Introduction

In todays world no economy is self-sufficient, so there is need for

exchange of goods and services amongst the different countries. So
in this global village, unlike in the primitive age the exchange of
goods and services is no longer carried out on barter basis. Every
sovereign country in the world has a currency that is legal tender in
its territory and this currency does not act as money outside its
boundaries. So whenever a country buys or sells goods and
services from or to another country, the residents of two countries
have to exchange currencies.
Foreign exchange risk (also known as FX risk, exchange rate risk
or currency risk) is a financial risk that exists when a financial
transaction is denominated in a currency other than that of the base
currency of the company.

NEED FOR FOREIGN EXCHANGE

Let us consider a case where Indian company exports
cotton fabrics to USA and invoices the goods in US dollar.
The American importer will pay the amount in US dollar,
as the same is his home currency. However the Indian
exporter requires rupees means his home currency for
procuring raw materials and for payment to the labor
charges etc. Thus he would need exchanging US dollar for
rupee. If the Indian exporters invoice their goods in
rupees, then importer in USA will get his dollar converted
in rupee and pay the exporter.
From the above example we can infer that in case goods
are bought or sold outside the country, exchange of
currency is necessary.

PARTICIPANTS IN FOREIGN EXCHANGE MARKET

CUSTOMERS
COMMERCIAL BANKS
CENTRAL BANK
EXCHANGE BROKERS
OVERSEAS FOREX MARKET
SPECULATORS

The Functions of the Foreign Exchange Market

1. The foreign exchange market serves two

functions: converting currencies and reducing
risk. There are four major reasons firms need to
convert currencies.
2. First, the payments firms receive from exports,
foreign investments, foreign profits, or licensing
agreements may all be in a foreign currency. In
order to use these funds in its home country, an
international firm has to convert funds from
foreign to domestic currencies.
3. Second, a firm may purchase supplies from
firms in foreign countries, and pay these suppliers
in their domestic currency.
4. Third, a firm may want to invest in a different
country from that in which it currently holds
underused funds.

EXCHANGE RATE SYSTEM

THE GOLD STANDARD
Many countries have adopted gold standard as
their monetary system during the last two
decades of the 19th century . Under this system
the parties of currencies were fixed in term of
gold.
Gold Bullion Standard
Under this system, the money in circulation was
either partly of entirely paper and gold served
as reserve asset for the money supply.
However, paper money could be exchanged for
gold at any time.

FLOATING RATE SYSTEM

In a truly floating exchange rate regime, the

relative prices of currencies are decided
entirely by the market forces of demand and
supply.
PURCHASING POWER PARITY (PPP)

under this theory the exchange rate was to be

determined and the sole criterion being the
purchasing power of the countries. As per this
theory if there were no trade controls, then the
balance of payments equilibrium would
always be maintained.

FACTOR AFFECTINGN EXCHANGE RATES

Commodity Prices
Interest Rates
Inflation rate
Strength of economy
Government Debt
Terms of Trade
Recession

Hedging Tools
1. Forward Contracts
Forward exchange contract is a firm and binding contract,
entered into by the bank and its customers, for purchase of
specified amount of foreign currency at an agreed rate of
exchange for delivery and payment at a future date or period
agreed upon at the time of entering into forward deal.

2. OPTIONS
An option is a Contractual agreement that
gives the option buyer the right, but not the
obligation, to purchase or to sell a specified
instrument at a specified price at any time of
the option buyers choosing by or before a
fixed date in the future.

3.SWAPS
A contract between two parties, referred to as
counter parties, to exchange two streams of
payments for agreed period of time. The
payments, commonly called legs or sides, are
calculated based on the underlying notional
using applicable rates.
4.FUTURES
In a futures contract there is an agreement to
buy or sell a specified quantity of financial
instrument in a designated Future month at a
price agreed upon by the buyer and seller.

Types of risk in foreign exchange

Position Risk
The exchange risk on the net openForexposition is
called the position risk. The position can be a
long/overbought
position
or
it
could
be
a
short/oversold position. The excess of foreign currency
assets over liabilities is called a net long position
whereas the excess of foreign currency liabilities over
assets is called a net short position
2. Mismatch Risk/Gap Risk:
Where a foreign currency is bought and sold for
different value
dates, it creates no net position i.e.
there is no FX risk. But due to the different value dates
involved there is a mismatch i.e. the purchase/sale
dates do not match.

3. Translation Risk:
Translation risk refers to the risk of adverse rate
movement on foreign currency assets and liabilities
funded out of domestic currency.

4. Operational Risk
The operational risks refer to risks associated with
systems, procedures, frauds and human errors. It is
necessary to recognize these risks and put
adequate controls in place, in advance.

5. Credit Risk
The credit is contingent upon the performance of
its part of the contract by the counter party. The
risk is not only due to non performance but also at
times, the inability to perform by the counter party.

Conclusion
Foreign exchange is the mechanism by which the
currency of one country gets converted into the
currency of another country. This is carried out
through the intermediation of banks .The term also
refers to foreign currencies and balance in foreign
currencies held abroad. Foreign Exchange is required
for settlement of economic transactions between
residents of two countries. India should continue to
follow the path of progressive liberalization with
continuous assessment and judicious monitoring. In
world of competition and liberalization, the survival
and growth of business enterprises depends
significantly on how well they recognize and manage
effectively the exchange risk and exposure