These arrangements are being listed below.There are many intermediate arrangements for determination of exchange values.
Domestic currency pegged to one foreign currency
Under this arrangement, the exchange rate of one currency is pegged to a dominant foreign currency, usually the U.S. dollar. For example the Argentine peso was till recently pegged to the US dollar in the ratio 1:1, due to the economic depression that started in the year 1999.
Managed Float
Central bank of a country decides the exchange rate in this system. The rates are revised from time to time depending on forex reserves, developments in parallel exchange markets, the real effective exchange rate etc.
Independent Float
In this system market forces determine the exchange rate. Most of the developed countries follow this system of exchange rate.
A currency pegged to a basket of currencies
The currency of a country may be pegged to a basket of currencies. The basket is generally formed by the currencies of major trading parties to make the pegged currency more stable than if a single currency peg is used. Trade, services and major capital flows may be used as currency weights while calculating the basket. The Indian Rupee is linked to a basket of currencies.
Flexibility limited in terms of a single currency
In this system, the value of the currency is maintained within certain margins of the peg. Some Middle Eastern countries follow this system and maintain their currency within a limit of the per against the U.S. dollar.
Pegged to some indicators
Under this arrangement, the currencies adjust more or less automatically to changes in the selected indicators. A common indicator is the real effective exchange rate (REER) that reflects inflation adjusted changes in the currency against major trading parties.
This category also includes cases where the exchange rate is adjusted according to a pre-announced schedule.
These are Spot Exchange Rates and Forward Exchange Rates.Currencies in the foreign exchange market may be transacted for immediately delivery or for a postponed delivery and consequently, there are two types of rates in the market.
Saturday, December 13, 2008
EXCHANGE RATE QUOTE
The foreign exchange transaction (i.e, for the sale and purchase of foreign currencies) takes place in foreign exchange market, which provides a mechanism for transfer of purchasing power from one currency to another. This market is not a physical entity like the Mumbai Stock Exchange or a trading center; rather it is network of telephones among banks, foreign exchange dealers and brokers etc.Every firm and individual operating in international environment is concerned with foreign exchange i.e, the exchange of foreign currency into domestic currency and vice-a-versa. Generally, the firm's foreign operations earn income denominated in some foreign currency, however, the shareholders expect payment in domestic currency and therefore, the firm must convert the foreign currency into domestic currency.
For example, a trader in Delhi may buy foreign exchange, say U.S. $, from a bank in Mumbai for making payment to a U.S. supplier against the purchases made. The bank in Mumbai, in turn may purchase the U.S. $ from a New York bank, which in turn may purchase from some other bank in New York itself or at some other center and so on. As the foreign exchange market provides transactions in a continuous manner for a large number and volume of sales and purchases, this market is an efficient one. Minute differences in exchange rates at different center may get eliminated without time lag.
In the foreign exchange market, the price of any currency may be quoted in terms of several currencies. It is important to realize that every price or exchange rate is relative. For example, if U.S. $ is worth Rs. 44, then it also implies that Re. 1 is worth $ 1/44. All foreign exchange rates in this way are related to each other in a reciprocal way. In other words, the value of $/Re. is just the reciprocal of the value of Re./$.
There are two major ways of offering exchange rate quotes. There are called the direct quote and indirect quote. These quotes are given after the exchange value has been established according to the practice being followed by a country. If the country follows a fixed rate of parity between its currency and a foreign currency, then the changes in parity value of that currency shall determine changes in the value of the domestic currency vis-a-vis other foreign currencies. These performances of the domestic economy is not reflected in the valuation of its currency. This is one extreme side of absolute rigidity in fixation of exchange data. The other extreme is allowing the exchange value of the national currency to float independently according to market forces without any intervention from the Central Bank. In between these two extremes, there are many intermediate arrangements for determination of exchange values...Quotations in the foreign exchange market are generally made in terms of local currency or the domestic currency in terms of per unit of a foreign currency. For example, the exchange rates of Re. in India may be quoted in terms of $, say Re./$ = Rs.44/$. It means that one $ is worth Rs.44. A change in price of one currency implies, therefore, a change in price of the other currency that appears in the quote. For example, if the price of Re. against the $ moves from Rs.44/$ to Rs.43.5/$, one can say that Re. has appreciated relative to $ by Re. 0.50. This is the same as saying that $ has depreciated relative to the Re.
For example, a trader in Delhi may buy foreign exchange, say U.S. $, from a bank in Mumbai for making payment to a U.S. supplier against the purchases made. The bank in Mumbai, in turn may purchase the U.S. $ from a New York bank, which in turn may purchase from some other bank in New York itself or at some other center and so on. As the foreign exchange market provides transactions in a continuous manner for a large number and volume of sales and purchases, this market is an efficient one. Minute differences in exchange rates at different center may get eliminated without time lag.
In the foreign exchange market, the price of any currency may be quoted in terms of several currencies. It is important to realize that every price or exchange rate is relative. For example, if U.S. $ is worth Rs. 44, then it also implies that Re. 1 is worth $ 1/44. All foreign exchange rates in this way are related to each other in a reciprocal way. In other words, the value of $/Re. is just the reciprocal of the value of Re./$.
There are two major ways of offering exchange rate quotes. There are called the direct quote and indirect quote. These quotes are given after the exchange value has been established according to the practice being followed by a country. If the country follows a fixed rate of parity between its currency and a foreign currency, then the changes in parity value of that currency shall determine changes in the value of the domestic currency vis-a-vis other foreign currencies. These performances of the domestic economy is not reflected in the valuation of its currency. This is one extreme side of absolute rigidity in fixation of exchange data. The other extreme is allowing the exchange value of the national currency to float independently according to market forces without any intervention from the Central Bank. In between these two extremes, there are many intermediate arrangements for determination of exchange values...Quotations in the foreign exchange market are generally made in terms of local currency or the domestic currency in terms of per unit of a foreign currency. For example, the exchange rates of Re. in India may be quoted in terms of $, say Re./$ = Rs.44/$. It means that one $ is worth Rs.44. A change in price of one currency implies, therefore, a change in price of the other currency that appears in the quote. For example, if the price of Re. against the $ moves from Rs.44/$ to Rs.43.5/$, one can say that Re. has appreciated relative to $ by Re. 0.50. This is the same as saying that $ has depreciated relative to the Re.
VARIABLES AFFECTING EXCHANGE
The expected difference in inflation rates between two countries equals, in equilibrium, the expected movement in spot rates. The forward rate for a given period, say 6 months, should equal the spot rate 6 months hence. The difference between the forward rate and the present spot represents the interest element for the period of the forward rate. In reality, the future spot rate would usually be higher or lower than the forward rate.Interest rate, inflation rates, forward margins, exchange rates and expectation across nations are inter-related as shown in the diagram below.Interest rate, inflation rates, forward margins, exchange rates and expectation across nations are inter-related as shown in the diagram below.
The diagram suggests that interest rates vary across countries because of varying expectations with regards to their rates of inflation. Under perfect competition, funds would move to a country where real interest rate (nominal interest rate less inflation rate) is higher, till the forces of demand and supply equiliberate them. In other words, the difference in interest rates between countries is equal in equilibrium to the expected difference in the inflation rates.
The diagram suggests that interest rates vary across countries because of varying expectations with regards to their rates of inflation. Under perfect competition, funds would move to a country where real interest rate (nominal interest rate less inflation rate) is higher, till the forces of demand and supply equiliberate them. In other words, the difference in interest rates between countries is equal in equilibrium to the expected difference in the inflation rates.
The diagram suggests that interest rates vary across countries because of varying expectations with regards to their rates of inflation. Under perfect competition, funds would move to a country where real interest rate (nominal interest rate less inflation rate) is higher, till the forces of demand and supply equiliberate them. In other words, the difference in interest rates between countries is equal in equilibrium to the expected difference in the inflation rates.
The diagram suggests that interest rates vary across countries because of varying expectations with regards to their rates of inflation. Under perfect competition, funds would move to a country where real interest rate (nominal interest rate less inflation rate) is higher, till the forces of demand and supply equiliberate them. In other words, the difference in interest rates between countries is equal in equilibrium to the expected difference in the inflation rates.
SPOT EXCHANGE RATE
In the spot exchange market, the quote may be denoted as direct or indirect. A direct quote indicates the number of units of the domestic currency required to buy one unit of foreign currency. That is, in Mumbai, the typical exchange rate quote indicates the number of Re. needed to buy one unit of a foreign currency e.g., Re. Per $ or Re. per Euro etc. The quotes in the spot market in New York are given in the terms of U.S. dollar and in Tokyo, the rates are given in the terms of Yen.A spot exchange rate is a rate at which currencies are being traded for delivery on the same day. For example, and Indian Importer may need U.S. $ to pay for the shipment that has just arrived. He will have to purchase the $ in the market to make payment for the import. The rate at which he will buy the $ in the market is known as the spot exchange rate. He will make the payments in terms of Rs. and gets in turn the U.S. $ which will be paid to the foreign exporter. The spot exchange rate therefore, for a currency is the current rate at which once currency can be immediately converted into another currency. For example, a spot rate of $0.6912/Euro indicates that one Euro can be converted into $0.6912 in the market place at present. In most of the cases, the spot exchange rates are set by the demand and supply forces in the foreign exchange market.
An indirect quote indicates the number of units of foreign currency that can be exchanged for one unit of the domestic currency. For example, in New York, the rates may be given as £ per $ or Euro per $ etc. As already stated, that the foreign exchange rates are relative to each other, the direct quote and indirect quote are related to each other in an inverse relationship i.e., an indirect quote is the inverse of a direct quote. So,
Indirect Quote = 1 / Direct Quote
In this case, the quote for $/Euro may be obtained as the inverse of Euro/$ i.e., 1/1.037 = 0.9643. So, he will require $0.9643 x 1,000 = $964.32 to pay for the German firm.In International transactions, both the direct quote and indirect quote are used. For example, if the direct quote of Euro in U.S. is Euro/$ = Euro 1.037 and American importer has to pay Euro 1,000 to a German Firm, then how many $ will be required by the American importer?
An indirect quote indicates the number of units of foreign currency that can be exchanged for one unit of the domestic currency. For example, in New York, the rates may be given as £ per $ or Euro per $ etc. As already stated, that the foreign exchange rates are relative to each other, the direct quote and indirect quote are related to each other in an inverse relationship i.e., an indirect quote is the inverse of a direct quote. So,
Indirect Quote = 1 / Direct Quote
In this case, the quote for $/Euro may be obtained as the inverse of Euro/$ i.e., 1/1.037 = 0.9643. So, he will require $0.9643 x 1,000 = $964.32 to pay for the German firm.In International transactions, both the direct quote and indirect quote are used. For example, if the direct quote of Euro in U.S. is Euro/$ = Euro 1.037 and American importer has to pay Euro 1,000 to a German Firm, then how many $ will be required by the American importer?
CURRENCY CROSS RATE
The exchange rate between two currencies calculated on the basis of the rate of these two currencies in terms of a third currency is known as a cross rate.The cross rate for a currency is the exchange rate based on the exchange rate of two other currencies. For example, an American trader gives the following quotations in New York: $0.99/Euro and $1.80/£, then the cross rates Euro/£ or £/Euro may be ascertained as follows:
Euro/£ = ( Euro / $ ) x ( $ / £)
= (1 / 0.99) x 1.80
= Euro 1.818 / £
Similarly, £ / Euro = ( £ / $ ) x ( $ / Euro )
= (1 / 1.80) x 0.99
= £ 0.555 / Euro
The forward rate for a currency may be higher of lower than the spot rate. Forward rate may be higher than the spot rate if the market participants expect the currency to apprecuate vis-a-vis the other currency, say USD. The currency, in such case is called trading at a forward premium. If the forward rate is lower than the spot rate, the participants expect the currency to depreciate vis-a-vis the USD. The currency in this case is said to be 'trading at forward discount'.The forward rate is a price quotation to deliver the currency in future. The exchange rate is determined at the time of concluding the contract, but payment and delivery are not required till maturity. Foreign exchange dealers and banks give the forward rate quotations for delivery in future according to the requirements if their clients. Generally, the forward quotations are given for delivery in 30 days, 90 days, and 180 days. But, the quotations may be given up to 2 years. Sometimes, forward contracts with maturities exceeding two years are also arranged by the dealers to meet specific requirements of their clients. Quotations are normally given for major currencies, but dealers also provide forward quotations for other currencies on the specific request of their clients.
Euro/£ = ( Euro / $ ) x ( $ / £)
= (1 / 0.99) x 1.80
= Euro 1.818 / £
Similarly, £ / Euro = ( £ / $ ) x ( $ / Euro )
= (1 / 1.80) x 0.99
= £ 0.555 / Euro
The forward rate for a currency may be higher of lower than the spot rate. Forward rate may be higher than the spot rate if the market participants expect the currency to apprecuate vis-a-vis the other currency, say USD. The currency, in such case is called trading at a forward premium. If the forward rate is lower than the spot rate, the participants expect the currency to depreciate vis-a-vis the USD. The currency in this case is said to be 'trading at forward discount'.The forward rate is a price quotation to deliver the currency in future. The exchange rate is determined at the time of concluding the contract, but payment and delivery are not required till maturity. Foreign exchange dealers and banks give the forward rate quotations for delivery in future according to the requirements if their clients. Generally, the forward quotations are given for delivery in 30 days, 90 days, and 180 days. But, the quotations may be given up to 2 years. Sometimes, forward contracts with maturities exceeding two years are also arranged by the dealers to meet specific requirements of their clients. Quotations are normally given for major currencies, but dealers also provide forward quotations for other currencies on the specific request of their clients.
SPOT RATES TYPES
Generally, in the spot exchange market, two types if spot rates may be quoted.
* Ask Price
* Bid Price
Bid Price:
Bid Price is the rate at which the dealer is ready to buy the foreign currency in exchange for the domestic currency. So, the bid price is the rate which the dealer is ready to pay in domestic currency in exchange for the foreign currency and therefore, it is the buying rate. The dealer sells the foreign currency for more than what they are ready to pay for buying it. Normally, the direct ask price is greater than the direct bid price and the difference between the two is known as the ask-bid spread.
Ask Price:
The Ask price is the rate at which the foreign exchange dealer ‘asks’ its customers to pay in local currency in the local exchange of the foreign currency. In other words, ask price is the selling rate or the offer rate and refers to the rate at which the foreign currency can be purchased from the dealer.
In case, when there is a large volume of transactions and the trading is continuous in any currency, the spread is small and may range between 0.1% to 0.5%. The spread is much higher for infrequently traded currencies.
The ask-bid spread depends upon the breadth and depth of the market for that currency and the volatility of the currency. This spread compensates the dealer for holding the risky foreign currency and for providing the service of converting currencies. The bid spread is usually stated as a percentage cost of transacting in the foreign exchange market and may be computed as follows:
For example, if the ask price of $/£ is $1.6646 and the bid price is $1.6629, then the % spread may be ascertain as follows:
% Spread = ((1.6646 – 1.6629)/ 1.6646) x 100 = 0.1%
% Spread = ((Ask Price – Bid Price) / Ask Price) x 100
* Ask Price
* Bid Price
Bid Price:
Bid Price is the rate at which the dealer is ready to buy the foreign currency in exchange for the domestic currency. So, the bid price is the rate which the dealer is ready to pay in domestic currency in exchange for the foreign currency and therefore, it is the buying rate. The dealer sells the foreign currency for more than what they are ready to pay for buying it. Normally, the direct ask price is greater than the direct bid price and the difference between the two is known as the ask-bid spread.
Ask Price:
The Ask price is the rate at which the foreign exchange dealer ‘asks’ its customers to pay in local currency in the local exchange of the foreign currency. In other words, ask price is the selling rate or the offer rate and refers to the rate at which the foreign currency can be purchased from the dealer.
In case, when there is a large volume of transactions and the trading is continuous in any currency, the spread is small and may range between 0.1% to 0.5%. The spread is much higher for infrequently traded currencies.
The ask-bid spread depends upon the breadth and depth of the market for that currency and the volatility of the currency. This spread compensates the dealer for holding the risky foreign currency and for providing the service of converting currencies. The bid spread is usually stated as a percentage cost of transacting in the foreign exchange market and may be computed as follows:
For example, if the ask price of $/£ is $1.6646 and the bid price is $1.6629, then the % spread may be ascertain as follows:
% Spread = ((1.6646 – 1.6629)/ 1.6646) x 100 = 0.1%
% Spread = ((Ask Price – Bid Price) / Ask Price) x 100
Spot And Forward Rates
Moreover, the relationship between spot and forward rates may be affected by the efficiency of the financial and exchange markets in two countries. Controls, restrictions and other interventions which can affect adjustments in exchange, and interest and inflation rates differential also influences the spot and forward rates.The collective judgment of the participants in the exchange market influences the appreciation or depreciation in the future spot price of a currency against other currencies. The forward premium or discount is also affected by the interest rate differential between two countries, differences in the rates of inflation between them, and the degree to which inflation rate differential is translated into interest rate differential in the expected time horizon.
Theoretically, in the efficient market and absence of intervention of control in the exchange or financial markets, the forward rate is an accurate predictor of the future spot rate. These requirements are, generally, satisfied if the following three conditions are found.It should, however, be noted that even if these conditions are satisfied, the future spot rate might not be identical to the forward rate. Random differences between the two rates may be found.
1. Interest rate parity:
According to interest rate parity principle, the forward premium (or discount) on currency of a country vis-a-vis the currency of another country will be exactly offset by the interest rate between the countries. The currency of the country with lower interest rate is quoted at a forward premium and vice-versa.
2. Purchasing Power Parity (PPP):
According to the PPP Principle, the currency of a country will depreciate vis-a-vis the currency of another country on the basis of differential in the rates of inflation between them. The rate of depreciation in the currency of the country would roughly be equal to the excess inflation rate in the country over the other country.
3. International Fisher Effect:
The interest rate differential between two countries, according to the Fisher effect, will reflect differences in the inflation rates in them. The high interest country will experience higher inflation rate.
Theoretically, in the efficient market and absence of intervention of control in the exchange or financial markets, the forward rate is an accurate predictor of the future spot rate. These requirements are, generally, satisfied if the following three conditions are found.It should, however, be noted that even if these conditions are satisfied, the future spot rate might not be identical to the forward rate. Random differences between the two rates may be found.
1. Interest rate parity:
According to interest rate parity principle, the forward premium (or discount) on currency of a country vis-a-vis the currency of another country will be exactly offset by the interest rate between the countries. The currency of the country with lower interest rate is quoted at a forward premium and vice-versa.
2. Purchasing Power Parity (PPP):
According to the PPP Principle, the currency of a country will depreciate vis-a-vis the currency of another country on the basis of differential in the rates of inflation between them. The rate of depreciation in the currency of the country would roughly be equal to the excess inflation rate in the country over the other country.
3. International Fisher Effect:
The interest rate differential between two countries, according to the Fisher effect, will reflect differences in the inflation rates in them. The high interest country will experience higher inflation rate.
Managing forex exchange Risk Rate
Likewise, firms operating foreign subsidiaries receive payment from these subsidiaries in foreign currency and have to convert this receipt into domestic currency. In addition, the firm may also be exposed to political and regulatory risk of the other countries.Changes in exchange rate give rise to foreign exchange risk, the firms dealing with other currencies usually face foreign exchange risk. Firms that import and export often need to make commitments to buy or sell the goods for delivery at some future time, with the payment to be made in foreign currency.
As soon as, a firm enters into a transaction that exposes it to the cash flows in a foreign currency, it is exposed to exchange rate risk. The financial manager can either leave the firm exposed to these risk and assume that the shareholders would be able to diversify away the risk; or can hedge the risk using a variety of options available. However, the options available to a firm for hedging against exchange risk are subject to the following:
a) Shareholders composition: For the shareholders to be able to diversify away foreign exchange risk that flows to the firm, they must be having internationally diversified portfolio. Thus, an investor who holds shares of the U.S. as well as the British firm may not be affected much by the movements in $/Yen rate because of offsetting effects of his investment. If on the other hand, if the shareholders are not internationally diversified, then the firm should try to diversify the risk itself.
b) Diversification across countries: Some firms accomplish a diversification of different kind by exposing to many countries and many currencies. For example Coca Cola having operations in a number of countries is less likely to be concerned about hedging the exchange rate risk.
c) Hedging risk: The cost of hedging risk in some currencies is less than hedging in other currencies or cost of hedging for a shorter period may be less than the cost of hedging for a longer period. Other thinks remaining same, the greater the cost of hedging risk, the less likely it is that the firms will be able to hedge.
The introduction of floating exchange rates in the early seventies has motivated companies to develop strategies to protect their bottom line from the adverse consequences of exchange rate fluctuations. An action that removes foreign exchange risk is said to cover that risk. The covering of foreign exchange exposure imposes certain costs on the companies. The companies have to strike a balance between foreign exchange risks and the costs of covering them. The systems to manage foreign exchange risks are guided by many factors in the companies, e.g., degree of centralization of foreign exchange transactions, accounting systems, responsibility for developing and complementing strategies, types of exposures to be managed system of formulation of corporate objectives and the design of the follow-up system to evaluate exchange risk management. Two of these most significant factors are discussed below:
Statement of objectives: The primary objective of foreign exchange risk management is to eliminate or reduce variations in the future earnings of a company due to unexpected currency fluctuations. The companies, to achieve this objective, should identify the types of exposures, which they would like to monitor. Moreover, they should convert this primary objective into a number of specific operational goals related to the types of exposures being managed. The operational objective of translation exposure management, for instance, may be to minimize half-yearly fluctuations in earnings due to exchange rate variations. The acceptable total cost of exposure management (including the cost of management time) should also be included in the statement. moreover, proper exposure management would save the company from excessive speculation.
Degree of centralization: In some of the companies, the policies to manage foreign exchange risk are decided at the head-office and the strategies are developed and implemented at the operating level. In the system, the administrative cost to manage foreign exchange may be low. However, the strategy may not be properly co-ordinated in the absence of perfect inter-divisional netting. In other companies, the policies as well as strategies are formulated at the head quarters. The implementation of the policies, in these companies, is done by the operating units. This system may involve high administrative costs but it is more effective. These companies are able to utilize various exposure management techniques. This system also helps in having maximum centralization of all the activities in the foreign exchange management system. However, it involves, like the first system, higher administrative costs and requires frequent reporting by various operating units.
As soon as, a firm enters into a transaction that exposes it to the cash flows in a foreign currency, it is exposed to exchange rate risk. The financial manager can either leave the firm exposed to these risk and assume that the shareholders would be able to diversify away the risk; or can hedge the risk using a variety of options available. However, the options available to a firm for hedging against exchange risk are subject to the following:
a) Shareholders composition: For the shareholders to be able to diversify away foreign exchange risk that flows to the firm, they must be having internationally diversified portfolio. Thus, an investor who holds shares of the U.S. as well as the British firm may not be affected much by the movements in $/Yen rate because of offsetting effects of his investment. If on the other hand, if the shareholders are not internationally diversified, then the firm should try to diversify the risk itself.
b) Diversification across countries: Some firms accomplish a diversification of different kind by exposing to many countries and many currencies. For example Coca Cola having operations in a number of countries is less likely to be concerned about hedging the exchange rate risk.
c) Hedging risk: The cost of hedging risk in some currencies is less than hedging in other currencies or cost of hedging for a shorter period may be less than the cost of hedging for a longer period. Other thinks remaining same, the greater the cost of hedging risk, the less likely it is that the firms will be able to hedge.
The introduction of floating exchange rates in the early seventies has motivated companies to develop strategies to protect their bottom line from the adverse consequences of exchange rate fluctuations. An action that removes foreign exchange risk is said to cover that risk. The covering of foreign exchange exposure imposes certain costs on the companies. The companies have to strike a balance between foreign exchange risks and the costs of covering them. The systems to manage foreign exchange risks are guided by many factors in the companies, e.g., degree of centralization of foreign exchange transactions, accounting systems, responsibility for developing and complementing strategies, types of exposures to be managed system of formulation of corporate objectives and the design of the follow-up system to evaluate exchange risk management. Two of these most significant factors are discussed below:
Statement of objectives: The primary objective of foreign exchange risk management is to eliminate or reduce variations in the future earnings of a company due to unexpected currency fluctuations. The companies, to achieve this objective, should identify the types of exposures, which they would like to monitor. Moreover, they should convert this primary objective into a number of specific operational goals related to the types of exposures being managed. The operational objective of translation exposure management, for instance, may be to minimize half-yearly fluctuations in earnings due to exchange rate variations. The acceptable total cost of exposure management (including the cost of management time) should also be included in the statement. moreover, proper exposure management would save the company from excessive speculation.
Degree of centralization: In some of the companies, the policies to manage foreign exchange risk are decided at the head-office and the strategies are developed and implemented at the operating level. In the system, the administrative cost to manage foreign exchange may be low. However, the strategy may not be properly co-ordinated in the absence of perfect inter-divisional netting. In other companies, the policies as well as strategies are formulated at the head quarters. The implementation of the policies, in these companies, is done by the operating units. This system may involve high administrative costs but it is more effective. These companies are able to utilize various exposure management techniques. This system also helps in having maximum centralization of all the activities in the foreign exchange management system. However, it involves, like the first system, higher administrative costs and requires frequent reporting by various operating units.
Managing Forex exchangeRisk Rate
Likewise, firms operating foreign subsidiaries receive payment from these subsidiaries in foreign currency and have to convert this receipt into domestic currency. In addition, the firm may also be exposed to political and regulatory risk of the other countries.Changes in exchange rate give rise to foreign exchange risk, the firms dealing with other currencies usually face foreign exchange risk. Firms that import and export often need to make commitments to buy or sell the goods for delivery at some future time, with the payment to be made in foreign currency.
As soon as, a firm enters into a transaction that exposes it to the cash flows in a foreign currency, it is exposed to exchange rate risk. The financial manager can either leave the firm exposed to these risk and assume that the shareholders would be able to diversify away the risk; or can hedge the risk using a variety of options available. However, the options available to a firm for hedging against exchange risk are subject to the following:
a) Shareholders composition: For the shareholders to be able to diversify away foreign exchange risk that flows to the firm, they must be having internationally diversified portfolio. Thus, an investor who holds shares of the U.S. as well as the British firm may not be affected much by the movements in $/Yen rate because of offsetting effects of his investment. If on the other hand, if the shareholders are not internationally diversified, then the firm should try to diversify the risk itself.
b) Diversification across countries: Some firms accomplish a diversification of different kind by exposing to many countries and many currencies. For example Coca Cola having operations in a number of countries is less likely to be concerned about hedging the exchange rate risk.
c) Hedging risk: The cost of hedging risk in some currencies is less than hedging in other currencies or cost of hedging for a shorter period may be less than the cost of hedging for a longer period. Other thinks remaining same, the greater the cost of hedging risk, the less likely it is that the firms will be able to hedge.
The introduction of floating exchange rates in the early seventies has motivated companies to develop strategies to protect their bottom line from the adverse consequences of exchange rate fluctuations. An action that removes foreign exchange risk is said to cover that risk. The covering of foreign exchange exposure imposes certain costs on the companies. The companies have to strike a balance between foreign exchange risks and the costs of covering them. The systems to manage foreign exchange risks are guided by many factors in the companies, e.g., degree of centralization of foreign exchange transactions, accounting systems, responsibility for developing and complementing strategies, types of exposures to be managed system of formulation of corporate objectives and the design of the follow-up system to evaluate exchange risk management. Two of these most significant factors are discussed below:
Statement of objectives: The primary objective of foreign exchange risk management is to eliminate or reduce variations in the future earnings of a company due to unexpected currency fluctuations. The companies, to achieve this objective, should identify the types of exposures, which they would like to monitor. Moreover, they should convert this primary objective into a number of specific operational goals related to the types of exposures being managed. The operational objective of translation exposure management, for instance, may be to minimize half-yearly fluctuations in earnings due to exchange rate variations. The acceptable total cost of exposure management (including the cost of management time) should also be included in the statement. moreover, proper exposure management would save the company from excessive speculation.
Degree of centralization: In some of the companies, the policies to manage foreign exchange risk are decided at the head-office and the strategies are developed and implemented at the operating level. In the system, the administrative cost to manage foreign exchange may be low. However, the strategy may not be properly co-ordinated in the absence of perfect inter-divisional netting. In other companies, the policies as well as strategies are formulated at the head quarters. The implementation of the policies, in these companies, is done by the operating units. This system may involve high administrative costs but it is more effective. These companies are able to utilize various exposure management techniques. This system also helps in having maximum centralization of all the activities in the foreign exchange management system. However, it involves, like the first system, higher administrative costs and requires frequent reporting by various operating units.
As soon as, a firm enters into a transaction that exposes it to the cash flows in a foreign currency, it is exposed to exchange rate risk. The financial manager can either leave the firm exposed to these risk and assume that the shareholders would be able to diversify away the risk; or can hedge the risk using a variety of options available. However, the options available to a firm for hedging against exchange risk are subject to the following:
a) Shareholders composition: For the shareholders to be able to diversify away foreign exchange risk that flows to the firm, they must be having internationally diversified portfolio. Thus, an investor who holds shares of the U.S. as well as the British firm may not be affected much by the movements in $/Yen rate because of offsetting effects of his investment. If on the other hand, if the shareholders are not internationally diversified, then the firm should try to diversify the risk itself.
b) Diversification across countries: Some firms accomplish a diversification of different kind by exposing to many countries and many currencies. For example Coca Cola having operations in a number of countries is less likely to be concerned about hedging the exchange rate risk.
c) Hedging risk: The cost of hedging risk in some currencies is less than hedging in other currencies or cost of hedging for a shorter period may be less than the cost of hedging for a longer period. Other thinks remaining same, the greater the cost of hedging risk, the less likely it is that the firms will be able to hedge.
The introduction of floating exchange rates in the early seventies has motivated companies to develop strategies to protect their bottom line from the adverse consequences of exchange rate fluctuations. An action that removes foreign exchange risk is said to cover that risk. The covering of foreign exchange exposure imposes certain costs on the companies. The companies have to strike a balance between foreign exchange risks and the costs of covering them. The systems to manage foreign exchange risks are guided by many factors in the companies, e.g., degree of centralization of foreign exchange transactions, accounting systems, responsibility for developing and complementing strategies, types of exposures to be managed system of formulation of corporate objectives and the design of the follow-up system to evaluate exchange risk management. Two of these most significant factors are discussed below:
Statement of objectives: The primary objective of foreign exchange risk management is to eliminate or reduce variations in the future earnings of a company due to unexpected currency fluctuations. The companies, to achieve this objective, should identify the types of exposures, which they would like to monitor. Moreover, they should convert this primary objective into a number of specific operational goals related to the types of exposures being managed. The operational objective of translation exposure management, for instance, may be to minimize half-yearly fluctuations in earnings due to exchange rate variations. The acceptable total cost of exposure management (including the cost of management time) should also be included in the statement. moreover, proper exposure management would save the company from excessive speculation.
Degree of centralization: In some of the companies, the policies to manage foreign exchange risk are decided at the head-office and the strategies are developed and implemented at the operating level. In the system, the administrative cost to manage foreign exchange may be low. However, the strategy may not be properly co-ordinated in the absence of perfect inter-divisional netting. In other companies, the policies as well as strategies are formulated at the head quarters. The implementation of the policies, in these companies, is done by the operating units. This system may involve high administrative costs but it is more effective. These companies are able to utilize various exposure management techniques. This system also helps in having maximum centralization of all the activities in the foreign exchange management system. However, it involves, like the first system, higher administrative costs and requires frequent reporting by various operating units.
Forecasting Exchange rate
The percentage change between the current and the forecasted exchange rates may be calculated to find our appreciation or depreciation in the currency. A positive percentage change represents currency appreciation whereas a negative percentage change shows depreciation.An exchange rate, as seen previously, is the price of one currency expressed in terms of another currency. The exchange rate among countries are affected by a large number of factors like rate of inflation, growth prospects, political stability, and economic policies. Most of these factors are difficult to predict in advance. As a result, the future exchange rates, like most of the events, become uncertain. Participants in the international markets therefore, face problems, in making decisions which are based on future exchange rates. For example, future exchange rates may be required by the companies to hedge against potential losses, arranging short-and long-term funds, performing investment analysis, and to assess earnings of a foreign subsidiary. The quality of decision, in such cases, depends on the accuracy of exchange rate projections.
The exchange rates may be fixed or floating. Different methods are used to forecast fixed and floating exchange rates. The floating exchange rates, as discussed previously are determined by the market focus of demand and supply. These are not influenced by government intervention. Fixed exchange rates, on the other hand, are decided by the regulating agencies.
Fixed exchange rate forecasts are based on the study of government decision-making structure. Attempts is made to determine the pressure to devalue he currency of the nation and the ability of the government to sustain the disequilibrium.
Forecasting fixed exchange rates requires an assessment of balance-of-payments disequilibrium on the basis of key economic variables such as inflation, money supply, international reserves, gap between official and market rates, and the balance of foreign trade. The change in the exchange rate required to restore the balance of payment equilibrium is estimated with the help of forward exchange rates, free market rates and the purchasing power parity principle. The capacity of the country to resist or postpone the use of corrective measures is evaluated on the basis of the ability to borrow hard currencies and the availability of international reserves. Attempt is also made to project the policies which may be followed by the Government to correct the position of the nation.
Thus, exchange rates are forecasted to make various decisions by the companies which require foreign exchange. These forecasts are made separately for the fixed and floating exchange rates with the help of different methods. Percentage change between forecasted and current exchange rates may be calculated to find out appreciation or depreciation in the currency.The floating exchange rates may be forecasted with the help of various methods. Fundamental and technical analysis are commonly used for this purpose. Fundamental analysis studies the relationship between macro economic variables (such as inflation rates, national income growth, and changes in money supply) and exchange rates to forecast the latter. Technical analysis uses past prices and volume movements to project future currency exchange rates. The technical analysis may produce useful results if the past trend is repeated. The companies normally use technical analysis for short-term forecasts. but, they use fundamental analysis for long-term projections. The primary methods of technical analysis are charting and mechanical rules. The reliability of the forecasts may be found out on the basis of forecasting error which is calculated by square root error. The root square error is computed with the help of the following formula:
Where RSE is the root square as a percentage of realized value; FV is the forecasted value and RV is the realized value.
The exchange rates may be fixed or floating. Different methods are used to forecast fixed and floating exchange rates. The floating exchange rates, as discussed previously are determined by the market focus of demand and supply. These are not influenced by government intervention. Fixed exchange rates, on the other hand, are decided by the regulating agencies.
Fixed exchange rate forecasts are based on the study of government decision-making structure. Attempts is made to determine the pressure to devalue he currency of the nation and the ability of the government to sustain the disequilibrium.
Forecasting fixed exchange rates requires an assessment of balance-of-payments disequilibrium on the basis of key economic variables such as inflation, money supply, international reserves, gap between official and market rates, and the balance of foreign trade. The change in the exchange rate required to restore the balance of payment equilibrium is estimated with the help of forward exchange rates, free market rates and the purchasing power parity principle. The capacity of the country to resist or postpone the use of corrective measures is evaluated on the basis of the ability to borrow hard currencies and the availability of international reserves. Attempt is also made to project the policies which may be followed by the Government to correct the position of the nation.
Thus, exchange rates are forecasted to make various decisions by the companies which require foreign exchange. These forecasts are made separately for the fixed and floating exchange rates with the help of different methods. Percentage change between forecasted and current exchange rates may be calculated to find out appreciation or depreciation in the currency.The floating exchange rates may be forecasted with the help of various methods. Fundamental and technical analysis are commonly used for this purpose. Fundamental analysis studies the relationship between macro economic variables (such as inflation rates, national income growth, and changes in money supply) and exchange rates to forecast the latter. Technical analysis uses past prices and volume movements to project future currency exchange rates. The technical analysis may produce useful results if the past trend is repeated. The companies normally use technical analysis for short-term forecasts. but, they use fundamental analysis for long-term projections. The primary methods of technical analysis are charting and mechanical rules. The reliability of the forecasts may be found out on the basis of forecasting error which is calculated by square root error. The root square error is computed with the help of the following formula:
Where RSE is the root square as a percentage of realized value; FV is the forecasted value and RV is the realized value.
Forex Trading Mechanics
Under retail market, the traveler and tourists exchange one currency for another in form of currency notes or traveller cheques. Here, the total turnover and average transaction size are very small. The spread between buying and selling price is large. Whereas wholesale market of inter bank market is a market with huge turnover. The major market participants of this market include commercial banks, corporation and central banks.Forex trading is an important aspect of forex management. It is basically concerned with various forex operations including purchase and sale of currencies of different countries in order to meet payments and receipts requirements as a result of foreign trade. Forex trading is done either in retail market or in whole sale market (also called inter bank market).
In the inter bank market deals are done on the telephone or on electronic media. Suppose bank A wishes to buy the British Pound sterling against the US dollar. A trader in bank A might call his counterpart in bank B and ask for a price quotation. If the price is acceptable they will agree to do the deal and both will enter the details the amount bought/sold, the price, the identity of the counter party etc. - in their respective banks' computerized records systems and go on to the next transaction. Subsequently, written confirmations will be sent containing all the details. On the day of settlement, bank A will turn over a US dollar deposit to bank B and B will turn over a sterling deposit to A. The traders are out of the picture once the deal is agreed upon and entered in the record systems. This enables them to do the deals very rapidly. At the international level inter-bank settlement is effected through the Clearing House Inter bank Payment System (CHIPS), located at New york.
When asked to quote a price between a pair of currencies, say pound sterling and dollar, a trader gives a "two-way quote" i.e. he quotes two prices: a price at which he will buy a sterling in exchange for dollars and a price at which he will sell a sterling for dollars. The enquirer does not have to specify whether the wants to sell or buy pounds against dollars; as mentioned above, the marker is ready to take either side of the transactions. Thus his quotation can be represented as (the numbers are hypothetical);
$/£: 1.7554-1.7560 or 1:7554/1.7560
The number on the left of the hyphen or the slash is the amount of dollars the trader will pay to buy a pound. This is the trader's bid rate for a pound sterling (against dollar). The number on the right is the amount of dollars the trader will require to sell a pound. This is the trader's ask rate (also called the offer rate). For a quote given above the Bid-ask spread is 0.0006 dollar or 0.06 cent per pound. This margin is the market maker's compensation for the costs incurred and normal profit on capital invested in the dealing function.
In a normal two-way market, a trader expects "to be hit" on both sides of his quote in roughly equal amounts. That is, in the pound-dollar case above, on a normal business day the trader expects to buy and sell roughly equal amount of pounds (and of course dollars). The Bank's margin would then be the bid-ask spread.
But suppose during the course of trading a trader finds that he is "being hit" on one side of his quote much more often than the other side. In our pound-dollar example this means that he is either buying many more pounds than he is selling or vice versa. This leads to the trader building up "a position". If he has sold (bought) more pounds than he had bought (sold) he is said to have net short position (long position) in pounds. Given the volatility of the exchange rates, maintaining a short or long position for too long can be a risky proportion. For instance, suppose that a trader has build up a net short position in pounds of 1,00,000. The pound suddenly appreciates from say $1.7500 to $1.7520, this implies that the bank's liability increases by $2000 ($0.0020 per pound for 1 million pounds). Of course, a pound depreciation would have resulted in a gain. Similarly, a net long position leads to a loss if it has to be covered at a lower price and gain if at a higher price. (By "covering a position" we mean undertaking transactions what will reduce the net position to zero. A trader net long in pounds must sell pounds to cover; a net short must buy pounds).
The potential gain or loss from a position depends upon the size of the position and the variability of exchange rates. Building and carrying such net positions for long durations would be equivalent to speculation and bank exercise tight control over their traders to prevent such activity. This is done by prescribing the maximum size of net positions a trader can build up during a trading day and how much can be carried overnight.
Communications pertaining to international financial transactions are handled mainly by a large network called Society for Worldwide Inter Bank Financial Telecommunication (SWIFT). This is a non-profit Belgian cooperative with main and on the location, a bank can access a regional processor or a main center which then transmits the information to the appropriate location.In an ordinary foreign exchange transaction, no fees are charged. The bid-ask spread itself is the transaction cost. Also, unlike the money or capital markets, where different rates of interest are charged to different borrowers depending on their creditworthiness, in the wholesale foreign exchange market no much distinction is made. Default risk - the possibility that the counter party in a transaction may not deliver in its side of the deal is handled by prescribing limits on the size of positions a trader can take with different corporate customers.
In the inter bank market deals are done on the telephone or on electronic media. Suppose bank A wishes to buy the British Pound sterling against the US dollar. A trader in bank A might call his counterpart in bank B and ask for a price quotation. If the price is acceptable they will agree to do the deal and both will enter the details the amount bought/sold, the price, the identity of the counter party etc. - in their respective banks' computerized records systems and go on to the next transaction. Subsequently, written confirmations will be sent containing all the details. On the day of settlement, bank A will turn over a US dollar deposit to bank B and B will turn over a sterling deposit to A. The traders are out of the picture once the deal is agreed upon and entered in the record systems. This enables them to do the deals very rapidly. At the international level inter-bank settlement is effected through the Clearing House Inter bank Payment System (CHIPS), located at New york.
When asked to quote a price between a pair of currencies, say pound sterling and dollar, a trader gives a "two-way quote" i.e. he quotes two prices: a price at which he will buy a sterling in exchange for dollars and a price at which he will sell a sterling for dollars. The enquirer does not have to specify whether the wants to sell or buy pounds against dollars; as mentioned above, the marker is ready to take either side of the transactions. Thus his quotation can be represented as (the numbers are hypothetical);
$/£: 1.7554-1.7560 or 1:7554/1.7560
The number on the left of the hyphen or the slash is the amount of dollars the trader will pay to buy a pound. This is the trader's bid rate for a pound sterling (against dollar). The number on the right is the amount of dollars the trader will require to sell a pound. This is the trader's ask rate (also called the offer rate). For a quote given above the Bid-ask spread is 0.0006 dollar or 0.06 cent per pound. This margin is the market maker's compensation for the costs incurred and normal profit on capital invested in the dealing function.
In a normal two-way market, a trader expects "to be hit" on both sides of his quote in roughly equal amounts. That is, in the pound-dollar case above, on a normal business day the trader expects to buy and sell roughly equal amount of pounds (and of course dollars). The Bank's margin would then be the bid-ask spread.
But suppose during the course of trading a trader finds that he is "being hit" on one side of his quote much more often than the other side. In our pound-dollar example this means that he is either buying many more pounds than he is selling or vice versa. This leads to the trader building up "a position". If he has sold (bought) more pounds than he had bought (sold) he is said to have net short position (long position) in pounds. Given the volatility of the exchange rates, maintaining a short or long position for too long can be a risky proportion. For instance, suppose that a trader has build up a net short position in pounds of 1,00,000. The pound suddenly appreciates from say $1.7500 to $1.7520, this implies that the bank's liability increases by $2000 ($0.0020 per pound for 1 million pounds). Of course, a pound depreciation would have resulted in a gain. Similarly, a net long position leads to a loss if it has to be covered at a lower price and gain if at a higher price. (By "covering a position" we mean undertaking transactions what will reduce the net position to zero. A trader net long in pounds must sell pounds to cover; a net short must buy pounds).
The potential gain or loss from a position depends upon the size of the position and the variability of exchange rates. Building and carrying such net positions for long durations would be equivalent to speculation and bank exercise tight control over their traders to prevent such activity. This is done by prescribing the maximum size of net positions a trader can build up during a trading day and how much can be carried overnight.
Communications pertaining to international financial transactions are handled mainly by a large network called Society for Worldwide Inter Bank Financial Telecommunication (SWIFT). This is a non-profit Belgian cooperative with main and on the location, a bank can access a regional processor or a main center which then transmits the information to the appropriate location.In an ordinary foreign exchange transaction, no fees are charged. The bid-ask spread itself is the transaction cost. Also, unlike the money or capital markets, where different rates of interest are charged to different borrowers depending on their creditworthiness, in the wholesale foreign exchange market no much distinction is made. Default risk - the possibility that the counter party in a transaction may not deliver in its side of the deal is handled by prescribing limits on the size of positions a trader can take with different corporate customers.
Convertibility of rupee - Capital account convertibility
It is worth nothing, at the outset, that India is not alone in its endeavor to make its currency convertibility, nor is it the only country which is facing the daunting task of overcoming several hurdles on its way to full currency convertibility. Indeed, only the developed economics of North America, Western Europe, Japan and Australia have joined the race towards full convertibility. A number of Latin American, Central European and Asian Countries, however, have joined the race towards full convertibility. Aside from India, the list of these countries include Argentina, China, Chile, Columbia, Indonesia, Malaysia, Philippines, Republic of Korea and Thailand. Importantly, these countries are not at the same stage of currency convertibility. The Korean currency, for example, is much convertible than the Chinese currency. Indeed, it is important to note at the outset that the issue is not a matter of choice between convertibility and non-convertibility. There exists a wide spectrum between these two extremes, and India and the aforementioned countries lie at various points of this spectrum. The important issue, in other words, is to decide the extent to which a currency (say, the rupee) will be convertible at a point of time, and the pace at which it will attain higher levels of convertibility in the future.
In order to appreciate the meaning and the implication of currency convertibility, however, one has to first take into consideration two different aspects. A currency, it has to be noted, can be convertible on the current account of balance of payments (BOP), and/or on the capital account of BOP. The currency is deemed fully convertible if it is convertible on both these accounts. A clear understanding of the notion of convertibility, therefore, entails an understanding of the current and capital accounts of BOP.
As such, the current account of the BOP comprises trade in goods and services. In other words, the current account balance takes into account exports, imports, and net foreign income from unilateral transfers. The capital account of the BOP, on the other hand, takes into account cross-border flow of funds that are associated with financial or other assets in the trading countries. For example, the direct and portfolio investments made by foreign investors, in India, are captured by the capital account balance of the BOP. The capital account also encompasses foreign investments of Indian companies, foreign aid and bank deposits of Non-resident Indians (NRI).
A currency is deemed convertible on the current account if it can be freely converted into other convertible currencies for purchase and sale of commodities and services. For example, if the rupee is convertible on the current account an Indian firm should be able to freely convert rupee into Yen (JPY) to purchase mods from a Japanese Company. Similarly, a German company should be able to freely convert the mark (DM) into rupee to pay an Indian software consultancy firm for its services. It is evident that the ideal of free trade lies at the heart of current account convertibility.
Capital account convertibility, on the other hand, implies the right to transact in financial and other assets with foreign countries without restriction. For example, if a currency is convertible on the capital account, the residents of the domestic currency may freely convert it into other (convertible) currencies to purchase and maintain bank accounts abroad. Similarly, residents of other countries should also be able to freely convert their currencies into the domestic currency to purchase domestic capital and money market instruments. In other words, capital account convertibility is associated with the vision of free capital mobility.
Convertibility as an issue, and subsequently as a goal, was a priority in the agenda of the member countries of the International Monetary Fund (IMF) which was born out of the Bretton Woods Agreement. During the Bretton Woods period, "[t]he term convertibility [was] used in two different contexts: convertibility into gold and convertibility into other currencies. Only the United States maintained gold convertibility during Bretton woods... Convertibility into other currencies for current account transaction purposes was a main goal of Bretton Woods and was reached, to a large extent, early on in the system; however, the agreements to the IMF allowed more flexibility with regard to the imposition of exchange controls on capital account transactions. The flexibility was partly a result of a prevailing feeling that short-run speculative capital flows could be potentially destabilising and governments should therefore have the freedom to resist them."
However, the currency as yet has limited convertibility on the capital account, and that indeed is the centre of a countrywide debate. What might be the rationale behind the aforementioned choice: making rupee convertible on the current account while maintaining exchange control for capital account transactions? What, indeed, are the policy implications of free capital mobility that is associated with capital account and have full convertibility? Is India ready for full currency convertibility?Owing to other reasons, developing countries have historically not had convertible currencies. Typically, their currencies have been partially convertible on the current account and the capital of the BOP, the rationale for the choice being embedded in the macroeconomic realities and the policy perspectives of the countries concerned. In India, the rupee was made convertible on the current account in August 1994.
In order to appreciate the meaning and the implication of currency convertibility, however, one has to first take into consideration two different aspects. A currency, it has to be noted, can be convertible on the current account of balance of payments (BOP), and/or on the capital account of BOP. The currency is deemed fully convertible if it is convertible on both these accounts. A clear understanding of the notion of convertibility, therefore, entails an understanding of the current and capital accounts of BOP.
As such, the current account of the BOP comprises trade in goods and services. In other words, the current account balance takes into account exports, imports, and net foreign income from unilateral transfers. The capital account of the BOP, on the other hand, takes into account cross-border flow of funds that are associated with financial or other assets in the trading countries. For example, the direct and portfolio investments made by foreign investors, in India, are captured by the capital account balance of the BOP. The capital account also encompasses foreign investments of Indian companies, foreign aid and bank deposits of Non-resident Indians (NRI).
A currency is deemed convertible on the current account if it can be freely converted into other convertible currencies for purchase and sale of commodities and services. For example, if the rupee is convertible on the current account an Indian firm should be able to freely convert rupee into Yen (JPY) to purchase mods from a Japanese Company. Similarly, a German company should be able to freely convert the mark (DM) into rupee to pay an Indian software consultancy firm for its services. It is evident that the ideal of free trade lies at the heart of current account convertibility.
Capital account convertibility, on the other hand, implies the right to transact in financial and other assets with foreign countries without restriction. For example, if a currency is convertible on the capital account, the residents of the domestic currency may freely convert it into other (convertible) currencies to purchase and maintain bank accounts abroad. Similarly, residents of other countries should also be able to freely convert their currencies into the domestic currency to purchase domestic capital and money market instruments. In other words, capital account convertibility is associated with the vision of free capital mobility.
Convertibility as an issue, and subsequently as a goal, was a priority in the agenda of the member countries of the International Monetary Fund (IMF) which was born out of the Bretton Woods Agreement. During the Bretton Woods period, "[t]he term convertibility [was] used in two different contexts: convertibility into gold and convertibility into other currencies. Only the United States maintained gold convertibility during Bretton woods... Convertibility into other currencies for current account transaction purposes was a main goal of Bretton Woods and was reached, to a large extent, early on in the system; however, the agreements to the IMF allowed more flexibility with regard to the imposition of exchange controls on capital account transactions. The flexibility was partly a result of a prevailing feeling that short-run speculative capital flows could be potentially destabilising and governments should therefore have the freedom to resist them."
However, the currency as yet has limited convertibility on the capital account, and that indeed is the centre of a countrywide debate. What might be the rationale behind the aforementioned choice: making rupee convertible on the current account while maintaining exchange control for capital account transactions? What, indeed, are the policy implications of free capital mobility that is associated with capital account and have full convertibility? Is India ready for full currency convertibility?Owing to other reasons, developing countries have historically not had convertible currencies. Typically, their currencies have been partially convertible on the current account and the capital of the BOP, the rationale for the choice being embedded in the macroeconomic realities and the policy perspectives of the countries concerned. In India, the rupee was made convertible on the current account in August 1994.
An INDIAN Case Of Capital account convertibility
Capital account convertibility of full convertibility in simple term refers to an economic tool expected to engender more efficient capital flows and catalyse growth impulses and enable the society to achieve a stable balance between its internal and external prices.Capital account convertibility is one of the essential parameter not only for an effective integration of the financial market of domestic economy to the world economy but also for India's maturing as mega world economic power in the prevailing environment of competition, deregulation and diffusion of information technology. The basic objective of capital account convertibility is to:
1. Deepen and integrate financial markets;
2. Raise the access to global savings;
3. Discipline domestic policy markets; and
4. Allow greater freedom to individual decision making.
A more open capital account will facilitate higher availability of larger capital stock, supplementing domestic resources thereby leading to higher growth and reducing the cost of capital and also facilitating access to the international financial market.
In a developing economies aspiring for high rate of economic growth and development, capital account convertibility brings capital account liberalization i.e. no restrictions on capital inflows and capital outflows. This exposes the economy to the volatility of cross border capital movements. The experiences of Latin America demonstrates that useless macro-economic fundamentals are in line with those in the rest of the world, such capital account liberalization is not sustainable. The macro-economic fundamentals include rate of infiction, interest rate, fiscal deficits, balance of payments equilibrium and adequate supervision over bank. India has a long way to go before all this is ensured, primarily because the domestic economic reforms have yet to take full hold. Indian Government have already permitted the full convertibility of rupee on current account. Full convertibility on capital account is yet to be materialized.
The Reserve Bank of India on 29.02.1997, appointed a Committee on Capital Account Convertibility under the Chairman of S.S. Tarapore. The Committee submitted its report for consideration of the Government and Reserve bank on 30.05.1997.
The Committee on Capital Account Convertibility was give the following terms of reference: (i) to review the International experience in relation to capital account convertibility (CAC), (ii) to recommend measures for achieving CAC, (iii) to specify the sequence and time-frame for such measures, and (iv) to suggest domestic policy measures and changes in institutional framework.
Against the backdrop of stable and sustainable growth in India and progress achieved in entrenching structural reforms, the Committee has recommended a phased implementation of CAC over a three-year-period: Phase I (1997-98), Phase II (1998-99) and Phase III (1999-2000). The committee has suggested that the implementation for each phase should be on a careful and continuous monitoring of certain preconditions/signposts and certain important attendant variables identified from the lessons of the International experiences and the specifics of the Indian situation.
The preconditions/signposts recommended by the committee include:
i) Mandated inflation rate for the three-year period at an average of 3-5 percent with an early empowering of the Reserve Bank to have full independence to achieve the inflation rate mandated by the Parliament,
ii) Fiscal consolidation in the form of gradual reduction in the Centre's Gross fiscal deficit to GDP ration to 3.5 percent in 1999-2000 accompanied by a reduction in the States' deficit as also a reduction in the quasi fiscal deficit, introduction of a Consolidated Sinking Fund (CSF);
iii) Consolidation of financial system with full deregulation in interest rate in 1997-98, gradual reduction in the average effective cash reserve ration (CRR) to 3 percent in 1999-2000, reducing in gross non-performing assets (NPAs) to 5 percent in 1999-2000 and conversion of the weak banks into narrow banks;
iv) Monitoring of attendant macro-economic indicators e.g. the exchange rate, the balance of payments, the adequacy of reserves while determining the appropriate timing and sequencing of CAC and strengthening of the financial system; and
v) Prepare the financial system for CAC in terms of bringing about a level playing field between various participants in the financial system, removing market segmentation, uniform treatment of resident and non-resident liabilities for purpose of reserve requirements, improving risk management systems in the financial system, introduction of more stringment capital adequacy standards and prudential norms, effective supervisory system and greater autonomy for banks and financial institutions.
In view of growing internationalisation of the Indian Economy, over the three-year period, external sector policies should be designed to ensure a rinsing trend in the current receipts (CR) to GDP ratio from the resent level of 15 percent as well as to reduce the debt-service ratio to 20 percent..On the exchange rate policy, the Reserve Bank should have a monitoring band of +/-5 percent around the neural Real Effective Exchange Rate (REER). While the REER band would be declared, the Reserve bank should ordinarily intervene as and when REER is outside the band.
1. Deepen and integrate financial markets;
2. Raise the access to global savings;
3. Discipline domestic policy markets; and
4. Allow greater freedom to individual decision making.
A more open capital account will facilitate higher availability of larger capital stock, supplementing domestic resources thereby leading to higher growth and reducing the cost of capital and also facilitating access to the international financial market.
In a developing economies aspiring for high rate of economic growth and development, capital account convertibility brings capital account liberalization i.e. no restrictions on capital inflows and capital outflows. This exposes the economy to the volatility of cross border capital movements. The experiences of Latin America demonstrates that useless macro-economic fundamentals are in line with those in the rest of the world, such capital account liberalization is not sustainable. The macro-economic fundamentals include rate of infiction, interest rate, fiscal deficits, balance of payments equilibrium and adequate supervision over bank. India has a long way to go before all this is ensured, primarily because the domestic economic reforms have yet to take full hold. Indian Government have already permitted the full convertibility of rupee on current account. Full convertibility on capital account is yet to be materialized.
The Reserve Bank of India on 29.02.1997, appointed a Committee on Capital Account Convertibility under the Chairman of S.S. Tarapore. The Committee submitted its report for consideration of the Government and Reserve bank on 30.05.1997.
The Committee on Capital Account Convertibility was give the following terms of reference: (i) to review the International experience in relation to capital account convertibility (CAC), (ii) to recommend measures for achieving CAC, (iii) to specify the sequence and time-frame for such measures, and (iv) to suggest domestic policy measures and changes in institutional framework.
Against the backdrop of stable and sustainable growth in India and progress achieved in entrenching structural reforms, the Committee has recommended a phased implementation of CAC over a three-year-period: Phase I (1997-98), Phase II (1998-99) and Phase III (1999-2000). The committee has suggested that the implementation for each phase should be on a careful and continuous monitoring of certain preconditions/signposts and certain important attendant variables identified from the lessons of the International experiences and the specifics of the Indian situation.
The preconditions/signposts recommended by the committee include:
i) Mandated inflation rate for the three-year period at an average of 3-5 percent with an early empowering of the Reserve Bank to have full independence to achieve the inflation rate mandated by the Parliament,
ii) Fiscal consolidation in the form of gradual reduction in the Centre's Gross fiscal deficit to GDP ration to 3.5 percent in 1999-2000 accompanied by a reduction in the States' deficit as also a reduction in the quasi fiscal deficit, introduction of a Consolidated Sinking Fund (CSF);
iii) Consolidation of financial system with full deregulation in interest rate in 1997-98, gradual reduction in the average effective cash reserve ration (CRR) to 3 percent in 1999-2000, reducing in gross non-performing assets (NPAs) to 5 percent in 1999-2000 and conversion of the weak banks into narrow banks;
iv) Monitoring of attendant macro-economic indicators e.g. the exchange rate, the balance of payments, the adequacy of reserves while determining the appropriate timing and sequencing of CAC and strengthening of the financial system; and
v) Prepare the financial system for CAC in terms of bringing about a level playing field between various participants in the financial system, removing market segmentation, uniform treatment of resident and non-resident liabilities for purpose of reserve requirements, improving risk management systems in the financial system, introduction of more stringment capital adequacy standards and prudential norms, effective supervisory system and greater autonomy for banks and financial institutions.
In view of growing internationalisation of the Indian Economy, over the three-year period, external sector policies should be designed to ensure a rinsing trend in the current receipts (CR) to GDP ratio from the resent level of 15 percent as well as to reduce the debt-service ratio to 20 percent..On the exchange rate policy, the Reserve Bank should have a monitoring band of +/-5 percent around the neural Real Effective Exchange Rate (REER). While the REER band would be declared, the Reserve bank should ordinarily intervene as and when REER is outside the band.
Committee Recomandations on Capital account convertibility
The committee's recommendations for a phased liberalization of controls on capital outflows and inflows over the three-year period, inter alia, include:The Committee has also stated that the timing and sequencing of capital account convertibility would be greatly facilitated by the proposed changes in the legislative framework governing foreign exchange transactions.
i) Indian Joint Ventures/Wholly-Owned Subsidiaries (JVs/WOSs) should be allowed to invest up to US $ 50 Million in ventures abroad at the level of the authorized dealers (ADs) in Phase I with transparent and comprehensive guidelines set out by the Reserve Bank. The existing requirement of repatriation of the amount of investment by way of divident, etc., within a period of 5 years may be removed. Furthermore, JVs/WOSs could be allowed to be set up by any party and not be restricted to only exporters/exchange earners.
ii) Exporters/exchange earners may be allowed 100 per cent retention of earnings in Exchange Earners Foreign Currency (EEFC) accounts with complete flexibility in operation of these accounts including cheque writing facility with Phase I
iii) Individual residents may be allowed to invest in assets and financial markets abroad up to US $ 25,000 in Phase I with progressive increase to US $ 50,000 in Phase II and US $ 1,00,000 in Phase III,. Similar limits may be allowed for non-residents out of their non-repatriable assets in India.
iv) SEBI registered Indian Investors may be allowed to set up funds for investments abroad subject to overall limits of US $ 500 million in Phase I, US $ 1 billion in Phase II and US $ 2 billion in Phase III.
v) Banks may be allowed more liberal limits in regard to borrowings from abroad and deployment of funds outside India. Borrowings (short and long-term) may be subject to an overall limit of 50 percent of unimpaired Tier I capital in Phase I, 75 percent in Phase II and 100 percent in Phase III with a sub-limit for short-term borrowing. In case of deployment of funds abroad, the requirement of section 25 of Banking Regulation Act and the prudential norms for open position and gap limits would apply.
vi) Foreign direct and portfolio investment and disinvestment should be governed by comprehensive and transparent guidelines, and prior Reserve Bank approval at various stages may be dispensed with subject to reporting by ADs. All non-residents may be treated on part for purposes of such investments.
vii) In order to develop and enable the integration of forex, money and securities markets, all participants in the spot market should be permitted to operate in the forward markets; FIIs, non-residents and non-resident banks may be allowed forward cover to the extent of their assets in Indial; all-India financial institutions (FIs) fulfilling requisite criteria should be allowed to become full fledged Ads; currency futures may be introduced with screen based trading and efficient settlement systems; participation in money market in Government securities the role of primary and satellite dealers should be increased; fiscal incentives should be provided for individuals investing in Government securities; the Government should set up its own Office of Public Debt.
viii) There is a strong case for liberating the overall policy regime on gold; banks and FIs fulfilling well defined criteria may be allowed to participate in gold markets in India and abroad and deal in gold products.
i) Indian Joint Ventures/Wholly-Owned Subsidiaries (JVs/WOSs) should be allowed to invest up to US $ 50 Million in ventures abroad at the level of the authorized dealers (ADs) in Phase I with transparent and comprehensive guidelines set out by the Reserve Bank. The existing requirement of repatriation of the amount of investment by way of divident, etc., within a period of 5 years may be removed. Furthermore, JVs/WOSs could be allowed to be set up by any party and not be restricted to only exporters/exchange earners.
ii) Exporters/exchange earners may be allowed 100 per cent retention of earnings in Exchange Earners Foreign Currency (EEFC) accounts with complete flexibility in operation of these accounts including cheque writing facility with Phase I
iii) Individual residents may be allowed to invest in assets and financial markets abroad up to US $ 25,000 in Phase I with progressive increase to US $ 50,000 in Phase II and US $ 1,00,000 in Phase III,. Similar limits may be allowed for non-residents out of their non-repatriable assets in India.
iv) SEBI registered Indian Investors may be allowed to set up funds for investments abroad subject to overall limits of US $ 500 million in Phase I, US $ 1 billion in Phase II and US $ 2 billion in Phase III.
v) Banks may be allowed more liberal limits in regard to borrowings from abroad and deployment of funds outside India. Borrowings (short and long-term) may be subject to an overall limit of 50 percent of unimpaired Tier I capital in Phase I, 75 percent in Phase II and 100 percent in Phase III with a sub-limit for short-term borrowing. In case of deployment of funds abroad, the requirement of section 25 of Banking Regulation Act and the prudential norms for open position and gap limits would apply.
vi) Foreign direct and portfolio investment and disinvestment should be governed by comprehensive and transparent guidelines, and prior Reserve Bank approval at various stages may be dispensed with subject to reporting by ADs. All non-residents may be treated on part for purposes of such investments.
vii) In order to develop and enable the integration of forex, money and securities markets, all participants in the spot market should be permitted to operate in the forward markets; FIIs, non-residents and non-resident banks may be allowed forward cover to the extent of their assets in Indial; all-India financial institutions (FIs) fulfilling requisite criteria should be allowed to become full fledged Ads; currency futures may be introduced with screen based trading and efficient settlement systems; participation in money market in Government securities the role of primary and satellite dealers should be increased; fiscal incentives should be provided for individuals investing in Government securities; the Government should set up its own Office of Public Debt.
viii) There is a strong case for liberating the overall policy regime on gold; banks and FIs fulfilling well defined criteria may be allowed to participate in gold markets in India and abroad and deal in gold products.
Committee Recomandations on Capital account convertibility
The committee's recommendations for a phased liberalization of controls on capital outflows and inflows over the three-year period, inter alia, include:The Committee has also stated that the timing and sequencing of capital account convertibility would be greatly facilitated by the proposed changes in the legislative framework governing foreign exchange transactions.
i) Indian Joint Ventures/Wholly-Owned Subsidiaries (JVs/WOSs) should be allowed to invest up to US $ 50 Million in ventures abroad at the level of the authorized dealers (ADs) in Phase I with transparent and comprehensive guidelines set out by the Reserve Bank. The existing requirement of repatriation of the amount of investment by way of divident, etc., within a period of 5 years may be removed. Furthermore, JVs/WOSs could be allowed to be set up by any party and not be restricted to only exporters/exchange earners.
ii) Exporters/exchange earners may be allowed 100 per cent retention of earnings in Exchange Earners Foreign Currency (EEFC) accounts with complete flexibility in operation of these accounts including cheque writing facility with Phase I
iii) Individual residents may be allowed to invest in assets and financial markets abroad up to US $ 25,000 in Phase I with progressive increase to US $ 50,000 in Phase II and US $ 1,00,000 in Phase III,. Similar limits may be allowed for non-residents out of their non-repatriable assets in India.
iv) SEBI registered Indian Investors may be allowed to set up funds for investments abroad subject to overall limits of US $ 500 million in Phase I, US $ 1 billion in Phase II and US $ 2 billion in Phase III.
v) Banks may be allowed more liberal limits in regard to borrowings from abroad and deployment of funds outside India. Borrowings (short and long-term) may be subject to an overall limit of 50 percent of unimpaired Tier I capital in Phase I, 75 percent in Phase II and 100 percent in Phase III with a sub-limit for short-term borrowing. In case of deployment of funds abroad, the requirement of section 25 of Banking Regulation Act and the prudential norms for open position and gap limits would apply.
vi) Foreign direct and portfolio investment and disinvestment should be governed by comprehensive and transparent guidelines, and prior Reserve Bank approval at various stages may be dispensed with subject to reporting by ADs. All non-residents may be treated on part for purposes of such investments.
vii) In order to develop and enable the integration of forex, money and securities markets, all participants in the spot market should be permitted to operate in the forward markets; FIIs, non-residents and non-resident banks may be allowed forward cover to the extent of their assets in Indial; all-India financial institutions (FIs) fulfilling requisite criteria should be allowed to become full fledged Ads; currency futures may be introduced with screen based trading and efficient settlement systems; participation in money market in Government securities the role of primary and satellite dealers should be increased; fiscal incentives should be provided for individuals investing in Government securities; the Government should set up its own Office of Public Debt.
viii) There is a strong case for liberating the overall policy regime on gold; banks and FIs fulfilling well defined criteria may be allowed to participate in gold markets in India and abroad and deal in gold products.
i) Indian Joint Ventures/Wholly-Owned Subsidiaries (JVs/WOSs) should be allowed to invest up to US $ 50 Million in ventures abroad at the level of the authorized dealers (ADs) in Phase I with transparent and comprehensive guidelines set out by the Reserve Bank. The existing requirement of repatriation of the amount of investment by way of divident, etc., within a period of 5 years may be removed. Furthermore, JVs/WOSs could be allowed to be set up by any party and not be restricted to only exporters/exchange earners.
ii) Exporters/exchange earners may be allowed 100 per cent retention of earnings in Exchange Earners Foreign Currency (EEFC) accounts with complete flexibility in operation of these accounts including cheque writing facility with Phase I
iii) Individual residents may be allowed to invest in assets and financial markets abroad up to US $ 25,000 in Phase I with progressive increase to US $ 50,000 in Phase II and US $ 1,00,000 in Phase III,. Similar limits may be allowed for non-residents out of their non-repatriable assets in India.
iv) SEBI registered Indian Investors may be allowed to set up funds for investments abroad subject to overall limits of US $ 500 million in Phase I, US $ 1 billion in Phase II and US $ 2 billion in Phase III.
v) Banks may be allowed more liberal limits in regard to borrowings from abroad and deployment of funds outside India. Borrowings (short and long-term) may be subject to an overall limit of 50 percent of unimpaired Tier I capital in Phase I, 75 percent in Phase II and 100 percent in Phase III with a sub-limit for short-term borrowing. In case of deployment of funds abroad, the requirement of section 25 of Banking Regulation Act and the prudential norms for open position and gap limits would apply.
vi) Foreign direct and portfolio investment and disinvestment should be governed by comprehensive and transparent guidelines, and prior Reserve Bank approval at various stages may be dispensed with subject to reporting by ADs. All non-residents may be treated on part for purposes of such investments.
vii) In order to develop and enable the integration of forex, money and securities markets, all participants in the spot market should be permitted to operate in the forward markets; FIIs, non-residents and non-resident banks may be allowed forward cover to the extent of their assets in Indial; all-India financial institutions (FIs) fulfilling requisite criteria should be allowed to become full fledged Ads; currency futures may be introduced with screen based trading and efficient settlement systems; participation in money market in Government securities the role of primary and satellite dealers should be increased; fiscal incentives should be provided for individuals investing in Government securities; the Government should set up its own Office of Public Debt.
viii) There is a strong case for liberating the overall policy regime on gold; banks and FIs fulfilling well defined criteria may be allowed to participate in gold markets in India and abroad and deal in gold products.
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