Chapter 1: Introduction
The term “foreign exchange” basically refers to buying the currency of one country while selling the currency of another country. All nations have their own, different kinds of money (currency). This has existed throughout the ages, probably since the time of the Babylonians. As trading developed between nations, the need to convert one kind of money to another also developed. This is how a formal system of foreign exchange arose. As trade between nations developed, Britain, as the nation with the largest and strongest navy, could spread its commercial interests far and wide. It therefore became the most active trading nation, with a vast ...view middle of the document...
In this market, the price of one unit of a currency is determined in the units of other currency. Major participants of FX Market are commercial banks, central banks, governments, interbank brokerage houses, exchange companies, people travelling abroad or receiving remittances from other countries & money changers.
1.3. Exchange Rate
Exchange Rate refers to the price paid in one currency to acquire the one unit of foreign currency or the foreign currency received to sell one unit of currency.
1.4. Foreign Exchange Regimes
How a country manages is its own country and the FX market in its country is the exchange rate regime that is being followed by the said country. A country can follow any of the below mentioned exchange rate regimes:
* Freely Floating
* Managed Float
1.5. Foreign Exchange Risk
Foreign Exchange risk arises when a bank holds assets or liabilities in foreign currencies and impacts the earnings and capital of bank due to the fluctuations in the exchange rates. No one can predict what the exchange rate will be in the next period, it can move in either upward or downward direction regardless of what the estimates and predictions were. This uncertain movement poses a threat to the earnings and capital of bank, if such a movement is in undesired and unanticipated direction.
Foreign Exchange Risk can be either Transactional or it can be Translational. When the exchange rate changes unfavorably it give rise to Transactional Risk, as the name implies because of transactions in Foreign Currencies, can be hedged using different techniques. Other one Translational Risk is an accounting risk arising because of the translation of the assets held in foreign currency or abroad.
1.6. Foreign Exchange Risk in Commercial Banks
Commercial banks, actively deal in foreign currencies holding assets and liabilities in foreign denominated currencies, are continuously exposed to Foreign Exchange Risk. Foreign Exchange Risk of a commercial bank comes from its very trade and non-trade services. Foreign Exchange Trading Activities (Saunders & Cornett, 2003) include:
1. The purchase and sale of foreign currencies to allow customers to partake in and complete international commercial trade transactions.
2. The purchase and sale of foreign currencies to allow customers (or the financial institution itself) to take positions in foreign real and financial investments.
3. The Purchase and sale of foreign currencies for hedging purposes to offset customer (or FI itself) exposure in any given currency.
4.To purchase and sale of foreign currencies for speculative purposes base on forecasting or expecting future movements in Foreign Exchange rates. The above mentioned Trade Activities do not expose a commercial bank to foreign exchange risk as a result of all of the above. The commercial bank is exposed to foreign exchange risk only up to the extent to which it has not hedged or covered its position....