Foreign Exchange Market and Nature of Forex Management

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FOREX, an acronym for Foreign Exchange, is the largest financial market in the world. Every firm and individual operating in international environment is concerned with foreign exchange i.e. the exchange of foreign currency into domestic currency and vice-a-versa. Generally, the firm’s foreign operations earn income denominated in some foreign currency; however, the shareholders expect payment in domestic currency and therefore, the firm must convert the foreign currency into domestic currency. So, what is foreign exchange?

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Exchange rate is the price of one country’s money in terms of other country’s money. When we say that exchange rate of Indian rupee is 52.40 per US Dollar, we mean than 52.40 Indian Rupees are required to purchase one US Dollar. When this exchange rate becomes 52.90 we say that the value of Indian Rupee has depreciated against the US Dollar. On the other hand when the exchange rate becomes 52.10 we say that Indian Rupee has appreciated against the US dollar. Assuming that there are no exogenous factors restricting the changes in exchange rates, their movement can be traced to pure demand and supply. When Indian rupee depreciates against the US Dollar, it indicates that demand for latter is more than its supply. Similarly when the supply of US dollar is more than its demand, it declines in value against the Indian Rupee.

Currency of a country is used for transactions with foreigners. Each country in the world has its own currency. Theoretically, a country should transact with all foreign entities on a one-to-one basis, i.e. for all imports from a foreign country, a host country should pay in the currency of the former and for all exports, the host country should be paid in its currency. But practically this is not possible because it involves keeping record of a multitude of exchange rates and associated payment problems. Therefore, most of the countries choose a common currency for trade amongst themselves. The U.S. dollar has emerged as the strongest international currency for the past sixty years and as such is used as the payment medium for most of the world trade. In the European Union the Euro has established itself as the common currency of about 25 countries.

It is clear that the currency of a country is evaluated against a common currency for external transactions. In case of countries having dominant economic power, trade would be held in their currency. Hence a country is required to trade in U.S. dollar or in other dominant currencies like Euro, Pound or the Japanese Yen. Account of a country’s external trade is kept in the form of a Balance of payment account which is a double book entry system. Receipts of foreign currencies are credited to this account while payments in foreign currency are debited to this account. The balance in this account shows a positive or a negative figure depending upon whether the receipts of foreign currency are more or less than the payments.

Other things being equal, the presumption is that a country having a deficit balance of payments position would have a weakening national currency and vice versa. A deficit in the balance of payment account results in more demand for foreign currencies. Hence their value vis-à-vis the domestic currency increases.

Forex management may be defined as the science of management of generation, use and storage of foreign currencies in the process of exchange of one currency into other called foreign exchange. The above definition of Forex management has the following essential elements:

It is part of management science

Forex management is part of the broader management science. It is a scientific discipline requiring scientific and analytic orientation. The techniques of management are applied to the broad spectrum of foreign currencies. This broad spectrum refers to all the currencies of the world excluding the domestic currency. These techniques include planning for Forex, organization of Forex and control of Forex. We use the terms Forex and foreign exchange interchangeably. The planning part includes budgeting for Forex, organization refers to utilization of Forex and control part focuses on creation of Forex reserves.

The tools of Forex management are akin to domestic currency management but the level of analytical skills required for it is slightly higher because of the existence of spot, forwards and futures markets unlike the domestic currency area. Operations in the Forex market require quicker response time because of the greater volatility in exchange rates.

It refers to generation of Forex

Forex is generated from international trade transactions. When a country exports goods or services, it earns Forex. When goods or services are imported by a country, Forex is consumed. If the exports of a country are more than the imports, the Forex would be accumulated in reserves of the country. If the imports are more than the exports, the result would be a Forex deficit which has to be met by international borrowings. Either way, the Forex needs to be generated. Generation of Forex is a more difficult proposition because of variation in international trade practices and extent of competition.

It pertains to use of Forex

Forex management is concerned with use of Forex in meeting the requirements of the user group. The tools of cash management come handy in using Forex. The process of use of Forex involves identification of suppliers of goods and services, negotiation of terms and conditions of the transaction and culmination of transaction with the exchange of goods and services with Forex. Because of relative uncertainty about availability of Forex and volatility in its rates, advance tie-up of Forex is made through forward purchase contracts. In this entire process, close track of exchange rates needs to be maintained.

It covers storage of Forex

Forex management involving firm level Forex storage could be done through forward purchase contracts or through deposits in foreign currency bank accounts. At the national level, Forex storage is done through Forex reserves which are held in the form of Gold, Special Drawing Right (SDRs) of IMF and foreign currencies. While some amount of foreign exchange reserves need to be maintained to meet unforeseen contingencies, excessive accretion to reserves involve a cost which is sometimes justified on other economic consideration at the firm’s level. Forex is stored for meeting future import liabilities, whether certain or contingent. While storing Forex, it is important to bear in mind the actual cost of storage and the opportunity cost of not using the Forex elsewhere. Depending upon availability of Forex, if the opportunity cost is more than the cost of storage, then it is better not to store it.

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