Foreign Exchange & Forex Risk Management

KMBN FM – 04
 PLAN OF UNIT 1
1 Lecture Zero Overview of the Subject
Understanding the meaning of Foreign trade, Foreign
Introduction: meaning and nature of foreign
2 exchange, FOREX market, it’s operations and the
exchange market
Significance.
Describing the meaning of Balance of Payment and it's
3 Balance of Payments and it's Components
components.
Determining the debit and credit entries of Balance of
4 Balance of Payments and it's Components
Payments
Summarizing the entries of balance of payment and it's
5 Balance of Payments and it's Components
components.
Describing foreign exchange market and recognizing
6 Participants in Forex Market
participants involved in foreign exchange market.
Investigating the role of participants involved in driving the
7 Participants in Forex Market
foreign exchange market.
8 Exchange Rate & and its types Classifying the exchange rate into different types.
Describing the Exchange rate system prior to IMF
9 International Monetary System
(International Monetary Fund) with the help of story.
Describing the Exchange rate system under IMF
10 International Monetary System
(International Monetary Fund) with the help of story.
1 Lecture Zero Overview of the Subject
LECTURE ZERO
 Vision & Mission Statements of the Institute
Vision Statement of the Institute:

• To achieve excellence in professional education and create an ecosystem for the holistic development of
all stakeholders

Mission Statement of the Institute:

• To provide an environment of effective learning and innovation transforming students into dynamic,
responsible and productive professionals in their respective fields, who are capable of adapting to the
changing needs of the industry and society.
 Vision & Mission Statements of the Department

Vision Statement of the Department:

• To be a recognized department of business management that excels at providing world-class business education that
inspires management professionals to work for the holistic development of society.

Mission Statement of the Department:

1. To provide value & skill-based experiential learning to develop future business leaders.

2. To promote a participative learning environment that results in generating creativity.

3. To adopt an inclusive teaching pedagogy blended with the demanding academics and value-added training programs.

4. To create responsible professionals capable of promoting the welfare of society and stakeholders.
 Program Educational Objectives (PEOs):

• The management graduates will be efficient leading business professionals with various management domains that
enable them to become corporate leaders/successful entrepreneurs.

• Management graduates will possess the capability of providing successful innovative solutions to real-life business
problems that are financially and economically viable and socially acceptable.

• Management graduates will be competent business professionals capable of working in cross-cultural teams embedded
with ethical values.

• The management graduates will be capable of adapting to dynamic business environment changes, consistently
enhancing their business acumen with an attitude of life-long learning.
 Program Outcomes (POs):

• Apply knowledge of management theories and practices to solve business problems.

• Foster analytical and critical thinking abilities for data-based decision-making.

• Ability to develop Value-based Leadership ability.

• Ability to understand, analyze and communicate global, economic, legal, and ethical aspects of the business

• Ability to lead themselves and others in the achievement of organizational goals, contributing effectively to a

team environment.

• Ability to develop entrepreneurial perspective and attributes.

Subject Name:
Foreign Exchange & Forex Risk Management

Subject Code : KMBN FM – 04

Exam Marks : 150

(i) 100 Marks ( External)
(ii) 50 Marks ( Internal )
 COURSE OBJECTIVES

This course is intended to introduce the basic theory, concepts and

practical approach in Foreign Exchange Management and to
enable students to handle various risk associated with forex and
its management.
 Course Outcomes (COs):

Describe the various concepts of foreign exchange, theories of foreign exchange rate,
exchange risk and exchange dealing.

Calculate the convertibility of rupee, different exchange rate, profit & loss arises in exchange
dealing and exchange risk in foreign exchange market.

Examine the B.O.P., foreign exchange transactions and foreign exchange risk in business
decision making.

Estimate the foreign exchange dealings and foreign exchange transactions to minimize the
loss.

Integrate the various concepts of foreign exchange and FOREX risk management in order to
minimize the risk and loss.
 Books & Reference Material
 Text Book - Madhu Vij, International Financial Management (Excel Books, 2006)

 Reference Book –

1. V.P Singh, International Business Environment and Foreign Exchange Economics, (New Age Publisher,2014)

2. V. Sharan, International Financial Management, (Prentice Hall India, 2004)

3. P. G. Apte, International Financial Management, (Tata McGraw Hill, 2004)

4. https://resource.cdn.icai.org/67847bos54415-cp9.pdf

5. https://www.icsi.edu/media/webmodules/publications/FTFM_Final.pdf

6. https://drive.google.com/file/d/15cZcVdXkQnuhWsCpquXxKIfMeo3vyF9k/view
 REAL WORLD EXAMPLE
https://cfo.economictimes.indiatimes.com/news/economy/how-will-donald-trumps-reciprocal-tariffs-play-out-for-india/118262675

https://www.livemint.com/opinion/online-views/trump-trade-policies-india-import-tariffs-export-rate-foreign-exchange-reserves-rupee-value-us-
dollar-value-fdi-gccs-11739102457092.html

https://www.icicidirect.com/research/equity/finace/how-can-changes-brought-by-trump-impact-india-and-its-stock-market

https://economictimes.indiatimes.com/news/international/global-trends/currency-manipulation-warning-sparks-debate-on-trumps-
plans/articleshow/117417257.cms?from=mdr
These fluctuations in exchange rates are precisely what create both opportunities
and risks in the world of international business.

Imagine an Indian exporter who sells textiles to the US and receives payment in dollars.

DEAL – Fifty thousand cartons sold for 1,00,000$ (Exchange rate 1$ = Rs. 85) i.e. Rs.85,00,000

If the rupee strengthens against the dollar (1$ = Rs. 80) before they convert those dollars back to rupees, their
earnings will be worth less in rupee terms.
( Rs. 80,00,000 only)

Conversely, if the rupee weakens (1$ = Rs 90), their dollar earnings translate to more rupees.

( Rs. 90,00,000/- !)

This is what we call foreign exchange risk, and it's a critical aspect of international
finance that we'll be learning about in this course.
 UNIT – I
 Foreign Exchange and Foreign Trade, Exchange Rate, Foreign Exchange as stock.

 Balance of Payments, Balance of Payments accounting, Components of Balance of Payments; Current

Account, Capital Account, Official Reserve Accounts, Debit and Credits Entries.

 International Exchange Systems; Fixed and Floating Exchange rate system.

 Exchange Rate System prior to IMF; Gold currency standard, Gold bullion standard, Gold exchange
standard.

 Exchange Rate System under IMF: Bretton woods system, The Smithsonian Agreement, The Flexible
Exchange Rate Regime.
 UNIT – II

 Convertibility of rupee; Current account convertibility, Capital Account Convertibility.

 Theories of Foreign Exchange Rate: Purchasing Power Parity (PPP), International

Fisher Effect (IFE), Interest Rate Parity (IRP).

 Administration of Foreign Exchange; Authorized persons, Authorized dealers,

Authorized Money Changers.

 Foreign Currency Accounts: Nostro Account, Vostro Account and Loro Account in
foreign transactions.
 UNIT – III

Foreign Exchange Transactions; Purchase and sale transactions;

Exchange quotations: Direct and Indirect Quotations, Two way Quotation;

Spot and Forward Transactions: Forward margin, Factors Determining forward margin.

Merchant Rates: Basis of Merchant Rates, Types of buying and Selling rates, Ready
rates based on cross rates.

Forward exchange contract: Fixed and option forward contracts, Calculation of fixed
and option forward rates; Inter Bank Deals; Execution of forward Contracts.
 UNIT – IV

Exchange Dealings: Dealing position – Exchange position, Cash Position.

Accounting and Reporting: Mirror account, Value date, Exchange profit

and loss, R returns.

Forex Risk Management: Risk in Forex Dealing, Measure of Value at

Risk.

Foreign Exchange markets.

Settlement of Transactions: Swift, Chips, Chaps, Fed wire.

 UNIT – V
Exchange Risk: Exchange exposure and exchange risk.

Transaction Exposure, Managing Transaction exposure: External Hedge-

Forward contract hedge, Money market hedge, hedging with futures and
options, Internal Hedge.

Translation exposure, Methods of translation, managing translation

exposure.

Economic exposure, managing economic exposure; Interest rate risk.

 Understanding the meaning of Foreign trade, Foreign
Introduction: meaning and nature of foreign
2 exchange, FOREX market, it’s operations and the
exchange market
Significance.
 Unit-1
Introduction to Foreign Exchange
 Foreign Trade?
• If you can walk into a supermarket and find an apple i-phone, Brazilian coffee,
and a bottle of South African wine, you're experiencing the impacts of foreign
trade.
 Foreign Trade?
• If you can walk into a supermarket and find an apple i-phone, Brazilian coffee, and
a bottle of South African wine, you're experiencing the impacts of foreign trade.
• Foreign trade allows countries to expand their markets and access goods
and services that otherwise may not have been available domestically.
• As a result of Foreign trade, the market is more competitive.
• Foreign Trade is the mutual exchange of services or goods between
international regions and borders.
• There are varieties such as imports and exports.
• Foreign trade is the flow of Products or capitals produced outside
national borders.
• The Purchase and sale transaction that enables the produced goods &
services to be offered to consumers represents the concept of trade.
 Foreign Trade:
the mutual exchange of services or
goods between international regions
and borders.
Foreign trade allows countries to
expand their markets and access
goods and services that otherwise
may not have been available
domestically.

As a result of Foreign trade, the

markets become more
competitive.
The foundation of foreign trade, like all trade, is
the purchase and sale transaction that enables
produced goods and services to be offered to
consumers.

This exchange is the core concept of trade itself.

Foreign trade refers to the exchange of goods,

services, and capital between countries..

Types of Foreign Trade: Within foreign trade,

there are different types of transactions, most
notably imports (bringing goods/services into a
country) and exports (sending goods/services
out of a country).
Why do we engage in international Trade?
• Lower Price
• The primary goal of foreign trade is to purchase goods and
services at a lower cost than those found anywhere else.
• Customers can purchase less costly commodities, and
producers can purchase less costly semi-manufactured goods
and raw materials.

• Geographical Variation
• Lithium, Critical Minerals etc.
 Why do we engage in international Trade?
• Greater Choice
• Access to Unique Products and Services: For example, a
consumer in the U.S. can buy French wine, Italian fashion, or
Japanese electronics. This diversity allows consumers to enjoy goods
that may not be produced in their own country.
• Innovation and New Technologies: For example, a smartphone
manufacturer in the U.S. may access cutting-edge technology from
South Korea or China, resulting in new and improved products for
consumers worldwide.
• Specialized Goods: For instance, a person living in a country
without a strong coffee culture can still enjoy premium, freshly
roasted coffee beans from Colombia or Ethiopia.
 Foreign Exchange Market: An Introduction

What is it?

The foreign exchange (forex) market is the global marketplace where currencies are traded.
Think of it as the world's currency exchange.

Why does it exist?

Because international trade and investment require exchanging currencies. If you want to buy
German cars with US dollars, you need to convert those dollars to euros first. That's where
the forex market comes in.
 Who's involved?

- Banks (major players)

- Companies (for
international business)
- Exporters and Importers
(for trade)
- Fund Managers (for
investments)
- Individuals (for travel,
investment, etc.)
- Central Banks (to manage
currency supply and
stability)
Where is it?

Everywhere and nowhere! The forex market is decentralized and operates electronically.
There's no single physical location. It's a global network.

When is it open?

Almost always! Because it's a global network, trading happens 24 hours a day, 5 days a
week (generally closed on weekends). Different trading centers around the world open
and close, keeping the market active.

How does it work?

Forex trading always involves currency pairs. You're simultaneously buying one currency
and selling another. The price of one currency relative to another is called the exchange
rate, and this rate constantly fluctuates based on supply and demand.
 The foreign exchange market's
decentralized nature is one of its
defining characteristics, setting it
apart from centralized markets like
stock exchanges.
 IMPORTANT POINTS - RECAP
1. No Central Location: Unlike a stock exchange with a physical building where
trading takes place, the forex market has no central hub. Instead, it's a global
network of interconnected computers and communication systems linking
banks, financial institutions, and individual traders worldwide.

2. Over-the-Counter (OTC) Trading: Forex transactions primarily occur over-the-

counter (OTC), meaning they happen directly between two parties who agree on
a price. This contrasts with exchanges where buyers and sellers place orders
that are matched by the exchange.
3. Network of Participants:

Central banks: They manage their country's currency reserves and influence exchange rates.

Commercial banks: They facilitate forex transactions for clients and trade on their own behalf.

Hedge funds and investment firms: They speculate on currency movements for profit.

Corporations: They exchange currencies for international business operations.

Individual traders: They participate through online trading platforms.

4. 24/5 Operation: Because the market is decentralized and operates across different
time zones, trading happens continuously 24 hours a day, five days a week. When one
major trading center closes, another opens, ensuring constant market activity.

- As the markets remain open at a different time on a given day, normally GMT is used to
refer to the trading hours at different locations.

For example, the trading duration in Asia is from GMT.00.00 till GMT 08.00. Trading
duration in London is from GMT 07:00 till GMT 15:00. Trading in the USA commences
from GMT 13.00 till GMT 22.00. Trading in London starts at GMT 8.00 and ends at GMT
17.00. Trading in Tokyo starts at GMT 0.00 ( midnight) and ends at GMT 9.00.

- Major foreign currency trading centers are located in London, Tokyo, New York.
5. Indian Forex Market Operations: Unlike the global forex market, which operates 24/5, India
has specific trading hours. This is primarily due to regulations and the structure of the Indian
financial market.

- The forex market in India is open from 9:00 AM to 5:00 PM Indian Standard Time (IST) on
weekdays (Monday to Friday). This is when trading in Indian Rupee (INR) currency pairs (like
USD/INR, EUR/INR, etc.) takes place.

4. No Single Authority: There's no single entity or regulatory body that controls the forex
market. Instead, it's a self-regulating system driven by supply and demand forces.
 Describing the meaning of Balance of Payment and it's
3 Balance of Payments and it's Components
components.
Determining the debit and credit entries of Balance of
4 Balance of Payments and it's Components
Payments
Summarizing the entries of balance of payment and it's
5 Balance of Payments and it's Components
components.
Recent news item related to international trade or a country's economic
performance.

TRADE NEWS SHARED

A country has to deal with other countries in respect of the following:

1.Visible items which include all types of physical goods exported and imported.

2.Invisible items which include all those services whose export and import are

not visible. e.g. transport services, medical services etc.

3.Capital transfers which are concerned with capital receipts and capital

payment.
 What is the Balance of Payments?

"The Balance of Payments (BOP) is a systematic record of all

economic transactions between residents of a country and the
rest of the world during a specific period (usually a year).“

“Residents" – this includes individuals, businesses, and

government entities within the country's borders.
Balance of Payments

According to Kindle Berger, "The balance of payments of a country is a

systematic record of all economic transactions between the residents of the
reporting country and residents of foreign countries during a given period of
time".

It is a double entry system of record of all economic transactions between the

residents of the country and the rest of the world carried out in a specific
period of time

when we say "a country's balance of payments" we are referring to the

transactions of its citizens and government.
Balance Of Payment: Definition

The balance of payments of a country is a systematic record of all economic

transactions between the residents of a country and the rest of the world. It presents
a classified record of all receipts on account of goods exported, services rendered and
capital received by residents and payments made by them on account of goods
imported and services received from the capital transferred to non-residents or
foreigners.

•Reserve Bank of India

Features

• It is a systematic record of all economic transactions between one country and the
rest of the world.
• It includes all transactions, visible as well as invisible.
• It relates to a period of time. Generally, it is an annual statement.
• It adopts a double-entry book-keeping system. It has two sides: credit side and
debit side.
• Receipts are recorded on the credit side and payments on the debit side.
 Balance of Payments: Meaning & Structure
• It is merely a way of listing receipts and payments in the international
transaction for a country.
• Each transaction is entered on the credit and debit side of the
balance sheet.
• Payment received from a foreign country is a credit transaction, and
payment to a foreign country is debit.
 Why is the BOP Important?

•Economic Health Indicator: The BOP reveals a country's financial and economic
standing. A persistent deficit or surplus can signal underlying economic issues.
•Currency Value: High demand for a country's goods (leading to a BOP surplus) can
strengthen its currency.
•Policy Decisions: Governments use BOP data to formulate fiscal and trade policies. For
example, a large trade deficit might prompt policies to boost exports.
•Economic Analysis: The BOP provides valuable information for analyzing a country's
economic relationships with other nations.
Traditional
Classification

Balance of Trade
 Balance of Trade

The difference between a country's imports and its exports. Balance of trade is the
largest component of a country's balance of payments.

Exports > Imports - BOT is favourable

Imports > exports - BOT is unfavourable

Balance of Trade V/s Balance of Payment

• The Balance of Payment takes into account all the transaction with the rest of the worlds

• The Balance of Trade takes into account all the trade transaction with the rest of the
worlds
Modern
Classification

COMPONENTS OF BOP

FINANCIAL
CURRENT CAPITAL
ACCOUNT (Inc.
ACCOUNT ACCOUNT
Reserve Account)
 Current Account

Records the flow of goods, services, and income between a country and the rest of the world.

Key Elements:

•Trade in Goods (Visible Trade): Imports and exports of physical goods (e.g., cars,
electronics, raw materials). The difference between exports and imports is the Balance of
Trade (BOT).
•Trade in Services (Invisible Trade): Imports and exports of services (e.g., tourism,
transportation, banking, IT).
•Income: Earnings from investments (interest, dividends) and wages.
•Current Transfers: Unilateral transfers like foreign aid, remittances, and gifts.
 Current Account
• The current account is used to monitor the inflow and outflow of goods and services
between countries.
• This account covers all the receipts and payments made with respect to raw
materials and manufactured goods.
• It also includes receipts from engineering, tourism, transportation, business
services, stocks, and royalties from patents and copyrights. When all the goods and
services are combined, together they make up a country’s Balance Of Trade (BOT).
• There are various categories of trade and transfers which happen across countries. It could
be visible or invisible trading, unilateral transfers, or other payments/receipts. Trading in
goods between countries is referred to as visible items and import/export of services
(banking, information technology, etc.) are referred to as invisible items.
• Unilateral transfers refer to money sent as gifts or donations to residents of foreign
countries. This can also be personal transfers like – money sent by relatives to their family
located in another country.
 Capital Account

Records transactions related to the purchase and sale of non-financial assets (e.g., land,
buildings) and capital transfers.

Key Elements:

• Loans and borrowings – It includes all types of loans from both the private and public sectors
located in foreign countries.
• Investments – These are funds invested in the corporate stocks by non-residents.
 Capital Account
• All capital transactions between the countries are monitored through the
capital account. Capital transactions include the purchase and sale of assets
(non-financial) like land and properties.
• The capital account also includes the flow of taxes, purchase, and sale of
fixed assets, etc. by migrants moving out/into a different country.
• The deficit or surplus in the current account is managed through the finance
from the capital account and vice versa.

There are 3 major elements of a capital account:

• Loans and borrowings – It includes all types of loans from both the private and public
sectors located in foreign countries.
• Investments – These are funds invested in the corporate stocks by non-residents.
• Foreign exchange reserves – Foreign exchange reserves held by the central bank of a
country to monitor and control the exchange rate do impact the capital account.
 Financial Account

Records transactions involving financial assets (e.g., stocks, bonds, real estate, foreign direct
investment).

Key Elements:

•Foreign Direct Investment (FDI): Investments made to gain a lasting interest in a foreign
enterprise.
•Portfolio Investment: Investments in stocks and bonds.
•Other Investment: Bank deposits, loans.
•Reserve Assets: The total foreign assets/gold held by a country's central bank.
 Financial Account
• The flow of funds from and to foreign countries through various
investments in real estate, business ventures, foreign direct
investments, etc. is monitored through the financial account.
• This account measures the changes in the foreign ownership of
domestic assets and domestic ownership of foreign assets.
• On analyzing these changes, it can be understood if the country is
selling or acquiring more assets (like gold, stocks, equity, etc.).
•Reserve Assets: The total foreign assets/gold held by a country's central bank.

RESERVE ASSETS

IMF SDR GOLD

These assets are used to support the country's currency, manage its foreign
exchange, and meet its international financial obligations.
IMF:
• Loan from International Monetary Fund (IMF)
SDR:
• SDR stands for Special Drawing Rights.
• Are reserve assets allocated to member countries.
• SDR is not a currency.
• Value of the SDR is based on a basket of five major currencies: the US dollar,
the euro, the Chinese renminbi, the Japanese yen, and the British pound
sterling. This basket is reviewed periodically.
• Countries hold SDRs as part of their reserves.
• They enhance international liquidity and support developing economies to
stabilize their economies.
GOLD RESERVE:

• This represents the gold bullion held by the central bank.

• Gold has historically been a significant reserve asset, and many
countries still hold it as part of their reserves.
The General Rule in BOP Accounting

a. If a transaction earns (+) foreign currency for the nation, it is a credit

b. If a transaction involves spending (-) of foreign currency it is a debit

 Transaction Debit Credit
Exports of goods and services Credit

Imports of goods and services Debit

Income earned from investments Credit

Income payments to foreign entities Debit

Remittances sent abroad Debit

Remittances received Credit

Sale of non-financial assets abroad Credit

Acquisition of foreign assets Debit

FDI inflows Credit

FDI outflows Debit

Portfolio investment inflows Credit

Portfolio investment outflows Debit

Transaction 1:

Export of goods USD 200 million; realization deposited in bank abroad

Transaction 2:

Import of goods USD 150 million; payment made from bank account
maintained abroad
Transaction 3:

Amount spent by the foreign tourist in the country USD 40 million.

Transaction 4:
Received goods as gift from another country USD 60 million.
Transaction 1:
Export of goods USD 200 million; realization deposited
in bank abroad

Debit ($ in Mn) Credit ($ Mn)

Bank Balance 200

Export of Goods 200

Transaction 2:
Import of goods USD 150 million; payment made from
bank account maintained abroad

Debit ($ in Mn) Credit ($ Mn)

Import of Goods 150

Bank Balance abroad 150

Transaction 3:
Amount spent by the foreign tourist in the country USD
40 million.

Debit ($ in Mn) Credit ($ Mn)

Bank Balance abroad 40

Export of Services 40
Transaction 4:
Received goods as gift from another country USD
60 million.

Debit ($ in Mn) Credit ($ Mn)

Import of Goods 60

Unilateral transfer 60
Transaction 5:
Export of Commodities for USD 80 million
on a government deal ; payment in gold by the
importing country’s government.

Debit ($ in Mn) Credit ($ Mn)

Official Reserve 80

Export of Goods 80
A statement of the BOP appear, after considering all the previous
transactions

Debit (-) Credit (+) Balance

A CURRENT ACCOUNT
1 Merchandise Trade 210 280 +70
2 Trade in Service 40 +40
3 Unilateral Transfer 60 +60
Current Accout Balance +170
B CAPITAL ACCOUNT
Bank Balance Abroad 240 150 -90
OFFICIAL RESERVE
C ACCOUNT
Gold 80 +80
 Credit and Debit Transactions of the Balance of Payments

Consider the following transactions for Country X during a year:

• Exports of goods: $100 million
• Imports of goods: $70 million
• Exports of services: $40 million
• Imports of services: $30 million
• Foreign Direct Investment (FDI) inflow: $50 million
• Foreign Direct Investment (FDI) outflow: $20 million
• Interest payments on foreign loans (paid to foreign entities): $10 million
• Interest earnings on foreign assets: $15 million
• Government grants received from abroad: $5 million
• Foreign exchange reserves increase: $25 million
Questions:

1.Classify the transactions into Credits (inflow) and Debits

(outflow).

2.Calculate the Current Account balance and Capital/Financial

Account balance.

3.What is the overall Balance of Payments (BOP) position?