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INTRODUCTIONForeign exchange risk (also known as FX risk, exchange rate risk or currency risk) is a financial risk that exists when a financial transaction is denominated in a currency other than that of the base currency of the company. Foreign exchange risk also exists when the foreign subsidiary of a firm maintains financial statements in a currency other than the reporting currency of the consolidated entity. The risk is that there may be an adverse movement in the exchange rate of the denomination currency in relation to the base currency before the date when the transaction is completed. Investors and businesses exporting or importing goods and services or making foreign investments have an exchange rate risk which can have severe financial consequences; but steps can be taken to manage (i.e., reduce) the riskThis risk usually affects businesses that export and/or import, but it can also affect investors making international investments.For example, if money must be converted to another currency to make a certain investment, then any changes in the currency exchange ratewill cause that investment's valueto either decrease or increase when the investment is sold and converted back into the original currency.In todays world no economy is self-sufficient, so there is need for exchange of goods and services amongst the different countries. So in this global village, unlike in the primitive age the exchange of goods and services is no longer carried out on barter basis. Every sovereign country in the world has a currency that is legal tender in its territory and this currency does not act as money outside its boundaries. So whenever a country buys or sells goods and services from or to another country, the residents of two countries have to exchange currencies. So we can imagine that if all countries have the same currency then there is no need for foreign exchange.

NEED FOR FOREIGN EXCHANGE

Let us consider a case where Indian company exports cotton fabrics to USA and invoices the goods in US dollar. The American importer will pay the amount in US dollar, as the same is his home currency. However the Indian exporter requires rupees means his home currency for procuring raw materials and for payment to the labor charges etc. Thus he would need exchanging US dollar for rupee. If the Indian exporters invoice their goods in rupees, then importer in USA will get his dollar converted in rupee and pay the exporter.

From the above example we can infer that in case goods are bought or sold outside the country, exchange of currency is necessary.

Sometimes it also happens that the transactions between two countries will be settled in the currency of third country. In that case both the countries that are transacting will require converting their respective currencies in the currency of third country. For that also the foreign exchange is required. If we would have the single currency all in the world, then we wouldnt need forex...because each country has its own politics or several together, and each of the country has its own incomes and outcomes etc.

PARTICIPANTS IN FOREIGN EXCHANGE MARKET

1. CUSTOMERSThe customers who are engaged in foreign trade participate in foreign exchange market by availing of the services of banks. Exporters require converting the dollars in to rupee and imporeters require converting rupee in to the dollars, as they have to pay in dollars for the goods/services they have imported

2. COMMERCIAL BANKS They are most active players in the forex market. Commercial bank dealing with international transaction, 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 goods. As every time the foreign exchange bought or oversold position. The balance amount is sold or bought from the market.

3. CENTRAL BANK In all countries Central bank 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.

4. EXCHANGE BROKERSForex brokers play very important role in the foreign exchange market. However the extent to which services of foreign brokers are utilized depends on the tradition and practice prevailing at a particular forex market center. In India as per FEDAI guideline the ADs are free to deal directly among themselves without going through brokers. The brokers are not among to allowed to deal in their own account allover the world and also in India

5. OVERSEAS FOREX MARKETToday 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 market is constituted of financial transaction 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.

6. SPECULATORSThe speculators are the major players in the forex market.Bank dealing are the major speculators in the forex market 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 go up in short term. They buy that currency and sell it as soon as they are able to make quick profit.

The Functions of the Foreign Exchange Market1. The foreign exchange market serves two functions: converting currencies and reducing risk. There are four major reasons firms need to convert currencies.2. First, the payments firms receive from exports, foreign investments, foreign profits, or licensing agreements may all be in a foreign currency. In order to use these funds in its home country, an international firm has to convert funds from foreign to domestic currencies.3. Second, a firm may purchase supplies from firms in foreign countries, and pay these suppliers in their domestic currency.4. Third, a firm may want to invest in a different country from that in which it currently holds underused funds.5. Fourth, a firm may want to speculate on exchange rate movements, and earn profits on the changes it expects. If it expects a foreign currency to appreciate relative to its domestic currency, it will convert its domestic funds into the foreign currency. Alternately stated, it expects its domestic currency to depreciate relative to the foreign currency. An example similar to the one in the book can help illustrate how money can be made on exchange rate speculation. The management focus on George Soros shows how one fund has benefited from currency speculation.6. Exchange rates change on a daily basis. The price at any given time is called the spot rate, and is the rate for currency exchanges at that particular time. One can obtain the current exchange rates from a newspaper or online.7. The fact that exchange rates can change on a daily basis depending upon the relative supply and demand for different currencies increases the risks for firms entering into contracts where they must be paid or pay in a foreign currency at some time in the future.8. Forward exchange rates allow a firm to lock in a future exchange rate for the time when it needs to convert currencies. Forward exchange occurs when two parties agree to exchange currency and execute a deal at some specific date in the future. The book presents an example of a laptop computer purchase where using the forward market helps assure the firm that will won't lose money on what it feels is a good deal. It can be good to point out that from a firm's perspective, while it can set prices and agree to pay certain costs, and can reasonably plan to earn a profit; it has virtually no control over the exchange rate. When spot exchange rate changes entirely wipe out the profits on what appear to be profitable deals, the firm has no recourse.9. When a currency is worth less with the forward rate than it is with the spot rate, it is selling at forward discount. Likewise, when a currency is worth more in the future than it is on the spot market, it is said to be selling at a forward premium, and is hence expected to appreciate. These points can be illustrated with several of the currencies.10. A currency swap is the simultaneous purchase and sale of a given amount of currency at two different dates and values.

EXCHANGE RATE SYSTEMINTRODUCTIONCountries of the world have been exchanging goods and services amongst themselves. This has been going on from time immemorial. The world has come a long way from the days of barter trade. With the invention of money the figures and problems of barter trade have disappeared. The barter trade has given way ton exchanged of goods and services for currencies instead of goods and services.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 pound against rupees at fixed rates. The interbank 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.Different countries have adopted different exchange rate system at different time. The following are some of the exchange rate system followed by various countries.THE GOLD STANDARDMany countries have adopted gold standard as their monetary system during the last two decades of the 19th century. This system was in vogue till the outbreak of World War. Under this system the parties of currencies were fixed in term of gold. There were two main types of gold standard:1) gold specie standardGol