Ans1: Foreign exchange risk is the chance that a company will lose money on international trade

because of currency fluctuations. Also known as currency risk, FX risk and exchange rate risk, it
describes the possibility that an investment’s value may decrease due to changes in the relative
value of the involved currencies. It affects investors and any business involved in international
trade.

The risk occurs when a contract between two parties specifies exact prices for goods or services
as well as delivery dates. If a currency’s value fluctuates between the date the contract is signed
and the delivery date, a loss for one of the parties could result.

Types of Foreign Exchange Risk

There are three main types of foreign exchange risk, also known as foreign exchange exposure:
transaction risk, translation risk, and economic risk. A fourth – jurisdiction risk – arises when
laws unexpectedly change in the country where the exporter is doing business. This is less
common and exists primarily in unstable countries.

Transaction Risk

Occurs when a company buys products from a supplier in another country, and price is provided
in the supplier’s currency. If the supplier’s currency appreciates vs. the buyer’s currency, the
buyer will have to pay more in its base currency to meet the contracted price.

The risk of transaction exposure typically impacts one side of a transaction: the business that
completes the transaction in a foreign currency. The company receiving or paying a bill using its
home currency is not subjected to the same risk.

While a high level of exposure to exchange rates can lead to major losses, savvy finance
professionals hedge or mitigate those risks.

Translation Risk

Refers to how a foreign exchange transaction will impact financial reporting; i.e., the risk that a
company’s equities, assets, liabilities or income will change in value as a result of exchange rate
changes.

This risk occurs because subsidiaries of a parent company in another country denominate their
currency in the countries where they are located. The parent company faces potential losses
when it must translate the subsidiaries’ financial statements into its own country’s currency.
Economic Risk

Also known as operating exposure, this refers to the impact on a company’s market value from
exposure to unexpected currency fluctuations. This can affect a company’s future cash flows,
foreign investments and earnings.

Economic exposure can have a substantial impact on a company’s market value:

• Exposure is greater for multinational companies with many overseas subsidiaries and a
large number of transactions involving foreign currencies.

• Globalization has increased economic exposure for all companies.

• Effects are far-reaching and long-term in nature.

• Economic exposure is difficult to measure precisely.

Because of this, hedging against economic exposure can be challenging as it deals with
unexpected changes in foreign exchange rates. However, there are way to managing the risk.

3 Ways to Manage Foreign Exchange Risk:

1. Establish a forward contract with a bank or foreign exchange service provider.

As the most direct and common method for managing foreign exchange risk, this option ensures
that a U.S. exporter will receive a predetermined payment in U.S. dollars even if the rate
fluctuates. To set one up, the exporter must know three things: the foreign currency amount; date
the importer will pay, and the currency exchange delivery date.

Setting up a forward contract involves several steps:

• Exporter agrees to accept payment in a different currency, such as euros.

• Exporter contacts a bank or foreign exchange service provider to negotiate a 60-day

forward rate. (Fees for forward contracts, along with their rates and terms, vary.)

• Exporter and importer finalize sales price and payment terms with a commitment from the
bank.

• Exporter then enters into a forward contract with its bank to lock in the rate and commit to
a delivery date to exchange euros for U.S. dollars.

• Finally, the importer pays the exporter on time.

• Exporter delivers the euros to its bank in exchange for U.S. dollars.
 If the exporter is uncertain when the importer will pay, an alternative is to request a window
forward contract with the bank or service provider. This gives the exporter a window of
delivery between the two dates.

2. The exporter accepts foreign currency payments only with cash in advance.

This option is ideal for small transactions as well as for new relationships with importers. It is
simple, ensures full payment, and is most risk-free. But some importers may balk, as cash in
advance is their least desirable method of payment.

3. Match foreign currency receipts with expenditures.

Here, the exporter sets up a foreign currency bank account to conduct transactions and eliminate
currency conversion fees. This is ideal for U.S. exporters that use the same foreign currency with
different trading partners.

Finally, before agreeing to an importer’s foreign currency requests, you’ll want to consult with a
bank to learn:

1. When should an exporter consider selling in a foreign country?

2. How common is it for a small exporter to set prices in a foreign currency?

3. What type of transactions is most suitable for foreign exchange?

4. What are the fees for using a forward contract?

Currency hedging is similar to insurance, which you buy to protect yourself from an unforeseen
event. Currency hedging is an attempt to reduce the effects of currency fluctuations on
investment performance. To hedge an investment, investment managers will set up a related
currency investment designed to offset changes in the value of the Canadian dollar. In general,
currency hedging reduces the increase or decrease in the value of an investment due to changes
in the exchange rate. In other words, it aims to even out results.

Role of the foreign exchange market and operations:

1. The function of Transfer:

The primary purpose of the foreign exchange market is to make it easier to convert one currency
into another or to make buying power transfers between nations.

2. The function of Credit:

Another important role of the foreign exchange market is to facilitate international trade by
providing credit, both domestic and international.
Ans2: Introduction: Inflation is generally defined as the continued increase in the average
prices of goods and services in a given region. Following the extremely high global inflation
experienced in the 1980s and 1990s, global inflation has been relatively stable since the turn of
the millennium, usually hovering between three and five percent per year. There was a sharp
increase in 2008 due to the global financial crisis now known as the Great Recession, but
inflation was fairly stable throughout the 2010s, before the current inflation crisis began in 2021.

Recent years

Despite the economic impact of the coronavirus pandemic, the global inflation rate fell to 3.25
percent in the pandemic's first year, before rising to 4.7 percent in 2021. This increase came as
the impact of supply chain delays began to take more of an effect on consumer prices, before
the Russia-Ukraine war exacerbated this further. A series of compounding issues such as rising
energy and food prices, fiscal instability in the wake of the pandemic, and consumer insecurity
have created a new global recession, and global inflation in 2022 is estimated to have reached
8.75 percent. This is the highest annual increase in inflation since 1996.

Inflation and Interest Rates

Inflation is closely related to interest rates, which can influence exchange rates. Countries
attempt to balance interest rates and inflation, but the interrelationship between the two is
complex and often difficult to manage.

Low-interest rates spur consumer spending and economic growth, and generally, they have
positive influences on currency value. If consumer spending increases to the point where demand
exceeds supply, inflation may ensue, which is not necessarily a bad outcome. But low-interest
rates do not commonly attract foreign investment. Higher interest rates tend to attract foreign
investment, which is likely to increase the demand for a country's currency.

The ultimate determination of the value and exchange rate of a nation's currency is the perceived
desirability of holding that nation's currency. That perception is influenced by a host of economic
factors, such as the stability of a nation's government and economy. Investors' first consideration
in regard to currency, before whatever profits they may realize, is the safety of holding cash
assets in the currency.

If a country is perceived as politically or economically unstable, or if there is any significant

possibility of a sudden devaluation or other change in the value of the country's currency,
investors tend to shy away from the currency and are reluctant to hold it for significant periods or
in large amounts.

Interest rates affect the exchange value in the forex market because the rates’ movements directly

impact demand for a currency.

This is because interest rates are a measure of the rate of return on certain investments and

savings. Due to the relative attractiveness of the interest rate, investors may want to move capital

into or out of a country, which impacts the supply and demand for a specific currency.

However, it’s important to remember that the effect of interest rate changes on forex is never

guaranteed. It also doesn’t happen in isolation, but rather depends on several factors such as the

perception of an economy’s future strength and stability.

As exchange rates depend on the supply and demand of a particular currency, all factors that

impact on either of these will affect the value of the currency. You should have this top of mind

at all times when you conduct your analysis of the markets.

Inflation is one of many factors affecting foreign exchange rates. Over the past decades,
developed nations have seen continuous low-level inflation across the board, making it very
predictable when dealing with foreign transactions, be it in US-Dollar, British Pounds or Euros.

Exchange rate fluctuations across these blocks were largely driven by economic factors such as
growth differentials or financial demand, particularly for the US-Dollar during the financial
crisis in 2008.

Inflation itself was more of a matter for dealing in emerging markets currencies. Still, this
dynamic may change if inflation is persistent and central banks in developed nations do not act
by raising interest rates in line with market expectations.

When looking at the impact of inflation, it is important to focus not on absolute inflation in a
country but on the relative inflation between countries such as the U.K., where inflation is rising
higher than in the U.S.

Ans3a: Floating Rate vs. Fixed Rate:

All of the volume traded in the currency markets trades around an exchange rate, 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.

Fixed exchange rates mean that two currencies will always be exchanged at the same price
while floating exchange rates mean that the prices between each currency can change depending
on market factors; primarily supply and demand.

Fixed Rate

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 U.S.
$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 Rate

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.

Ans3b : Difference between Spot Market and Forward Market!

Foreign exchange markets are sometimes classified into spot market and forward market on
the basis of the period of transaction carried out. It is explained below:
(a) Spot Market:
If the operation is of daily nature, it is called spot market or current market. It handles only
spot transactions or current transactions in foreign exchange.

Transactions are affected at prevailing rate of exchange at that point of time and delivery of
foreign exchange is affected instantly. The exchange rate that prevails in the spot market for
foreign exchange is called Spot Rate. Expressed alternatively, spot rate of exchang e refers
to the rate at which foreign currency is available on the spot.

For instance, if one US dollar can be purchased for Rs 40 at the point of time in the foreign
exchange market, it will be called spot rate of foreign exchange. No doubt, spot rate of
foreign exchange is very useful for current transactions but it is also necessary to find what
the spot rate is. In addition, it is also significant to find the strength of the domestic
currency with respect to all of home country’s trading partners. Note that the measure of
average relative strength of a given currency is called Effective Exchange Rate (EER).

(b) Forward Market:

A market in which foreign exchange is bought and sold for future delivery is known as
Forward Market. It deals with transactions (sale and purchase of foreign exchange) which
are contracted today but implemented sometimes in future. Exchange rate that prevails in a
forward contract for purchase or sale of foreign exchange is called Forward Rate. Thus,
forward rate is the rate at which a future contract for foreign currency is made.

This rate is settled now but actual transaction of foreign exchange takes place in future. The
forward rate is quoted at a premium or discount over the spot rate. Forward Market for
foreign exchange covers transactions which occur at a future date. Forward exchange rate
helps both the parties involved.