Question

a. Define the term Foreign Exchange Market. Discuss three participants in this market and the reasons for their participation.

b. Compare and contrast Spot exchange and Forward exchange rates. Discuss how a company may use a forward exchange rate contract to facilitate an international purchase transaction.

c. “Companies must consider Exchange Rate Risk related to International Trade Contracts”. Discuss and analyze this quote.

Answer 1

(a) The Foreign Exchange Market is the global market place that determines the exchange rates for different currencies around the world. Different market participants buy, sell, and exchange different currencies for various reasons in the foreign exchange market. There are various participants in this market:

Commercial banks and MNC's- These banks serve their clients- both retail and corporates to transfer money from one place to another in different currencies. A bank buys in a particular currency and sells it in another currency where the operations are carried out. Multinational companies actively participate in the Forex markets to carry out their financial operations arising due to operations in various countries with different domestic currencies.

Foreign exchange brokers - These brokers facilitate trading between dealers. These brokers do not have any of their own money and are only dealing with the customers' money. They earn through the bid-ask spread between the exchange rates of currencies.

Central Banks - The majority of the central banks of the world play an active role in maintaining the foreign-exchange levels of its domestic currency so that any extreme fluctuation can be curtailed. They do this via forex reserves with them.

(b) The spot exchange rate is the current exchange rate that is available for buying or selling at that point of time. A forward exchange rate is a speculated exchange rate at a future time. This forward exchange rate is determined by a number of factors, the inflation and interest rate regime in the respective countries being the most important.

A company might have to purchase or sell a commodity or a service at a future point of time to another country with a different currency. In this case, if the exchange rate fluctuates highly over time, the costs estimated by either party goes for a toss as if the domestic currency appreciates, the exporter will be adversely hurt and vice-versa. Hence, it becomes favorable for corporations to enter a forward contract, which assures a certain exchange rate today, of a future time period. For eg. a company with an international purchase transaction of machinery scheduled after 3 months wants to hedge its currency risk, will enter into a forward contract, locking in the exchange rate, at which the purchase of the machine will be facilitated 3 months later.

(c) Companies must consider Exchange Rate Risk related to International Trade Contracts. Exchange rate risk arises when any transaction is to be taken place in the future, and the exchange rate fluctuates beyond expectations throwing the financial projections of the involved party for a toss. In short, due to unexpected movement in the exchange rate, a company or a firm might suffer unexpected losses. For eg. an Indian automobile company intends to purchase a machinary from US, 3 months later, at $1 million.If the Indian firm, expects the USDINR rate to remain at 70 Rupee per USD, it would expect that the machinary would be purchased for 70 million Indian rupees. However, after 3 months the USDINR exchange rate spikes to 80 Rupee per USD, the Indian firm will have to consider the cost of the machine equal to 80 million Indian rupees. This is the exchange rate risk associated with International Trade Contracts.