1. Unit-1
PAYMENT INSTRUMENTS
Payment instruments are an essential part of payment systems. Payment cards, credit transfers, direct
debits and cheques are non-cash payment instruments with which end-users of payment systems
transfer funds between accounts at banks or other financial institutions.
The safety and efficiency of payment instruments are important for both maintaining confidence in the
currency and keeping the economy running smoothly. The risks in the provision and use of payment
instruments have not generally been considered to be of systemic concern.
International Payment Instruments
Payment
Method
Features Advantages Disadvantages
Wire Transfer Fully electronic means of
payment
Uses correspondent bank
accounts and Fed Wire
U.S. Dollars and foreign
currencies
Same convenience and security
as domestic wires
Pin numbers for each authorized
individual
Repetitive codes for frequent
transfers to same Beneficiaries
Fastest way for Beneficiary
to receive good funds
Easy to trace movement of
funds from bank to bank
Cost is usually more than
other means of payment
Funds can be hard to recover
if payment goes astray
Intermediary banks deduct
charges from the proceeds
Details needed to apply
funds received for credit
management purposes are
often lacking/insufficient
Impossible to stop payment
after execution
Foreign Checks Paper instrument that must be
sent to Beneficiary and is
payable in Beneficiary's country
Uses account relationships with
foreign correspondent banks
Available in U.S. Dollars and all
major foreign currencies
Convenient when
Beneficiary's bank details
are not known
Useful when information/
documentation must
accompany payment
(subscriptions,
registrations, reservations,
etc.)
Relatively easy to stop
payment if necessary
Mail or courier delivery can
be slow
Good funds must still be
collected from the drawee
bank
If payable in foreign
currency, value may change
during the collection period
Stale dating rules differ in
various countries
Commercial
Letters of
Credit
Bank's credit replaces Buyer's
credit
Payment made against
compliant documents
Foreign bank risk can be
eliminated via confirmation of a
bank in Beneficiary's country
Acceptance credits offer built-in
financing opportunity
Rights and risks of Buyer
and Seller are balanced
Seller is assured of
payment when conditions
are met
Buyer is reasonably
assured of receiving the
goods ordered
Confirmation eliminates
country risk and
commercial risk
More costly than other
payment alternatives
Issuance and ammendments
can take time
Strict documentary
compliance by Seller is
required
Reduces applicant's credit
facilities

2. Standby
Letters of
Credit
Powerful instrument with
simple language
Increasingly popular in U.S. and
abroad
Foreign bank risk can be
eliminated via confirmation of a
bank in Beneficiary's country
"Evergreen" clauses shift expiry
risk from Beneficiary to issuer
May be cheaper than
Commercial Letter of
Credit
More secure than open
account or Documentary
Collection
Discrepancies less likely
than under Commercial
L/C
Confirmation eliminates
country risk and
commercial risk
Weak language can give
Beneficiary unintended
advantages
More costly than
Documentary Collections
Reduces Buyer's credit
facilities
Documentary
Collections
Seller uses banks as agents to
present shipping documents to
Buyer against Buyer's payment
or promise to pay
With Direct Collection Letter
(DCL), Seller ships and sends
shipping documents directly to
Buyer's bank, which collects and
remits funds to Seller's bank
Somewhat more secure
than open account
Cheaper and less rigid than
Commercial L/C
No strict compliance rules
apply
No credit facilities required
Country risk and commercial
risk exist
No guaranty of payment by
any bank
No protection against order
cancellation
No built-in financing
opportunity as with
Commercial L/C
PAYMENT MECHANISM
Setting up International Trade Mechanisms involves inter disciplinary processes including Finance,
Logistics, Taxation and Supply Chain disciplines. Every Business Manager would need to know the
nuances of the trade even though he may or may not be involved in the micro management of the
processes.
Any Import or Export entails commercial transaction and payment. When an import is made into the US,
the foreign supplier would have to be paid in the currency in which he has raised the invoice. Normally
international transactions are made using USD as the currency. However in many cases of transactions
with Europe, the Euro Dollar is used as the currency too.
When an Export originates out of US to another country, the Exporter would have to receive payment
from the End Customer.
In Exports we have several types of trade or export transactions and the nature of the business
determines the payment terms.
1. Advance Payment
When a new customer approaches and places an order on the Exporter, normally might insist on
advance payment for executing the order. This method normally continues for a few times until mutual
trust is built between the two parties and they get to know each other.

3. 2. Letters of Credit
An Exporter if dealing with an unknown customer at the other end may not have any prior exposure to
the credit worthiness of the Customer and would normally insist on Confirmed Letter of Credit to be
opened by the Customer before shipping the goods. In such cases the Exporter may not be extending
any credit. Also in case of high value transactions with known customers too; exporters prefer to get
paid through Letter of Credit.
While dealing with a customer, the Exporter can check seek a credit worthiness rating from the
customer’s bank to be able to ascertain the authenticity and credibility of the Customer. Normally Large
Multi Nationals demand such credit worthiness reports as a part of their policy.
3. Bill of Exchange of Documentary Drafts
When there has been sufficient relation between an Exporter and the Customer (Importer) and the
customer’s credit worthiness is known through previous records, the Exporter might decide to extend
credit and accept payment on bill of exchange basis. This system is also called as Documentary Drafts.
Documentary drafts are of two types namely Sight Drafts and Date and Time Drafts.
4. Open or Ongoing Account
When there is a huge volume of continuous business transactions between the Exporter and Importer
and exports continue to happen on ongoing basis, the Exporter can simply export on the basis of a
purchase order and expect the Importer to pay promptly on due date. This is the usual method adopted
by most of the Multi National Companies as well as the large organizations that have sufficient import
volumes spread across various countries and are dealing with multiple vendors on ongoing basis. In such
cases they just determine the annual volumes to be supplied by each vendor, issue an open purchase
order and keep reviewing only the delivery schedule. They offer standard payment commitment on a
particular date to all vendors as a global policy. The payment process will be set and determined as a
part of their business agreement.
5. Other Types of Trade and Related Payment Mechanisms
Besides the above types of payment mechanisms based on normal Exports and Imports, there are other
types of business models which work on various other modes of payment terms too.
6. Consignment Sale
An exporter might sign up a contractor with a distributor overseas to import, hold stock and sell the
goods on his behalf. In such a situation, the distributor may not own the stocks and the ownership might
continue to lie with the exporter. The distributor would only be an intermediary to sell the stocks and
repatriate the money realized back to the exporter and get remunerated in terms of service charges or
commission. In such cases there may be a business agreement in place but no fixed payment mechanism
may be adopted.

4. 7. Counter Trade / Counter Purchase / Barter Trade
In yet another case of business arrangement called counter trade, exports may be linked with return
purchase of some other items from the importer or from another source in the country. The payment
may also involve services other than products. This kind of trade becomes a necessity while dealing with
countries that do not have sufficient foreign currency. There is also another system of international
barter which is not very commonly practiced in the commercial world.
EXCHANGE RATE MECHANISM
System established in March 1979 for controlling exchange rates within the European Monetary System
of the European Union (EU) that was intended to prepare the way for a single currency. The member
currencies of the ERM were fixed against each other within a narrow band of fluctuation based on a
central European Currency Unit (ECU) rate, but floating against non-member countries. If a currency
deviated significantly from the central ECU rate, the European Monetary Cooperation Fund and the
central banks concerned stepped in to stabilize the currency.
The ERM was revised from 1 January 1999, with the launch of the single European currency (euro), and
Greece and Denmark became members of ERM II (a structure linking the currencies of some non-
participating member states to the euro). Greece then became a full member of the eurozone on 1
January 2001. The United Kingdom (which had withdrawn from the mechanism in turbulent
circumstances in October 1992) and Sweden were, in 2001, not members of the ERM.

5. Unit-2
Concept of Foreign Exchange Rate
We have an expert understanding of domestic trading. When you are in Germany and you buy rice from
a shop, you will naturally pay in Euros, and of course, the shop will be willing to accept Euros. This trade
can be conducted in Euros. Trading of goods within a country is relatively simple.
However, things get complicated if you want to buy a US-made computer. You might have paid in Euros
at the shop. However, through transactions in banks and financial institutions, the final payment will be
made in US dollars and not Euros. Similarly, when Americans want to buy German products, they will
have to eventually pay in Euros.
From this example of international trading, we introduce the concept of foreign exchange rate. Foreign
exchange rate is the value at which a country’s currency unit is exchanged for another country’s
currency unit. For example, the current foreign exchange rate for Euros is: 100 EUR = USD 130.
2. World Currency Symbols
USD : US Dollar
HKD : Hong Kong Dollar
EUR : European Union Euro
JPY : Japanese Yen
GBP : British Pound
CHF : Swiss Franc
CAD : Canadian Dollar
SGD : Singapore Dollar
AUD : Australian Dollar
RMB : Chinese Renminbi
3. Methods of Quoting Foreign Exchange Rates
Currently, domestic banks will determine their exchange rates based on international financial markets.
There are two common ways to quote exchange rates, direct and indirect quotation.
Direct quotation: This is also known as price quotation. The exchange rate of the domestic currency is
expressed as equivalent to a certain number of units of a foreign currency. It is usually expressed as the
amount of domestic currency that can be exchanged for 1 unit or 100 units of a foreign currency. The
more valuable the domestic currency, the smaller the amount of domestic currency needed to exchange
for a foreign currency unit and this gives a lower exchange rate. When the domestic currency becomes
less valuable, a greater amount is needed to exchange for a foreign currency unit and the exchange rate
becomes higher.

6. Under the direct quotation, the variation of the exchange rates are inversely related to the changes in
the value of the domestic currency. When the value of the domestic currency rises, the exchange rates
fall; and when the value of the domestic currency falls, the exchange rates rise. Most countries uses
direct quotation. Most of the exchange rates in the market such as USD/JPY, USD/HKD and USD/RMD
are also quoted using direct quotation.
Indirect quotation: This is also known as the quantity quotation. The exchange rate of a foreign currency
is expressed as equivalent to a certain number of units of the domestic currency. This is usually
expressed as the amount of foreign currency needed to exchange for 1 unit or 100 units of domestic
currency. The more valuable the domestic currency, the greater the amount of foreign currency it can
exchange for and the lower the exchange rate. When the domestic currency becomes less valuable, it
can exchange for a smaller amount of foreign currency and the exchange rate drops.
Under indirect quotation, the rise and fall of exchange rates are directly related to the changes in value
of the domestic currency. When the value of the domestic currency rises, the exchange rates also rise;
and when the value of the domestic currency falls, the exchange rates fall as well.
Most Commonwealth countries such as the United Kingdom, Australia and New Zealand use indirect
quotation. Exchange rates such as GBP/USD and AUD/USD are quoted indirectly.
Direct Quotation Indirect Quotation
USD/JPY = 134.56/61 EUR/USD = 0.8750/55
USD/HKD = 7.7940/50 GBP/USD = 1.4143/50
USD/CHF = 1.1580/90 AUD/USD = 0.5102/09
There are two implications for the above quotations:
(1) Currency A/Currency B means the units of Currency B needed to exchange for 1 unit of Currency A.
(2) Value A/Value B refers to the quoted buy price and sell price. Since the difference between the buy
price and sell price is not large, only the last 2 digits of the sell price are shown. The two digits in front
are the same as the buy price.
4. Defintion of “pip” in foreign exchange rates quotation
Based on the market practice, foreign exchange rates quotation normally consists of 5 significant
figures. Starting from right to left, the first digit, is known as the “pip”. This is the smallest unit of
movement in the exchange rate. The second digit is known as “10 pips”, so on and so forth.
For example: 1 EUR = 1.1011 USD; 1 USD = JPY 120.55 If EUR/USD changes from 1.1010 to 1.1015, we
say that the EUR/USD has risen by 5 pips.If USD/JPY changes from 120.50 to 120.00, we say that
USD/JPY has dropped by 50 pips.

7. SPREAD RATE
Constant difference between the average rate and the buying rate, or between the average rate and the
bank selling rate.
For exchange rate types, you can define fixed exchange rate spreads between average rate and buying
rate, as well as between average rate and bank selling rate.
You then only have to enter exchange rates for the average rate. The system then calculates the
exchange rates for the buying rate and bank selling rate by adding and subtracting the exchange rate
spread for the average rate.
OFFICIAL RATE
Official exchange rate refers to the exchange rate determined by national authorities or to the rate
determined in the legally sanctioned exchange market. It is calculated as an annual average based on
monthly averages (local currency units relative to the U.S. dollar).
CROSS RATE
The currency exchange rate between two currencies, both of which are not the official currencies of the
country in which the exchange rate quote is given in. This phrase is also sometimes used to refer to
currency quotes which do not involve the U.S. dollar, regardless of which country the quote is provided
in.
For example, if an exchange rate between the Euro and the Japanese Yen was quoted in an American
newspaper, this would be considered a cross rate in this context, because neither the euro or the yen is
the standard currency of the U.S. However, if the exchange rate between the euro and the U.S. dollar
were quoted in that same newspaper, it would not be considered a cross rate because the quote
involves the U.S. official currency.
FORWARD RATE
A rate applicable to a financial transaction that will take place in the future. Forward rates are based on
the spot rate, adjusted for the cost of carry and refer to the rate that will be used to deliver a currency,
bond or commodity at some future time. It may also refer to the rate fixed for a future financial
obligation, such as the interest rate on a loan payment.
In forex, the forward rate specified in an agreement is a contractual obligation that must be
honored by the parties involved. For example, consider an American exporter with a large export
order pending for Europe, and undertakes to sell 10 million euros in exchange for dollars at a rate
of 1.35 euros per U.S. dollar in six months' time. The exporter is obligated to deliver 10 million
euros at the specified rate on the specified date, regardless of the status of the export order or the
exchange rate prevailing in the spot market at that time. Forward rates are widely used for
hedging purposes in the currency markets, since currency forwards can be tailored for specific

8. requirements, unlike futures, which have fixed contract sizes and expiry dates and therefore
cannot be customized.
In the context of bonds, forward rates are calculated to determine future values. For example, an
investor can purchase a one-year Treasury bill or buy a six-month bill and roll it into another six-
month bill once it matures. The investor will be indifferent if they both produce the same result.
The investor will know the spot rate for the six-month bill and the one-year bond, but he or she
will not know the value of a six-month bill that is purchased six months from now. Given these
two rates though, the forward rate on a six-month bill will be the rate that equalizes the dollar
return between the two types of investments mentioned earlier.
Forward rate calculation
To extract the forward rate, one needs the zero-couponyield curve. The general formula used to
calculate the forward rate is:
is the forward rate between term and term ,
is the time length between time 0 and term (in years),
is the time length between time 0 and term (in years),
is the zero-coupon yield for the time period ,
is the zero-coupon yield for the time period ,
QUOTING FOREX FORWARD RATE
A forex forward rate reflects in pips the interest differential between the currencies of the currency
pair for the period the forward is being quoted for.
Introduction:
Future risks are hedged using the forward foreign exchange markets. There is in reality only one motive
for an institution to use forex forwards and that is to hedge a foreign currency exposure. Hence the
forward markets have become an essential constituent of risk management to all categories of users of
the currency markets who are the market makers or banks, the large corporations who are the hedgers
and the speculators.
Quoting Forex Forward Rates:
Theoretically there is not any reason why the spot rate and the forward rate should not be the same.
However, in reality they seldom are since interest rates vary between different countries. If we assume

9. that the interest rate for one month is 8% in the UK and 5% in the United States and the spot rate and
forward rate were the same at 1.5600.
Seeing this investors would want to invest in the pound sterling which has higher interest rates than the
dollar interest rate. There would follow a series of events that would restore the imbalance between
interest rates and spot and forward rates.
· Investors purchasing spot sterling to take advantage of the higher interest rates would put
pressure on the sterling exchange rate in spot to appreciate.
· At the same time as more investors put their money into 1 month Sterling deposits there
would be pressure for the 1 month rate to decrease.
· Likewise investors fleeing the dollar would pressure the 1 month Eurodollar rate to rise.
· The act of many investors entering into sterling1 month forward contracts would pressure the
sterling 1month forward exchange rate to depreciate.
So to avoid the above in balance in the markets and to take away the opportunity for arbitrage between
currencies forex forward rate are calculated by taking the spot rate and either adding a premium in pips
which reflects the interest rate differential between the two currencies (the interest rate is lower) or
subtracting a discount (the interest rate is higher) which also reflects the interest rate differential
between the two currencies.
Forex forward rates are always quoted in pips. These pips are either added or subtracted from the spot
rate. As an example let us take a one year forward forex quote for GBP/USD as say 260/250 and the
current spot rate is 1.5150-55. We already recognize that the forward rate should be at a discount
forward since the sterling interest rate for the same period is higher than the dollar interest rate for one
year. Therefore we will subtract the pips from the spot rate.
Spot GBP/USD is 1.5150 – 1.5155
1 year forward 260 – 250
Therefore the 1 year GBP/USD forward outright is 1.4890 - 1.4905 because we subtracted the forward
pips from the spot rate. We should always subtract the pips if the bid (left) side pips are higher than the
offer (right) side pips and conversely add the pips if the bid (left) side pips are lower than the offer
(right) side pips.

10. Unit-3
CURRENCY FUTURE
A currency future, also FX future or foreign exchange future, is a futures contract to exchange one
currency for another at a specified date in the future at a price (exchange rate) that is fixed on the
purchase date; see Foreign exchange derivative. Typically, one of the currencies is the US dollar. The
price of a future is then in terms of US dollars per unit of other currency. This can be different from the
standard way of quoting in the spot foreign exchange markets. The trade unit of each contract is then a
certain amount of other currency, for instance €125,000. Most contracts have physical delivery, so for
those held at the end of the last trading day, actual payments are made in each currency. However,
most contracts are closed out before that. Investors can close out the contract at any time prior to the
contract's delivery date.
CURRENCY OPTION
A Currency option (also FX, or FOREX option) is a financial product called a derivative where the value is
based off an underlying instrument, which in this case is a foreign currency. FX options are call or put
options that give the buyer the right (not the obligation) to buy (call) or sell (put) a currency pair at the
agreed strike price on the stated expiration date.
FOREX option trading was initially conducted only by large institutions where fund managers, portfolio
managers and corporate treasurers would offload risk by hedging their currency exposure in the FX
option market. However, currency options are now very popular amount retail investors as electronic
trading and market access is now so widely available.
CURRENCY SWAP
A currency swap is a foreign-exchange agreement between two institute to exchange aspects (namely
the principal and/or interest payments) of a loan in one currency for equivalent aspects of an equal in
net present value loan in another currency; see foreign exchange derivative. Currency swaps are
motivated by comparative advantage. A currency swap should be distinguished from a central bank
liquidity swap.
Structure
Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps.
However, unlike interest rate swaps, currency swaps can involve the exchange of the principal.
There are three different ways in which currency swaps can exchange loans:
1. The simplest currency swap structure is to exchange only the principal with the counterparty at
a specified point in the future at a rate agreed now. Such an agreement performs a function
equivalent to a forward contract or futures. The cost of finding a counterparty (either directly or
through an intermediary), and drawing up an agreement with them, makes swaps more

11. expensive than alternative derivatives (and thus rarely used) as a method to fix shorter term
forward exchange rates. However for the longer term future, commonly up to 10 years, where
spreads are wider for alternative derivatives, principal-only currency swaps are often used as a
cost-effective way to fix forward rates. This type of currency swap is also known as an FX-swap.
2. Another currency swap structure is to combine the exchange of loan principal, as above, with an
interest rate swap. In such a swap, interest cash flows are not netted before they are paid to the
counterparty (as they would be in a vanilla interest rate swap) because they are denominated in
different currencies. As each party effectively borrows on the other's behalf, this type of swap is
also known as a back-to-back loan.
3. Last here, but certainly not least important, is to swap only interest payment cash flows on loans
of the same size and term. Again, as this is a currency swap, the exchanged cash flows are in
different denominations and so are not netted. An example of such a swap is the exchange of
fixed-rate US dollar interest payments for floating-rate interest payments in Euro. This type of
swap is also known as a cross-currency interest rate swap, or cross currency swap.
Currency swaps have two main uses:
To secure cheaper debt (by borrowing at the best available rate regardless of currency and then
swapping for debt in desired currency using a back-to-back-loan).
To hedge against (reduce exposure to) exchange rate fluctuations.
Hedging example
For instance, a US-based company needing to borrow Swiss francs, and a Swiss-based company needing
to borrow a similar present value in US dollars, could both reduce their exposure to exchange rate
fluctuations by arranging any one of the following:
If the companies have already borrowed in the currencies each needs the principal in, then exposure is
reduced by swapping cash flows only, so that each company's finance cost is in that company's domestic
currency.
Alternatively, the companies could borrow in their own domestic currencies (and may well each have
comparative advantage when doing so), and then get the principal in the currency they desire with a
principal-only swap.
1st Example of Currency Swap
Company A is doing business in USA and it has issued bond of $ 20 Million to bondholders that has been
nominated in US $. Other company B is doing business in Europe. It has issued bond of $ 10 Million
Euros. Now, both company's directors sit in one room and agreed for exchanging the principle and
interest of both bonds. Company A will get $ 10 million Euros Bonds with its interest payment and
Company B will get $ 20 million bond for exchanging his principle and interest. This is the simple
example of currency swap.

12. 2nd Example of Currency Swap
Suppose one USA company wants to start his factory in India. For this it gets $10 billion dollar in the
form of loan from USA market and Exchanges this amount from India company B. Now company A has
Indian currency for doing business in India and company B which is Indian company has USA currency
and it can getForex earning. It means that both are benefited with single deal of currency swap.
3rd Example of Currency Swap
Currency Swap is very useful for multinational companies who have many branches in different
countries. Suppose, A company's head office in UK and it is doing business in USA. A company has
1,00,000 pounds in bank which it got from public loan for doing business. But UK's one branch in USA
which needs 50,000 USA dollars for 2 months because we can do business in USA with dollars not with
pounds. Now, with the help of currency swap, UK company can use his 100000 pounds for covering the
need of 50,000 $ of USA branch. Currency swap allows you to get any foreign currency with the
exchange of own currency on the basis of exchange rate on any future date without taking foreign
exchange risk. Again same currency buy back by currency buy back swap. Company of UK did same and
with the help of Financial Intermediary, it get 50,000$ for its USA branch for 2 months.
FOREIGN EXCHANGE ARITHMATIC
A foreign exchange transaction has two aspects – Purchase (Buy) and Sell.
The Foreign exchange transaction is always talked from the Bank’s point of view and the item referred
to is the foreign currency.
Hence when we say “Purchase”, it means that the bank has purchased and it has purchased foreign
currency & when we say “Sale”, the bank has sold and sold the foreign currency.
In purchase transaction, the Bank acquires the foreign currency and parts with home currency.
In a sale transaction the Bank parts with the foreign currency and acquires home currency.
The Exchange rate is quoted as “Direct Quotation” and / or “Indirect Quotation”.
In a “ Direct Quotation “, the foreign currency is fixed and the home currency is variable.
For example, USD – Rs. 46.
In a “ Indirect Quotation “, the home currency is fixed and the foreign currency is variable.
For example, Rs. 100 = USD 2.20.
Except in London Market, the direct quotations are only used.
In India all quotes are on “Direct Method.”.
There are three markets, where foreign exchange rates are quoted.

13. While quoting rates for customers, the rate is called Merchant Rate and normally quoted either as a sale
or purchase transaction.
A customer wants a demand draft for USD 100. It implies that the customer wants to purchase USD 100
from the Bank and will sell him foreign currency by acquiring rupees.
The rate quoted will be a “ Sale Rate” say USD 1 = 45.00. It means that Bank will take Rs.45 from the
customer for each dollar sold to him.
The exchange rate is always quoted in four decimals in multiples of 0.0025. The rates quoted will be USD
1 – 45.2525. The last two digits will be rounded off to quarter. All currencies are quoted in the units of “
One”, meaning thereby USD 1 = Rs. 45.2525, GBP 1 = Rs. 80.55.
Following currencies are however, quoted in the units of “100”. Japanese Yen, Belgian Franc, Italian Lira,
Indonesian Rupiah, Kenyan Shilling, Spanish Peseta and currencies of Asian Clearing Union countries (
Bangladesh Taka, Myanmar Kyat, Iranian Riyal, Pakistani Rupee and Sri Lankan Rupee).
In India, rupee amount received or paid to the customer on account of exchange transaction should be
rounded off to the nearest rupee. ieupto 49 paise ignored and 50 to 99 paise rounded off to higher Rs.
Transactions In Interbank Market
While the rates quoted to the customers by their Banks are called merchant rates, the rates quoted by
the Bank to another Bank is called interbank rate. Inter Bank Rates are always quoted two – way. The
market maker bank, ie who is quoting a rate will express his intention either to buy or sell foreign
currency.
For example, a Bank in Mumbai quotes a rate as under : USD 1 = Rs. 48.1525 / 1650
More often the rate would be quoted as USD 1 = 1525/1650 as the market players understand the big
number ie 48. It indicates that the quoting Bank is willing to buy USD 1 from the other party by giving
the other Bank Rs. 48.1525 for each Dollar. (It is also called Bid rate or purchase rate).
It also indicates that the quoting Bank is willing to sell USD 1 from the other party by taking Rs. 48.1650
for each USD it will be selling.
If the Bank buys dollars in the market at Rs. 48.1525 and sells each dollar at Rs. 48.1650, the difference
of Rs.0.0125 is spread or profit of the Bank.

14. Unit-4
Foreign currency exposure is the extent to which the future cash flows of an enterprise, arising from
domestic and foreign currency denominated transactions involving assets and liabilities, and generating
revenues and expenses are susceptible to variations in foreign currency exchange rates. It involves the
identification of existing and/or potential currency relationships which arise from the activities of an
enterprise, including hedging and other risk management activities.
Types of Exposure
Translation Exposure
Translation exposure is also referred to as accounting exposure or balance sheet exposure. The
restatement of foreign currency financial statements in terms of a reporting currency is termed
translation. The exposure arises from the periodic need to report consolidated worldwide operations of
a group in one reporting currency and to give some indication of the financial position of that group at
those times in that currency.
Translation exposure is measured at the time of translating foreign financial statements for reporting
purposes and indicates or exposes the possibility that the foreign currency denominated financial
statement elements can change and give rise to further translation gains or losses, depending on the
movement that takes place in the currencies concerned after the reporting date. Such translation gains
and losses may well reverse in future accounting periods but do not, in themselves, represent realized
cash flows unless, and until, the assets and liabilities are settled or liquidated in whole or in part. This
type of exposure does not, therefore, require management action unless there are particular covenants,
e.g., regarding gearing profiles in a loan agreement, that may be breached by the translated domestic
currency position, or if management believes that translation gains or losses will materially affect the
value of the business. International Accounting Standards set out best practice.
Transaction Exposure
This is also referred to as conversion exposure or cash flow exposure. It concerns the actual cash flows
involved in setting transactions denominated in a foreign currency. These could include, for example:
1. sales receipts
2. payments for goods and services
3. receipt and/or payment of dividends
4. servicing loan arrangements as regards interest and capital
The existence of an exposure alerts one to the fact that any change in currency rates, between the time
the transaction is initiated and the time it is settled, will most likely alter the originally perceived
financial result of the transaction. It is, for example, important to commence monitoring the exposure
from the time a foreign currency commitment becomes a possibility, not merely when an order is
initiated or when delivery takes place. The financial or conversion gain or loss is the difference between

15. the actual cash flow in the domestic currency and the cash flow as calculated at the time the transaction
was initiated, i.e., the date when the transaction clearly transferred the risks and rewards of ownership.
Where financing of a transaction takes place, such as a loan obligation, there are also gains/losses which
may result.
Economic Exposure
Economic exposure or operational exposure moves outside of the accounting context and has to do with
the strategic evaluation of foreign transactions and relationships. It concerns the implications of any
changes in future cash flows which may arise on particular transactions of an enterprise because of
changes in exchange rates, or on its operating position within its chosen markets. Its determination
requires an understanding of the structure of the markets in which an enterprise and its competitors
obtain capital, labour, materials, services and customers. Identification of this exposure focuses
attention on that component of an enterprise's value that is dependent on or vulnerable to future
exchange rate movements. This has bearing on a corporation's commitment, competitiveness and
viability in its involvement in both foreign and domestic markets. Thus, economic exposure refers to the
possibility that the value of the enterprise, defined as the net present value of future after tax cash
flows, will change when exchange rates change.
Economic exposure will almost certainly be many times more significant than either transaction or
translation exposure for the long term well-being of the enterprise. By its very nature, it is subjective
and variable, due in part to the need to estimate future cash flows in foreign currencies. The enterprise
needs to plan its strategy, and to make operational decisions in the best way possible, to optimize its
position in anticipation of changes in economic conditions.
ALTERNATIVE DEFINITION OF FOREIGN EXCHANGE RISK
Foreign currency risk is the net potential gains or losses which can arise from exchange rate changes to
the foreign currency exposures of an enterprise. It is a subjective concept and concerns anticipated or
forecasted rate fluctuations together with the assessment of the vulnerability of an enterprise to such
fluctuations. The element of uncertainty gives rise to the risk and creates an opportunity for profitable
action.
Currency risk may be usefully classified as recurring or nonrecurring. Recurring risks may arise from the
financial structure of the enterprise and are directly attributable to the exchange rate movements
arising from an enterprise's currency composition. Or they may result from the enterprise's specific line
of business and hence are related to an enterprise's operating activities. Nonrecurring risks result from
one-off transactions and relate to transaction exposure.
The solutions to currency risk differ depending on whether the risk is nonrecurring or ongoing. Short-
term strategies are more appropriate for nonrecurring risks, whereas ongoing risks should be dealt with
using long-term strategies. An analysis of the frequency of the risk determines the appropriate method
of managing that risk.

16. TECHNIQUES OF EXPOSER MANAGEMENT
The following are the methods/techniques of hedging a currency transaction exposure.
Internal Techniques
Invoicing in home currency
Leading and lagging
Multilateral netting and matching
External Techniques
Forward contracts
Money market hedges
Currency futures
Currency options
Currency swaps
Internal Techniques
(i) Invoicing in home currency: The currency of invoice decision
A company exporting goods or services has to decide whether to invoice in its own currency, the buyer’s
currency or another acceptable currency. For, example, a Tanzanian company exporting goods to Kenya
can decide to invoice its customers in Tshs. In doing so, it avoids an exposure to a risk of fall in the value
of the Kshs (which it would have if it invoiced in Kshs). The currency risk is shifted to the Kenyan
customers.
Drawback to invoicing in domestic currency is that foreign customers might go to a different supplier
who is willing to invoice them in their domestic currency. As always with sales-related decisions,
marketing and financing arguments must be balanced.
So, although invoicing in the home currency has the advantage of eliminating exchange differences, the
company is unlikely to compare well with a competitor who invoices in the buyer’s currency. It is also
necessary to revise prices frequently in response to currency movements, to ensure that the prices
remain competitive.
Invoicing in the buyer’s currency should promote sales and speed up payment and currency movements
can be hedged using forward cover. How ever, this is only available for the world’s major traded
currencies.
A seller’s ideal currency, in order of preference, is
Home currency
Currency stable relative to home currency
Market leader’s currency

17. Currency with a good forward market
A seller may also have a healthy interest in a foreign currency in which there is definitely, or likely, to be
future expenditure.
A buyer’s ideal currency is: -
Own currency
Currency stable relative to own currency
Currency other suppliers sell in (for convenience and the ease of justifying a purchase)
(ii) Leading and lagging
‘Leading’ and ‘Lagging’ are terms relating to the speed of settlement of debts.
Leading refers to an immediate payment or the granting of very short-term credit. This is
beneficial to a payer whose currency (used to settle) is weakening against the payee’s currency
Lagging refers to granting (or taking) of long-term credit.
It is beneficial to a payer if he is to pay payee’s weakening currency.
In relation to foreign currency settlements, additional can be obtained by the use of these techniques
when currency exchange rates are fluctuating (assuming one can forecast the changes)
If the settlement were in the payer’s currency, then ‘leading’ would be beneficial to the payer if this
currency were weakening against the payee’s currency. ‘Lagging’ would be beneficial for the payer if the
payer’s currency were strengthening against the payee’s.
If the settlement were to be made in the payee’s currency, the ‘lagging’ would be benefit the payer
when the currency is weakening against the payee’s currency. ‘Leading’ would benefit the payer if the
payee’s currency were strengthening against the payer’s.
Note: in either case, the payee’s view would be the opposite.
(iii) Multilateral netting and matching
Matching - involves the use of receipts in particular currency to meet payment obligations in the same
currency.
For example, suppose that a company expects to make payments of USS$470,000 in two months time,
and also expects to receive income of USS$250,000 in two months. The company can use its income of
$250,000 to meet some of the payments of $470,000.
This reduces to $220,000 (i.e. 470,000-250,000) its exposure to a rise in the value of the dollar over the
next two months.

18. Similarly, suppose that a company expects to receive ∈ 700,000 in three month’s time, when it also
expects to incur payments of ∈ 300,000. It can use some of its income in euros to make the payments,
so that its net exposure is to income of just ∈ 400,000 (700,000-300,000).
Matching receipts and expenditures is very useful way of partially hedging currency exposures. It can be
organized at group level by the treasury team, so that currency income for one subsidiary can be
matched with expenditures in the same currency by another subsidiary. This is most easily managed
when all subsidiaries are required to pay their income into a ‘group bank account’ and all payments are
made out of this central account.
Successful matching, however, depends on reliable forecasts of amounts and timing of future inflow and
outflows of currencies.
Netting - involves offsetting the group’s debtors and creditors in the same currency and only covering
the net position. This reduces the amount to be hedged by the group. For example, there is no point in
one subsidiary hedging a $1 million debt receivable at same time as another subsidiary is hedging a $ 1
million debt payable.
If the subsidiaries use different functional currencies, a currency of conversion is agreed in which all
inter- group debts are converted before canceling them to remain only with net amount to be hedged
by the group.
The parent company treasury department can assess the overall group position and only cover the
group’s net exposure.
External Techniques
(iv) Hedging with forward contracts (forward market hedge)
Forward contracts are an important method of hedging currency risks. This is because a forwardcontact
can be used now to fix an exchange rate for a future receipt or payment in currency. Ifhe exchange rate
is fixed now, there is no need to worry about how the spot rate might change,because the future cash
flow in domestic currency is now known with certainty.
To hedge with forward contract, we need to: -
Establish what the future cash flow will be in the foreign currency
Fix the rate now for buying or selling this foreign currency by entering into a forwardexchange
transaction with a bank
A forward contract is a binding contract on both parties. This means that having made a
forwardcontract; a company must carry out the agreement, and buy or sell the foreign currency on
theagreed date and at the rate of exchange fixed by the agreement. If the spot rate moves in
thecompany’s favor, that is too bad. By hedging against the risk of an adverse exchange ratemovement

19. with a forward contract, the company also closes any opportunity to benefit from afavorable change in
the spot rate.
(a) Hedging foreign receivable
It concerns the exporters when fear a possible depreciation of the foreign currency up on exchanging
the foreign currency for domestic currency.
Hedging foreign receivables involves selling the foreign currency forward, this means fixing the rate at
which the foreign currency will be exchanged in the future. Specifically the process involves the
following steps
Sell the foreign currency amount forward at the forward rate/ enter forward contract
Receive the foreign currency amount from the customer; deliver the amount to the bank in
exchange for domestic currency.
(b) Hedging foreign payables
Importers would hedge foreign payable when they fear a possible appreciation of the foreign currency.
It involves the purchasing of foreign currency forward.
This means fixing the exchange rate at which the customer will purchase the foreign currency.
Specifically the process involves
Purchase the foreign currency amount forward at a forward rate
When the payment falls due deliver domestic currency amount to the bank, in exchange for
foreign currency amount and pay the supplies.
(V) MONEY MARKET HEDGE (HEDGING IN MONEY MARKETS)
The money markets are markets for wholesale (large-scale) lending and borrowing, or trading inshort-
term financial instruments. Many companies are able to borrow or deposit funds through their bank in
the money markets.
Instead of hedging a currency exposure with a forward contract, a company could use the
moneymarkets to lend or borrow, and achieve a similar result.
Since forward exchange rates are derived from spot rates and money market interest rates, the end
result from hedging should be roughly the same by either method.
Objective of money market.
Borrow or lend to lock in home currency value of cash flow
Establishing a money market hedge

20. To work out how to use the money markets to hedge, you need to go back to the basic question of what
is the exposure, and what is needed to hedge the exposure.
There are basically two situations to consider:
A company is expecting to receive income in a foreign currency at a future date, and intends to
exchange it into domestic currency
A company is expecting to make a foreign currency payment at some time in the future, and use
domestic currency to buy the foreign currency it needs to make the payment
Exposure: future income foreign currency (hedging receivables)
When the exposure arises from future income receivable in foreign currency, a hedge can be created by
fixing the value of that income now in domestic currency. In other word, we need to fix the effective
exchange value of the future currency income.
Ways of doing this is as follows:
Borrow now in the foreign currency. The term of the loan should be from now until the currency
income is receivable. Ideally, borrow just enough money so that the loan plus interest repayable
when the loan matures equals the future income receivable in the currency. In this way, the
currency income will pay off the loan plus interest, so that the currency income and currency
payment match each other.
Exchange the borrowed currency immediately into domestic currency at the spot rate. The
domestic currency can either be used immediately, or put on deposit to earn interest. Either
way, the value of the future income in domestic currency is fixed.
Exposure: future payment in foreign currency (hedging payables)
A similar approach can be taken to create a money market hedge when there is an exposure to a future
payment in a foreign currency. In this situation, a hedge can be created by exchanging domestic
currency for foreign currency now (spot) and putting the currency on deposit until the future payment
has to be made. The amount borrowed plus the interest earned in the deposit period should be exactly
enough to make the currency payment when it falls due.
Specifically it involves the following steps: -
Determine present value of the foreign currency to be paid ( using foreign currency interest rate
as a discount rate)
Borrow equivalent amount of home currency( considering spot exchange rate)
Convert the home currency into PV equivalent of foreign currency( in spot market now) and
make a foreign currency deposit
On payment day, withdraw the foreign currency deposit (which by the time equals the payable
amount) and make payment.

21. The cash flows are fixed because the cost in domestic currency is the cost of buying foreign currency
spot to put on deposit.
(V)Currency Future
A currency future, also FX future or foreign exchange future, is a futures contract to exchange one
currency for another at a specified date in the future at a price (exchange rate) that is fixed on the
purchase date; see Foreign exchange derivative. Typically, one of the currencies is the US dollar. The
price of a future is then in terms of US dollars per unit of other currency. This can be different from the
standard way of quoting in the spot foreign exchange markets. The trade unit of each contract is then a
certain amount of other currency, for instance €125,000. Most contracts have physical delivery, so for
those held at the end of the last trading day, actual payments are made in each currency. However,
most contracts are closed out before that. Investors can close out the contract at any time prior to the
contract's delivery date.
(VI)Currency Option
In finance, a foreign-exchange option (commonly shortened to just FX option or currency option) is a
derivative financial instrument that gives the owner the right but not the obligation to exchange money
denominated in one currency into another currency at a pre-agreed exchange rate on a specified
date.[1] See Foreign exchange derivative.
The foreign exchange options market is the deepest, largest and most liquid market for options of any
kind. Most trading is over the counter (OTC) and is lightly regulated, but a fraction is traded on
exchanges like the International Securities Exchange, Philadelphia Stock Exchange, or the Chicago
Mercantile Exchange for options on futures contracts. The global market for exchange-traded currency
options was notionally valued by the Bank for International Settlements at $158.3 trillion in 2005.
Example :For example a GBPUSD contract could give the owner the right to sell £1,000,000 and buy
$2,000,000 on December 31. In this case the pre-agreed exchange rate, or strike price, is 2.0000 USD per
GBP (or GBP/USD 2.00 as it is typically quoted) and the notional amounts (notionals) are £1,000,000 and
$2,000,000.
This type of contract is both a call on dollars and a put on sterling, and is typically called a GBPUSD put,
as it is a put on the exchange rate; although it could equally be called a USDGBP call.
If the rate is lower than 2.0000 on December 31 (say at 1.9000), meaning that the dollar is stronger and
the pound is weaker, then the option is exercised, allowing the owner to sell GBP at 2.0000 and
immediately buy it back in the spot market at 1.9000, making a profit of (2.0000 GBPUSD – 1.9000
GBPUSD)*1,000,000 GBP = 100,000 USD in the process. If they immediately convert the profit into GBP
this amounts to 100,000/1.9000 = 52,631.58 GBP.
(VII)Currency Swap

22. A currency swap is a foreign-exchange agreement between two institute to exchange aspects (namely
the principal and/or interest payments) of a loan in one currency for equivalent aspects of an equal in
net present value loan in another currency; see foreign exchange derivative. Currency swaps are
motivated by comparative advantage.[1] A currency swap should be distinguished from a central bank
liquidity swap.
Structure
Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps.
However, unlike interest rate swaps, currency swaps can involve the exchange of the principal.[1]
There are three different ways in which currency swaps can exchange loans:
The simplest currency swap structure is to exchange only the principal with the counterparty at
a specified point in the future at a rate agreed now. Such an agreement performs a function
equivalent to a forward contract or futures. The cost of finding a counterparty (either directly or
through an intermediary), and drawing up an agreement with them, makes swaps more
expensive than alternative derivatives (and thus rarely used) as a method to fix shorter term
forward exchange rates. However for the longer term future, commonly up to 10 years, where
spreads are wider for alternative derivatives, principal-only currency swaps are often used as a
cost-effective way to fix forward rates. This type of currency swap is also known as an FX-
swap.[2]
Another currency swap structure is to combine the exchange of loan principal, as above, with an
interest rate swap. In such a swap, interest cash flows are not netted before they are paid to the
counterparty (as they would be in a vanilla interest rate swap) because they are denominated in
different currencies. As each party effectively borrows on the other's behalf, this type of swap is
also known as a back-to-back loan.[2]
Last here, but certainly not least important, is to swap only interest payment cash flows on loans
of the same size and term. Again, as this is a currency swap, the exchanged cash flows are in
different denominations and so are not netted. An example of such a swap is the exchange of
fixed-rate US dollar interest payments for floating-rate interest payments in Euro. This type of
swap is also known as a cross-currency interest rate swap, or cross currency swap.[3]
Uses
Currency swaps have two main uses:
To secure cheaper debt (by borrowing at the best available rate regardless of currency and then
swapping for debt in desired currency using a back-to-back-loan).
To hedge against (reduce exposure to) exchange rate fluctuations.

23. Unit-6
INTERNATIONAL LIQUIDITY
The concept of international liquidity is associated with international payments. These payments arise
out of international trade in goods and services and also in connection with capital movements between
one country and another. International liquidity refers to the generally accepted official means of
settling imbalances in international payments.
In other words, the term 'international liquidity' embraces all those assets which are internationally
acceptable without loss of value in discharge of debts (on external accounts).
In its simplest form, international liquidity comprises of all reserves that are available to the monetary
authorities of different countries for meeting their international disbursement. In short, the term
'international liquidity' connotes the world supply of reserves of gold and currencies which are freely
usable internationally, such as dollars and sterling, plus facilities for borrowing these. Thus, international
liquidity comprises two elements, viz., owned reserves and borrowing facilities.
Under the present international monetary order, among the member countries of the IMF, the chief
components of international liquidity structure are taken to be:
1. Gold reserves with the national monetary authorities - central banks and with the IMF.
2. Dollar reserves of countries other than the U.S.A.
3. £-Sterling reserves of countries other than U.K.
It should be noted that items (2) and (3) are regarded as 'key currencies' of the world and their reserves
held by member countries constitute the respective liabilities of the U.S. and U.K. More recently Swiss
francs and German marks also have been regarded as 'key currencies.
4. IMF tranche position which represents the 'drawing potential' of the IMF members; and
5. Credit arrangements (bilateral and multilateral credit) between countries such as 'swap agreements'
and the 'Ten' of the Paris Club.
Of all these components, however gold and key currencies like dollar today entail greater significance in
determining the international liquidity of the world.
However, it is difficult to measure international liquidity and assess its adequacy. This depends on gold
and the foreign exchange holdings of a country, and also on the country's ability to borrow from other

24. countries and from international organisations. Thus, it is not easy to determine the adequacy of
international liquidity whose composition is heterogeneous.
Moreover, there is no exact relationship between the volume of international transactions and the
amount of necessary reserves In fact, foreign exchange reserves (international liquidity) are necessary to
finance imbalances between international receipts and payments. International liquidity is needed to
service the regular How of payments among countries, to finance the shortfall when any particular
country's out payments temporarily exceed its in-payments, and to meet large withdrawals caused by
outflows of capital.
Thus, external or internal liquidity serves the same purpose as domestic liquidity, viz., to provide a
medium of exchange and a store of value. And the primary function of external liquidity is to meet
short-term fluctuations in the balance of payments.
EURO CURRENCY MARKET-
Definition of 'Eurocurrency Market'
The money market in which Eurocurrency, currency held in banks outside of the country where it is legal
tender, is borrowed and lent by banks in Europe. The Eurocurrency market is utilized by large firms and
extremely wealthy individuals who wish to circumvent regulatory requirements, tax laws and interest
rate caps that are often present in domestic banking, particularly in the United States.
Investopedia explains 'Eurocurrency Market'
Rates on deposits in the Eurocurrency market are typically higher than in the domestic market, because
the depositor is not protected by domestic banking laws and does not have governmental deposit
insurance. Rates on loans in the Eurocurrency market are typically lower than those in the domestic
market, because banks are not subject to reserve requirements on Eurocurrency and do not have to
pay deposit insurance premiums.
The development of the money market in the euro area or the euro money market made its inception
with very low rates of interest.
Turnover of the euro money market
The total turnover of the euro money market was moribund in the second quarter of 2004 although
there was a huge surge in the turnover in the second quarter of 2003. Such developments were
discontinuous across the market. After this upturn in all the market segments in the second quarter of
2003, there was a sharp downturn in the interest rate, cross currency and FX swaps in the second
quarter of 2004. This was contrasted by a rise in the turnover in the unsecured, secured and other
interest rate swaps. The forward rate agreement and the short term securities also witnessed a rise. The
secured segment happens to be the largest money market segment.

25. The overnight interest rate swap segment also saw a sharp downfall in the second quarter of 2004
although it had experienced a strong rise in the second quarter of 2003. this change is attributed to the
interest rate speculation which was high in 2003 but low in 2004. The overnight interest rate swap
segment of the money market is provided impetus by the EUIRIBOR-ACI.
The unsecured, secured and the overnight interest rate swap and the FX swap segments are
characterized by activities that have very short term maturity periods. The instruments like the cross
currency and other interest rate swaps are the money market instruments that are traded at long
maturities.
Structure of the euro money market
In regard to structure, the euro money market has been less concentrated over the past years. But
differences across the various money market segments continue to exist. The market that is least
concentrated is the unsecured money market segment. The money market segments that are highly
condensed are the forward rate agreement, other interest rate agreement and the cross currency swap
segments. They constitute about 70% of the entire money market share.
The euro money market products are short term deposits, repos, EONIA swaps and foreign exchange
swaps. There is an increase in the liquidity in these money market instruments that is projected by the
thinning in the bid–offer spread.
Transactions in the euro money market
Transactions in the euro money market occur mainly through the electronic mode. The secured market
segment experiences that largest electronic mode of transaction.