Answer 1

Foreign exchange risk refers to the potential financial loss that arises due to fluctuations in exchange
rates when conducting international transactions. As an intern with XYZ Indian Bank, this report aims
to explore the various methods used for managing foreign exchange risk, with a particular focus on
currency hedging.

Role of the Foreign Exchange Market

The foreign exchange market facilitates the exchange of one currency for another. Its primary
functions are as follows:

1. Conversion: The market allows participants to convert one currency into another to facilitate
international trade and investment.
2. Price Determination: Exchange rates are determined in the foreign exchange market based
on the supply and demand for different currencies.
3. Liquidity Provision: The market ensures the availability of liquidity, allowing participants to
buy or sell currencies quickly.
4. Risk Management: Market participants, including banks, corporations, and investors, utilize
the foreign exchange market to manage foreign exchange risk through hedging strategies.

Operation of the Foreign Exchange Market

The foreign exchange market operates in a decentralized manner across various financial centres
worldwide.

The key aspects of its operation include:

1. Participants: The market involves a range of participants, including banks, corporations,

central banks, institutional investors, retail traders, and speculators. These entities engage in
currency trading for various purposes, such as international trade, investment, and
speculation.
2. Market Structure: The foreign exchange market operates as an over-the-counter (OTC)
markets, meaning trades are conducted directly between participants without a centralized
exchange. Trading occurs electronically, connecting participants globally.
3. Currency Pairs: Currencies are quoted in pairs, such as USD/INR, EUR/USD, or GBP/JPY. The
first currency in the pair is the base currency, while the second is the quote currency.
Exchange rates indicate the value of the quote currency required to obtain one unit of the
base currency.
4. Market Participants' Activities: Participants in the foreign exchange market engage in buying
and selling currencies. For example, importers may purchase foreign currencies to pay for
imports, while exporters sell foreign currencies received from overseas sales.
5. Factors Influencing Exchange Rates: Exchange rates are influenced by several factors,
including interest rates, inflation, political stability, economic indicators, market sentiment,
 and geopolitical events. The interaction of these factors determines the supply and demand
for currencies, leading to fluctuations in exchange rates.

Managing Foreign Exchange Risk

Currency Hedging Currency hedging is a risk management strategy used by market participants to
mitigate foreign exchange risk. It involves taking positions in the foreign exchange market that offset
potential losses resulting from adverse exchange rate movements. Some common currency hedging
methods include:

1. Forward Contracts: A forward contract is an agreement to buy or sell a specified amount of

currency at a predetermined exchange rate on a future date. This allows participants to lock
in an exchange rate, providing certainty for future transactions.
2. Currency Options: Currency options provide the holder with the right, but not the obligation,
to buy (call option) or sell (put option) a specified amount of currency at a predetermined
price (strike price) within a specific timeframe. Options offer flexibility and protection
against unfavorable exchange rate movements.
3. Currency Swaps: Currency swaps involve the exchange of principal and interest payments in
different currencies between two parties. These agreements enable participants to access
foreign currency funding while mitigating exchange rate risk.
4. Money Market Hedging: Money market hedging involves borrowing or lending funds in
different currencies for short-term periods. By matching inflows and outflows of currencies,
market participants can offset exchange rate risk.
5. Natural Hedging: Natural hedging refers to conducting business operations in multiple
currencies. By diversifying sales and purchases across different currencies, companies can
reduce their exposure to exchange rate fluctuations.

The foreign exchange market plays a vital role in facilitating global trade and investment. Its
decentralized nature and liquidity make it an essential platform for managing foreign exchange risk.
Currency hedging techniques, such as forward contracts, options, swaps, money market hedging,
and natural hedging, provide market participants with various tools to mitigate potential losses due
to adverse exchange rate movements. Understanding and effectively employing these methods are
crucial for financial institutions like XYZ Indian Bank to help clients navigate foreign exchange risk
successfully.
Answer 2

The impact of interest rates and inflation on the foreign exchange market can be significant. Here's a
discussion on how these factors influence currency exchange rates:

Interest Rates:

A. Higher Interest Rates: When a country's interest rates rise, it often attracts foreign investors
seeking higher returns on their investments. As a result, the demand for that country's
currency increases, leading to an appreciation in its exchange rate. This occurs because
higher interest rates make holding that currency more attractive, increasing its demand.
B. Lower Interest Rates: Conversely, when a country's interest rates decrease, it may
discourage foreign investors as the potential returns are lower. This reduced demand for the
currency can lead to depreciation in its exchange rate.
C. Interest Rate Differentials: The interest rate differential between two countries also affects
their exchange rates. If one country has higher interest rates compared to another, it may
attract capital inflows, causing its currency to appreciate relative to the other country's
currency.

Inflation:

A. Higher Inflation: When a country experiences higher inflation compared to its trading
partners, its goods and services become relatively more expensive. This situation erodes the
country's export competitiveness, reducing demand for its currency. As a result, the
currency may depreciate in the foreign exchange market.
B. Lower Inflation: Conversely, when a country has lower inflation rates than its trading
partners, its goods and services become relatively cheaper. This can increase export
competitiveness and raise the demand for its currency, potentially leading to currency
appreciation.
C. Inflation Expectations: Expectations of future inflation can also impact exchange rates. If
market participants anticipate higher inflation in a particular country, they may sell its
currency in advance, leading to depreciation in the current exchange rate.

It's important to note that the relationship between interest rates, inflation, and exchange rates is
complex, and other factors such as economic growth, political stability, and market sentiment also
come into play. Additionally, central bank policies, such as monetary tightening or easing, can
influence interest rates and inflation expectations, further affecting the foreign exchange market.

Overall, changes in interest rates and inflation levels have a significant impact on currency exchange
rates as they affect the supply and demand dynamics of currencies in the foreign exchange market.
Monitoring and understanding these factors are crucial for investors, businesses, and financial
institutions to make informed decisions in managing foreign exchange risk.
Answer 3A

Fixed Exchange Rate System

Meaning

In a fixed exchange rate system, the value of a currency is pegged or fixed to another currency, a
basket of currencies, or a commodity such as gold. The exchange rate remains relatively stable and is
maintained by the central bank or monetary authority through active intervention in the foreign
exchange market.

Features

1. Exchange rates are predetermined and do not fluctuate freely.

2. Central bank intervention is necessary to maintain the fixed rate by buying or selling
currencies in the foreign exchange market.
3. Capital flows are restricted to ensure stability in the exchange rate.
4. The objective is to provide certainty and stability for international trade and investments.
5. Examples of fixed exchange rate systems include the Bretton Woods system and currency
boards.

Impact on International Borrowing

Under a fixed exchange rate system, borrowers and lenders can have a predictable outlook on
exchange rates, which reduces uncertainty in international borrowing. It allows borrowers to plan
their repayment obligations without being exposed to exchange rate fluctuations. However, it may
limit the ability to benefit from favourable exchange rate movements.

Floating Exchange Rate System

Meaning

In a floating exchange rate system, the value of a currency is determined by market forces of supply
and demand in the foreign exchange market. Exchange rates fluctuate freely and are not actively
managed or controlled by the central bank. The exchange rate is determined by various factors,
including interest rates, inflation, economic performance, and market expectations.

Features

1. Exchange rates fluctuate continuously and reflect market dynamics.

2. Central bank intervention is limited, mainly for managing extreme volatility or addressing
disorderly market conditions.
3. Capital flows are generally free, allowing market forces to determine exchange rates.
4. The objective is to allow exchange rates to adjust according to market conditions, promoting
competitiveness and external balance.
5. Examples of floating exchange rate systems include the majority of major currencies today.
Impact on International Borrowing

Under a floating exchange rate system, international borrowing can be more exposed to exchange
rate fluctuations. Borrowers bear the risk of changes in exchange rates between borrowing and
repayment. It adds an element of uncertainty as repayment amounts in the home currency can vary
based on the exchange rate at the time of repayment. However, it also provides the opportunity to
benefit from favourable exchange rate movements if the borrowing is in a different currency.

Answer 3B

Spot Transaction

A spot transaction refers to the purchase or sale of currencies for immediate delivery in the foreign
exchange market. It involves the exchange of currencies at the prevailing spot exchange rate, which
is the current market rate at the time of the transaction. Settlement typically occurs within two
business days, known as the spot date.

Features

1. Immediate exchange of currencies at the prevailing market rate.

2. Settlement occurs within a short period, usually two business days.
3. Primarily used for immediate currency needs, such as paying for imports or receiving foreign
currency from exports.
4. The exchange rate for spot transactions is influenced by supply and demand dynamics in the
foreign exchange market.

Forward Transaction

A forward transaction involves the agreement between two parties to exchange currencies at a
predetermined exchange rate on a future date. The exchange of currencies takes place at a future
date beyond the spot date. The forward rate is determined based on the interest rate differentials
between the two currencies and market expectations.

Features

1. Exchange of currencies occurs at a future date, beyond the spot date.

2. Parties agree on a predetermined exchange rate for the future transaction.
3. Forward transactions are used to hedge against exchange rate risk, especially when there is
uncertainty in future exchange rates.
4. Forward contracts allow participants to lock in an exchange rate for future transactions,
providing certainty and reducing exposure to exchange rate fluctuations.
Difference between Spot and Forward Transactions

1. Timing: Spot transactions involve immediate exchange, while forward transactions occur at
a future specified date.
2. Settlement: Spot transactions settle within two business days, whereas forward transactions
settle on the future date specified in the contract.
3. Exchange Rate: Spot transactions occur at the prevailing market exchange rate, while
forward transactions involve a predetermined exchange rate agreed upon in the contract.
4. Purpose: Spot transactions are used for immediate currency needs, while forward
transactions are primarily used for hedging against future exchange rate risk.

Understanding the distinction between spot and forward transactions is crucial for market
participants in managing their foreign exchange exposure, hedging strategies, and planning
international transactions.