Lecture 30 monetry and foreign exchange market
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Lecture 30 monetry and foreign exchange market Lecture 30 monetry and foreign exchange market Document Transcript

  • INTERNATIONAL BUSINESS MANAGEMENT LESSON 30 INTERNATIONAL MONETARY SYSTEM AND FOREIGN EXCHANGE MARKETLesson Objectives correction of a dis equilibrium in the balance of payments• To understand the importance of Pre Bretton Woods through changes in the monetary gold reserves of nations. The system for monetary system balance of payments situation could be improved also by other such monetary measures as manipulation of the bank rate. For• To understand how the Bretton Woods System collapsed example, an increase in the bank rate encouraged hot money and gave rise to managed floating system movement and helped the country to improve its balance of• To have an elementary knowledge of currencies e.g payments position. (Hot money movement refers to the Euro movement of short-term funds to take advantage of the• To have a clear cut understanding of what is Foreign differences in interest rates). Exchange Markets Until the outbreak of World War I, the gold standard worked• To understand what are the functions of Foreign remarkably well, and the stability of exchange rates was Exchange market maintained with so little conscious effort that it came to be• To analyze the various methods of affecting regarded as natural. During this period, nations were eager to International Payments abide by the golden rule of the gold standard: expand credit when gold is coming in and contract credit when gold is going• To understand on how to deal on Foreign Exchange out. The gold standard, however, was shattered in the first Markets weeks of World War I (1914-1918). Every belligerent country in• To have an elementary discussion on concepts of Europe, and many in other continents, withdrew the privilege Futures, Options, Swaps, Arbitrage. of conversion and prohibited the export and import of goldInteraction within a few days of the declaration of war; in the course of theAn efficient international monetary system is a necessary struggle, most of the neutrals followed suit. Inconvertibleprecondition for the smooth functioning and expansion of paper currencies became the order of the day.international business. This chapter gives a brief account of the After the war, and the hectic boom and slump that followed it,transition of the international monetary system from the early the international gold standard was restored in nearly everynineteenth century to this day and certain salient features of country of the world. As Crowther points out, 1 two causesforeign exchange and foreign exchange market. were responsible for this. The first was the natural wish toInternational Monetary System return to normality, the wish for “back to pre-war” conditions. Normalcy in currency arrangements meant the gold standard,The Pre-bretton Woods Period and by most, if not all of those in authority, it was taken forFrom the early nineteenth century until the post- World War I granted that an international system of gold convertibilityperiod, which was regarded as the great age of internationalism, would follow the period of war-time inconvertibility, just asmost of the major industrialized nations of the world and peace followed war. The second impelling force was thetheir trading partners operated, at least nominally, under a fixed appalling chaos produced in continental Europe by wild post-exchange system called the gold standard. Under this system, each war inflation.nation defined its currency in terms of gold. In 1900, for As Crowther points out,2 in many ways the post-war goldexample, the dollar was equal to 1/20 of an ounce of gold and standard went much further than the pre-war gold standard. Itthe pound to 5/20 of an ounce (hence £ 1 = $5). In addition, embraced, for example, many more countries, and by theeach nation agreed to convert its paper money into gold on middle of 1929, almost the only countries that were not on thedemand, and there were no restrictions on the shipment of gold standard were China, Spain and Mexico. Not all of thesegold from one country to another. countries adopted the full gold standard or even the goldUnder the gold standard, accounts between countries were bullion standard but the gold exchange standard was exten-settled, in theory, and to a considerable extent in practice, by the sively employed.exchange of gold. If a country imported goods worth more However, within a little more than a decade from the beginningthan those it exported, gold flowed out. As, under the gold of its post-war reincarnation, the great majority of the nationsstandard, money supply depended on monetary gold reserves, a had once more abandoned the gold standard. It was one of thereduction in these reserves due to a deficit in the balance of first casualties of the great depression (1929-33), which engulfedpayments caused a contraction in money supply, resulting in a the entire world. Great Britain suspended the gold standard indecline in prices and leading to an increase in demand for 1931; and one by one, other countries followed suit; by 1937,exports and a decline in demand for imports, to enable the there was not a single country on the gold standard, and nonecountry to restore the balance of payments equilibrium. Thus, showed any desire to revive it.the gold standard provided for, in theory, an automatic © Copy Right: Rai University11.625.1 189
  • The breakdown of the gold standard in the 1930s was followed key source of reserves in the Bretton Woods system, toINTERNATIONAL BUSINESS MANAGEMENT by the era of inconvertible currencies. Some leading countries provide. a steady and sufficient increase in international liquidity attempted to stabilize exchange rates by establishing exchange over time also contributed to this trend. Indeed, as Gomes equalisation/stabilisation funds and agreements. However, observes, “The dollar was not merely as good as gold, it was with the outbreak of World War II (1939-45), nations began to better than gold because dollars (as reserves) earned interest impose far-reaching systems of exchange control, and monetary while gold did not.”3 agreements became inoperative. The designers of the par value system realized that the exchange The Irellon Woods System rate between two currencies would not hold constant forever, During World War II, eminent economists and civil servants in but they hoped that changes would be infrequent and would be the Allied Nations were seriously planning to evolve a purpose- made for valid reasons, under controlled conditions. The ful international economic system in the post-war period. provisions of the Agreement relating to changes in par values President Roosevelt of America, in fact, assigned a high priority may be summarized as follows: to planning for peace, offering every encouragement to those 1. A member shall not propose a change except ‘to correct a advisers and civil servants who were anxious to devote them- fundamental disequilibrium’ and it shall act only after selves to this cause. The United Nations Monetary and Financial consultation with the Fund. Conference held at Bretton Woods, USA, in July 1944 while the 2. The Fund will not object to change not exceeding 10 per cent war was still going on, and in which 44 nations participated, of the initial par value. proposed the establishment of: 3. If a change is proposed exceeding 10 per cent, but not 1. The International Monetary Fund (lMF) to achieve exchange exceeding 20 per cent of the initial par value, the Fund may rate stability and to help member countries to finance short- agree or object, but must declare its attitude within 72 hours. term balance of payments deficits; 4. If the proposed change is larger than 20 per cent, the Fund 2. The International Bank for Reconstruction and Development may concur or object without limit of time. (lBRD), now popularly known as the World Bank, to assist 5. The Fund must agree “if it is satisfied that the change is in the post-war reconstruction and development of the necessary to correct a fundamental disequilibrium.” It has member countries; and been further laid down that, in deciding what is a 3. An International Trade Organisation (lTO) to be the focal fundamental disequilibrium, the Fund may not take point of cooperation in trade matters. objection to the “domestic and social or political policies of Of these the proposal to establish the ITa did not materialize; the member proposing the change.” however later (1948), the GATT was formed and it was The IMF was also meant to provide credit facilities to member transformed in to the WTO in 1995. The IMF and the IBRD, countries suffering from payments problems. The credit however, took birth. Though the negotiations at Bretton facilities, which a member country could avail of, normally, Woods ended in 1944, the IMF began its operation only in depended on its quota i.e., the member’s contribution to the 1947. Fund, which was determined on the basis of the nation’s The international monetary system introduced at Bretton income, reserve holdings, imports, ratio of exports to income Woods rested on two pillars: the maintenance of stable and the variability of imports. Prior to the 1976 changes, new exchange rates and a multilateral credit mechanism institutional- members were required to pay part of their quota, normally 25 ized in the IMF and supervised by it. per cent, in gold or American dollars and the rest in the The international monetary system that existed from 1947 to member’s own currency. Now a new member pays part of its 1971 is generally known as the par value system or pegged exchange quota in foreign currencies and the rest in its own currency. The rate system. Under this system, each member country of the IMF Fund also extends certain permanent, temporary and special was required to define the value of its currency in terms of gold facilities to its members, such as the compensatory financing or the US dollar and to maintain (to peg) the market value of facility and the buffer stock financing facility. its currency within 1 per cent of the defined (par) value. The An important contribution of the IMF to an increase in value of the US dollar was set at 1/35 of an ounce of gold, and international liquidity is the creation of Special Drawing Rights - the United States promised that all US dollars in the hands of SDRs. The SDR is an international reserve asset created by the central banks would be redeemed in gold, upon demand, at the Fund, taking into account the global need for supplementing fixed price of $35 per ounce. Every other nation then defined its existing reserve assets. The allocation of SDRs was made to currency in terms of the dollar and/or gold. those member countries that were participating in this facility in At the end of the World War II, the United States held over 74 proportion to their quotas. per cent of the world’s monetary gold stock and accounted for Breakdown of the Bretton Woods System about half of the world’s real GNP. An important reason for and Emergence of Managed Floating this was that because of the financial dominance of the United Let us now return to the par value system. Despite severe States, it was inevitable that other countries came to regard the strains in its later years, it lasted until 1971. The stabilization US dollar as international money. As a result, they accumulated process under this system required reserve assets, just as it did dollars in official reserves and used it as an intervention currency under the gold system. The difference was that nations kept to stabilize exchange rates in the market. The failure of gold, a their reserves not only in gold but also in dollars. An expansion © Copy Right: Rai University 190 11.625.1
  • in trade, however, required an increase in international liquidity. dollars foreign central banks -were no longer willing to purchase INTERNATIONAL BUSINESS MANAGEMENTSince major part of the gold and dollars, the international t e T ee e t a o t o w st ec l a s o t evalue h m. h v n u l u c me a h o l p e f par hreserves, were in the USA, growth could come only from an system. The IMF’s par value system officially ended on August 15,outflow of gold and dollars from there. 1971, when President Nixon withdrew United States’ commit-In the early period, the supply of dollars outside the US came ment to buy and sell gold at $35 per ounce, thus abrogating thefrom the Marshall Plan and other American aid programmes, IMF agreement. This amounted to severing the link betweencontributions to the World Bank, multinational investments, gold and the international value of the dollar. Along with theand American defence expenditure abroad. The small deficits in suspension of the gold convertibility of the dollar, Presidentthe American balance of payments in the 1950s were generally Nixon imposed a surcharge of 10 per cent on dutiable importswelcomed because they increased international liquidity, and it to the US.appeared that the Bretton Woods System by permitting the President Nixon justified the suspension of convertibility asexpansion of world monetary reserves at a much faster rate necessary to “... defend the dollar against speculators” whothan a system restricted by the supply of gold, solved one of “have been waging an all-out war on the American dollar.” But,the major problems of the gold standard. But the key factor in actually, it was designed to compel foreign governments to raiseguaranteeing the workability of the system was the acceptability the value of their currencies against the dollar. The foreignof the dollar. If anything were to happen that would shake the governments were thus left with two alternatives: either toworld confidence in the ability or desire of the United States to continue to maintain existing exchange rates by accumulatingcontinue exchanging dollars for gold, the system could very well more dollars without convertibility or to revalue the unfaircollapse. And the Bretton Woods System did collapse in 1971, as, exchange rates.because of the huge accumulation of dollars abroad, the USA However, the European and Japanese governments firmlycould neither command world confidence in her ability and resisted any change in the par value of their currencies, fairingwillingness to exchange dollars for gold at the fixed, rate, nor the harmful consequences of revaluation on their exports andcould it afford to undertake the conversion of dollars into gold domestic economic situations. They held the view that if the USif all the foreign dollar holdings were presented for such dollar were overvalued, the way out should be a unilateralexchange. devaluation of the dollar.It was the burgeoning balance of payments deficits of the The immediate response to the US action of the suspension ofUnited States from the late 1950s that led to this situation. The dollar convertibility was a closing of foreign exchange marketsUnited States moved from a balance of payments surplus of $4 in Europe and Japan. When they reopened, all of the majorbillion in 1947 to a deficit of over $29 billion in 1971; and the currencies were left to float vis-a-vis the dollar, with the exceptiondollar shortage of the 1950s turned into the dollar glut of the of the French franc. Although France refused to float its1960s and early 1970s. The US official gold stock dropped from currency for commercial transactions, it permitted a floating rateabout $25 billion in 1949 to around $10 billion by 1971. for financial transactions.However, only a part of the US deficit was financed by the The floating of currencies was, however, not ‘clean’, for centralexport of gold. As the dollar was regarded as an international banks intervened in the market to prevent a full appreciation.reserve, the US deficit became a significant means of expanding The European and Japanese governments were reluctant to letthe total supply of international liquidity. their currencies float freely because they hoped to persuade theHowever, the depletion of US gold reserves and the huge United States to devalue the dollar.accumulation of liquidity liabilities (dollars and dollar convert- An urgent need for putting an end to the fluid, situation wasible assets) held by foreigners perpetuated a crisis of confidence. felt by major countries, and international monetary negotiationsBy 1971, these liabilities had risen to about $68 billion; in 1971, were undertaken within the framework of the Croup of Ten,the Central Bank of Germany alone held enough dollars to which included the Finance Ministers of ten leading IMFexhaust the entire gold stock of the US at $35 an ounce. trading nations. The first meeting of the Group in London andForeign exchange markets became hectic in early 1971, and the second meeting in Rome (both in September 1971) failed tocentral banks with the strongest currencies, had to buy massive resolve the crisis. However, some encouraging developmentsamounts of dollars in order to maintain exchange rates at the resulted after its third meeting, which started on November 30official par value (:t1 per cent). They closed foreign exchange in Rome. Finally, the meeting of the Group of Ten onmarkets for brief periods, allowed currencies to float tempo- December 17-18, at the Smithsonian Institution in Washing-rarily, imposed exchange controls and even charged negative rates ton, brought about an agreement for the re-alignment ofof interest on foreign-owned deposits - all in a vain effort to exchange rate to correct the prior over-valuation of the dollar.stem the tide. While foreign central banks became increasingly Following the Smithsonian Agreement, the United States increasedreluctant to continue the stabilization procedure, speculators the dollar price of gold by 8.57 per cent (from $35 an ounce toand multinational corporations became very eager to unload $38 announce) and the Yen and major European currenciesdollars (which, they felt, would soon be worthless) and to appreciated relatively to the dollar - the Yen by 17 per cent, theacquire other currencies instead. Thus, the international Mark by 14 per cent and most other European currencies bymonetary system was confronted with two interrelated prob- something under 10 per cent. Overall, the dollar was depreciatedlems. On the one hand, there was a tremendous desire to sell by an average of approximately 12 per cent.dollar’s; on the other hand, the traditional buyers of those © Copy Right: Rai University11.625.1 191
  • Under the Smithsonian Agreement, currencies were allowed to however, is not completely free or clean but dirty (i.e., it is subjectINTERNATIONAL BUSINESS MANAGEMENT fluctuate within a wider 2.5 per cent range on either side of the to some governmental intervention). newly-fixed rates called the central rates. Like the Bretton Woods As Paul Samuelson remarks, “Floating exchange rates remove System, the Smithsonian Agreement also required central bank the gold standard discipline on nominal or money price-and- stabilization efforts but it allowed more fluctuation of rate (2.5 wage levels. Nothing can remove the irreducible constraints of a per cent as against 1 per cent). system’s real productivity levels. Floating is not a panacea. It is at The Smithsonian Agreement, however, did not last long. best only an opportunity.” Renewed speculative activity in 1972 and early 1973 forced most Ems, Ecu and Euro major countries to abandon fixed rates. In February 1973, The Common Market (EEC) countries wanted to have stability President Nixon announced a 10 per cent devaluation of the of fixed exchange rates a themselves, while at the same time, dollar from $38 to $42.2 an ounce. In mid-March, six leading having flexibility in exchange rates with the rest of the wor1d nations of Europe (West Germany, France, Belgium, the They, therefore, adopted the system of common margin Netherlands, Luxembourg and Switzerland) announced that arrangements or the snake, referred toil the preceding section. they would replace the Smithsonian Agreement by a new However, with effect from March 13, 1979, they introduced an system {the snake in the tunnel,, under which these nations arrangement known as the European Monetary System (EMS). would confine stabilisation efforts to maintaining the current With the introduction of EMS, the snake ceased to exist. All the fixed price relationship only among their own currencies, while European Common Market countries, except the United allowing their currencies to float against all others. Kingdom decided to participate in all aspects of the EMS, in The Smithsonian Agreement, thus, lasted only for fourteen particular the operational heart of the system - the exchange rate months. The collapse of the agreement resulted in a floating mechanism. exchange rate system. Monetary authorities have not, however, According to the European Council, “...the purpose of the been allowing their currency values to be determined solely by European Monetary System establish a greater measure of demand and supply, but have been intervening from time to monetary stability in the community. It should be seen as a time to keep the exchange rates within desired limits. This is fundamental component of a more comprehensive strategy known as the managed float. Some people described it as the dirty aimed at lasting growth with stability, a progressive return to float for the managed float was not a clean float. The managed full employment, the harmonization of living standards, and float provided the advantages of floating exchange rates while the lessening of regional disparities in the Community. The avoiding sharp fluctuations in rates. European Monetary System will facilitate the convergence of The Jamaica Agreement of January 1976 formally ratified the economic development and give fresh impetus to the process floating exchange rate system. The agreement recognised that of European Union.’ although exchange rates should reflect the basic forces .of The Council expected the European Monetary System to have a demand and supply, governments should have the right to stabilizing effect on international monetary and economic maintain their own stabilisation policies and to intervene in the relations. foreign exchange market. All governments, however, should pursue the common goals of international stability and growth. At the heart of the EMS was a system of fixed but adjustable It also eliminated the official price of gold. The IMF sold one- exchange rates. Each currency had a central rate expressed in sixth of its gold reserves and used the proceeds to help the terms of the European Currency Unit (ECU). The ECU LDCs. The IMF has no further obligation to use gold. consisted 0 a basket of fixed amounts of currencies of the Common Market countries. The central rates determined a grid Since 1972, the world may be said to be following flexible of bilateral central rates with fluctuation margins of plus or exchange rates, although the peggers far outnumber the minus 2.25 “per cent (6 per cent for the Italian Lira). Interven- floaters. Despite the large number of countries that peg their tion by the participating central banks kept the exchange rates of currencies, in trade-weighted terms, the current system is their currencies within the margins in EMS currencies. Interven- generally regarded as floating because most of the largest traders tion in other currencies (chiefly in US dollar), was allowed and maintain more flexible forms of exchange arrangements. In had been undertaken on a substantial scale. The grid of bilateral fact, in trade weighted terms, about two-thirds to four-fifths of central rates and intervention limits was supplemented by the world trade is conducted at floating rates. ‘divergence indicator’, which showed the movement of the During the period of flexible rates since 1973, there has been a exchange rate of each EMS currency against the (weighted) trend away from pegged exchange arrangements, and within average movement of the others. If a currency crossed a these, from single currency to composite pegs (with former US ‘threshold of divergence’, this led to a presumption that the dollar peggers accounting for the bulk of the latter shift). Many authorities concerned would correct the situation by taking developing countries have been pegging their currencies while adequate measures. the industrial countries, by and large, have been on the flexible The European Currency Unit (ECU) played a central role in the system. However, as stated in the preceding paragraph, the EMS. It served as the unit of account for the exchange rate flexible currencies transact the major chunk of world trade and mechanism and for the operations in both the intervention and hence, the world is regarded to be following the flexible the credit mechanisms. It also served as a reference point for exchange rate system, by and large. The floating of currencies, the divergence indicator, and as a means of settlement and a © Copy Right: Rai University 192 11.625.1
  • reserve asset of EMS central banks. The central banks participat- There are different interpretations of the term foreign exchange, INTERNATIONAL BUSINESS MANAGEMENTing in the exchange rate mechanism of the EMS received an of which the following two are most important and common:initial supply of “ECUs at the start of the EMS, against the 1. Foreign exchange is the system or process of converting onedeposit of 20 per cent of both their gold holdings and gross national currency into another, and of transferring moneyUS dollar reserves (at market related valuations) with the from one country to another (Dr. Paul Einzig).6European Monetary Cooperation Fund, which was established 2. Secondly, the term foreign exchange is used to refer to foreignas an institution of the European Community and served as currencies. For example, the Foreign Exchange Regulationthe agency for operations under the snake and subsequently the Act, 1973 (FERA) defines foreign exchange as foreignEMS. currency and includes all deposits, credits and balance payableTo finance interventions in EMS currencies, there were mutual in any foreign currency and any drafts, traveller’s cheque,credit lines among the participating central banks (the very letters of credits and bills of exchange, expressed or drawn inshort-term financing facility). Claims and debts arising out of Indian currency, but payable in any foreign currency.‘such interventions were settled according to certain rulesgoverning, among other things, the use of ECUs, for such Functions of Foreign Exchange Marketpurposes. The ‘short-term monetary support’ and the ‘me- The foreign exchange market is a market in which foreigndium-term financial assistance’ mechanisms that had been exchange transactions take place. In other words, it is a marketestablished in 1970 and 1971, respectively, had been substan- in which national currencies are bought and sold against onetially enlarged. These were designed for mutual financial another. A foreign exchange market performs three importantassistance in cases of balance of payments difficulties. functions:Under the provisions governing the EMS, adjustments of Transfer of Purchasing Power: The primary function of acentral rates were “subject to mutual agreement by a common foreign exchange market is the transfer of purchasing powerprocedure, which comprised all countries participating in the from one country to another and from one currency to another.exchange rate mechan4sm and the Commission.” The international clearing function performed by foreign exchange markets plays a very important role in facilitatingAt the Maastricht Summit held in December 1991, leaders of international trade and capital movements.member countries of the European Community (EC) con-cluded an agreement on the requirements and time table for Provision of Credit: The credit function performed by foreignEuropean Monetary Union (EMU) and for the accompanying exchange markets also plays a very important role in the growthmove to a common European monetary policy. The agreement of foreign trade, for international trade depends to a greatspecified a three-stage transition to EMU. extent on credit facilities. Exporters may get pre-shipment and post-shipment credit. Credit facilities are available also forDuring stage one which was launched in July 1990, the free importers. The Euro-dollar market has emerged as a majorinternal market of the EC would be completed and obstacles to international credit market.financial integration removed. The member countries alsoagreed to intensify their multilateral surveillance, and coordina- Provision of Hedging Facilities: The other importanttion of monetary and fiscal policies. function of the foreign exchange market is to provide hedging facilities. Hedging refers to covering of export risks, and itIn stage two which began in January 1994, the member provides a mechanism to exporters and importers to guardcountries worked towards a common monetary policy, estab- themselves against losses arising from fluctuations in exchangelishment of the European Monetary Institute (EM!) which rates.would develop a framework for closer coordination of mon-etary policies that affect the EMU area as a whole, and the Methods of Affecting Internationalestablishment of the European Central Bank (ECB). Payments There are five important methods to effect internationalThe third and final phase of the Economic and Monetary payments.Union (EMU) was ushered in on January 1, 1999, with thelaunch of the common currency, the Euro, by 11 of the 15 Telegraphic Transfer: By this method, a sum can be trans-members of the European Union. See the section European ferred from a bank in one country to a bank in another part ofUnion in Chapter 2 for more information related to the Euro. the world by cable or telex. It is, thus, the quickest method of transmitting funds from one centre to another.Foreign Exchange MarketThe subject of foreign exchange is, in the words of H.E. Evitt, Mail Transfer: just as it is possible to transfer funds from a“that section of economic science which deals with the means bank account in one centre to an account in another centreand methods by which rights to wealth in one country’s within the country by mail, Mail Transfer can accomplishcurrency are converted into rights to wealth in terms of another international transfers of funds. These are usually made by aircountry’s currency.4 As he further observes, it “involves the mail.investigation of the method by which the currency of one Cheques and Bank Drafts: International payments may becountry is exchanged for that of another, the causes which made by means of cheque and bank drafts. The latter is widelyrender such exchange necessary, the forms which such exchange used. A bank draft is a cheque drawn on a bank instead of amay take, and the ratios or equivalent values at which such customer’s personal account. It is an acceptable means ofexchanges are effected.” payment when the person tendering is not known, since its © Copy Right: Rai University11.625.1 193
  • value is dependent on the standing of a bank which is widely from the bill to enable Menon to claim the goods on theirINTERNATIONAL BUSINESS MANAGEMENT known, and not on the credit-worthiness of a firm or indi- arrival at the Cochin port. vidual known only to a limited number of people. Dealings on the Foreign Exchange Foreign Bill of Exchange: A bill of exchange is an uncondi- Market tional order in writing, addressed by one person to another, A very brief account of certain important types of transactions requiring the person to whom it is addressed to pay a certain conducted in the foreign exchange market is given below. sum on demand or on a specified future date. Spot and Forward Exchanges There are two important differences between inland and foreign The term spot exchange refers to the class of foreign exchange bills. The date on which an inland bill is due for payment is transaction which requires the immediate delivery, or exchange calculated from the date on which it was drawn, but the period of currencies on the spot. In practice, the settlement takes place of a foreign bill runs from the date on which the bill was within two days in most markets. The rate of exchange effective accepted. The reason for this is that the interval between a for the spot transaction is known as the spot rate and the market foreign bill being drawn and its acceptance may be considerable, for such transactions is known as the spot market. since it may depend on the time taken for the bill to pass from The forward transaction is an agreement between two parties, the drawer’s country to that of the acceptor. The second requiring the delivery at some specified future date of a specified important difference between the two types of bill is that the amount of foreign currency by one of the parties, against foreign bill is generally drawn in sets of three, although only payment in domestic currency by the other party, at the price one of them bears a stamp, and of course, one of them is paid. agreed upon in the contract. The rate of exchange applicable to Nowadays, it is mostly the documentary bill that is employed in the forward contract is called the forward exchange rate and the international trade. This is nothing more than a bill of exchange market for forward transactions is known as the forward market. with the various shipping documents - the bill of lading, the The foreign exchange regulations of various countries, generally, insurance certificate and the consular invoice - attached to it. By regulate the forward exchange transactions with a view to using this, the exporter can make the release of the documents curbing speculation in the foreign exchanges market. In India, conditional upon either (a) payment of the bill, if it has been for example, commercial banks are permitted to offer forward drawn at sight, or (b) its acceptance by the importer if it has cover only with respect to genuine export and import transac- been drawn for a period. tions. Documentary (or Reimbursement) Credit: Under this Forward exchange facilities, obviously, are of immense help to method, a bill of exchange is necessarily employed, but the exporters and importers they can cover the risks arising out of distinctive feature of the documentary credit is the opening by exchange rate fluctuations by entering into an appropriate the importer of a credit in favour of the exporter, at a bank in forward exchange contract. the exporter’s country. To illustrate the use of the documentary credit, let us assume Forward Exchange Rate that Menon of Cochin intends to purchase goods from Ronald With reference to its relationship with the spot rate, the forward of New York and that the terms of the deal have been agreed rate may be at par, discount or premium. upon by them. Then the transaction would be carried through At Par: If the forward exchange rate quoted is exactly equivalent the following stages: to the spot rate at the time of making the contract, the forward (a) Menon, the importer, instructs his bank, say the State Bank exchange rate is said to be at par. of India (SBI), to open a credit in favour of Ronald, the At Premium: The forward rate for a currency, say the dollar, is exporter, at the New York branch of the SBI (if the SBI has said to be at a premium with respect to the spot rate when one no branch in New York, it will appoint some other bank to dollar buys more units of another currency, say rupee, in the act as its agent there). The SBI will then inform Mr Ronald forward than in the spot market. The premium is usually by a letter of credit that it will pay him a specified sum in expressed as a percentage deviation from the spot rate on a per exchange for the bill of exchange and the shipping annum basis. documents. At Discount: The forward rate for a currency, say the dollar, is (b) Ronald may now dispatch the goods to Menon at Cochin, said to be at discount with respect to the spot rate when one draw a bill of exchange on the SBI and then present the dollar buys fewer rupees in the forward than in the spot market. documentary bill to the New York branch of the SB!. If all The discount is also usually expressed as a percentage deviation the documents are in order, the bank will pay Ronald. The from the spot rate on a per annum basis. bank will charge for its services, and will also charge interest The forward exchange rate is determined mostly by the demand if the bill is not payable at sight. for and supply of forward exchange. Naturally, when the (c) The New York branch of the SBI then sends the demand for forward exchange exceeds its supply, the forward documentary bill to its Cochin office for payment or rate will be quoted at a premium and, conversely, when the acceptance, as the case may be, by Menon. When the bill is supply of forward exchange exceeds the demand for it, the rate paid, Menon’s account will be debited by that amount. Every will be quoted at discount. When the supply is equivalent to the thing being in order, the banker will release the bill of lading demand for forward exchange, the forward rate will tend to be at par. © Copy Right: Rai University 194 11.625.1
  • Futures situation wherein one can purchase one pound sterling in INTERNATIONAL BUSINESS MANAGEMENTWhile a futures contract is similar to a forward contract, there are London for two dollars and earn a profit of $0.10 by selling theseveral differences between them. While a forward contract is pound sterling in New York for $2.10. This situation would,tailor-made for the client by his international bank, a futures hence, lead to an increase in demand for sterling in London andcontract has standardized features -1 the contract size and consequently, an increase in the supply of sterling in New York.maturity dates are standardized. Futures can be traded only on Such operations, i.e., arbitrage, could result in equalizing the3m organised exchange and they are traded competitively. exchange rates in different markets (in our example London andMargins are not required in respect of a forward contract but New York).margins are required of all participants in the futures market- an Arbitrage in foreign currencies is possible because of the easeinitial margin must be deposited into a collateral account to and speed of modern means of communication betweenestablish a futures position. commercial centres throughout the world. Thus, an operator inOptions New York might buy dollars in Amsterdam and sell them a fewWhile the forward or futures contract protects the purchaser of minutes later in London.the contract from the adverse exchange rate movements, it The effect of arbitrage, as has already been mentioned, is to ironeliminates the possibility of gaining a windfall profit from out differences in the rates of exchange of currencies in differentfavourable exchange rate movements. For example, if an Indian centres, thereby creating, theoretically speaking, a single -worldexporter has forward contract to sell his future dollar receipts at market in foreign exchange.$1 = Rs. 48/ he is protected against the risk of a depreciation of Notes:the dollar by the time he receives the payment (for example, $1= Rs. 46). However, the forward contract prevents him fromgaining the profit of possible appreciation of the dollar (say, $1= Rs. 50). Currency options are designed to overcome thisproblem.An option is a contract or financial instrument that gives holderthe right but not the obligation, to sell or buy a given quantity ofan asset at a specified price at a specified future date. An optionto buy the underlying asset is known as a call option, and anoption to sell the underlying asset is known as a put option.Buying or selling the underlying asset via the option is knownas exercising the option. The stated price paid (or received) isknown as the exercise or striking price. The buyer of an option isknown as the long and the seller of an option is known as thewriter of the option, or the short. The price for the option isknown as premium. With reference to their exercise characteristics,there are two types of options, American and European. AnEuropean option can be exercised only at the maturity orexpiration date of the contract, whereas an American option canbe exercised at any time during the contract.Swap OperationCommercial banks who conduct forward exchange businessmay resort to a swap operation to adjust their fund position.The term swap means simultaneous sale of spot currency for theforward purchase of the same currency or the purchase of spotfor the forward sale of the same currency. The spot is swappedagainst forward. Operations consisting of a simultaneous saleor purchase of spot currency accompanied by a purchase or sale,respectively, of the same currency for forward delivery, aretechnically known as swaps or double deals, as the spot currencyis swapped against forward.ArbitrageArbitrage is the simultaneous buying and selling of foreigncurrencies with the intention of making profits from thedifferences between the exchange rate prevailing at the sametime in different markets.For illustration, assume that the rate of exchange in London is£ 1 = $2 while in New York £ 1 = $2.10. This presents a © Copy Right: Rai University11.625.1 195