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Money Matters

Foreign exchange is a crucial element of any international transaction. Vasant R. Kothari elaborates.

Foreign Exchange
businessman, who is dealing, day in and day out in various commodities, uses local legal currency to buy and sell items in his country; for example, for doing the business in India, one needs to use Indian rupees. Each country has its own currency and any currency other than the countrys home currency is known as foreign exchange/currency.

Basics of

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The raTe of conversion of one currency To anoTher is called The raTe of exchange... such raTes are arrived from The base raTe...

When a businessman imports goods and services, he buys foreign currency using his home currency. The process is reversed when a businessman is exporting goods and services.

Why is ConVeRsion neCessaRy?

No nation in the world is so entirely self-sufficient that they can boast about manufacturing all the commodities they need. They need to import the goods and services they need and in turn export the assets they have. This is the situation of the world and no country is an exception. India exports textiles, food, metals etc. and imports technology, food and other commodities. Even if we so wish, there is no universal currency by way of which transactions across national borders can be enabled. This scenario makes conversion of currencies a necessity.

Till the early sixties, currencies of different countries were on gold standard, i.e. a unit of a currency was valued in terms of certain amount of gold. The currency in circulation was kept at parity with gold or backed by gold reserves. Since gold is a scarce metal and the value of gold kept fluctuating depending upon its demand and supply, the system of gold standard was abandoned.

exChange Rate Quotes

There are two standard ways in which exchange rates are quoted in different countries. Under the direct quote system, the exchange rate for a fixed unit of foreign currency is expressed in terms of variable units of domestic currency, e.g. USD 1 = INR 45. Under the indirect quote system, foreign currency is expressed with reference to fixed/specific units of home currency i.e., the foreign currency is the variable, e.g. INR 100 = USD 2.22. Both direct and indirect quotes represent the same value of the exchange rate. Till August 1993 India had the indirect system of exchange rates. With effect from 2nd August 1993 India switched over to the more convenient system of direct quotes. Now exchange rates are quoted according to how much per unit of foreign currency amounts to in Indian rupees.

exChange Rates

The rate of conversion of one currency to another is called the rate of exchange. It is also considered as the worth of one countrys currency in terms of another currency. Such rates are arrived from the base rate, which is decided by market forces and is quoted on a daily basis.

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a currency will appreciaTe whenever demand for iT is greaTer Than The available supply and iT will depreciaTe if demand is less Than available supply.
FoReign exChange RisKs
Year 1973 1980 1980 1985 1986 1990 1991 1995 1996 2000 2001 2005 2006 - 2010 Minimum 7.27 7.75 12.24 18.33 34.31 43.58 39.26 Maximum 9.11 12.95 18.12 34.71 43.59 49.01 51.12 From the above table it is clear that exchange rate of a currency changes frequently. The assets, liabilities and cashflows of export and import firms, which are involved in international transactions, are affected by fluctuations in exchange rates. Depending upon the situation, fluctuations may cause a loss or profit to a firm as orders are booked well in advance. There is always the possibility that a company might be unable to adjust prices and costs to offset changes in exchange rate. This is called Exchange risk. Good for Import Good for Export Dollar Purchase rate is less Dollar Selling rate is more

One of the important problems an apparel export firm, with international business, may encounter is the currency exchange rate risk. The rate at which currency is exchanged will change when the values of either of the two currencies in question change. A currency will appreciate whenever demand for it is greater than the available supply and it will depreciate if demand is less than available supply. While almost every economic event has at least some indirect influence on the relative value of different currencies, there are generally six major factors that cause the value of currencies to appreciate or depreciate relative to one another: 1. Purchasing power parity 2. Relative interest rates 3. Trade imbalances 4. Political stability 5. Government intervention 6. Speculators

Table 1: USD Vs INR from 1973 to 2010

Rupee appreciates Rupee depreciates

Rupee rate is falling against dollar Rupee rate is rising against dollar

Dollar becomes cheaper Dollar becomes expensive

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The asseTs, liabiliTies and cashflows of exporT and imporT firms, which are involved in inTernaTional TransacTions, are affecTed by flucTuaTions in exchange raTes.

inspe | dreamstime.com

Lets try to understand this with a few examples.

inR appReCiation

If an exporter has confirmed the order of 10,000 garments @ USD 5.00 per piece to the importer in US, normally, such orders are confirmed at least 610 months in advance. For example, in the above case, the order might be booked in October 2006 for delivery in August 2007 for which the payment is expected in September 2007.

At the time of confirming the costing to the buyer, the exchange rate was R45. So total inflow expected by the exporter is USD 50,000 or R22,50,000. But in September 2007 when the exporter got the payment, the exchange rate was R40 and he actually received just R20,00,000, incurring a total loss of R2,50,000 because the Indian rupee appreciated against the USD.

inR DepReCiation

mithun chakravarthy | dreamstime.com

In the same way, for example, an exporter has confirmed the order of 10,000 garments @ USD 5.00 per piece to the importer in US, in December 2007 for delivery in September 2008 for which the payment is expected in October 2008. At the time of confirming the costing to the buyer, the exchange rate was R40. So the total inflow expected by the exporter was 50000 USD or R20,00,000. But in October 2008, when exporter got the payment, the exchange rate was R50 and he actually received additional R25,00,000, incurring a total profit of R5,00,000 because the Indian Rupee had depreciated against the USD.

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