Balance of Payments

1. Meaning

The balance of payments of a country is a systematic record of all its economic

transactions with the outside world in a given year.

It is a statistical record of the character and dimensions of the country’s economic

relationships with the rest of the world. According to Bo Sodersten, The balance of
payments is merely a way of listing receipts and payments in international
transactions for a country. B. J. Cohen says, “It shows the country’s trading position,
changes in its net position as foreign lender or borrower, and changes in its official
reserve holding.”

2. Structure of Balance of Payments Accounts

The balance of payments account of a country is constructed on the principle of

double-entry bookkeeping. Each transaction is entered on the credit and debit side of
the balance sheet. But balance of payments accounting differs from business
accounting in one respect. In business accounting, debits (-) are shown on the left
side and credits (+) on the right side of the balance sheet. But in balance of payments
accounting, the practice is to show credits on the left side and debits on the right side
of the balance sheet.

When a payment is received from a foreign country, it is a credit transaction while

payment to a foreign country is a debit transaction. The principal items shown on the
credit side (+) are exports of goods and services, unrequited (or transfer) receipts in
the form of gifts, grants, etc. from foreigners, borrowings from abroad, investments
by foreigners in the country, and official sale of reserve assets including gold to
foreign countries and international agencies.

The principal items on the Debit side (-) include imports of goods and services,
transfer (or unrequited) payments to foreigners as gifts, grants, etc., lending to
foreign countries, investments by residents to foreign countries, and official purchase
of reserve assets or gold from foreign countries and international agencies.

These credit and debit items are shown vertically in the balance of payments account
of a country according to the principle of double-entry book-keeping.

Horizontally, they are divided into three categories:

The current account, the capital account, and the offcial settlements account or the
Official reserve assets account.

The balance of payments account of a country is constructed in Table 1.

1. Current Accounting:
The current account of a country consists of all transactions relating to trade in goods
and services and unilateral (or unrequited) transfers. Service transactions include
costs of travel and transportation, insurance, income and payments of foreign
investments, etc. Transfer payments relate to gifts, foreign aid, pensions, and private
remittances, charitable donations etc. received from foreign individuals and
governments to foreigners.

In the current account, merchandise exports and imports are the most important
items. Exports are shown as a positive item and are calculated f.o.b. (free on board)
which means that costs of transportation, insurance, etc are excluded. On the other
side, imports are shown as a negative item and are calculated c.i.f. which means that
costs, insurance and freight are included.

The difference between exports and imports of a country is its balance of visible trade
or merchandise trade or simply balance of trade. If visible exports exceed visible
imports, the balance of trade is favourable. In the opposite case when imports exceed
exports, it is unfavourable.

It is, however, services and transfer payments or invisible items of the current
account that reflect the true picture of the balance of payments account. The balance
of exports and imports of services and transfer payments is called the balance of
invisible trade. The invisible items along with the visible items determine the actual
current account position. If exports of goods and services exceed imports of goods
and services, the balance of payments is said to be favourable. In the opposite case, it
is unfavourable.

In the current account, the exports of goods and services and the receipts of transfer
payments (unrequited receipts) are entered as credits (+) because they represent
receipts from foreigners. On the other hand, the imports of goods and services and
grant of transfer payments to foreigners are entered as debits (-) because they
represent payments to foreigners. The net value of these visible and invisible trade
balances is the balance on current account.

2. Capital Account:
The capital account of a country consists of its transactions in financial assets in the
form of short-term and long-term lending’s and borrowings, and private and official
investments. In other words, the capital account shows international flow of loans
and investments, and represents a change in the country’s foreign assets and
liabilities.

Long-term capital transactions relate to international capital movements with

maturity of one year or more and include direct investments like building of a foreign
plant, portfolio investment like the purchase of foreign bonds and stocks, and
international loans. On the other hand, short-term international capital transactions
are for a period ranging between three months and less than one year.

There are two types of transactions in the capital account—private and government.
Private transactions include all types of investment: direct, portfolio and short-term.
Government transactions consist of loans to and from foreign official agencies.

In the capital account, borrowings from foreign countries and direct investment by
foreign countries represent capital inflows. They are positive items or credits because
these are receipts from foreigners. On the other hand, lending to foreign countries
and direct investments in foreign countries represent capital outflows. They are
negative items or debits because they are payments to foreigners. The net value of the
balances of short-term and long-term direct and portfolio investments is the balance
on capital account.

Sodersten and Reed refer to the external wealth account of a country which shows
the stocks of foreign assets held by the country (positive item) and of domestic assets
held by foreign investors (liabilities or negative item). The net value of a country’s
assets and liabilities is its balance of indebtedness. If its assets are more than its
liabilities, then it is a net creditor. If its liabilities are more than its assets, then it is a
net debtor.

Basic Balance:
The sum of current account and capital account is known as the basic balance.

3. The Official Settlements Account:

The official settlements account or official reserve assets account is, in fact, a part of
the capital account. But the U.K. and U.S. balance of payments accounts show it as a
separate account. “The official settlements account measures the change in nation’s
liquidity and non-liquid liabilities to foreign official holders and the change in a
nation’s official reserve assets during the year. The official reserve assets of a country
include its gold stock, holdings of its convertible foreign currencies and SDRs, and its
net position in the IMF.” It shows transactions in a country’s net official reserve
assets.
Errors and Omissions:
Errors and omissions is a balancing item so that total credits and debits of the three
accounts must equal in accordance with the principles of double entry book-keeping
so that the balance of payments of a country always balances in the accounting sense.

3. Measuring Deficit or Surplus in Balance of Payments

If the balance of payments always balances, then why does a deficit or surplus arise
in the balance of payment of a country? It is only when all items in the balance of
payments are included that there is no possibility of a deficit or surplus. But if some
items are excluded from a country’s balance of payments and then a balance is
struck, it may show a deficit or surplus.

There are three ways of measuring deficit or surplus in the balance of

payments:
First, there is the basic balance which includes the current account balance and the
long-term capital account balance.

Second, there is the net liquidity balance which includes the basic balance and the
short-term private non-liquid capital balance, allocation of SDRs, and errors and
omissions.

Third, there is the official settlements balance which includes the total net liquid
balance and short-term private liquid capital balance.

If the total debits are more than total credits in the current and capital accounts,
including errors and omissions, the net debit balance measures the deficit in the
balance of payments of a country. This deficit can be settled with an equal amount of
net credit balance in the official settlements account.

On the contrary, if total credits are more than total debits in the current and capital
accounts, including errors and omissions, the net debit balance measures the surplus
in the balance of payments of a country. This surplus can be settled with an equal
amount of net debit balance in the official settlements account.
4. Balance of Trade and Balance of Payments

The balance of payments of a country is a systematic record of its receipts and

payments in international transactions in a given year. Each transaction is entered
on the credit and debit side of the balance sheet (see Table 1).

The principal items on the credit side are:

(1) Visible exports which relate to the goods exported for which the country receives
payments.

(2) Invisible exports which refer to the services rendered by the country to other
countries.

Such services consist of banking, insurance, shipping, and other services rendered in
the form of technical know-how, etc., money spent by tourists and students visiting
the country for travel and education, etc.

(3) Transfer receipts in the form of gifts received from foreigners.

(4) Borrowings from abroad and investments by foreigners in the country.

(5) The official sale of reserve assets including gold to foreign countries and
international institutions.

The principal items on the debit side are:

(1) Visible imports relating to goods imported for which the country makes payments
to foreign countries.

(2) Invisible imports in the form of payments made by the home country for services
rendered by foreign countries. These include all items referred to under (2) In the
above para.

(3) Transfer payments to foreigners in the form of gifts, etc.

(4) Loans to foreign countries, investments by residents in foreign countries, and

debt repayments to foreign countries.
(5) Official purchase of reserve assets or gold from foreign countries and
international institutions.

If the total receipts from foreigners on the credit side exceed the total payments to
foreigners on the debit side, the balance of payments is said to be favourable. On the
other hand, if the total payments to foreigners exceed the total receipts from
foreigners, the balance of payments is unfavourable.

The balance of trade is the difference between the value of goods and services
exported and imported. In contains the first two items of the balance of payments
account on the credit and the debit side. This is known as “balance of payment on
current account.” Some writers define the balance of trade as the difference between
the value of merchandise exports and imports. Prof. Meade regards this way of
defining the balance of trade as wrong and of minor economic significance from the
point of view of the national income of the country.

5. Disequilibrium in Balance of Payments

Disequilibrium in the BOP of a country may be either a deficit or a surplus. A deficit

or surplus in BOP of a country appears when its autonomous receipts (credits) do not
match its autonomous payments (debits). If autonomous credit receipts exceed
autonomous debit payments, there is a surplus in the BOP and the disequilibrium is
said to be favourable. On the other hand, if autonomous debit payments exceed
autonomous credit receipts, there is a deficit in the BOP and the disequilibrium is
said to be unfavourable or adverse.

6. Measures to Correct Deficit in Balance of Payments

When there is a deficit in the balance of payments of a country, adjustment is

brought about automatically through price and income changes or by adopting
certain policy measures like export promotion, monetary and fiscal policies,
devaluation and direct controls.

We study these as follows:

1. Adjustment through Exchange Depreciation (Price Effect):
Under flexible exchange rates, the disequilibrium in the balance of payments is
automatically solved by the forces of demand and supply for foreign exchange. An
exchange rate is the price of a currency which is determined, like any other
commodity, by demand and supply. “The exchange rate varies with varying supply
and demand conditions, but it is always possible to find an equilibrium exchange rate
which clears the foreign exchange market and creates external equilibrium.’ This is
automatically achieved by depreciation of a country’s currency in case of deficit in its
balance of payments.

Depreciation of a currency means that its relative value decreases. Depreciation has
the effect of encouraging exports and discouraging imports. When exchange
depreciation takes place, foreign prices are translated into domestic prices. Suppose
the dollar depreciates in relation to the pound. It means that the price of dollar falls
in relation to the pound in the foreign exchange market.

This leads to the lowering of the prices of U.S. exports in Britain and raising of the
prices of British imports in the U.S. When import prices are higher in the U.S., the
Americans will purchase less goods from the Britishers. On the other hand, lower
prices of U.S. exports will increase exports and diminish imports, thereby bringing
equilibrium in the balance of payments.

2. Devaluation or Expenditure-Switching Policy:

Devaluation raises the domestic price of imports and reduces the foreign price of
exports of a country devaluing its currency in relation to the currency of another
country. Devaluation is referred to as expenditure switching policy because it
switches expenditure from imported to domestic goods and services. When a country
devalues its currency, the price of foreign currency increases which makes imports
dearer and exports cheaper. This causes expenditures to be switched from foreign to
domestic goods as the country’s exports rise and the country produces more to meet
the domestic and foreign demand for goods with reduction in imports. Consequently,
the balance of payments deficit is eliminated.

3. Direct Controls:
To correct disequilibrium in the balance of payments, government also adopts direct
controls which aim at limiting the volume of imports. The government restricts the
import of undesirable or unimportant items by levying heavy import duties, fixation
of quotas, etc. At the same time, it may allow Imports о essential goods duty free or
at lower import duties, or fix liberal import quotas for them.

For instance the government may allow free entry of capital goods, but impose heavy
import duties on luxuries.’ Import quotas are also fixed and the importers are
required to take licenses from the authorities in order to import certain essential
commodities in fixed quantities.

In these ways, imports are reduced in order to correct an adverse balance of

payments. The government also imposes exchange controls. Exchange controls have
a dual purpose. They restrict imports and also control and regulate the foreign
exchange. With reduction in imports and control of foreign exchange, visible and
invisible imports are reduced. Consequently, an adverse balance of payment is
corrected.

4. Adjustment through Capital Movements

A country can use capital imports to correct a deficit in its balance of payments. A
deficit can be financed by capital inflows. When capital is perfectly mobile within
countries, a small rise in the domestic rate of interest brings a large inflow of capital.
The balance of payments is said to be in equilibrium when the domestic interest rate
equals the world rate. If the domestic interest rate is higher than the world rate, there
will be capital inflows and the balance of payments deficit is corrected.

5. Adjustment through Income Changes:

Given the foreign exchange rate and prices in a country, an increase in the value of
exports, causes an increase in the incomes of all persons associated with the export
industries. These, in turn create demand for other goods and services within the
country. This will raise the incomes of persons engaged in the latter industries and
services. This process will continue and the national income increases by the value of
the multiplier.
6. Stimulation of Exports and Import Substitutes:
A deficit in the balance of payments can also be corrected by encouraging exports.
Exports can be encouraged by producing quality products, by reducing exports
through increased production and productivity, and by better marketing. They can
also be increased by a policy of import substitution it means that the country
produces those goods which it imports.

In the beginning, imports are reduced in the long run exports of such goods start. An
increase in exports causes the national income to rise by many times through the
operation of the foreign trade multiplier. The foreign trade multiplier expresses the
change in income caused by a change in exports. Ultimately, the deficit in the balance
of payments is removed when exports rise faster than imports.
 Exchange Rate

What Is an Exchange Rate?

An exchange rate is the rate at which one currency can be exchanged for
another. In other words, it is the value of another country's currency compared
to that of your own. If you are traveling to another country, you need to "buy"
the local currency. Just like the price of any asset, the exchange rate is the
price at which you can buy that currency. If you are traveling to Egypt, for
example, and the exchange rate for U.S. dollars is 1:5.5 Egyptian pounds, this
means that for every U.S. dollar, you can buy five and a half Egyptian pounds.
Theoretically, identical assets should sell at the same price in different
countries, because the exchange rate must maintain the inherent value of one
currency against the other.

What are Fixed and Floating Exchange Rates?

Fixed Exchange Rates

There are two ways the price of a currency can be determined against
another. A fixed, or pegged, rate is a rate the government (central bank) sets
and maintains as the official exchange rate. A set price will be determined
against a major world currency (usually the U.S. dollar, but also other major
currencies such as the euro, the yen or a basket of currencies). In order to
maintain the local exchange rate, the central bank buys and sells its own
currency on the foreign exchange market in return for the currency to which it
is pegged.

If, for example, it is determined that the value of a single unit of local currency
is equal to US$3, the central bank will have to ensure that it can supply the
market with those dollars. In order to maintain the rate, the central bank must
keep a high level of foreign reserves. This is a reserved amount of foreign
currency held by the central bank that it can use to release (or absorb) extra
funds into (or out of) the market. This ensures an appropriate money supply,
appropriate fluctuations in the market (inflation/deflation) and ultimately, the
exchange rate. The central bank can also adjust the official exchange rate
when necessary.

Floating Exchange Rates

Unlike the fixed rate, a floating exchange rate is determined by the private
market through supply and demand. A floating rate is often termed "self-
correcting," as any differences in supply and demand will automatically be
corrected in the market. Look at this simplified model: if demand for a currency
is low, its value will decrease, thus making imported goods more expensive
and stimulating demand for local goods and services. This in turn will generate
more jobs, causing an auto-correction in the market. A floating exchange rate
is constantly changing.

In reality, no currency is wholly fixed or floating. In a fixed regime, market

pressures can also influence changes in the exchange rate. Sometimes, when
a local currency reflects its true value against its pegged currency, a "black
market" (which is more reflective of actual supply and demand) may develop.
A central bank will often then be forced to revalue or devalue the official rate
so that the rate is in line with the unofficial one, thereby halting the activity of
the black market.

In a floating regime, the central bank may also intervene when it is necessary
to ensure stability and to avoid inflation. However, it is less often that the
central bank of a floating regime will interfere.

The World Once Pegged

Between 1870 and 1914, there was a global fixed exchange rate. Currencies
were linked to gold, meaning that the value of a local currency was fixed at a
set exchange rate to gold ounces. This was known as the gold standard. This
allowed for unrestricted capital mobility as well as global stability in currencies
and trade. However, with the start of World War I, the gold standard was
abandoned.

At the end of World War II, the conference at Bretton Woods, an effort to
generate global economic stability and increase global trade, established the
basic rules and regulations governing international exchange. As such, an
international monetary system, embodied in the International Monetary
Fund(IMF), was established to promote foreign trade and to maintain the
monetary stability of countries and therefore, that of the global economy.

It was agreed that currencies would once again be fixed, or pegged, but this
time to the U.S. dollar, which in turn was pegged to gold at US$35 per ounce.
What this meant, was that the value of a currency was directly linked with the
value of the U.S. dollar. So, if you needed to buy Japanese yen, the value of
the yen would be expressed in U.S. dollars, whose value in turn was
determined in the value of gold. If a country needed to readjust the value of its
currency, it could approach the IMF to adjust the pegged value of its currency.
 The peg was maintained until 1971, when the U.S. dollar could no longer hold
the value of the pegged rate of US$35 per ounce of gold.

From then on, major governments adopted a floating system, and all attempts
to move back to a global peg were eventually abandoned in 1985. Since then,
no major economies have gone back to a peg, and the use of gold as a peg
has been completely abandoned.

How to Hedge Currency

Three Methods: Hedging with Currency Swaps, Hedging with Forward Contracts & Other Hedging
Options

The hedge is an insurance policy. Whether you're transacting business abroad or

simply holding onto foreign currencies as an investment, a fluctuation in currency
can cause serious losses very quickly. A hedge is a way to guard against this: Invest
in an offsetting position with an investment you already own, and any losses in one
position will be buoyed up by gains in the other.

Method 1 of 3: Hedging with Currency Swaps

Swap currencies and interest rates with a party in a currency swap. In a
currency swap, two parties agree to swap equivalent amounts of cash (called
principal) as well as interest rate payments over a fixed period of time. The cash
usually originates as debt (a party issues a bond) or as credit (a party gets a loan).
Whereas the principals exchanged are usually equivalent amounts — Party A swaps
$1,000,000 for €750,0000 from Party B, based on the exchange rate — the swapped
interest rate payments are usually different.
 Here's a very basic example. Vitaly Partners, an Italian company, wants to hedge
against the euro by buying dollars. Vitaly agrees on a currency swap with Brand
USA, an American company. Over 5 years, Vitaly sends Brand USA €1,000,000 in
exchange for the dollar equivalent, about $1,400,000. Vitaly agrees to swap interest
payments with Brand USA as well: Vitaly will send over 6% interest on its swapped
principal, €1,000,000, while Brand USA will send over 4.5% interest on its swapped
principal, $1,400,000.

Exchange interest payments in a currency swap, not principals. The principal

that the two parties agree to swap isn't actually exchanged. It is kept by both parties.
The principal is what financiers call a notional principal, or an amount that is
theoretically exchanged but actually kept.[1] Why is the principal needed, then? It's
needed to calculate the interest payments, which are the backbone of any currency
swap.
1.

Calculate your interest rate payment. Interest rate payments are usually swapped
at 6-month or 1-year intervals, and this is where the parties transfer currencies that
help them hedge against fluctuations in their own currency. Let's look at an example:

 Vitaly agreed to swap €1,000,000 at 6% to Brand USA in exchange for $1,400,000 at

4.5%. Let's assume that interest rate payments are swapped every 6 months.
 Vitaly's interest rate payment will be calculated as follows: Notional principal xinterest
rate x frequency. Every six months, Vitaly will pay Brand USA €30,000, in euros.
(€1,000,000 x .06 x .5 [180 days/360 days] = €30,000.)
 Brand USA's interest rate payment will be calculated as follows: $1,400,000 x .045 x
.5 = $31,500. Brand USA will pay Vitaly $31,500, in dollars, every six months.

2.

Work with a partnering financial institution to mediate the swap. For simplicity,
this example so far has avoided a third party that's involved in the swap — banks.
When Vitaly sends its interest payments over to Brand USA, it does so by sending
the bank the interest payment first; the bank takes a small cut and sends the rest of
the interest payment on over the Brand USA. Ditto for Brand USA; it must also
 mediate the transaction through the bank, which takes a small cut from their swap for
the granting the privilege.

3.

Use currency swaps if you get better loan rates at home than you do abroad.
Why choose currency swaps instead of just buying foreign currency? Currency
swaps involve two parties. Remember Vitaly and Brand USA. Vitaly gets a better
interest rate on its loan of €1,000,000 in Italy than it would if it asked for the loan in
America. Likewise, Brand USA gets a better interest rate on its $1,400,000 loan in
America than it would if it got the loan in Italy. By agreeing to exchange interest rate
payments, currency swaps bring together two parties that each have better loan
agreements in different countries, and therefore, different currencies.[2]

Method 2 of 3: Hedging with Forward Contracts

1.
 Purchase forward contracts. A forward contract is like a futures contract, or
derivative. It is an agreement to buy or sell a currency at a fixed price on a later date.
Here's an example:

 Dave is worried that the price of the dollar is going to plummet relative to the British
pound. He's got $1,000,000 in cash, which would fetch him about £600,000 in 2014.
Dave wants to use a forward contract to lock in the exchange rate of the dollar
relative to the pound. Here's what Dave does.
 Dave offers to sell Vivian $1,000,000 of US currency in exchange for £600,000 of
British currency in 6 months. Vivian accepts the deal. This is a forward contract.

2.

Evaluate the forward contract at the agreed-upon time. Let's continue with our
example of Dave offering a forward contract to Vivian. In 6 months (the agreed-upon
time), there are three possible outcomes about the price of the dollar relative to the
pound. Each of these possibilities affects the forward contract:

 The price of the dollar goes up relative to the pound. Hypothetically, let's say 1 dollar
now fetches .75 pounds instead of .6 pounds. Dave pays Vivian the difference
between the current price of exchange and the price agreed upon in the contract:
($1,000,000 x .75) - ($1,000,000 x .6) = $150,000.
 The price of the dollar goes down relative to the pound. Hypothetically, let's say 1
dollar now fetches .45 pounds instead of .6 pound. Vivian agreed to pay Dave .6
pounds for every one million of his dollars six months ago, so Vivian has to pay Dave
the difference between the price agreed upon in the contract and the current price:
($1,000,000 x .6) - ($1,000,000 x .45) = $150,000.
 The exchange rate between the dollar and the pound stays the same. No exchange
happens between partners in the contract.
3.

Use forward contracts as a way to hedge against currency drops and

spikes.Like any derivative, a forward contract is a great way to ensure you don't lose
a lot of money if a currency you have a sizable position on drops in value. Here's
how Dave came ahead by using a forward contract:

 If the dollar gained in value, Dave is a winner, although he still has to pay out. If one
dollar fetches .75 pounds instead of .6, Dave has to pay Vivian $150,000, but his
million dollars suddenly buys a lot more pounds.
 If the dollar fell in value, Dave isn't a loser. Remember, Vivian owes him the
exchange rate they agreed upon at the beginning of the contract. So it's as if the
value of the dollar never fell. Dave takes the payout, none the poorer than he was
before.

Method 3 of 3: Other Hedging Options

1.

Buy foreign currency options. Foreign currency options give the purchaser the
option to sell or buy a foreign currency contract at a specific price on a specific date.
This hedging technique is similar to forward contracts, except that the owner of the
option doesn't need to exercise the option.
  When the specific date (known as the expiration date) of the contract arrives, the
buyer of the contract can exercise the option at the agreed price (known as the strike
price), if currency fluctuations have made it profitable for them. If fluctuations have
made the option worthless, it expires without the company or individual exercising it.

2.

Buy gold. You can use gold and other precious metals to hedge currency positions.
Investors have used gold as a hedge since ancient times, and many investors still
keep gold in their portfolios to guard against economic pitfalls or disasters.

3.

Exchange some of your native currency for a foreign currency. One of the
simplest ways to hedge your currency holdings is to buy some foreign currencies. If
you live in a country that uses the Euro, for example, you can buy U.S. dollars, Swiss
francs or Japanese yen. If the value of the Euro drops relative to the other
currencies, you’ve sheltered yourself to the extent that you’ve purchased other
currencies.
4.

Buy spot contracts. A spot contract is an agreement to sell or buy foreign currency
at the current rate and requires execution within two days. Spot contracts are
essentially the opposite of futures contracts, where the deal is agreed upon well
before the assets or goods are delivered, if at all.

Three Reasons to Hedge

Hedgers shun the risk of price change and look for ways to transfer it, while
speculators assume the risk of price change by taking one position (either long or
short) in a market, and waiting for the price of their commodity to go in "their"
direction. Hedgers, on the other hand, have a position, either long or short, usually in
the cash market, and attempt to limit their risk of price change loss by entering into
an opposite and approximately equal position in another market (usually futures or
options).

A short hedger is someone who has a long position (owns the commodity) in
the cash market and transfers the risk of price decline by selling a futures contract or
buying a put option. If the cash market price declines and the futures market price
also declines, the loss he suffers in the cash market will be offset by the gain he
realizes in the futures market—at least that's the plan! Of course, it's likely that the
cash and futures prices won't move exactly in tandem, in which case the short
hedger may either achieve a better or worse price than he targeted when he entered
the hedge.

Take, for example, a farmer growing his crop. As harvest time approaches,
reality starts to set in, and the farmer realizes that he isn't the only one about to
harvest a crop, so he wonders how low his crop's price will go as the large harvest
supply reaches the market. At this point, he says, "Gee, I wish I knew more about
hedging, but it sounds so scary."

What some people find scary is the “volatility” of the futures markets;
however, the futures markets are no more volatile than the cash markets. In fact,
futures markets are so liquid, that they are actually less volatile and cash market
prices generally key off them. Furthermore, futures prices are easily determined and
widely published.

So why not use futures to hedge? Hedging has the following three
advantages to offer:

Price risk transfer. Cash market prices change and there’s nothing you can do
about it. What’s more, they’re going to keep changing, no matter what you do. So
you have three choices: assume the risk of price change (be a speculator), transfer
the risk of price change to a speculator (be a hedger), or get out of the market.

To be a hedger, you must have a cash market position (you must have a
position to hedge). You must either produce a commodity, such as cotton, corn, or
crude oil, use a commodity, such as silver, soybeans or sugar. If you produce a
commodity, you have a “long” cash market position. As a speculator with a long cash
market position, you want prices to rise because you are either storing the
commodity for sale at a later date or you expect to supply the commodity for sale at
a later date. By holding the commodity until it hits a higher price and then selling, you
earn a profit.

Unfortunately, the market prices don’t always cooperate with buyers and
sellers. How often do you think the price of a given commodity is going to be at its
annual high when you’re ready to sell? Or at its annual low when you’re ready to
buy? Because many commodities are seasonal, most commodity producers would
agree: the answer is “never.” So what can you do?

Instead of waiting until you have the cash market product in hand, you can do
a “substitute sale” in the futures market—this is also called “hedging.” This means
that you sell now in the futures market, substituting your actions in the futures market
today for what you will do in the cash market later. Of course, the trick is to
“substitute” a better price today for a worse price that you would have to accept in
the cash market in the future. By selling today at a higher price, you lock in a sales
price (except for possible changes in basis—the difference between cash and
futures prices), thus reducing your risk of loss from price changes. Because cash
market prices and futures market prices tend to move together, if you substitute a
sale today in the futures market for a later one in the cash market, then if prices do
go down, as you expect them to, you can buy back the futures at a lower price than
you sold them, pocketing a profit that approximately covers the opportunity price you
missed in the cash market. When you close your futures position, you market your
cash commodity the same way you always have done.

On the other hand, people who have a need for a commodity at some point in
the future can do a "substitute purchase" in the futures market. This is also called
hedging, and the person who is in such a position is a long hedger. Long hedgers
buy now in the futures market to cover an anticipated need for the commodity in the
future—they are short the cash commodity they will need later. They hope to
substitute a better price today for a worse price they would have to accept in the
cash market in the future. By buying today at a lower price, they reduce their risk of
loss from price changes. If prices increase as expected, long hedgers sell the futures
at a higher price than they were purchased, pocketing a profit that approximately
offsets the higher cost of the cash commodity purchased in the usual way.

Profit potential. It is possible (but not guaranteed) that after a short hedge has
been put in place, both the cash and futures prices will drop, with the futures price
dropping more than the cash price. This is a “favorable” change in basis. If this
happens, the futures position more than offsets the loss in the cash market, thus
earning a profit greater than that originally targeted. That can’t happen if you simply
forward contract for the sale of your commodity. Of course, the opposite could also
occur (futures price dropping less than the cash price), bringing in less than originally
targeted.

Similarly, after a long hedge has been put in place, both the cash and futures
prices may rise, with the futures price rising more than the cash price. This is a
"favorable" change in basis. If this happens, the futures position more than offsets
the loss in the cash market, thus reducing costs more, for a profit greater than that
originally targeted. That can’t happen if you simply forward contract for the purchase
of your commodity. Of course, the opposite could also occur (futures price rising less
than the cash price), costing more than originally targeted.

Cash Flow Smoothing. If you establish a hedge six months before your cash
market transaction and then prices move unfavorably, your futures market position
will start to earn you cash in the short run. The reason is that futures positions are
“marked to the market” daily: if your futures position has a gain during today’s
trading, the gained amount will be deposited to your account at the close of business
today. This cash may help your cash flow until your cash market transaction. By
providing a positive cash flow, overall operations may be easier to plan and less
stressful to manage. It can also help to establish a better relationship with your
banker because bankers prefer to work with the less-risky hedger rather than the
riskier speculator.

Some people still object to hedging, in spite of these benefits, on the grounds
that there is unlimited risk associated with a futures position. Perhaps they don't
realize that, for hedgers, any money lost in the futures market is probably offset by
gains enjoyed in the cash market. Maybe it was for these people that options on
futures were invented.

What is the nominal and real exchange rate?

The nominal exchange rate E is defined as the number of units of the domestic
currency that can purchase a unit of a given foreign currency. A decrease in this
variable is termed nominal appreciation of the currency. (Under the fixed
exchange rate regime, a downward adjustment of the rate E is termed
revaluation.) An increase in this variable is termed nominal depreciation of the
currency. (Under the fixed exchange rate regime, an upward adjustment of the
rate E is called devaluation.)
By contrast, the real exchange rate R is defined as the ratio of the price level
abroad and the domestic price level, where the foreign price level is converted
into domestic currency units via the current nominal exchange rate. Formally,
R=(E.Pz)/Pd, where the foreign price level is denoted as Pz and the domestic
price level as Pd. An increase in R is termed appreciation of the real exchange
rate, a decrease is termed depreciation. The real rate tells us how many times
more goods and services can be purchased abroad (after conversion into a
foreign currency) than in the domestic market for a given amount. In practice,
changes of the real exchange rate rather than its absolute level are important.
In contrast to the nominal exchange rate, the real exchange rate is always
”floating”, since even in the regime of a fixed nominal exchange rate E, R can
move via price-level changes.

Rather than focusing on the nominal exchange rate, it is more sensible to

monitor the real exchange rate when assessing the effect of exchange rates on
international trade. For simplicity, assume that the domestic price level rises by
10%, the foreign price level remains unchanged and the domestic currency
depreciates nominally by 10%. Then the real exchange rate, i.e. the ratio of
prices at home and abroad, remains unaffected, depreciation of the domestic
currency notwithstanding. Other things held equal in our simplified framework,
there would be no change in the demand for imports in the domestic economy
and in the demand for exports of the domestic economy abroad.

Nominal versus Real Exchange Rates

When discussing international trade and foreign exchange, two types of exchange
rates are used. The nominal exchange rate simply states how much of one currency
can be traded for a unit of another currency. The real exchange rate, on the other
hand, describes how many of a good or service in one country can be traded for one
of that good or service in another country. For example, a real exchange rate might
state how many European bottles of wine can be exchanged for one US bottle of
wine.
This is, of course, a bit of an oversimplified view of reality- after all, there are
differences in quality and other factors between the US wine and the European wine.
The real exchange rate abstracts away these issues, and it can be thought of as
comparing the cost of equivalent goods across countries.

There are two types of options: calls and puts. When you buy a call, you are
buying the right to take delivery of something (let’s say one futures contract for 5,000
troy ozs. of silver) at a specific price (let’s say $13.50 per troy oz.) within a certain
time (if it’s an October call, exercise of the option [and subsequent delivery of the
underlying futures contract] must occur before the option expires in September). If
the price of the underlying futures contract (which reflects the price of silver) goes up
before the call expires, the call’s value may also go up. On the other hand, if the
price of silver goes down, the call’s value will probably decline. (If this price/time
relationship is of interest to you, you may want to read more about the time value
and intrinsic value of options—see Making Sense of Futures Options, available from
Center for Futures Education, Inc.)

On the other hand, purchasing a put gives you the right to deliver (sell)
something (let’s say one futures contract for 100 troy ozs. of gold) at a specific price
(let’s say $660.00 per troy oz.) within a certain time (if it’s an October put, delivery
must occur before the option expires in September). If the price of the underlying
futures contract (which reflects the price of gold) goes down before the put expires,
the put’s value can go up. On the other hand, if the price of gold goes up, the put’s
value will probably go down. In short, a speculator who buys a gold put wants to see
the price of gold drop as fast as possible (the faster, the better). Conversely, the
cash market seller who hedges his holdings by purchasing a put, may not care what
happens to the price of gold. He’s going to gain from his cash commodity sale if the
gold price goes up and, depending on how quickly the price drops, he can gain from
his put.

While there is a lot to learn if you want to hedge properly, either with futures
contracts or options on futures, it can be worth your while. The risk reduction
potential is sizeable, and the cash flow smoothing effects from hedging consistently,
year in and year out, allow for longer-term planning, an overall better profit margin,
and less stress. Hedging sure can beat speculating in the cash market.

The Effects of a Devaluation

The adoption of a fixed exchange rate regime does not mean that the exchange rate will never be
changed. Changes in official or parity exchange rates have typically been frequent. Here we deal
with the question of how output, employment, prices and the balance of payments are affected
when countries adjust the level at which they fix their exchange rates.

A devaluation of the official exchange rate operates like a tariff---it shifts world demand for goods
and services off of foreign and onto domestic output. An increase in the official parity value of the
currency---an appreciation or revaluation---has the opposite effect.

Let us look again at the goods and asset market equilibrium conditions of the small open economy:

1. Y = ( a + δ + ΦBT + DSB)/(s + m) − μ/(s + m) r + m*/(s + m) Y* − σ/(s + m) Q

2. r* = − (1/θ)( M/P + ΦM ) − τ + (ε/θ) Y

where Y and Y* denote domestic and foreign output and income and
employment, ΦBT represents exogenous shocks to the balance of trade, DSB is the debt service
balance, Q is the real exchange rate, defined as the relative price of domestic in terms of rest-of-
world output, r* is the domestic real interest rate which, is determined by world market
conditions, s is the domestic marginal propensity to save, m and m* are the domestic and foreign
marginal propensities to import, M is the nominal money stock, P is the domestic price
level, ΦM represents an exogenous shift factor in the demand for real money balances and τ is the
expected rate of domestic inflation.
A devaluation of the official exchange rate under conditions of less than full employment
lowers Q in Equation 1, making domestic goods cheaper in world markets. The current account
balance increases, increasing aggregate demand and shifting IS to the right. Given a fixed exchange
rate and less than full employment, small-open-economy equilibrium is determined by the
intersection of the IS curve and the ZZ line. The rightward shift of the IS curve resulting from a
devaluation of the nominal exchange rate and corresponding reduction in Q leads to an increase in
output and employment.As output rises in Equation 2 at the given world real interest rate, the
quantity of money demanded increases leading to a sale of assets abroad by domestic residents
and an increase in official reserve holdings as the authorities purchase the foreign exchange
necessary to keep the exchange rate from appreciating back to its old level. This is shown in Figure
1. The LM curve shifts to pass through the new IS-ZZ intersection, which happens here to be at the
full-employment level of output.

These money supply and foreign exchange reserve adjustments can be seen more easily if we
rewrite the asset Equation 2 in the form

3. M = P [ ΦM − θ (r* + τ) + ε Y ]

which puts M on the left-hand side.

Taking advantage of the fact that

4. H = mm H = mm (R + Dsc)

where H is the stock of base or high-powered money, mm is the money multiplier, R is the stock
of foreign exchange reserves and Dsc is the domestic source component of the stock of base
money, Equation 3 can be written

5. R = (P / mm) [ ΦM − θ (r* + τ) + ε Y ] − Dsc

The devaluation-induced rise in income leads to an increase in the demand for base money, given by
the expression in the square brackets [..]. At a given level of Dsc , this results in an increase in the
stock of official foreign exchange reserves.

A devaluation under less-than-full-employment conditions thus leads to an increase in output and

employment and a one-shot increase in the stock of foreign exchange reserves. This increase in
foreign exchange reserves would be avoided if the central bank were to
increase Dsc appropriately by purchasing bonds in the open market.

It is sometimes argued that devaluations are necessary to eliminate deficits in the balance of
payments. A balance of payments deficit is a continual outflow of foreign exchange reserves as
indicated by a negative rate of change of R through time. For such a deficit to occur Dsc must be
growing at a faster rate through time than the terms in the square brackets in Equation 5. A
devaluation will increase the stock of reserves but not necessarily increase the rate of growth or
reduce the rate of decline through time in that reserve stock. Thus, it will not necessarily cure a
balance of payment deficit. A balance of payments deficit can be easily cured without changing
the exchange rate by simply reducing the rate at which Dsc is growing through time. Also, a one-
shot increase in the stock of reserves can be brought about by a one-shot reduction
in Dsc without changing the official rate of exchange of domestic for foreign currency. Since a
devaluation is not necessary to improve the balance of payments, what would be its purpose?

One possible reason for devaluing the currency would be to expand output and employment in a
recession. The problem is, however, that when all other countries maintain their fixed exchange
rates this is a strict beggar-thy-neighbor policy---any gain in domestic output which occurs through
an increase in the current account balance comes at the expense of employment and output in the
rest of the world.

It turns out that, apart from fiscal policies, a devaluation (or appreciation) of the exchange rate
parity is the only way a country can change its price level in a fixed-exchange-rate regime under full-
employment conditions. As the devaluation shifts IS to the right the price level rises to shift it back to
its intersection with the ZZ curve at output and income YF. The money supply must then be
increased either by an open market purchase of domestic bonds or an accumulation of official
foreign exchange reserves by the central bank to maintain the position of the LM curve through that
same intersection. Similarly, an appreciation of the country's currency will lower the domestic price
level. Money supply manipulation is not possible when the exchange rate does not change
because the authorities are forced to provide domestic residents with their desired money
holdings in order to prevent the exchange rate from moving off its parity. But the price level
change consequent on a devaluation can be equally well achieved by increasing the money supply
and letting the exchange rate float. Indeed, the same money supply change will be associated with
a given movement in the exchange rate whether the money supply adjustment is exogenous (and
the exchange rate adjusts endogenously) or the exchange rate adjustment is exogenous (and the
money supply adjusts endogenously). The shifts in IS and LM curves are identical in the two cases.

When countries change their official exchange rates, they usually move them by several percentage
points. Since an appreciation of the domestic currency by, say, 10 percent will lower the equilibrium
domestic price level by the same percentage, it would seem that official exchange rate movements
are a rather blunt instrument for manipulating the domestic price level. A better approach would
probably be to let the exchange rate float and gradually change the rate of domestic monetary
expansion.

Time for a test. Be sure and think up your own answers before looking at the ones provided.
 Economic effect of a devaluation of the currency
A devaluation occurs in a fixed exchange rate. A depreciation occurs in a floating
exchange rate system. Both mean a fall in the value of the currency. e.g. a devaluation
in the Pound means it is worth less Euros.

Effects of a devaluation
1. Exports cheaper. A devaluation of the exchange rate will make exports more
competitive and appear cheaper to foreigners. This will increase demand for exports
2. Imports more expensive. A devaluation means imports will become more expensive.
This will reduce demand for imports.
3. Increased AD. A devaluation could cause higher economic growth. Part of AD is (X-
M) therefore higher exports and lower imports should increase AD (assuming demand is
relatively elastic). Higher AD is likely to cause higher Real GDP and inflation.
4. Inflation is likely to occur because:
 Imports are more expensive causing cost push inflation.
 AD is increasing causing demand pull inflation
 With exports becoming cheaper manufacturers may have less incentive to cut costs and become
more efficient. Therefore over time, costs may increase.
5. Improvement in the current account. With exports more competitive and imports
more expensive, we should see higher exports and lower imports, which will reduce the
current account deficit.

DEFINITION OF 'DEVALUATION'

A deliberate downward adjustment to the value of a country's currency,

relative to another currency, group of currencies or standard. Devaluation is a
monetary policy tool of countries that have a fixed exchange rate or semi-fixed
exchange rate. It is often confused with depreciation, and is in contrast to
revaluation.

INVESTOPEDIA EXPLAINS 'DEVALUATION'

Devaluating a currency is decided by the government issuing the currency,
and unlike depreciation, is not the result of non-governmental activities. One
reason a country may devaluate its currency is to combat trade imbalances.
Devaluation causes a country's exports to become less expensive, making
them more competitive on the global market. This in turn means that imports
are more expensive, making domestic consumers less likely to purchase
them.
 While devaluating a currency can seem like an attractive option, it can have
negative consequences. By making imports more expensive, it protects
domestic industries who may then become less efficient without the pressure
of competition. Higher exports relative to imports can also increase aggregate
demand, which can lead to inflation.

Evaluation of a Devaluation
The effect of a devaluation depends on:

1. Elasticity of demand for exports and imports. If demand is price inelastic, the a fall
in the price of exports will lead to only a small rise in quantity. Therefore, the value of
exports may actually fall. An improvement in the current account on the Balance of
Payments depends upon the Marshall Lerner condition and the elasticity of demand for
exports and imports
 If PEDx + PEDm > 1 then a devaluation will improve the current account
 The impact of a devaluation may take time to have effect. In the short term, demand may be
inelastic, but over time demand may become more price elastic and have a bigger effect.
2. State of the global economy. If the global economy is in recession, then a
devaluation may be insufficient to boost export demand. If growth is strong, then there
will be a greater increase in demand. However, in a boom, a devaluation is likely to
exacerbate inflation.
3.Inflation The effect on inflation will depend on other factors such as:
 Spare capacity in the economy. E.g. in a recession, a devaluation is unlikely to cause inflation.
 Do firms pass increased import costs onto consumers? Firms may reduce their profit margins, at
least in the short run.
 Import prices are not the only determinant of inflation. Other factors affecting inflation such as
wage increases may be important.
4. It depends why the currency is being devalued. If it is due to a loss of
competitiveness, then a devaluation can help to restore competitiveness and economic
growth. If the devaluation is aiming to meet a certain exchange rate target, it may be
inappropriate for the economy.

DEFINITION OF 'CURRENCY SWAP'

A swap that involves the exchange of principal and interest in one currency for
the same in another currency. It is considered to be a foreign exchange
transaction and is not required by law to be shown on a company's balance
sheet.

INVESTOPEDIA EXPLAINS 'CURRENCY SWAP'

For example, suppose a U.S.-based company needs to acquire Swiss francs
and a Swiss-based company needs to acquire U.S. dollars. These two
companies could arrange to swap currencies by establishing an interest rate,
an agreed upon amount and a common maturity date for the exchange.
Currency swap maturities are negotiable for at least 10 years, making them a
very flexible method of foreign exchange. Currency swaps were originally
done to get around exchange controls.

currency Swap is an agreement between two parties of two countries for exchanging of
principle and interest of loan at its present value. This swap is very useful
for controlling foreign exchange risk. Interest rate swap is different from currency
swap, because in interest rate swap, we just exchange the interest from fixed to floating
rates but in currency swap, we both principle and interest of loan is exchanged from one
party to another party for mutual benefits.

Now. We are explaining currency swap examples:

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.

2nd Example of Currency Swap

Federal Reserve bank of USA exchanged his taken debt with foreign country and its
value is 0.06 Billion Dollars. Now getting money will be asset in the form of central bank
liquidity swaps.

3rd 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 get Forex earning. It
means that both are benefited with single deal of currency swap.

4th Example of Currency Swap

An agreement to pay 1% on a Japanese Yen principal of ¥1,040,000,000 and receive 5%

on a US dollar principal of $10,000,000 every year for 3 years.

5th 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.
Hedging With Currency Swaps
The volume of wealth that changes hands in the currency market dwarfs that
of all other financial markets. Specialist brokers, banks, central banks,
corporations, portfolio managers, hedge funds and retail investors trade
staggering volumes of currencies throughout the world on a continuous
basis.(There are no strictly-forex programs, but there are still some advanced
education alternatives for forex traders. See 5 Forex Designations.)

Because of the sheer size of transactions in the currency market, participants

are exposed to currency risk. This is the financial risk that arises from potential
changes in the exchange rate of one currency in relation to another. Adverse
currency movements can often crush positive portfolio returns or diminish the
returns of an otherwise prosperous international business venture. The
currency swap market is one way to hedge that risk.

Currency Swaps

A currency swap is a financial instrument that helps parties swap notional

principals in different currencies and thus pay interest payments on the
received currency. The purpose of currency swaps is to hedge against risk
exposure associated with exchange rate fluctuations, ensure receipt of foreign
monies, and to achieve better lending rates.

Currency swaps are comprised of two notional principals that are exchanged
at the beginning and at the end of the agreement. Companies that have
exposure to foreign markets can often hedge their risk with four specific types
of currency swap forward contracts (Note that in the following examples,
transaction costs have been omitted to simplify explaining payment structure):

 Party A pays a fixed rate on one currency, Party B pays a fixed rate on
another currency.
Consider a U.S. company (Party A) that is looking to open up a plant in
Germany where its borrowing costs are higher in Europe than at home.
Assuming a 0.6 Euro/USD exchange rate, the U.S. company needs 3
million euros to complete an expansion project in Germany. The
company can borrow 3 million euros at 8% in Europe, or $5 million at
7% in the U.S. The company borrows the $5 million at 7%, and then
enters into a swap to convert the dollar loan into euros. The
counterparty of the swap may likely be a German company that requires
$5 million in U.S. funds. Likewise, the German company will be able to
attain a cheaper borrowing rate domestically than abroad – let's say that
 the Germans can borrow at 6% within from banks within the country's
borders.

Let's take a look at the physical payments made using this swap
agreement. At the outset of the contract, the German company gives
the U.S. company the 3 million euros needed to fund the project, and in
exchange for the 3 million euros, the U.S. company provides the
German counterparty with $5 million.

Subsequently, every six months for the next three years (the length of
the contract), the two parties will swap payments. The German bank
pays the U.S. company the product of $5 million (the notional amount
paid by the U.S. company to the German bank at initiation), 7% (the
agreed upon fixed rate), and .5 (180 days / 360 days). This payment
would amount to $175,000 ($5 million x 7% x .5). The U.S. company
pays the German bank the product of 3 million euros (the notional
amount paid by the German bank to the U.S. company at initiation), 6%
(the agreed upon fixed rate), and .5 (180 days / 360 days). This
payment would amount to 90,000 euros (3 million euros x 6% x .5).

The two parties would exchange these fixed two amounts every 6
months. 3 years after initiation of the contract, the two parties would
exchange the notional principals. Accordingly, the U.S. company would
pay the German company 3 million euros and the German company
would pay the U.S. company $5 million.

 Party A pays a fixed rate on one currency, Party B pays a floating

rate on another currency. Using the example above, the U.S. company
(Party A) would still make fixed payments at 6.0% while the German
bank (Party B) would pay a floating rate (based on a predetermined
benchmark rate, such as LIBOR). These types of modifications to
currency swap agreements are usually based on the demands of the
individual parties in addition to the types of funding requirements and
optimal loan possibilities available to the companies. Either party A or B
can be the fixed rate pay while the counterparty pays the floating rate.

 Part A pays a floating rate on one currency, Party B also pays a gloating
rate based on another currency. Both the U.S. company (Party A) and
 the German bank (Party B) make floating rate payments based on a
benchmark rate. (Learn how these derivatives work and how companies
can benefit from them. See An Introduction To Swaps.)

Hedging Risk

Currency translations are big risks for companies that conduct business
across borders. A company is exposed to currency risk when income earned
abroad is converted into the money of the domestic country, and when
payables are converted from the domestic currency to the foreign currency.

Recall our plain vanilla currency swap example using the U.S. company and
the German company. There are several advantages to the swap
arrangement for the U.S. company. First, the U.S. company is able to achieve
a better lending rate by borrowing at 7% domestically as opposed to 8% in
Europe. The more competitive domestic interest rate on the loan, and
consequently the lower interest expense, is most likely the result of the U.S.
company being better known in the U.S. than in Europe. It is worthwhile to
realize that this swap structure essentially looks like the German company
purchasing a euro-denominated bond from the U.S. company in the amount of
3 million euros.

The advantages of this currency swap also include assured receipt of the 3
million euros needed to fund the company's investment project and other
instruments, such are forward contracts, can be used simultaneously to
hedgeexchange rate risk.

Investors benefit from hedging foreign exchange rate risk as well. A portfolio
manager who must purchase foreign securities with a heavy dividend
component for an equity fund could hedge risk by entering into a currency
swap. To hedge against exchange ratevolatility, a portfolio manager could
execute a currency swap in the same way as the company. Because hedging
will remove the foreign exchange rate volatility, potential favorable currency
movements will not have a beneficial impact on the portfolio. (This trading
strategy can reduce your risk - but only if you use it effectively. Refer
toHedging With Puts And Calls.)

The Bottom Line

Parties with significant forex exposure can improve their risk and return profile
through currency swaps. Investors and companies can choose to forgo some
return by hedging currency risk that has the potential to negatively impact an
investment.

Volatile currency rates can make managing global business operations very
difficult. A company that does business around the world can have its
earnings deeply impacted by big changes in currency rates. Yet it is no longer
the case that currency risk affects only companies and international investors.
Changes in currency rates around the globe result in ripple effects that impact
market participants throughout the world. Hedging this currency risk is
possible using currency swaps.