PART-B: FOREIGN EXCHANGE

BALANCE OF PAYMENT:

It is a measurement of all transactions across the

borders over a specified time period.

FOREIGN EXCHANGE TRANSACTIONS

i) Current Transactions:

a) Goods and services during one financial year i.e.

visible items & it is called balance of trade also. It
includes non visible items like services also & factor
income i.e. dividend payment & interest payments across
the borders.

b) Receipt and payments which do not create new capital

items or cancel previous such items (visible or
invisible).

ii) Capital Transactions:

a)Receipts and payments of capital nature which do

not pertain to current year.It includes DFI,
portfolio investment & other capital investments.

b)Long term capital claims.

iii) Short term financial Transaction:

a) Citizen of a country can transfer their foreign

exchange recourses to another country due to political
or economic reasons.
 iv) Working Balances:

The commercial Banks maintain foreign currency

deposit with Banks in some other countries to avoid
various disturbances.

FOREIGN CURRENCY ACCOUNTS:

Banks play a vital role in the international trade

settlement. This settlement is made with the help of
“NOSTRO” and “VOSTRO”

NOSTRO: Latin word means OUR:

a) A bank can have relationship with foreign

correspondents.

b) In UK, can have sterling nostro a/c and so on.

c They are in current account and do not earn interest.

VOSTRO: a) Latin word means “YOUR”.

b) Convertible Pak.RS. accounts maintained by foreign

Banks.

EXCHANGE CONTROL

OBJECTIVES OF EXCHANGE CONTROL

Exchange control is management of available resources

in foreign currency. It refers to following points:

i) OVERVALUATION: More than the value determined by

market forces.

ii) UNDER VALUATION: Less than the value determined by

market forces.
iii)STABILITY OF EXCHANGE RATES: Conversion at official
rate of exchange to stabilize value.

iv) PREVENTION OF CAPITAL FLIGHT: Gold and foreign

currency cannot be exported without Permission.

v) PROTECTION TO DOMESTIC INDUSTRY: To encourage

business environment in the country.

vi) CHECKING NONESSENTIAL IMPORTS: To control import of

luxury items.

vii) HELP TO PLANNING PROCESS: How to spend foreign

currency on result oriented items.

viii) BALANCE OF PAYMENT PROBLEMS: With prudent

policies BOP problem can be controlled.

ix) EARNING REVENUE: Foreign exchange is sold

to Businessmen, traders etc. at a certain rate.

x) REPAYING FOREIGN DEBT: By earning and

conserving Foreign exchange.

xi) RETALIATION: Monopoly power and better bargaining

terms.

FORMS OF EXCHANGE CONTROL

a)EXCHANGE RATIONING:

i) To face foreign exchange difficulties, the citizens

will be required to surrender foreign exchange earnings
to SBP fully.

ii) Partial rationing

iii) Different official rate for different transactions

b)BLOCKED ACCOUNTS: It refers to the following:

 i) Bank deposits and other assets held by foreigners
in controlling country.

ii)The interest and dividend can be used for

reinvestment in the same country but will not
be allowed to transfer or convert funds.

iii)Allowed to be utilized within the country, if

essential.

iv)For export purposes.

v)Sometimes for traveling purposes.

c)PAYMENT AGREEMENTS:

It refers to the following points:

i) Can be made through agreement between two

countries, which want rationing.

ii) Can be made through agreement between debtor

and creditor countries.

iii) Sometimes forced to be formed by creditor for

encouragement of their exports.

CLEARING AGREEMENTS:

i) Direct bilateral exchange of goods.

ii) May be between individuals and firms located in

different countries.

iii) More comprehensive as designed to settle debt in

shortest possible time.

iv) The transactions are settled at an official rate of

exchange.
v) Quantity and specification of goods is also pre-
defined.

vi) Results are always not fruitful.

Precisely can be done by Government intervention i.e.

purchasing of foreign currency by selling local
currency as being done in Pakistan.

PREREQUISITES OF EXCHANGE CONTROL:

i) Full control of Government over import and export of

gold and bullion.

ii) Buying and selling of Government securities

should be controlled so that foreign transactions are
restricted.

iii) Stock market operations must be monitored closely

so that conversion of foreign assets into interest
bearing foreign securities may be avoided.

iv)An effective custom agency is required to control

import and export.

v) Trade control may be exercised to ensure early

repatriation of export proceeds while free imports may
be controlled for a favorable BOP.

The above mentioned methods are DIRECT METHODS in which

we can call the OVERVALUATION as PEGGING UP and
UNDERVALUATION as PEGGING DOWN.Besides, following are
other direct methods:

a) EXCHANGE RESTRICTIONS:As per rules of SBP, forex

is released and kept by the Government.

b) ALLOCATION AS PER PRIORITY

c) MULTIPLE EXCHANGE RATE.

INDIRECT METHODS:

a)QUANTITATIVE RESTRICTIONS:

There is import embargoes, import quota and other

restrictions to control disequilibrium in BOP.

b)EXPORT BOUNTIES:

To encourage exports, provided funds are available

with SBP.

c)RAISING INTEREST RATE:

It will attract the inflow of deposits in foreign

exchange.

THE FINANCIAL MARKETS:

It is a set of facilities that makes it possible to

exchange money for goods or goods for money on regular
basis. Securities are the goods.

Major functions of financial markets:

a) Shifting of credit: Mobilize the funds for users.

b) Liquefying securities. Customer should be confident
about sale/purchase.
c) Pricing: Mark-up rates.
d) Foreshadowing future: Forecasting of future for
financial management.
e)Allocating resources: Considering growth, safety and
yield.

CLASSIFICATION OF FINANCIAL MARKET:

 a)Primary market.
b)Secondary market
c)Money market
d)Capital market

FUNCTIONS OF FOREIGN EXCHANGE MARKET

Currently operating in London, Paris, Brussels, Zurich,

New York, Hong Kong and Tokyo.

MOTIVES FOR INVESTING IN FOREIGN EXCHANGE MARKETS:

a) Economic Conditions: The investors can invest in

a currency where economy is stable so return can
be higher.
b) Exchange rate expectations: The securities in a
currency may be bought where appreciation is
higher than the domestic currency.
c) International Diversification: Risk &
fluctuations can be managed by investing in other
currencies.

MOTIVES FOR PROVIDING CREDIT IN FOREIGN EXCHANGE

MARKETS:

a) Higher interest rates: Due to shortage of forex

reserves the country may offer better rates on
foreign currency deposits.
b) Exchange rate expectations: One can make
investment in a country currency which is expected
to appreciate against domestic currency.
c) International Diversification: The chances of risk
& fluctuations can be avoided. The economic
conditions of the concerned country are very
important.

MOTIVES FOR BORROWING IN FOREIGN EXCHANGE MARKETS:

a) Low interest rates: Many countries have bulk
supply of foreign reserves so rate of interest are
relatively low.
b) Exchange rate expectations: The risk & return can
be managed.
FUNCTIONS:

i) To transfer purchasing power from one country to

another.

ii) It takes place by debiting and crediting accounts

of each Bank.

iii) No physical delivery of currency takes place

usually.

iv) It provides credit also to the business community.

v) HEDGING: Hedging means avoidance of foreign exchange

risk or covering of an position without buying or tying
up funds. This process is carried out in forward
Market. This promotes foreign trade.

vi) SPECULATION:

a) It is opposite of hedging.

b) The speculator takes the risk Of any transaction.

c) Speculation can take place in forward or spot

market.

d)If the speculator buys a currency in expectation of

reselling it on profit it will be called” LONG
POSITION” it will have STABILIZING EFFECT otherwise it
will be called “SHORT POSITION” or DESTABILIZING
EFFECT.

VII) SWAP TRANSACTIONS:

 It refers to following:

i) Simultaneous buying and selling of foreign currency

for different delivery dates in opposite
direction.

ii) May cover spot against forward.

iii) May take place between commercial parties or Bank

etc.

iv) May be for a limited period of time.

v) May be lesser risky.

vi) Very popular with speculators, as well.

FOREIGN EXCHANGE POSITION MANAGEMENT:

OVER BOUGHT/SOLD AND SQUARE POSITION:

i) In order to facilitate foreign exchange transactio the

Bank buy/sell currency in spot of forward.

ii) The difference between buy and sell shows the

commitment position of the Bank.

iii) If purchase side is more than sale side it is

called overbought and the opposite one is called
oversold.

iv) If both positions are equal it is called SQUARE.

v) If both positions are nearly equal, it is called

near square.

vi) Sometimes delay in transmitting takes place, which

may disturb position.

LEADS AND LAGS:

If a foreign currency weakens or it is devalued, the
importers stand to gain on their spot purchases from
the Bank while the exporter will lose. The importer and
exporter will move accordingly and this pressure will
weaken the currency. If a currency is strong and is
expected to be revalued exporter will delay shipment
and the importer will expedite payment. This will make
the currency actually strong.

THIS PHENOMENON OF DELAYING AND EXPEDITING SETTLEMENT

BY CUSTOMERS IN ANTICIPATION OF CURRENCY’S
DEVALUATION AND REVALUATION IS CALLED “LEADS AND
LAGS”.

SYSTEM OF EXCHANGE RATE

TWO major systems:

FIXED RATE: Remains fixed in terms of foreign unit of

currency with the home currency. This system has a
demerit that when there is adverse BOP, substantial
foreign exchange reserves will be needed to maintain
the rate at fixed level.

FLOATING (FREE)RATE: It moves in a following direction:

i) Demand and supply of the currency.

ii) Places a currency at the mercy of world’s judgment.

iii) May give rise to speculation.

TYPES OF EXCHANGE RATE:

DIRECT QUOTATION:
Rate of exchange is expressed in units of national
currency in most currencies:

Rs.60=US$1

INDIRECT QUOTATION:

It values the currencies in terms of the other

currencies than in national currencies.

US$ 0.5=Rs.1

CROSS RATES:

i) The rate of exchange between any two currencies is

kept the same in different money centers by
“ARBITRAGE”.

ii)Sale and purchase is made in and from money centers

where the currency is available at lower or higher
rates respectively.

iii) When two currencies and two centers are involved it

is called “TWO POINT ARBITRAGE’.

iv) When three currencies and three centers are involved

it is called “THREE POINT ARBITRAGE’ OR TRIANGULAR.

v)When national currency is not used in the transaction

and exchange rate is calculated on the basis of a third
currency, it is called CROSS RATE.

vi)It is known as calculated parity between two money

centers through a third e.g.

The chain rule is followed….

We can buy EURO in London against GBP then can use EURO
to buy $ in France then we can sell $ in UK.
SPOT RATE:

The spot rate of the currency is the value quoted for

the nearest settlement date for the purchase and sale
of the currency against another one. The transaction
may be settled in two to three working days.

FORWARD RATE:

It covers following concepts:

i) Rate at which the currency can be bought or sold for

the delivery on a future date.

ii) Agreement to buy or sell at a specified future date

at rate agreed today.

iii) No payment will be made except security deposit at

the time of signing of contract.

iv) No consideration for spot rate at the time of

settlement.

v) May be for one to six months or longer.

vi)Longer period contracts are not common due to

uncertainties involved.

vii) If forward rate is less than spot, it is called

“FORWARD DISCOUNT” otherwise it will be called “FORWARD
PREMIUM”.

viii) With its help the importer/exporter can avoid

fluctuations.

ix) The Bank can take help from speculators.

x ) There can be BULL or BEAR run.

OTHER SYSTEM OF EXCHANGE RATE:

i) Dirty float:

a) To avoid sharp changes in rates under any

system.
b) It is a compromise between fixed & floating
rate system.
c) Can be done with interest rate policy.
d) The objective is to stabilize rate of exchange.

ii) Wider band:

a) The rate can be moved in 2.25% range on either side

of official rate of exchange.

b) It was allowed by IMF in 1971 for the first time.

c) Total variation comes to 4.5%.

d) It helps in avoiding currency uncertainty.

iii) Crawling Peg:

a) The value of currency is revised automatically.

b) There is a support point when it reaches then the

central bank intervenes.

c) According to previous agreed weeks or months the

support point is changed based on currency average.

d) If new support point is near to low point then it

will be set downward otherwise upward.

e) It gives certainty to rate of exchange.

CURRENCY DERIVATIVES
A forward contract is an agreement between a company &
a commercial bank to exchange a specified amount of
currency at specified exchange rate (forward rate) on a
specified date in the future. The normal period is 30,
60 & multiple. Initial deposit may be needed.

BID/ASK RATE:

The ask rate is the selling rate whereas bid rate is

the purchase rate. The spread between bid & ask rate is
wider in forward contracts.

How to calculate BID & ASK rate in %:

Ask rate-Bid rate/Ask rate

A future contract refers to a specific settlement date

for a particular currency’s volume. It is popular with
speculators.

DIFFERENCE BETWEEN FORWARD & FUTURE CONTRACTS:

FORWARD FUTURE
Size of contract Tailored to Standardized
individual needs
Delivery date Tailored to Standardized
individual needs
Participants Bankers, Bankers, brokers,
brokers, MNC, MNC, qualified
speculators not speculators
encouraged
Security deposit Not essential Needed
Transaction cost Set by spread Negotiable

CURRENCY CALL OPTIONS:

It grants right to buy specific currency at a
designated price within a specific period of time. The
currency options are desirable when one wishes to lock
in a maximum price to be paid for the currency in the
future. The price at which the person is allowed to buy
that currency is known as exercise/strike price.

Call options are desirable when….

a) One wishes to lock maximum price to be paid for a

currency in the future.
b) If the spot rate of currency rises above strike
price owners of call options can exercise option
by purchasing it at strike price.
c) Future contract is obligatory but currency option
is not.
d) Owners of call option loses premium paid by them
initially but that is maximum.

A currency call option is said to be in the money when

present exchange rate exceeds strike price, at the
money when both are equal & out of money present
exchange rate is less that strike price. Higher premium
is there in the money option.

FACTORS AFFECTING CURRENCY CALL OPTION PREMIUM:

a) Higher the spot rate relative to strike price,

higher the option price will be. This will be due
to higher probability of buying currency at lower
rate than what you could sell it for.
b) The relationship of expiration date & premium is
there.
c) If time is long then chances of raising the spot
rate will be higher as compared with strike
price.
d) The volatility of currency can increase spot
price more rapidly.
CURRENCY PUT OPTIONS:

It grants right to sell specific currency at a

designated price (strike price) within a specific
period of time. It is also not obligatory like call
option.

The owners of put option loses premium paid by them

initially but that is maximum.

A currency put option is said to be in the money when

present exchange rate is less than strike price, at the
money when both are equal & out of money when present
exchange rate exceeds the strike price. For a given
currency & expiration date, an in the money put option
will require a higher premium than options that are
there in at the money or out of money.

EXAMPLE FOR CALL OPTION:

Call option premium on C$=$.01/unit

Strike price=$0.70

One option contract represents C$ 50,000

Amount in C$

Narration Per unit price Per contract

Selling price of 0.74 37,000
C$
Purchase price -0.70 -35,000
of C$
Premium paid for -.01 -500
option
Net Profit 0.03 1,500
If the seller does not purchase the C$ till option was
about to be exercised the net profit of seller will be
as follows:

Amount in C$

Narration Per unit price Per contract

Selling price of 0.70 35,000
C$
Purchase price -0.74 -37,000
of C$
Premium received .01 +500
for option
Net Profit -0.03 -1,500

EXAMPLE FOR PUT OPTION:

Put option premium on GBP=0.04/unit

Strike price=GBP1.40

One option contract represents GBP 31,250

Amount in GBP

Narration Per unit price Per contract

Selling price of 1.40 43,750
GBP
Purchase price 1.30 40,625
of C$
Premium paid for -.04 -1,250
option
Net Profit 0.06 1,875
If the seller does not purchase the GBP till option was
about to be exercised the net profit of seller will be
as follows:

Amount in GBP

Narration Per unit price Per contract

Selling price of 1.30 40,625
C$
Purchase price -1.40 -43,750
of C$
Premium received .04 +1,250
for option
Net Profit -0.06 -1,875

EURO CURRENCY MARKETS: They exist in all countries to

transfer surplus units (savers) to deficit units
(borrowers).So out side USA demand of $ will be called
EURO DOLLARS & so on for long term it will be EURO
BONDS.

DIRECT FOREIGN INVESTMENT:Investment in real assets

like land, buildings etc in the foreign countries are
called DFI.

MOTIVES:Normally the objectives are to maximize share

holders’ wealth & to improve profitability but they can
be interested in boosting revenue, reducing costs or
both.

REVENUE RELATED MOTIVES:

a) Attract new source of demand: This can be done to

avoid domestic competition & to increase growth.
b) Enter profitable markets: When the other market
is profitable MNC can take its benefit.
 c) Exploit monopolistic advantages: More chances for
technically advanced MNCs & products in other
markets.
d) React to trade restrictions: May enter in other
markets where trade restrictions are no there.

COST REALTED BENEFITS:

a) Fully benefit from economies of scale: Lower

average cost with more production.
b) Use foreign factors of production: Set up where
factors are available at cheap rates.
c) Use foreign raw material: Let us set up factory
where raw material is available. This is to
avoid many hindrances.
d) Use foreign technology: Advanced technology can
be used & can be imported to home country of
MNC.
e) React to exchange movements: When the currency
is undervalued then MNC can go for FDI to take
benefit of initial low outlay.

OFFSHORE BANKING:

i) Bank decides to deal with foreign nationals.

ii) In the non-tariff area.

iii) May be free from legislations.