This chapter discusses foreign exchange concepts, exchange rates, and exchange rate management. It covers the participants in foreign exchange markets, different exchange rate systems, and factors that influence exchange rates. The chapter also examines how governments can intervene in markets and influence exchange rates, as well as the objectives of exchange controls. Finally, it explores measuring and managing different types of foreign exchange exposure, including transaction, economic, and translation exposures, using tools like currency futures, forwards, and options.

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Chapter 3
Foreign Exchange Control and
Management

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Foreign exchange concepts
Types and factors of exchange rates
Government influence on exchange
rate
Aims and Methods of Exchange control
Managing Foreign exchange risk
Translation, Transaction, and Economic
Exposures
Currency futures and options
Chapter contents
International Public financial management

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Forex is the value of one unit of
currency in terms of another currency
markets where currencies of different
countries are traded
spot rate and forward rate
3.1 Foreign exchange concepts
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Participants
Retail customers-includes businesses,
international investors, multinational
corporations and the like who need foreign
exchange for the purposes of operating their
businesses.
Commercial banks - the commercial banks
carry out buy/sell orders from their retail
clients and buy/sell currencies on their own
account so as to alter the structure of their
assets and liabilities in different currencies.
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Participants
 Foreign exchange brokers - often
banks do not trade directly with one
another, rather they offer to buy and
sell currencies via foreign exchange
brokers.
 Central banks – buy/sell foreign
currencies to influence its value
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Foreign exchange regimes
 Fixed exchange rate system- is where
a value of a currency in terms of other
currencies is fixed.
 Floating exchange rate system – is
where value of a currency is
determined by the force of demand
and supply.
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Foreign exchange regimes
 Pegged exchange rate system- value
of a given currency is attached to
another currency
 Managed floating exchange rate
system-currency is floated but
interventions are made when there
are significant fluctuations.
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the determinants include:
 relative inflation rates
 relative interest rates
 relative income levels
 government controls
 expectations
3.2 Determinants of forex rate
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1) Direct intervention
by exchanging foreign currency with
local currency
can be sterilized or non-sterilized
intervention
3.3 Government influence on exchange
rate
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Sterilized intervention
 the government buys or sells local
currency(in the forex market) to
manipulate the exchange rate and at
the same time undertakes an
offseting transaction in the money
market to keep money supply
unaffected
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rate
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Non-sterilized intervention
 the the government buys or sells
local currency to manipulate its value
 no offseting transaction is
undertaken in the money market to
keep money supply unaffected
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rate
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2) indirect intervention
adjustment of interest rate-
increase interest rate to discourage
outflow of funds
using foreign exchange controls-
restriction on the exchange of the
currency
3.3 Government influence on exchange
rate
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Effects of stronger local currency
Lower inflation
Higher unemployment
3.3 Government influence on exchange
rate
International Public financial management

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Effects of weaker local currency
Higher inflation
Low unemployment
3.3 Government influence on exchange
rate
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Price stability
Lower unemployment
3.4Aims of exchange rate control
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Types of exposure
1. Transaction exposure
2. Economic exposure
3. Translation exposure
3.5 Measuring exposure to exchange
rate
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Transaction exposure- is the
sensitivity of the firm’s contractual
transactions in foreign currencies to
exchange rate movements
Economic exposure-sensitivity of the
firm’s cash flows to exchange rate
movements.
Eg. Impact of a stronger ETB on export
earnings.
3.5 Measuring exposure to exchange
rate
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Translation exposure-exposure of the
MNC’s consolidated financial
statements to exchange rate
fluctuations.
3.5 Measuring exposure to exchange
rate
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Transaction exposure
Futures hedge-for small transactions
Forward hedge-for large transactions
Money market hedge
Currency option hedge
 Economic exposure
 through restructuring - shifting sources of
costs and revenues to other locations to
match cash inflows and outflows in foreign
currencies
3.6 Managing foreign exchange
exposure
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Currency forward contract
agreement between buyer and seller to
trade currencies at a specific rate on a
specific date
Currency future contract
similar to forward contract, except that
it is traded in an organized exchange
indeminity is available in case of default
3.6 Managing foreign exchange
exposure
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Options are contracts that allow, but do not
require, one or both parties to obtain certain
benefits under certain conditions.
Currency options provide the right to
purchase or sell currencies at specified
prices.
3.6 Managing foreign exchange
exposure
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End of chapter 3