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Ans 1
The following are the important functions of a foreign
exchange market:
1. To transfer finance, purchasing power from one nation to another.
Such transfer is affected through foreign bills or remittances made
through telegraphic transfer. (Transfer Function).
2. To provide credit for international trade. (Credit Function).
3. To make provision for hedging facilities, i.e., to facilitate buying and
selling spot or forward foreign exchange. (Hedging Function).
1. Transfer Function:
The basic function of the foreign exchange market is to facilitate the
conversion of one currency into another, i.e., to accomplish transfers
of purchasing power between two countries. This transfer of
purchasing power is effected through a variety of credit instruments,
such as telegraphic transfers, bank draft and foreign bills.
In performing the transfer function, the foreign exchange market
carries out payments internationally by clearing debts in both
directions simultaneously, analogous to domestic clearings.
2. Credit Function:

Another function of the foreign exchange market is to provide credit,

both national and international, to promote foreign trade. Obviously,
when foreign bills of exchange are used in international payments, a
credit for about 3 months, till their maturity, is required.
3. Hedging Function:
A third function of the foreign exchange market is to hedge foreign
exchange risks. Hedging means the avoidance of a foreign exchange
risk. In a free exchange market when exchange rate, i. e., the price of
one currency in terms of another currency, change, there may be a
gain or loss to the party concerned. Under this condition, a person or a
firm undertakes a great exchange risk if there are huge amounts of net
claims or net liabilities which are to be met in foreign money.
Exchange risk as such should be avoided or reduced. For this the
exchange market provides facilities for hedging anticipated or actual
claims or liabilities through forward contracts in exchange. A forward
contract which is normally for three months is a contract to buy or sell
foreign exchange against another currency at some fixed date in the
future at a price agreed upon now.
No money passes at the time of the contract. But the contract makes it
possible to ignore any likely changes in exchange rate. The existence of
a forward market thus makes it possible to hedge an exchange
position.
Foreign bills of exchange, telegraphic transfer, bank draft, letter of
credit, etc., are the important foreign exchange instruments used in
the foreign exchange market to carry out its functions.

Ans 2
Risks associated with international projects- financial, political, others
1. Financial risk
In general, international projects are prone to greater financial risk as a bulk of finance
is in the form of debt. The major factors affecting financial risk are degree of
indebtedness, the terms and conditions of repayment of debt and currency used.
Some projects will have expenses and revenues that involve several currencies. As a
result the exchange rate risk is very high.
Projects maybe financed with floating rates. In view of the volatility observed on the
rates like LIBOR, the interest rate risk is also significant. Therefore it is necessary to
plan the coverage of all these risks.
2. Foreign Exchange Risk
As corporations expand their international activities, they begin to acquire foreign assets
and foreign liabilities. As exchange rates change, the values of these foreign assets and
liabilities change accordingly. For a corporation, exchange rate risk is the sensitivity of
the value of the corporation when the exchange rates change. Obviously, the change in
the corporation value is related to the net change in the values of the foreign assets and
foreign liabilities. (E.g. foreign direct investment, foreign exchange loss, sales and
income from foreign sources.)
3. Economic Risk
Economic risk is risk created by changes in the economy. Typically, it is related to
technological changes, the actions of competitors, shifts in consumer preferences, etc.
Ideally, a pure domestic firm is affected only by domestic economic conditions the
domestic economic risk. However, in todays integrated world economy, the concept of a
pure domestic firm has less practical relevance. Many firms that appear strictly pure
domestic confront foreign economic risk indirectly. (E.g.: local restaurant/dept store, real
estate agent)
4. Political Risk
Political risk is risk created by political changes or instability in a country. These factors
include, but are not limited to, nationalization, confiscation, price controls, foreign

exchange and capital controls, administrative hurdles, uncertain property rights,

discriminative or arbitrary regulations on business practices (hiring, contract
negotiation), civil wars, riots, terrorism, etc. Each country in the world presents a
different political profile and represents a unique source of political risk that firms must
assess and manage when they make foreign investments.
In order to minimize this risk, local investors or the local government may be associated
with the project. Insurance against political risk is another useful technique
recommended for the purpose.
What constitutes political risk and how to measure it?
The political risk management typically involves:
Identifying political risk and its likely consequences
Developing policies in advance to cope with the possibility of political risk
Strengthening a firms bargaining position
Devising measures to maximize compensation in the event of expropriation
Country Risk: It refers to elements of risk inherent in doing business in the economic,
social, and political environment of another country.
5. Counter party Risk The risk that a counter party will default on a financial obligation.
6. Liquidity Risk -The risk that a financial position cannot be sold quickly at prevailing
prices.
7. Delivery Risk The risk that a buyer will not deliver payment of funds after a seller
has delivered securities or foreign exchange that were purchased.
8. Rollover Risk The risk of being closed out from a financial market and unable to
renew (or roll over) a short-term contract.

Ans 3
Hedging

There are a number of different types of hedge that an investor can

purchase. All perform the same basic task, which is to provide a
counterposition that offsets the investor's main position. In the event

that the main position fails to mature in the way that the investor
foresaw, the counterposition with reduce his losses, either partially
or in full, depending on the nature of the hedge.
Advantages

The main advantage of the hedge is that it lowers the risk of an

investment significantly. If an investor makes an investment in which
variables are out of his control -- as is the case in nearly any
investment -- then he stands to lose money if things do not go as he
planned. A hedge can help him offset these losses and thus reduce
any unwanted risk.
Currency hedging is a strategy that allows an investor to minimize and control the risks involved in
foreign investment, particularly one that relates to foreign currency trading. This strategy aims to
compensate for any movement in the value of the currency being used in the investment portfolio. Like
any other type of moneymaking approach, hedging has both advantages and disadvantages. As an
investor, you need to ensure that the benefits of an investment strategy can offset the disadvantages.
Here are the pros and cons of hedging currencies.

Benefits of Currency Hedging

The main advantage of this investment approach is to help reduce the risks and losses of the investor.
Hedging is a good strategy when dealing with foreign investment opportunities. The price of currencies
are volatile, however, hedging currencies can provide investors with more leverage when they put
money in the very risky Forex market.

Moreover, investors who do not have the time to monitor and check their investments can also benefit
from hedging. There are many hedging tools that can effectively lock profits for investors. The gains
from hedging are often realized in long term gains.
Also, since the objective of hedging currencies is to minimize losses, it can also allow traders to survive

economic downturns, or bearish market periods. If you are a successful hedger, you will be protected
against inflation, interest rate changes, commodity price volatility and currency exchange rate
fluctuations.
Ans 4

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