International financial environment is broadly concerned with the economic interactions between different countries rather than focus- ing on individual markets. It focuses on areas such as foreign direct investment, inflation rates, debt securities, and exchange rates of var- ious currencies. International financial environment also plays a vital role in investing foreign debt securities to have a clear look about the market. It also helps in boosting the capital and business of organisations in foreign markets.
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Foreign Exchange Markets
A foreign exchange market is a market in which currencies are bought and sold. It is to be distinguished from a financial market where currencies are borrowed or lent. Foreign exchange market can be referred to as an OTC (Over the counter) market as there is no physical place where the participants meet to perform the deals. It is more an informal arrangement among the banks and brokers operating in a financing centre purchasing and selling currencies, connected to each other by telecommunications, such as telex, telephone, and a satellite communication network, SWIFT.
As Kindle-Berger puts, “the foreign exchange market is a place where foreign moneys are bought and sold.” For example, one can exchange Indian rupees for the U.S. dollar.
Foreign exchange is only a part of the commodity that is being traded in the market. This market is served by large commercial banks by holding inventories of each currency so that they can accommodate request by individuals or MNCs. When an individual travels to foreign countries, he has to rely on foreign exchange market for the currency exchange. For example, people from America exchanges dollar for Yen when they visit Japan or Indian rupee when they visit India.
For the currency exchange, there need to be an exchange rate that specifies the rate at which currency can be exchanged for another. Exchange rates provide the price of one currency in terms of another as it is a mechanism in which world currencies are tied together in the global marketplace.
In International market, these exchange rates of currency help in operating MNCs. MNCs are multinational corporations who have headquarters in one country and operate all over the world. The lead- ing foreign exchange market in India is situated in Mumbai, Calcutta, Chennai and Delhi as these states account for bulk of the exchange dealings in India.
Exchange rates are determined by a myriad of economic and political conditions, most importantly, interest rates, international trade, inflation, and political stability. Usually, the government participates in the foreign exchange market to influence the value of the country’s currency by either flooding the market with their domestic currency to lower the price or buy to raise the price. This is known as central bank intervention.
Functions of Exchange Rate in Foreign Exchange Market
Exchange rate plays a pivotal role as it directly affects imports, exports, and cross-border investments.
Let us discuss these functions in detail:
Transfer Function: It offers ease in the process of currency con- version from one country to another, i.e., to complete transfers of purchasing power between two countries. It is an important function of foreign exchange market. Basically, it affects the purchasing power of one country’s cur- rency to another country’s currency through foreign bills, bank draft, telegraphic transfer, and direct dealing telephone service. Transfer function also offer simultaneous international settle- ment of claims. 2. Credit Function: Foreign exchange market also provides the credit facility to promote the foreign trade, i.e., transfer of goods from one country to another. Bills of exchange is generally used in international payments for the credit facility, Bill of exchange has a three-month maturity period. The credit function performed by foreign exchange markets also plays a very important role in the growth of foreign trade, for international trade depends to a great extent on credit facilities. Exporters may get pre shipment and post shipment credit. Credit facilities are available also for importers. The foreign market facilitates in instant payment to exporters through discounting facilities and it allows time to the importers in making payment. For example, an Indian company that wants to purchase machinery from Japan, can pay for the machinery by issuing a bill of exchange. 3. Hedging Function: Hedging in the FOREX market is to elimi- nate or hedge the foreign risk resulting from transactions in for- eign currencies. The companies are afraid of the fluctuations in the exchange rate. These fluctuations (changes in exchange rate of currency) result in profit or loss to the companies. Hedging in the foreign exchange market is the process of protecting a cur- rency’s position from the risk of losses. risks. Basically, hedging function safeguards from foreign trade risks. It provides a mech- anism to exporters and importers to shield themselves against losses arising from fluctuations in exchange rates. The fluctua- tion in the foreign exchange rate makes the concerned parties gain or incur a loss in the market.
Types of Exposure in Foreign Exchange Market
Foreign exchange exposure is the risk associated with the foreign exchange rates that changes frequently and has adversely affected the financial transactions. It can be delineated as the risk involved in undertaking the financial transactions in the foreign market. Foreign exchange exposure is classified into three types, which are transac- tion exposure, translation exposure and economic exposure.
Transaction Exposure
This exposure involves risk in the cross-currency transactions. Trans- action exposure involves risk of loss due to changing exchange rate. This kind of risk arises when a company enters into a transaction involving foreign currency and commits to make or receive payment in a currency other than its domestic currency.
For example, in the us, a company may sell goods to a Indian company to be paid in Rupee worth $200,000 at the reservation date. The exchange rate has subsequently changed when the customer pays to the company, which results in a payment of $1,90,000 in rupees. The changes in the foreign currency associated with a transaction have thus caused the seller $10,000 loss.
The basic rules for transaction exposure are:
- Importing goods: When a company imports goods and its domes- tic currency weakens, the company loses. If the domestic currency is stronger, it will be.
- Exporting goods: When a company exports goods and weakens its home currency, the companies are getting a profit. It leads to a loss when the home currency is strengthened.
Translation Exposure
Translation exposure is also known as accounting exposure. Translation exposure is a sort of accounting risk that surface owing to changes in foreign exchange rates. For example, translation exposure occurs when an organisation has foreign currency assets, liabilities, equity, or income and must return them to their own currency.
Translation exposure is the risk of loss when stock, revenue, assets or liabilities evaluated in foreign currency changes with the change in foreign exchange rates. Translation exposure predominantly faced by multinationals organisations. Translation exposure can lead to what appears to be a monetary gain or loss that is not a result of a change in assets, but in the change in the current value of the assets based on exchange rate fluctuations.
In two situations, translation exposure is most common, i.e., firstly, when a company has subsidiaries in other countries and secondly, when a company engages in major sales transactions in other countries.
Economic Exposure
Economic exposure, also called operational exposure, is a measure of the change in a company’s future cash flow due to unexpected foreign exchange rate changes (FX). Economic exposure affects the value of a company directly. For example, small manufacturers of Europe sell their product only in European local markets and avoid exporting products as selling in the foreign country would be negatively affected by a stronger euro, since it would make imports from Asia and North America cheaper and may increase competition in European markets.
Exposure to foreign exchange results in an impact on the market value of the company as the risk is inherent to the company and affects the profitability over the years. As the unanticipated rate changes affect cash flows of a company, a significant adverse effect on its operations and profitability may be caused by an economic exposure. Stronger foreign currency can increase the cost of production inputs, resulting in lower earnings.
An organisations’ economic exposure to the exchange rate is the impact on net cash flow effects of a change in the exchange rate. The fluctuation in exchange rate can affect the organisation’s market share with regards to its competitors, future cash flows, and its market value. Economic exposure influences the organisation’s long-term business decisions pertaining to products, markets, sources of supply, and location of production facilities, etc. which can be managed through product variation, pricing, branding, outsourcing, etc.
Theories of Exchange Rate Determination
The market may freely determine the exchange rate value under a well-organised system. By combining exchange rates with price of gold or major currencies such as the us dollar, the government, or central bank determines the official exchange rate. The exchange rate is based on demand and supply forces. There are different theories related to exchange rate determination which explain how exchange rate determination work.
Purchasing Power Parity
The purchasing power parity theory was propounded by Professor Gustav Cassel of Sweden. Purchasing power parity (PPP) is a theory wherein the exchange rates between currencies are at equilibrium when their respective purchasing power is the same in each of the two countries. In this theory, the exchange rate between two countries remains equal to the ratio of the two countries’ price level of a fixed basket of goods and services.
The PPP theory states that exchange rate between two countries equates the ratio of country’s price level. The PPP is based on the assumption that in the world there exists the law of one price. This law states that identical goods should be sold at identical prices. The law of one price states that exchange rates should be adjusted to compensate for price differences between coun- tries. Therefore, when a country experiences inflation because of increasing domestic price level, then it needs to depreciate its exchange rate to return to PPP.
The basis for PPP is the “law of one price”. PPP is an economic metric that is used to compare economic productivity and standards of living between countries. This theory compares the currencies of different countries through a “basket of goods” approach. As per this theory, the prices of identical goods are same in two countries when they are defined in the same country.
Interest Rate Parity (IRP)
Interest Rate Parity (IRP) is a theory wherein the difference between the two countries’ interest rates continues to be equivalent to the difference calculated using the forward currency and spot exchange techniques. The parity of interest rates is interconnected between interest, spot, and exchange rates.
In Forex markets, it plays a key role. The IRP theory helps in the analysis of spot rate relationships with a corresponding (future) currency ratio. According to this theory, the interest rate variations of two different currencies will not be arbitrated and this difference will be reflected in the front exchange rate discount or premium on the foreign exchange.