Foreign Currency Management Pdf

Table of contents

Foreign Currency Management

This is the rate at which the currency of one country would change hands with the currency of another country. E. g. $1 = SLR 130

Types of Exchange Rate

Floating Rate. This rate depends on the levels of the international trade of a country and it does not interfere with the government of that country.
Fixed-Rate. This is the rate that the government of the country would set its own currency rate and it is not depending on the market rate.
Dirty Float. This is the rate that mixed between floating-rate and fixed-rate system.

This is where the government would allow the exchange rate to float between a particular two limits. If it goes outside either of the limits, then the government would take further action. 

Bid Price The price at which the currency is bought by the dealer.
Offer Price The price at which the currency is sold by the dealer. When regarding the forex dealings, Offer Price > Bid Price Example 01: David is a UK businessman. He needs $ 400,000 to buy US equipment. Identify the amount of required to buy the Dollars? ($/? 1. 75 – 1. 77).

Answer: The amount of  required = $ 400,000 $/1. 75 = 228571. 43 Example 02: James is a US businessman. He has just received a payment of 150,000 from his main customer in the UK. Identify the amount of $ received by James when 150,000 are given? ( /$ 0. 61 – 0. 63)

Answer: The amount of $ received = 150,000 /$ 0. 63 = $ 238095. 24 Spot Rate and Forward Rate Spot Rate This is the rate that is applicable for the immediate delivery of currency as of now.

Forward Rate

This is a rate that set for future transactions for a fixed amount of currency. The transaction would take place on the future date at this agreed rate by disregarding the market rate.

Discounts & Premiums


If the forward rate is quoted cheaper, then it is set to be quoted at a discount. E. g. $/? current spot is 1. 8500-1. 8800 and the one-month forward rate at 0. 0008-0. 0012 at a discount. When quoted at a discount.

Answer: 1. 8500-1. 8800 there should be more Dollars + 0. 0008-0. 0012 is received at a given Pound. = 1. 508-1. 8812 So the discount factor has to be added to the spot rate. Premiums If the forward rate is quoted more expensively, then it is set to be quoted at a premium. E. g. $/? current spot is 1. 9000-1. 9300 and the one-month forward rate at 0. 0010-0. 0007 at a premium. When quoted at a premium.

Answer: there should be fewer Dollars being 1. 9000-1. 9300 received at a given Pound because – 0. 0010-0. 0007 of the expensiveness of Dollars. So = 1. 8990-1. 9293 the premium factor has to be deducted from the spot rate.

Foreign Exchange Rate Risks .

Transaction Risk

This is the risk that adverse exchange rate movements occurring in the cause of normal international trading transactions. This arises when the prices of imports or exports are fixed in foreign currency terms and there is a movement in the exchange rate between the date when the price is agreed and when the cash is paid or received.
Translation Risk. This is the risk that the organization will make exchange losses when the accounting results of its foreign branches or subsidiaries translated into the local currency.
Economic Risk. This is the risk that supposes to the effect of exchange rate movements on the international competitiveness of the company.
Direct & Indirect Currency Quotes Direct Quote: This means the exchange rate is mentioned in terms of the amount of domestic currency that needs to be given in returns for one unit of foreign currency. E. g. SLR 130 for $1 Indirect Quote: This means the number of foreign currency units that need to be given to obtaining one unit of the domestic currency. E. g. $ 1/130 for SLR 1

Example 01

ABC Ltd is a US company, buying goods from Sri Lanka which cost SLR 200,000. These goods are resold in the US for $2000 at the time of the import purchased. The current spot rate is $1 = SLR 126-130. Calculate the expected profit of the resale in terms of US Dollars using both direct & indirect quote methods.

Answer: 1. ) Under Direct Quote Method $/SLR = 1/126 – 1/130 = 0. 00794 – 0. 00769 Sales = $2000 (-)Purchase Cost=SLR200,000*$/SLR0. 00794 =($1588) Expected Profit = $412 2. ) Under Indirect Quote Method Sales (-)Purchase Cost=SLR200,000/SLR126/$ Expected Profit = $2000 =($1587) = $413

Managing the Exchange Rate Risk

Invoicing in domestic currency Since the exporter does not have to do any currency transaction in this method, the risk of currency conversion is transferred to the importer or vice versa.
Money Market Hedging Because of the close relationship between the forward exchange rate and the interest rate in two currencies, it is possible to calculate a forward rate by using the spot exchange rate and money market lending or borrowing which is called a money market hedge.

Entering into forwarding Exchange Rate Contracts

A person can enter into an agreement with a bank to purchase the foreign currency on the fixed date at a fixed rate.
Matching receipts & payments. Under this method, a company can set off its payments against its receipts in that particular currency.
Options. These are similar to forward trade agreements, but the consumer can choose between the bank’s rate and the market rate. Example 01 A Sri Lankan company has to settle $800,000 after three months’ time. The current spot rate is $1 = SLR 126-130.

The foreign currency depositing interest rate is 12%per annum and the borrowing rate in Sri Lanka is 8% per annum. The agreed exchange rate with the bank is $1 = SLR128. The company has identified to overcome the exchange rate under Money Market Hedging & Forward Exchange Rate Contract methods. Identify the cheapest method to overcome the exchange rate risk.


Using Money Market Hedging Method FV = PV* (1+r)n PV = $800,000* (1+ 0. 03)-1 PV = $776,699 r = 0. 12*3/12 r = 0. 03 n=1 Purchase Cost(SLR) = $776,699*SLR130/$1 = SLR 100,970,870 Interest Cost(SLR) = SLR 100,970,870*0. 8*3/12=SLR 2,019,417 Total Cost(SLR) = SLR(100,970,870+2,019,417) = SLR 102,990,287
Using Forward Exchange Rate Contract Method Total Cost (SLR) = $ 800,000*SLR128/$1 = $102,400,000 The best method is the forward Exchange Rate Contract Method because it gives the lowest total cost when compared to Money Market Hedging Method.

Reasons for Short Term Changes of Exchange Rate

Investment. Flows. If a country does more investment in outside countries, then there would be a higher demand for foreign currency. Therefore the domestic will depreciate or vice versa.
Trade Flows. In a given time if a country has more imports and fewer exports, the domestic currency will depreciate, because of the higher demand for foreign currency or vice versa.
Economic Prospectus. If a country has good economic policies and is showing shines of economic growth, it could receive more investment and therefore the domestic currency would appreciate it.

Purchasing Power Parity Theory

This theory describes how the differences in the inflation rate among the two countries would lead to changes in the exchange rates.

Future Rate(A/B)=Spot Rate(A/B) 

(1+ Inflation Rate of A) (1 +Inflation Rate of B)

Interest Rate Parity Theory. This theory links the future currency rates with differences in interest rates among the two countries. Future Rate (A/B)=Spot Rate(A/B) * (1+ Interest Rate of A) (1 +Interest Rate of B)
Monetarist Theory. This theory identifies the relationship between the exchange rate and the government money supply to the economy of one country. E. g. When the government released more money to its economy, the individual would have more money. So they would purchase more, the demand will increase & through that result in higher prices & high inflation. This would lead to a high level of depreciation to the currency.
Keynesian Approach. This theory says that an exchange rate may not change in a balanced and sometimes currency may continuously appreciate or depreciate without reverse. E. g. There is a high taste & demand for the imported products in one country while their exports are losing their export position in other countries. Therefore, without any appreciation of currency will continuously depreciate over a long time period in that country.

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