ASSIGNMENT OF INTERNATIONAL FINANCE PGDM TERM -5 SEC- B TOPIC:- EXCHANGE RATE RISK MANAGEMENT BATCH: 2011-2013

SUBMITTED TO: PROF. Dr KC PADHY DATE OF SUBMISSION: 22nd DECEMBER

SUBMITTED BY: SNEHA CHOWDHURY( 11DM072) BISHAJEETAMOHANTA(11DM073) KALPANA(11DM074) ANAND SINGH(11DM077) SAKET ANAND(11DM079)

Exchange risk simply means that the rate at which a currency is exchanged for another currency may be uncertain and volatile and the amount that an exporter receives in domestic currency or an importer has to pay in terms of domestic currency will be unpredictable and uncertain . Similarly, if funds are transmitted from one country to country to another the amounts to be sent or to be received will not be certain, if exchange rates are not fixed. The fluctuating rates result in uncertainty and risk, which will have to be managed by the genuine traders and investors in foreign countries and dealers in foreign exchange and banks.

FACTORS AFFECTING EXCHANGE RATES:1. Hot money flows as between countries and currencies will take place to take advantage of short term economic and political factors or disturbances or fears of such developments leading to changes in currency rates and interest rates. 2. Speculative attacks on currencies in anticipation of exchange rate changes and interest rate changes through short term flow of funds due to rumors news and expectations.

3. Exchange rates volatility emerges out of erratic fund flows as between countries short term flow of funds in either direction and inflows of funds followed by immediate reversals etc. 4. Freely fluctuating exchange rates across countries do sometimes lead to erratic movements of rates on either side, unless counter veiled by central bank of the country to offset such excesses.

5. Present international monetary system under IMF imposes the burden of adjustments on the deficit countries to change their exchange rates rather than on the surplus countries. 6. Limited powers of IMF to discipline the surplus countries also lead to partial adjustment or lack of adjustment as between currencies of countries with the result that currency rate may fluctuate.

TYPES OF RISK IN GENERAL:1. 2. 3. 4. 5. 6. 7. 8. Risk of credit worthiness Risk of credit control Risk of economic and political policy. Risk of interest rate changes Risk of market changes Risk of uncertainty in exchange rates Risk of war and epidemics Risk of changes in cross currency

Exchange Rate Theories Background of International Monetary System

International monetary system has been in existence since late nineteenth century. It was during this period that the gold standard began. The Gold Standard: 1880-1914

Under gold standard, currencies are valued in terms of gold equivalent, known as mint parity price. Each currency is defined in terms of its gold value. Thus, all currencies are linked together in a system of fixed exchange rate. An ounce of gold was worth $20.76 in terms of U.S. dollars. The International Gold Standard, 1879-1913 With stable exchange rates and a common monetary policy, prices of tradable commodities were much equalized across countries.Real rates of interest also tended toward equality across a broad range of countries. On the other hand, the workings of the internal economy were subservient to balance in the external economy

Gold Standard
How it worked? If 1 unit of currency A is worth 0.10 ounce of gold, whereas 1 unit of currency B is worth 0.2 o Maintaining gold standard requires a commitment from participating countries to buy and sell gold to anyone in the world at the fixed price. If the government does not stand willing to buy and sell at the mint parity price, then the price will fluctuate with changes in the supply and demand for money once gold, then 1 unit of currency B is worth twice as much as A. Exchange rate= 1 currency B=2 currency .

The Interval Period, 1918-1939

World War I ended the gold standard. Europe had experienced rapid inflation during war and afterward and it was not possible to restore the gold standard. United Stated experienced little inflation during the war and thus returned to a gold standard

The Gold Exchange Standard: 1944-1970

After World War II, countries desired to establish an international monetary system based on mutual cooperation and freely convertible currencies. Led to an international conference at Breton Woods, New Hampshire in 1944.The result of this conference is to tie all currencies together

The gold standard

Under the gold standard, each nation specified the gold content of its currency. The exchange rate of $4.87/ is known as mint paritys the cost of shipping gold from New York to London was approximately

3 cents, the actual exchange rate would always lie between $4.84/ and$4.90/.$4.84/ is the gold import point.$4.90/ is the gold export point.

Adjustment under the gold standard

Adjustment to equilibrium under the gold standard occurs via the price-specie-flow mechanism. The concept of the price-specie-flow mechanism was initially introduced in 1752 by David Hume. Adjustment to equilibrium under the gold standard occurs via the price-specie-flow mechanism. If a trade imbalance exists, gold will flow from the country with a trade deficit to the country with a trade surplus. Adjustment to equilibrium under the gold standard occurs via the price-specie-flow mechanism. If a trade imbalance exists, gold will flow from the country with a trade deficit to the country with a trade surplus. The fall in gold supplies in the trade deficit country reduces its money supply and pushes its price level lower; the increase in gold supplies in the trade surplus country increases its money supply and raises its price level.

Bretton Woods Agreement

The Breton Woods agreement required that each country fix the value of its currency in terms of gold. The U.S. dollar was the key currency in the system. $1 was defined as being equal to 1/35 ounce of gold. Nations belonging to the system were committed to maintaining the parity value. The International Monetary Fund (IMF) was created to monitor the operation of the system.

The Transition Years: 1971-1973

In 1971 international monetary conference was held in Washington to realign foreign-exchange values of the major currencies. Change in dollar value in terms of gold from $35 to $38. Dollar was being devalued by about 8%, currencies of countries with balance-of-payment surplus revalued upward In 1972 Britain allowed pound to float according demand and supply conditions By 1973 major currencies were all floating.

Floating Exchange Rates: Since 1973

In this system, exchange rate is determined by free market forces of demand and supply. Although we described the system since 1973 as floating system, it has never been fully determined by free market forces. The system in operation can be best described as managed float.

International Monetary Arrangements in Theory and Practice

The international financial system can promote the gains from international trade and the economic integration of regions, but it may also be a conduit for the transfer of macroeconomic shocks from one nation to another.

Introduction

An exchange rate is the relative price of one currency in terms of another .It influences allocation of resources within and across countries .During the Breton Woods era exchange rate was treated as an exogenous variable. With the advent of floating rates in 1973, attention once again shifted to determinants of exchange rates themselves. Basics of exchange rate economics to be able to evaluate forecasts given by experts.

Some Fundamental Relationships

Investors are risk averse and therefore would not be guided only by expected returns Even if all investors are risk neutral, they could have differing views about future exchange rate movements Transaction costs and liquidity needs would force people to hold some of their wealth in the currency of their operating habitat even though the expected return on a foreign currency is higher .Exchange controls may prohibit portfolio shifts between currencies and interfere with realization of UIP.

Exchange Rate Forecasting

Exchange rate forecasts are an important input into a number of corporate financial decisions Forecasting methodologies can be divided into two broad categories. Structural economic models of exchange rate determination such as the PPP or the monetarist model Pure forecasting models" that includes time series methods and "technical analysis" Recent developments in modeling and predicting financial time series have applied mathematical tools like Chaos Theory and Neural Networks. Composite Forecasts A combination of different forecasts. The use to which the forecast is put .The Corporations "loss function" i.e. the cost incurred when forecasts turn out to be wrong How much does the forecast contribute to better decision making given that the firm has its own sources of information and is able to generate its own forecasts. The forward rate is always available as a forecast free of charge. Any forecast paid for must do considerably better than forward rate in predicting direction and magnitude of movement. The exchange rate system in India has had a chequered history .Determinants of exchange rate movements in India are difficult to assess during the period of managed float. The RBI policy in 2000: No fixed target for exchange rate nominal or real. RBI acts to moderate excessive fluctuations and prevent panics. Behavior of the spot rate in India is largely governed by trade related flows since the capital account continues to be strictly controlled .In the very short run, portfolio decisions of FIIs can generate significant volatility in the rupee exchange rate.

Exchange Rate Theories

Interest Rate Parity Purchasing Power Parity The Fisher Effects Forecasting Exchange Rates

Interest Rate Parity

Interest Rate Parity Defined Covered Interest Arbitrage Interest Rate Parity & Exchange Rate Determination Reasons for Deviations from Interest Rate Parity IRP is an arbitrage condition. If IRP did not hold, then it would be possible for an astute trader to make unlimited amounts of money exploiting the arbitrage opportunity. Since we dont typically observe persistent arbitrage conditions, we can safely assume that IRP holds.

Purchasing Power Parity

Purchasing Power Parity and Exchange Rate Determination PPP Deviations and the Real Exchange Rate Evidence on PPP. PPP probably doesnt hold precisely in the real world for a variety of reasons. Haircuts cost 10 times as much in the developed world as in the developing world. Film, on the other hand, is a highly standardized commodity that is actively traded across borders. Shipping costs, as well as tariffs and quotas can lead to deviations from PPP. PPP-determined exchange rates still provide a valuable benchmark.

The Fishers Effect

It states that currencies with high rate of inflation should bear higher rates of interest than currencies with lower rates of inflation. The real rate of interest is the net increase in the wealth that people expect to achieve when they save and invest their current income. All financial contracts are stated in nominal terms, the real rates of interest must be adjusted to reflect inflation.

Forecasting exchange rates

It states that exchange adjusted price of identical trade able goods and assets must be within the cost of equality worldwide. Assumptions:-

1. To hold a rational market there should be no barriers of trade. 2. The goods have to be homogeneous. 3. There are no transaction cost involving buying a commodity in one market and selling it on another.

Reasons for Exchange Rates

Trade movements Capital inflow Granting of loans Banking operations Speculations Protection Inflation Financial policy Bank rate Peace on security Political condition

Risk in Foreign Trade and Finance

Credit risk of customer Country risk Currency risk Market risk

Exchange Rate Management in India

In the real world, expectations cannot be easily subjected to definitive formulae; goods cannot be transferred across countries simultaneously; shipping and other transactions costs can turn out to be much different from the initial conditions; trade and other restrictions often exist, distorting prices. The main objective of India's exchange rate policy is to ensure that economic fundamentals are reflected in the external value of the rupee. Subject to this predominant objective, the conduct of exchange rate policy is guided by three major purposes. First, to reduce excess volatility in exchange rates, while ensuring that the market correction of overvalued or undervalued exchange rate is orderly and calibrated. Exchange rate policy will form part of the overall macroeconomic policy and will, therefore, have to be subservient to overall macroeconomic targets. Developing exchange markets is another important consideration in exchange rate management. Recently, several measures were initiated to further integrate the Indian fore market with the global financial system.