FOREX

THE FOREX AND RISK MANAGEMENT

Executive Summary

___________________________________________________________________________

The foreign exchange market does not have a physical market place called the foreign

exchange market. It is a mechanism through which one country's currency can be exchange

i.e. bought or sold for the currency of another country. The foreign exchange market does not

have any geographic location. The market comprises of all foreign exchange traders who are

connected to each other through out the world. They deal with each other through telephones,

telexes and electronic systems. The foreign exchange market operates twenty four hours a

day during the business week; the only time it is silent is after the New York market closes

on Friday afternoon and before the Sydney market opens on Monday morning (which would

be Sunday evening New York time).

In the aftermath of the Asian crisis, which curbed and restricted offshore trading in regional

currencies, most derivatives markets in Asia are still in their infancy. Financial institutions

trying to introduce or transplant products from mature markets to those that are lesser

developed are meeting with limited success.

The RBI has ushered rupee derivatives trading into the country: it has formally allowed

banks and corporate to hedge against interest rate risks through the use of interest rate swaps

(IRS) and forward rate agreement (FRA). According to the guidelines issued by RBI there

will be no restriction on the tenure and size of the IRS and FRA entered into by banks. The

IRS will also allow corporate to hedge their interest rate risks and also to provide an

opportunity to swap their old high cost loans with cheaper ones. With the new guidelines in

place, commercial banks, primary institutions and financial institutions can now undertake

IRS and FRA as a product of their own balance sheet management and market making

purposes. Initially, there was a lot of enthusiasm shown over swaps by corporates and

financial institutions but now it seems to have waned. Not many deals have been reported for

long. Market participants now realize that one can strike a couple of deals for the sake of


publicity, but one cannot have a sustainable interest rate market based on a single benchmark

that too when it is as short as an overnight call money market. The issues of concern being

the lack of a term market and domestic interest rates, particularly the overnight rate being

hostage to the fortunes of the rupee in the Forex market. The swap market is expected to

grow with growth in the money and forex markets.


Objective

The main idea was to know what is foreign exchange market and what are Derivatives and

how corporate use these Derivatives to manage the risk that they would have faced if there

were no derivatives. And how these Derivatives helps corporate to minimize the risk and

survive in world.

Research Methodology

The data for the project report was collected from diverse sources like books, Internet.

The details of the books and sites visited have been mentioned in reference and bibliography.

This report is a collection of secondary data.


FOREIGN EXCHANGE

INTRODUCTION

Foreign exchange is the process of conversion of one currency into another currency. For a

country its currency becomes money and legal tender. For a foreign country it becomes the

value as a commodity. This commodity character can be understood when we study about

‘Exchange Rate’ mechanism. Since the commodity has a value its relation with the other

currency determines the exchange value of one currency with the other. For example, the US

dollar in USA is the currency in USA but for India it is just like a commodity, which has a

value which varies according to demand and supply.

Foreign exchange is that section of economic activity, which deals with the means, and

methods by which rights to wealth expressed in terms of the currency of one country are

converted into rights to wealth in terms of the current of another country.

It involves the investigation of the method, which exchanges the currency of one country for

that of another. Foreign exchange can also be defined as the means of payment in which

currencies are converted into each other and by which international transfers are made; also

the activity of transacting business in further means.


Authorised Dealers In Foreign Exchange

The Reserve Bank of India (RBI) has granted licenses to certain established firms, hotels and

other organizations permitting them to deal in foreign currency notes, coins and travellers

cheques subject to directions issued to them from time to time. Except for transactions

involving purchase or sale of foreign currency between any person and an authorized money

changer, no person, firm or company, other than an authorized dealer, is permitted to enter

into transactions involving the buying, acquiring or borrowing from, or selling, transferring

or lending to, or exchanging with a person not being an authorized dealer, any foreign

exchange except with the general or special permission of the RBI.

Authorised Money Changer

In order to provide facilities for encashment of foreign currency to visitors from abroad,

especially foreign tourists, Reserve Bank has granted licenses to certain established firms,

hotels and other organizations permitting them to deal in foreign currency notes, coins and

travellers cheques subject to directions issued top them from time to time. The firms and

organizations generally known as ‘authorized moneychangers’ fall into two categories,

namely

‘Full-fledged money-changers’ who are authorized to undertake both purchase and sale

transactions with the public and ‘Restricted money-changers’ who are authorized only to

purchase foreign currency notes, coins and travellers cheques, subject to the collections are

surrendered by them in turn to an authorized dealer in foreign exchange/full-fledged money-

changer.


FOREIGN EXCHANGE MARKET

Foreign exchange markets allow market participants to exchange one currency for another.

One counterparty buys a specified currency from the other counterparty in exchange for

another currency. The relative amount of the two currencies is determined by the foreign

exchange rate between those two countries.

The date on which the two currencies are exchanged is known as settlement date or value

date.

Foreign exchange market is the single largest market in the world. More than USD 1.44

trillion is traded in the FX market each day, according to the Bank for International

Settlements, which monitors the FX market activity. To put this figure in perspective, the

sum total of global trade in physical goods in one year accounts for the same amount of trade

as a few days in the foreign exchange market. Hence the FX market is much, much bigger

than all other markets put together.


Exchange Rate

Countries of the world have been exchanging goods and services amongst themselves from

time immemorial. With the invention of money, the rigors and problems of barter trade have

disappeared. The barter trade has given way to exchange of goods and services for currencies

instead of exchange for goods and services.

As every sovereign nation has a distinct national currency, international trade has

necessitated exchange of currencies and this exchange of currencies had necessitated

exchange rate.

Like any other commodity, the price of one unit of foreign currency can be stated in terms of

domestic currency. Thus, the rate of exchange means the price of one currency in terms of

another country’s currency.

For instance, the price of US Dollar can be expressed in terms of Indian Rupees. If US Dollar

1 = INR 48.50(as on august 28’2002), it means the exchange rate of US Dollar and Indian

Rupees is 1:48.50.

Exchange rates are normally quoted in terms of a buying rate, a flat rate, and a selling rate.

The buying rate in that which a bank will pay for foreign currency. The selling rate is the rate

a bank will charge for currency, and the flat is an average of the buying and selling rates. In

other words, the exchange rate is said to be the rate at which a number of units of one

currency can be exchanged for a number of another currency.


Exchange Determination and Forecasting

INTRODUCTION: -

EXCHANGE RATE – AN OVERVIEW

What is Exchange rate?

Countries of the world have been exchanging goods and services amongst themselves from

time immemorial. With the invention of money, the rigors and problems of barter trade have

disappeared. The barter trade has given way to exchange of goods and services for currencies

instead of exchange for goods and services.

As every sovereign nation has a distinct national currency, international trade has

necessitated exchange of currencies and this exchange of currencies necessitated exchange

rate.

Like any other commodity, the price of one unit of foreign currency can be stated in terms of

domestic company. Thus, the rate of exchange means the price of one currency in terms of

another country.

For instance, the price of US Dollar can be expressed in terms of Indian Rupees. If US Dollar

1 = INR 48.50(as on August 28, 2002), it means the exchange rate of US Dollars and Indian

Rupees is 1: 48.50.

Exchange rates are normally quoted in terms of a buying rate, a flat rate, and a selling rate.

The buying rate is that which a bank will pay for a foreign currency. The selling rate is the

rate a bank will charge for the currency, and the flat rate is an average of the buying and the

selling rates. In other words, the exchange rate is said to be the rate at which a number of

units of one currency can be exchanged for a number of units of another currency.


Some Important Terms

1. Fixed Exchange Rate System

In a fixed exchange rate system foreign central banks stand ready to buy and sell their

currencies at a fixed price in terms of dollars.

2. Intervention

Intervention is the buying or selling of foreign exchange by the central bank. Foreign

exchange market intervention occurs when a government buys and sells foreign

exchange in an attempt to influence the exchange rate.

3. Flexible Exchange Rate System

In a flexible exchange rate system, the central banks allow the exchange rate to adjust

to equate the supply and demand for foreign currency. The terms flexible and floating

rates are used interchangeably.

In a system of Clean Floating Rate, Central Banks stand aside completely and allow

exchange rates to be freely determined in the foreign exchange markets.

Under a Managed or a Dirty floating rate, Central banks intervene to buy and sell

foreign currencies in attempts to influence exchange rates.

4. Devaluation

Devaluation takes place when the price of foreign currencies under a fixed rate

regime is increased by official action. The outfall of this is that the foreigners pay less

for the devalued currency and the residents of the devaluing currency pay more for

foreign currencies.


5. Depreciation

A change in price of foreign exchange under flexible exchange rates is referred to as

currency depreciation or appreciation. A currency depreciates when, under floating

rates, it becomes less expensive in terms of foreign currencies. The reverse results in

appreciation.

If the exchange rate falls, the domestic currency is worth more; it costs fewer

domestic currencies to buy a unit of foreign currency.


Fixed Rate To Flexible Exchange Rate System

Different countries have adopted different exchange rate systems at different times. The

following are some of such systems in brief

Gold Bullion

In modern times, the operative system of exchange rates has evolved from a gold

bullion standard to a system of floating exchange rates with several alternative

systems used in between.

The gold bullion standard prevailed from about 1870 until 1914, and intermittently

thereafter until 1944. Under this system, central governments defined their currencies

in terms of a specific amount of gold bullion and agreed to redeem their currencies at

the set rates (mint parities). However, as a commodity, the international market price

of a currency (the exchange rate) would fluctuate above or below parity based on the

supply and demand of that currency relative to others. If excessive demand forced the

market price of a currency above the parity band, external debtors found it cheaper to

pay their debts in gold. Conversely, if insufficient demand for a currency lowered its

market price below the parity band, external creditors demanded payments in gold.

Under this system, unless a country maintained a reasonable trade balance over time,

continuing trade deficits would drain its gold reserves. The lower level of gold

reserves would, in turn, result in shrinkage of that country's money supply and a

lower internal price level. Lower domestic prices would eventually make the

country's products more competitive in the international marketplace. As exports

increased, the demand for the country's currency would also increase resulting in an

inflow of gold reserves. With a self-balancing system such as this, the governments'

role was a passive one in which they would merely permit the free flow of gold to

stabilize economies and exchange rates. Thus, the gold bullion standard acted as an

automatic stabilizer, at least in theory.


The Gold Standard

Many countries had accepted the Gold Standard as their monetary system during the

last two decades of the nineteenth century. Under this system, the parities of

currencies were fixed in terms of gold. The currencies of the countries, which were on

gold standards, could be exchanged freely and the rate varied depending upon the

gold content of the currencies. This was also known as the Mint Parity Theory of

exchange rates.

Gold Standard helped in maintaining the stability in exchange rates and correcting the

disequilibria in their balance of payments on an automatic basis. This system was in

vogue till the outbreak of World War I. Several efforts went futile in reviving this

system and the era of Gold Standard came to an end by late 1930s.

Bretton Woods System

During the world wars, economies of almost all the countries suffered. In order to

correct the balance of payments disequilibrium, many countries devalued their

currencies. Consequently, the international trade suffered a deathblow. In 1944,

following World War II, the United States and most of its allies ratified the Bretton

Woods Agreement, which set up an adjustable parity exchange-rate system under

which exchange rates were fixed (pegged) within narrow intervention limits (pegs) by

the United States and foreign central banks buying and selling foreign currencies.

This agreement, fostered by a new spirit of international cooperation, was in response

to the financial chaos that had reigned before and during the war.

In addition to setting up fixed exchange parities (par values) of currencies in

relationship to gold, the agreement established the International Monetary Fund

(IMF) to act as the "custodian" of the system.


Under this system,

a. Member governments were obligated to defend the exchange rates within a

narrow band of about 1 percent above or below parity (the official exchange

rate).

b. The revaluation or devaluation of a currency was called for only in the case of

"fundamental disequilibria" (chronic surpluses or deficits in a nation's balance

of payments).

c. Incase of insufficiency of the reserve amount available with a member

country, the Monetary Fund could draw from their quota through Special

drawing Rights (SDRs) with the IMF.

Despite the fact that the IMF expressed currencies in terms of gold, in practice currencies

were expressed in terms of dollars, and the Bretton Woods Agreement became a rigid dollar

standard. This situation arose because the United States was the only country that agreed to

redeem its currency for gold.

Naturally, the dollar could not serve as both a national and an international currency, since

under these conditions international liquidity (total trade financing potential) could be

expanded only through larger balance-of-payments deficits on the part of the United States.

The ensuing massive United States balance-of-payments deficits led to an erosion of

confidence in the dollar as a store of wealth, the cancellation of the gold convertibility of the

dollar in August 1971 by the United States, and the signing of the Smithsonian Agreement in

December 1971 by the major trading nations, referred to as The Group of Ten. This was an

attempt to restore monetary order by devaluing the dollar and establishing a wider parity

band (plus or minus 2.25 percent). The Smithsonian agreement was reached wherein USA

agreed to devalue its currency provided Germany and Japan revalued their currencies.


Despite this effort, the United States continued to experience balance-of-payments deficits.

In early 1973, an additional 1 percent devaluation of the dollar, along with agreement of

several European Economic Community (EEC) member nations to let their currencies float

against the dollar, dealt the death knell to the Bretton Woods and Smithsonian Agreements.

Allowing exchange rates to float in the midst of financial chaos was like setting a boat adrift

in the middle of a storm--smooth sailing was next to impossible. To make matters worse, the

tripling of oil prices by the Organization of Petroleum Exporting Countries (OPEC) during

1973 hit the foreign exchange markets like a hurricane, causing global inflation to raise with

the tide.

However, the circumstances under which floating exchange rates were introduced are by no

means the only problem with the system. The lack of an official common denominator and

the diminished authority of the IMF have not helped matters. Money has become a

commodity that is bought and sold at market prices. In the international economic sense,

money has become a circular concept--defined only in terms of the price that each currency

will bring in other currencies.

In addition, three important trends developed that contributed to the problem.

1. There was a persistent increase in liquid resources available to the private sector

relative to the monetary reserves held by the central banks. (The money supply was

no longer tied to a country's gold reserves and the multiplier effect allowed for this

growth.)

2. There were constantly improving techniques permitting market participants to shift

large amounts of capital rapidly from one currency to another.

3. There were improving communication methods making information available

instantaneously to a growing number of analysts throughout the world


Thus with the uncontrollable capital flows, major countries suspended their obligation to

intervene in the market and the Bretton Wood System, with its fixed parities, was effectively

buried.

Floating Rate System

With the exit of fixed parities system, different countries experimented with exchange rate

systems. The breakdown of Bretton Woods System and the subsequent adoption of

generalized floating by major industrialized countries, the option was left open to the

developing countries to choose their own exchange rate regime in line with national

preferences. Today, exchange rate regimes and practices vary considerably across countries.

The widespread adoption of flexible exchange rate system has made major contributions by

offering many countries the easier use of an effective means of adjustment and by reducing

the political biases against adjustments, which existed under the par value system.


Exchange Rate Systems In Different Countries

The member countries generally accept the IMF classification of exchange rate regime,

which is based on the degree of exchange rate flexibility that a particular regime reflects.

However, it has been generally observed that there exists no strict relationship between a

particular regime and the degree of exchange rate flexibility it faces, either at the nominal or

real exchange rate levels.

The exchange rate arrangements adopted by the developing countries cover a broad

spectrum, which are as follows:

a) Single Currency Peg

The country pegs to a major currency, usually the U. S. Dollar or the French franc

(Ex-French colonies) with infrequent adjustment of the parity. Many of the

developing countries have single currency pegs.

b) Composite Currency Peg

A currency composite is formed by taking into account the currencies of major

trading partners. The objective is to make the home currency more stable than if a

single peg was used. Currency weights are generally based on trade in goods –

exports, imports, or total trade. About one fourth of the developing countries have

composite currency pegs.

c) Flexible Limited vis-à-vis Single Currency

The value of the home currency is maintained within margins of the peg. Some of the

Middle Eastern countries have adopted this system.


d) Adjusted to indicators

The currency is adjusted more or less automatically to changes in selected macro-

economic indicators. A common indicator is the real effective exchange rate (REER)

that reflects inflation adjusted change in the home currency vis-à-vis major trading

partners.

e) Managed floating

The Central Bank sets the exchange rate, but adjusts it frequently according to certain

pre-determined indicators such as the balance of payments position, foreign exchange

reserves or parallel market spreads and adjustments are not automatic.

f) Independently floating

Free market forces determine exchange rates. The system actually operates with

different levels of intervention in foreign exchange markets by the central bank.

It is important to note that these classifications do conceal several features of the developing

country exchange rate regimes. A particular regime may be compatible with dual or multiple

rates, separate exchange rates for capital and current account transactions, a combination of

fixed-floating arrangement and tax-subsidy schemes for export – import trade.


The Evolution Of India’s Exchange Rate Regime

Market in India

The Rupee was historically linked with Pound Sterling. India was a founder member of the

IMF. During the existence of the fixed exchange rate system, the intervention currency of the

Reserve Bank of India (RBI) was the British Pound; the RBI ensured maintenance of the

exchange rate by selling and buying pounds against rupees at fixed rates. The inter-bank rate

therefore ruled the RBI band. During the fixed exchange rate era, there was only one major

change in the parity of the rupee- devaluation in June 1966.

According to John E. Rule, it is the views of participants in the foreign-exchange markets

that result in the daily buying and selling pressures on currencies. The views of these

participants, such as traders, bankers, and businessmen, are in turn influenced by political,

economic and psychological factors.

Political Factors

The political factors influencing exchange rates include the established monetary

policy along with government action or inaction on items such as the money supply,

inflation, taxes, and deficit financing. Active government intervention or

manipulations, such as central bank activity in the foreign currency markets, also

have an impact. Other political factors influencing exchange rates include the political

stability of a country and its relative economic exposure (the perceived need for

certain levels and types of imports). Finally, there is also the influence of the

International Monetary Fund.

Economic Factors

Economic factors affecting exchange rates include hedging activities, interest rates,

inflationary pressures, trade imbalances, and EuroMarket activities. Irving Fisher, an


American economist, developed a theory relating exchange rates to interest rates.

This proposition, known as the Fisher Effect, states that interest rate differentials tend

to reflect exchange rate expectations.

On the other hand, the purchasing-power-parity theory relates exchange rates to

inflationary pressures. In its absolute version, this theory states that the equilibrium

exchange rate equals the ratio of domestic to foreign prices. The relative version of

the theory relates changes in the exchange rate to changes in price ratios.

Other economic factors influencing exchange rates are included in a theory proposed

by Dombush, who presented both a long-run view and a short-run view of exchange

rate determinants. According to Dombush, the long-run determinants of exchange

rates are the nominal quantities of monies, the real money demands and the relative

price structure. Among the factors that exert an influence on real money demand are

interest rates, expected inflation, and real income growth. In the short run, Dombush

theorizes, exchange rates are determined by interest arbitrage together with

speculation about future spot rates.

Psychological Factors

Psychological factors also influence exchange rates. These factors include market

anticipation, speculative pressures, and future expectations.

A few financial experts are of the opinion that in today’s environment, the only

‘trustworthy’ method of predicting exchange rates is by “gut feel”. ‘Bob Eveling’,

vice-president of financial markets at SG, is Corporate Finance's top foreign

exchange forecaster for 1999. Eveling's gut feeling has, defied convention, and his

method proved uncannily accurate in foreign exchange forecasting in 1998. SG ended

the Corporate Finance forecasting year with a 2.66% error overall, the most accurate

among 19 banks. The secret to Eveling's intuition on any currency is keeping abreast

of world events. Any event, from a declaration of war to a fainting political leader,

can take its toll on a currency's value. Today, instead of formal models, most


forecasters rely on an amalgam that is part economic fundamentals, part model and

part judgment.

Factors Influencing Fx Rates

The government to control its foreign exchange rates uses the interest rates.

The three key factors affecting interest rates are:

The supply and demand for money

The rate of inflation

Government interventions

There are a number of other factors which have both long and short term influences on

exchange rates which also need to be considered for a complete picture. These influences can

be grouped broadly as shown in the following diagram:

Economic

Influences on

Exchange rate

Political

People


Economic Factors

In this category there are four factors to be considered:

Relative interest rates

Purchasing power parity (PPP)

Economic conditions

Supply and demand for capital

Relative Interest Rates

Large investors can easily switch investments between different currencies so it is important

for them to compare the returns from investments in different currencies to make sure they

obtain the best investment performances.

If an investor can receive a higher interest rate by lending money in a foreign currency than

he can by lending money in his domestic currency, it makes sense for that investor to lend in

the foreign currency.

Comparing interest rates in different currencies in this way is called comparing relative

interest rates.

However, as the FX rate may vary over the tenor of the loan, the investor is exposed to the

risk that the foreign currency may be depreciate against the domestic currency by more than

the difference between the two interest rates. In this case, the investor will make a loss by

lending in foreign currency.

In fact, currencies with higher interest rates tend to appreciate against other currencies

because more investors buy the high –interest currency in order to chase the higher returns.


Purchasing Power Parity (PPP)

Purchasing power parity is the measure of the relative purchasing power of different

currencies. It is measured by the price of the same goods in different countries, translated by

the FX rate of that country’s currency against a ‘base currency’, usually the dollar. The

concept behind purchasing power parity is that if goods are cheap in one country it pays to

export them to another country where they are more expensive.

If the equivalent amount of currency purchases exactly the same amount of goods in every

country then international trade is no longer profitable. That is, every currency is in

purchasing power parity.

Economic Conditions

FX exchange rates are affected in the long-term by a country’s economic conditions and

trends such as:

Balance of payments

Economic growth

Rate of inflation

Money supply

Unemployment figures

Rates of taxation


Supply and demand for capital

Capital flows to a country where investors see opportunities. Some countries need capital and

offer appropriate interest rates – others have a surplus of money and so have lower interest

rates.

However, investors do no always invest purely for high interest rate returns. For example,

Japanese car and electronic manufacturers have invested in manufacturing operations in the

USA and Europe to overcome tariff and quota problem.

In short-term normal business activities affect the supply and demand for capital.

Political Factors

Foreign exchange rates can be affected in the long and short term by political factors such as:

The type of economic policies pursued by the government

The amount of uncertainty in the political situation

The regulatory policies followed by central banks and/or other regulatory bodies

Central bank intervention in the FX market to strengthen or weaken its currency

Market Sentiment

Short term changes in FX rates are often a result of what market participants call market

sentiment. This is the perception traders have of the short term prospects for the movement

in the currency.


Market sentiment is usually said to be ‘positive’ or ‘negative’. A currency will normally

strengthen relative to other currencies on positive sentiment and weaken relative on other

currencies on negative sentiment.

Traders act as news about a given economy. Often, traders will anticipate a news report or

significant government announcement by buying and selling the currency before the news is

actually reported. Sentiment affects how the currency moves when the news really breaks.

For example, if the market sentiment is positive ahead of the Government’s announcements

of GDP figures, the currency will probably rise in anticipation of the figures being

announced. If the government’s GDP figure is less than the market was expecting, the

currency will fall, even if the GDP figure is still good news for the economy.

Technical Analysis

Many market participants trade on the basis of past price movements. This is because they

believe past market moves, rather than economic fundamentals or news, predict future

market moves.

This practice is called technical analysis. Technical analysis highlights the trends in the

market based on the assumption that market participants will react in the same way today as

they did in the past.


INTEREST RATE SWAPS

An IRS can be defined as an exchange between two parties of interest rate obligations

(payments of interest) or receipts (investment income) in the same currency on an agreed

amount of notional principal for an agreed period of time.

The most common type of interest rate swaps are the "plain vanilla" IRS. Currently, these are

the only kind of swaps that are allowed by the RBI in India. Dealing in `Exotics' or advanced

interest rate swaps have not been permitted by the RBI.

In a plain vanilla swap, one party agrees to pay to the other party cash flows equal to the

interest at a predetermined fixed rate on a notional principal for a number of years. In

exchange, the party receiving the fixed rate agrees to pay the other party cash flows equal to

interest at a floating rate on the same notional principal for the same period of time.

Moreover, only the difference in the interest payments is paid/received; the principal is used

only to calculate the interest amounts and is never exchanged.

An example will help understand this better:

Consider a swap agreement between two parties, A and B. The swap was initiated on July 1,

2001. Here, A agrees to pay the 3 month NSE-MIBOR rate on a notional principal of Rs. 100

million, while B pays a fixed 12.15% rate on the same principal, for a tenure of 1 year.

We assume that payments are to be exchanged every three months and the 12.15% interest

rate is to be compounded quarterly. This swap can be depicted diagrammatically as shown

below:


An interest rate swap is entered to transform the nature of an existing liability or an asset. A

swap can be used to transform a floating rate loan into a fixed rate loan, or vice versa.

BENEFITS FROM SWAPPING

a) Swap for a comparative advantage

Comparative advantages between two firms arise out of differences in credit rating, market

preferences and exposure.

Example: Say, Firm A with high credit rating can borrow at a fixed rate of 12% and at a

floating rate of MIBOR + 20 bps. Another firm B with a lower credit rating can borrow at a

fixed rate of 14 % and a floating rate of MIBOR + 150 bps.

Party Fixed Rate Loan Floating Rate Loan

A 12% MIBOR + 0.20%

B 14% MIBOR + 1.50%

Firm A has an absolute advantage over firm B in both fixed and floating rates. Firm B pays

200 bps more than firm A in the fixed rate borrowing and only 120 bps more than A in the

Party A Party B

MIBOR (3m)

12.5%


floating rate borrowing. So, firm B has a comparative advantage in borrowing floating rate

funds.

Now, Firm A wishes to borrow at floating rates and becomes the floating rate payer in the

swap arrangement. However, A actually borrows fixed rate funds in the cash market. It is the

interest rate obligations on this fixed rate funds, which are swapped. At the same time, B

wishes to borrow at a fixed rate, and thus will actually borrow from the market at the floating

rate.

Then, both the parties will exchange their underlying interest rate exposures with each other

to gain from the swap. The calculation of the gain from the swap is shown below:

The gain to firm A, because it borrows in the fixed rate segment is:

14% - 12% = 200 bps.

And, the loss because firm B borrows in the floating rate segment is:

(MIBOR + 20 bps) (MIBOR + 120 bps) = 130 bps.

Thus, the net gain in the swap = 200 120 = 70 bps. The firms can divide this gain equally.

Firm B can pay fixed at 12.15% to firm A and receive a floating rate of MIBOR as illustrated

below:


Effective cost for firm A = 12% + (MIBOR 12.15)

= MIBOR - 15 bps

This results into a net gain of ((MIBOR + 20) - (MIBOR - 15)) i.e., a gain of 35 bps.

Effective cost for firm B = (MIBOR + 150) + (12.15% - MIBOR)

= 13.65%

This results into a gain of (14% - 13.65%) i.e., a gain of 35 bps.

Thus, both the parties gain from entering into a swap agreement.

b) Swap for Reducing Cost of Borrowing

With the introduction of rupee derivatives, the Indian corporates can attempt to reduce their

cost of borrowing and thereby add value. A typical Indian case would be a corporate with a

high fixed rate obligation.

MIPL, an AAA rated corporate, 3 years back had raised 4-year funds at a fixed rate of

18.5%. Today a 364-day T-bill is yielding 10.25%, as the interest rates have come down. The

3-month MIBOR is quoting at 10%.

Party A Party B

MIBOR (3m)

12.5%

12% MIBOR + 150 bps


Fixed to floating 1 year swaps are trading at 50 bps over the 364 day T- bill vs. 6-month

MIBOR.

The treasurer is of the view that the average MIBOR shall remain below 18.5% for the next

one year. The firm can thus benefit by entering into an interest rate fixed for floating swap,

whereby it makes floating payments at MIBOR and receives fixed payments at 50 bps over a

364-day treasury yield i.e. 10.25 + 0.50 = 10.75 %.

The effective cost for MIPL= 18.50 + MIBOR - 10.75

= 7.75 + MIBOR

At the present 3m MIBOR is 10%, the effective cost is = 10 + 7.75 = 17.75%

The gain for the firm is (18.5 - 17.75) = 0.75 %

The risks involved for the firm are:

Default/credit risk of party B: Since the counterparty is a bank, this risk is much lower

than would arise in the normal case of lending to corporates. This risk involves losses to

the extent of the interest rate differential between fixed and floating rate payments.

MIPL Party B

10.75% MIBOR

MIBOR (3m)

18.5%


The firm is faced with the risk that the MIBOR goes beyond 10.75%. Any rise beyond

10.75% will raise the cost of funds for the firm. Therefore it is very essential that the

firm hold a well-suggested view that MIBOR shall remain below 10.75%. This will

require continuous monitoring.

How does the bank benefit out of this transaction?

The bank either goes for another swap to offset this obligation and in the process earn a

spread. The bank may also use this swap as an opportunity to hedge its own floating liability.

The bank may also leave this position uncovered if it is of the view that MIBOR shall rise

beyond 10.75%.

CURRENCY SWAP TRANSACTION PROCESS

It may be noted that transaction-taking place in currency swaps are done in exactly the

same manner as in the case of Interest Rate Swaps. The only difference is that in

Interest Rate Swaps the underlying asset is interest rate while in case of Currency

Swaps the underlying asset is that specified currency.

Thus, here we need not see the swapping process all over again. It may be referred to in

the Fixed Income Derivatives part of the project.


BENEFITS OF CURRENCY SWAPS

To mange the exchange rate risk

To lower financing cost

To access restricted markets

The international trade implies returns and payments in a variety of currencies whose relative

values may fluctuate it involves taking foreign exchange risk. All the players, namely, FIs,

banks, exchange dealers, etc are facing the risk. A key question facing the players then is

whether these exchange risks are so large as to affect their business. A related question is

what special strategies should be followed to reduce the impact of foreign exchange risk. One

way to minimize the long-term risk of one currency being worth more or less in the future is

to offset the particular cash flow stream with an opposite flow in the same currency. The

currency swap helps to achieve this without raising new funds; instead it changes existing

cash flows.


THE FX DEAL

A foreign exchange deal may be defined as:

It’s a contract wherein one party (country,fiis,fdis) Exchange with other party in the global

market.

Foreign Exchange Markets are OTC operating worldwide, with trading hours overlapping to

make a 24 hour global market.

The principal components of a deal are:

Trade date

Counterparty

Currencies

Exchange rate

Amounts

Value date

Payment instructions


THE FX MARKETS AT WORK

The Dealing Arena

The range of products available in the FX market has increased dramatically over the last 30

years. Dealers at banks provide these products for their clients to allow them to invest,

speculate or hedge.

The complex nature of these products , combined with huge volumes of money that are being

traded, mean banks must have three important functions set up in order to record and monitor

effectively their trades.

Front Office/Dealing Room

This is where OTC trading in financial markets takes place

Middle Office

This provides the dealers with specialist facilities, support, advice and guidance from risk

managers, economists, technical analysis, legal advisers etc.

Back Office

This is where the processing, confirmation, settlement, query handling and cash management

functions are carried out. It is important to remember that dealers cannot trade without back

office.


WORKING OF FOREIGN EXCHANGE MARKET

Banks will generally lend their customers money in any currency they demand. Thus, banks

regularly have to participate in the foreign exchange market to buy and sell the currencies

they are lending or receiving.

In order that banks may deal quickly and efficiently in the FX market, there is an inter bank

market, in which banks may buy and sell currencies in wholesale amounts.

However, the bulk of FX trading is not directly related to international trade or investment.

Most FX trading is carried out inter bank and is for profit.

The main methods of trading FX are via:

Direct inter bank

Voice brokers

Electronic broking system

Most FX dealers specialize in one or a small group of closely related currencies.

A liquidly in major currency is good but some of more ‘exotic’ currencies can be thinly

traded. The US dollar remains the major currency in FX terms with over 90% of world trade

being settled in USD. In 1995 the USD was involved in 86% of FX transactions world-wide.

Foreign exchange rates and interest rates are closely linked and affect one another, and in

turn both can make an impact on a country’s domestic economy.


The FX rate also affects a country’s balance of payments – the net amount of inflows and

outflows of money from a country in relation to trade payments. A strong domestic currency

makes imports cheaper and tends to stimulate demand for imports, resulting in a balance of

payments deficit. Conversely, a weak currency makes imports expensive and dampens

demand for imports, resulting in a balance of payments surplus.


The Participants In Foreign Exchange Markets

CUSTOMERS

The customers who are engaged in foreign trade participate in foreign exchange

markets by availing of the services of banks. For example, Exporters require

converting the dollars in to rupee and importers require converting rupee in to the

dollars, as they have to pay in dollars for the goods/services they have imported.

COMMERCIAL BANKS

They are most active players in the Forex market. Commercial banks dealing with

international transactions offer services for conversion of one currency in to another.

They have wide network of branches. Typically banks buy foreign exchange from

exporters and sells foreign exchange to the importers of the goods. As every time the

foreign exchange bought and sold may not be equal banks are left with the

overbought or oversold position. The balance amount is sold or bought from the

market.

Nowadays, in international foreign exchange markets, the international trade turnover

accounts for a fraction of huge amounts dealt, i.e. bought and sold. The balance

amount is accounted for either by financial transactions or speculation. Banks have

enough financial strength and wide experience to speculate the market and banks does

so. Which is popularly known as the trading in the Forex market.

Commercial banks have following objectives for being active in the foreign exchange

markets.

They render better service by offering competitive rates to their customers engaged in

international trade;


They are in a better position to manage risks arising out of exchange rate fluctuations;

Foreign exchange business is a profitable activity and thus such banks are in a

position to generate more profits for themselves;

They can manage their integrated treasury in a more efficient manner.

In India Reserve Bank of India has given license to the commercial banks to deal

in foreign exchange under section 6 Foreign Exchange Regulation Act, 1973,

who are called the Authorized Dealers (A Ds).

CENTRAL BANK

In all countries central banks have been charged with the responsibility of

maintaining the external value of the domestic currency. Generally this is

achieved by the intervention of the bank. Apart from this central banks deal in

the foreign exchange market for the following purposes:

Exchange rate management: It is achieved by the intervention though

sometimes banks have to maintain external rate of the domestic currency at a

level or in a band so fixed.

Reserve management: Central bank of the country is mainly concerned with

the investment of countries foreign exchange reserve in a stable proportions in

range of currencies and in a range of assets in each currency. For this bank has

to involve certain amount of switching between currencies.

EXCHANGE BROKERS

Forex brokers play a very important role in the foreign exchange markets. However

the extent to which services of Forex brokers are utilized depends on the tradition and

practice prevailing at a particular Forex market center. In India as per FEDAI

guidelines the ADs are free to deal directly among themselves without going through


brokers. The Forex brokers are not allowed to deal on their own account all over the

world and also in India.

HOW EXCHANGE BROKERS WORK?

Banks seeking to trade display their bid and offer rates on their respective pages of

Reuters's screen, but these prices are indicative only. On inquiry from brokers they

quote firm prices on telephone. In this way, the brokers can locate the most

competitive buying and selling prices, and these prices are immediately broadcast to a

large number of banks by means of hotlines / loudspeakers in the banks dealing

room / contacts many dealing banks through calling assistants employed by the

broking firm. If any bank wants to respond to these prices thus made available, this is

done by counterparty bank by clinching the deal. Brokers do not disclose

counterparty bank's name until the buying and selling banks have concluded the deal.

Once the deal is struck the broker exchange the names of the bank who has bought

and who has sold. The brokers charge commission for the services rendered.

In India broker's commission bas been fixed by FEDAI.

OVERSEAS FOREX MARKETS

Today the daily global turnover is estimated to be more than US $ 1.5 trillion a day.

The international trade however constitutes hardly 5 to 7 % of this total turnover. The

rest of trading in world Forex markets is constituted of financial transactions and

speculation. As we know that the Forex market is 24-hour market, the day begins

with Tokyo and thereafter Singapore opens, thereafter India, followed by Bahrain,

Frankfurt, Paris, London, New York, Sydney, and back to Tokyo.


SPECULATORS

The speculators are the major speculators in the Forex market .

Banks dealing are the major speculators in the Forex markets with a view to make

profit on account of favorable movement in exchange rate, take position i.e. if

they feel that rate of particular currency is likely to go up in short term. They buy

that currency and sell it as soon as they are able to make quick profit.

Corporations' particularly Multinational Corporation and transnational

corporations having business operations beyond their national frontiers and on

account of their cash flows being large and in multi currencies get in to foreign

exchange exposures. With a view to make advantage of exchange rate movement

in their favor they either delay covering exposures or do not cover until cash flow

materialize. Sometimes they take positions so as to take advantage of the

exchange rate movement in their favor and for undertaking this activity, they have

state of the art dealing rooms. In India, some of the big corporate are as the

exchange control have been loosened, booking, and canceling forward contracts,

and at times the same borders on speculative activity.

Governments borrow or invest in foreign securities and delay coverage of the

exposure on account of such deals.

Individuals like share dealings also undertake the activity of buying and selling of

foreign exchange for booking short-term profits. They also buy foreign currency

stocks, bonds and other assets without covering the foreign exchange exposure

risk. This also results in speculations.

Corporate entities take positions in commodities whose price are expressed in

foreign currency. This also adds to speculative activity.


FOREIGN EXCHANGE EXPOSURE

Foreign exchange risk is related to the variability of the domestic currency values of assets,

liabilities or operating income due to unanticipated changes in exchange rates, whereas

foreign exchange exposure is what is at risk.

Foreign currency exposures and the attendant risk arises whenever a business has an income

or expenditure or an asset or liability in a currency other than that of the balance-sheet

currency. Indeed exposures can arise even for companies with no income, expenditure, asset

or liability in a currency different from the balance-sheet currency.

When there is a condition prevalent where the exchange rates become extremely volatile the

exchange rate movements destabilize the cash flows of a business significantly. Such

destabilization of cash flows that affects the profitability of the business, is the risk from

foreign currency exposures.

TYPES OF EXPOSURES

Financial economists distinguish between three types of currency exposures - transaction

exposures, translation exposures, and economic exposures. All three affect the bottom- line

of the business.

TRANSACTION EXPOSURE

Suppose that a company is exporting deutsche mark and while costing the transaction had

reckoned on getting say Rs 24 per mark. By the time the exchange transaction materializes

i.e. the export is effected and the mark sold for rupees, the exchange rate moved to say Rs 20

per mark. The profitability of the export transaction can be completely wiped out by the

movement in the exchange rate. Such transaction exposures arise whenever a business has

foreign currency denominated receipt and payment. The risk is an adverse movement of the


exchange rate from the time the transaction is budgeted till the time the exposure is

extinguished by sale or purchase of the foreign currency against the domestic currency.

TRANSLATION EXPOSURE

Translation exposure arises from the need to "translate" foreign currency assets or liabilities

into the home currency for the purpose of finalizing the accounts for any given period. A

typical example of translation exposure is the treatment of foreign currency borrowings.

Consider that a company has borrowed dollars to finance the import of capital goods worth

Rs 10000. When the import materialized the exchange rate was say Rs 30 per dollar. The

imported fixed asset was therefore capitalized in the books of the company for Rs 300000.

In the ordinary course and assuming no change in the exchange rate the company would have

provided depreciation on the asset valued at Rs 300000 for finalizing its accounts for the year

in which the asset was purchased.

If at the time of finalization of the accounts the exchange rate has moved to say Rs 35 per

dollar, the dollar loan has to be translated involving translation loss of Rs50000. The book

value of the asset thus becomes 350000 and consequently higher depreciation has to be

provided thus reducing the net profit.

ECONOMIC EXPOSURE

An economic exposure is more a managerial concept than a accounting concept. A company

can have an economic exposure to say Yen: Rupee rates even if it does not have any

transaction or translation exposure in the Japanese currency. This would be the case for

example, when the company's competitors are using Japanese imports. If the Yen weekends

the company loses its competitiveness (vice-versa is also possible).

The company's competitor uses the cheap imports and can have competitive edge over the

company in terms of his cost cutting. Therefore the company's exposed to Japanese Yen in an

indirect way.


In simple words, economic exposure to an exchange rate is the risk that a change in the rate

affects the company's competitive position in the market and hence, indirectly the bottom-

line. Broadly speaking, economic exposure affects the profitability over a longer time span

than transaction and even translation exposure. Under the Indian exchange control, while

translation and transaction exposures can be hedged, economic exposure cannot be hedged.


Models And Theories Of Exchange Rate

Purchasing Power Parity Theory(PPP)

Purchasing Power Parity Theory was pronounced by Prof. Gustav Cassel. The theory

argues that exchange rate movements primarily reflect differences in inflation rates

between countries. It advocated that currencies are valued for what they can buy and

the currencies had no intrinsic value attached to it. Therefore, under this theory the

exchange rate was to be determined and the sole criterion being the purchasing power

of the countries. As per this theory if there were no trade controls, then the balance of

payments equilibrium would always be maintained. Examining the real exchange

rate, ePf /P, the theory maintains the following

When Pf and /or P changes, e changes in such a way as to maintain ePf /P constant.

Where, P is the domestic price, Pf is the foreign price level and e is the exchange

rate.

PPP is a plausible description of the trend behaviour of exchange rates, especially

when inflation differentials between the countries are large. This theory does hold in

the case of an increase in the money stock.

However, in this theory some factors like the methods of production, the consumer

preferences, transportation costs and the existence of trade controls was overlooked

Influence of non-monetary disturbances affecting exchange rates was totally ignored.


The Mundell Fleming Model: Perfect Capital Mobility

Robert Mundell and Marcus Fleming, extended the standard IS-LM model to the

open economy under perfect capital mobility. It is advocated that under fixed

exchange rates and perfect capital mobility, a country cannot pursue an independent

monetary policy. Interest rates cannot move out of line with those prevailing in the

world market. Any attempt at independent monetary policy leads to capital flows and

a need to intervene until interest rates are back in line with those in the world market.

Under perfect capital mobility the slightest interest differential provokes infinite

capital flows. It follows that with perfect capital mobility, central banks cannot

conduct an independent monetary policy under fixed exchange rate system. It tightens

the monetary policy, and interest rates rise resulting in portfolio changes. As a result

of huge capital inflow, the balance of payments shows huge surplus. The foreigners

tend to buy domestic assets, appreciating the exchange rate and forcing the central

bank to intervene to hold the exchange rate constant. This intervention results in

increase in home currency stocks. As a result, the initial monetary contraction is

reversed and the process ends when home interest rates have been pushed back to the

initial level. The following is represented by Figure 1 below.

Figure 1: Monetary Expansion Under Fixed Rates And Perfect Capital Mobility

Extending this model to flexible exchange rate system, the absence of central bank

intervention implies a zero balance of payments. Any current account deficit must be


financed by private capital inflows: a current account surplus is balanced by capital

outflows. Adjustments in the exchange rate ensure that the sum of the current and

capital accounts is zero.

Dornbush Theory on Monetary Expansion: Short and Long term effects

With given prices a monetary expansion under flexible rates and perfect mobility

leads to depreciation and increased income. However when adjustments in prices are

taken into consideration, the output increase is transitory. In the long un a monetary

expansion leads to an exchange depreciation and to higher prices with no change in

competitiveness. The important feature of the adjustment process is that exchange

rate and prices do not move at the same rate. When a monetary expansion pushes

interest rates down, the exchange rate adjusts immediately but prices adjust only

gradually. Monetary expansion therefore leads in the short run to an immediate and

abrupt change in relative prices and competitiveness.

Table 2: Effects of Monetary Expansion

Exchange Rate Price ePf /P Output

Short run+ 0 + +

Long run + + 0 0

The exchange rate overshoots its new equilibrium level when, in response to a

disturbance, it first moves beyond the equilibrium it ultimately will reach and then

gradually returns to the long-run equilibrium position. Here, overshooting means that

changes in monetary policy produce large changes in exchange rates.

An application of the above-described models in the real life has been discussed

below based on a model developed by some experts.


RBI’s Intervention in Foreign Exchange Market

An Econometric Analysis

By

1. Sumon Kumar Bhaumik

2. Hiranya Mukhopadhyay

The objective of this study was to

Derive a reduces form specification that will allow us to link a central bank’s

direct interventions in the foreign exchange market with changes in the

country’s exchange rate

We would test this relationship with the Indian data to see whether indeed the

magnitude of an offset is significant.

The model owes its origin to the Keynes-Mundell-Fleming (KMF) model. The

endogenous variables of the model are Y, r and e. The extent of any change in the

value of foreign exchange reserves with the central bank is perfectly correlated with

the amount of dollars that the bank buys and sells in the foreign exchange market.

Once the central bank purchases dollars from the foreign exchange market, the

exchange rate depreciates. As e depreciates, ceteris paribus, trade balances improve

and hence there is an increase in the effective demand facing the economy.

Moreover, a rise in income leads to higher imports, and the initial improvement in

trade balance is dampened. At the same time, the inflow of dollars from foreign

investors too tends to rise, dampening the initial downward pressure on account of

depreciation of the exchange rate.


To relate to the Indian context, monthly data on net purchase of foreign exchange by

RBI, expressed in dollars, and monthly exchange rates of US Dollars (e), expressed as

rupees per dollar.36 data points have been considered.

The conclusion derived is that in response to an appreciation of the rupee vis-à-vis

other currencies, if there is an increase in the net purchase of dollars by the RBI,

change in e will decrease, indicating that the rupee will appreciate further. In other

words, the effect of the RBI’s direct intervention in the foreign intervention in the

foreign exchange market is more than offset by the impact of the intervention on the

macro-economic variables, which, in turn, influence capital flows and nominal

exchange rates.

Annexure 2 gives the data regarding the RBI intervention in Indian markets.

ARIMA

MAPE 0.37715

Thiel’s U 0.01002

Simple

Moving

Avg

Double

Moving Avg

Single

Exponen

Smoothen

Brown’s

Method

Holt’s

Method

Winter’s

Method

MSE 4.327164 4.513591 3.566822 2.912831 3.258937 408.8397

MAPE 1.882539 1.950541 1.702292 0.015037 1.528195 22.32619


Forecasting

NET EFFECTIVE EXCHANGE RATE (NEER)

Performance over the past five years

NEER is a good indicator of the exchange rate of the country. It is a multi-lateral

measurement of the exchange rate of the Rupee, which depends on the trade based

weights of five countries.

Trends in the movement of NEER from 1993 April to February 1999 are illustrated in

Table 2 on the next page. This is in effect the performance of the NEER after the

implementation of the Modified Liberalized Exchange Rate Management System

(Modified – LERMS) with effect from 1st March 1993.

The performance of the NEER makes a good study of the effect of the policies on the

exchange rate after April 1993.


Foreign Exchange Rate Forecasting

Forecasting foreign exchange rates is important for treasury and forex managers as it

reduces the uncertainties associated with commitments to accept or to make payments

in foreign currencies with short-term and long-term investment decisions, with

financing decisions and with income earned in foreign currencies. It is also important

for a forex manager to understand the intricacies and the limitations of forecasting

foreign exchange rates as it helps them to utilize the alternate avenues to manage

exchange rate risk. Though an intra-day forecast of the exchange rate is not possible,

but the direction and magnitude of change in longer term can be forecasted with a fair

degree of accuracy. Exchange rate forecasts also help to:

Analyze attractiveness of foreign borrowings;

Plan investments in foreign countries;

Plan long-term export-import strategy;

Manage exchange rate risks and plan hedging strategies.

Now, the exchange rate between two currencies could be either fluctuating or fixed.

Logically, forecast for fluctuating exchange rates only would be required by treasury

manager, as fixed rates are more or less kept within a narrow band by intervention of

the two governments.

Techniques of forecasting Exchange rate

There are several techniques available to forecast future rates. These can be classified under

following categories:

1. Forward rates as short-term forecasters.

2. Technical Analysis


3. Economic Models.

Forward Rates as Short-term forecasters . Forward rates are

sometimes used to predict future spot rates. Banks act as clearing houses for

both forward and spot contracts. Firms generally anticipate future spot rate:

The evaluation of any forecasts can be done based on two criteria.

1. Accurate Forecast Indicator: If the future values are forecasted accurately

every time with minor forecast errors, then it is an accurate forecast indicator.

2. Unbiased Forecast Indicator: An unbiased estimator is one, which can

overestimate the value as much with the same probability as it can

underestimate which implies that positive errors are as much probable as

negative errors. If the forecasts are done accurately on an average they are

called unbiased forecasts.


Foreign Exchange Rate Forecasting with Technical Analysis

Forecasting future exchange rates with the use of past exchange rate movements is called

technical analysis. The forecasters are called technicians. Economic factors such as inflation

rates, interest rates, balance of payments and political stability are ignored by pure

technicians. The pure technicians believe that clues in the past movements lead them to the

future. A technician believes that exchange rate movements are mechanistic and are not

caused by economic and political changes. Technicians develop their own forecasts about

future currency values and each technician has his individual method.

There are many methods used by technicians such as sophisticated statistical models, charts

of past exchange rate movements etc. Some technicians use historical data from primary

analysis and then recommend the client in an informal fashion by keeping in view the

economic and political factors.

Evaluation of technical Forecasts

Economists do not like technical analysis, as it does not obey the principles of economics.

The logical explanation given by economists in support of their view is that according to

efficient market hypothesis, prices reflect all available information. In an efficient forex

market, the impact of available information is already reflected in the present rates, therefore,

forecasts based on historical data do not help develop accurate forecasts.

Economic research indicates that forex movements follow a pattern of random walk, which

implies that a specific present change is unrelated to past changes and therefore a forecast is

not possible. The explanation given by economists is that current exchange rates change with

the unforeseeable events. The unforeseeable events occur in random fashion and hence

exchange rate changes follow a random pattern.

Technical analysts assert that their approach works and it is very difficult to disapprove their

assertions. The evaluation of technical forecasts is difficult because it works at times. To


prove the efficiency of technical forecasts, it is necessary to prove them to be superior to

other methods over a period of time. This is not possible as at a given time, the technical

analysis has proved to be superior.

Technical forecasts arte often used in conjunction with economic model based forecasts, but

technical forecasts are widely used by speculators in the forex markets to book quick profits

since technical forecasts emphasize on short-term exchange rates.

We have made a forecast of the NEER, which was shown in the previous chapter, using

various time-series techniques. These time-series techniques are technical forecasts and their

accuracy can be studied by sing MAPE, MSE and Thiel’s statistic. In the tables given below,

the different techniques and their respective MAPE, MSE and Thiel’s statistics are given.

ARIMA

MAPE 0.37715

Thiel’s U 0.01002

Simple

Moving

Avg

Double

Moving Avg

Single

Exponen

Smoothen

Brown’s

Method

Holt’s

Method

Winter’s

Method

MSE 4.327164 4.513591 3.566822 2.912831 3.258937 408.8397

MAPE 1.882539 1.950541 1.702292 0.015037 1.528195 22.32619


Exchange rate forecasting with Economic Models

The difference between technical analysis and economic forecasting is that economic

forecasting is based on established and verified economic relationships such as BoP,

inflation, interest rates, etc.

The approach adopted is cause and effect approach. For example, in case of inflation

rate, we know that inflation rates affect future exchange rates. Future exchange rates

can be forecasted by forecasting inflation rate. The statistical models work by

establishing a relationship between future exchange rates and the variables that affect

future exchange rates. Usually, as it involves more than two variables, a multiple

regression analysis based on statistical models is done. In any forecasting model, the

future exchange rate is a dependent variable as it depends on various economic

indicators. These indicators such as BOP, inflation, and interest rates are independent

variables. The accuracy of the predicted changes in the independent variables and the

gathering of accurate historical data on the variables such as inflation, GNP is

difficult. In case of three or four variables gathering historical information for a

specific period for all the variables is also difficult. There is a difference of opinion in

inclusion and exclusion of variables. Any statistical model does not give fruitful

results unless political factors and impact of news are quantified. It also requires for a

good forecast to predict the future direction and extent of government intervention.

The superiority of a forecasting model depends on its accuracy over market forecast.

If some forecasts are superior to others its advantage is quickly eliminated by the

market forces as they act favorably towards the forecasts and brings the price to the

forecasted level if it is an efficient market. If a firm develops a superior forecast it is

not sufficient to gain from it. A firm should have enough capital to materialize the

gains out of its forecast. So, it will be advantageous to firms to keep abreast of the


latest information regarding economic indicators such as BOP, inflation rates, interest

rates etc.


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of the newest ways to trade forex, these “fx” trading

signals are delivered maintaining a simple and natural

structure that’s easy-to-understand. The InciteFX™

program’s signals are organized with just enough

information so you can make very basic, well-

informed trades.

http://www.gftforex.com/products/incitefx/index.asp%00%E5%A1%B9%EF%92%81%E1%B4%BB%E4%A1%BF%E2%B2%AF%E5%B6%82%E8%97%84%E6%8C%A7%00%00%EA%AE%A5

FOREX

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Transcript of FOREX