Newspaper quotes

Example I.7: the Wall Street Journal publishes daily exchange rate quotes in the Money &
Investments section (i.e., the third section). The first two columns provide the direct
quotation and the last two columns provide the indirect quotation. On November 9, 1994, the
Wall Street Journal published the following currency (spot and forward) quotes:

2.C Other Instruments to Manage Currency Risk

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2.C.1 Currency Futures

Currency futures are contracts traded in organized exchanges. They are standardized
contracts that work like commodity futures. The International Monetary Market (IMM), a
division of the Chicago Mercantile Exchange, lists contracts on major currencies with respect
to the USD. The Philadelphia Board of Trade, the MidAmerica Commodity Exchange, and
the Singapore International Monetary Exchange (SIMEX) also list currency futures contracts.
Take the IMM's yen contract as an example. It settles in the months of March, June,
September and December and calls for delivery of JPY 12.5 million at expiration. Margins
are required.

2.C.2 Currency Options

I.14 Currency options are both exchange-listed and over-the-counter (OTC). Call options are
contracts giving the owner ("buyer") the right, but not the obligation, to purchase a quantity
of foreign currency at a fixed price (strike price) for a limited interval of time. Put options
give the buyer the right to sell. The seller of the option is called the writer. The buyer pays an
amount called a "premium" to the seller for the put or call option. The Philadelphia Stock
Exchange lists calls and puts on foreign currency. Calls and puts on currency futures
contracts are listed on the IMM and SIMEX.

Exhibit I.1
Size of FX Market by Instruments

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