A STUDY ON FOREIGN EXCHANGE AND PARITY THEORY

KAILASH.R.S

LEU

STUDENT

THE FOREIGN EXCHANGE MARKET

INTRODUCTION

The international trade and investments have grown at a tremendous pace in last

few decades. To enable free flow movement of goods and services and capital

across national boundaries, a well functioning system is needed which would

determine the amount of payments to be made in relevant currency.

The number of currencies present in the world needs to transact in them to settle

payments. For a foreign exchange to arise, either buying or selling has to be with

another country or foreign currency. For example, if an Indian exporter sells some

goods to an American resident and the price has to denominate in dollars, the

exporter (Indian) would be dealing in a foreign currency. Sometimes there might

be two way foreign transactions for example, if an Australian buys goods with

Italian denominated in US dollar both of the parties will be dealing in foreign

currency. All these transaction were dealt in an OTC market but now it is the

SWIFT system (society for worldwide interbank financial telecommunications)

OBJECTIVES OF THE STUDY

To determine the exchange rate of a currency.

To illustrate two types of determination of exchange rate.

To explore how FEDAI has categorized exchange dealers.

To illustrate the market mechanism and conventions.

To study different types of quotes.

To understand multi-national operations.

To illustrate the accounting issues in hyperinflation economies.

The above mentioned objectives are subjected to the following limitations.

LIMITATIONS OF THE STUDY

The study is limited to the categorization of FEDAI rules

The flow effect only is been considered.

The holding effect has not been shown.

THE STRUCTURE

The main players in the foreign exchange market are large commercial banks,

forex brokers, large commercial and central banks but central banks enter only to

smoothen the fluctuation in the exchange rate.

Large commercial banks deals with the market to execute their clients’

orders .These large commercial banks stand ready to buy or sell various

currencies at specific pries at all time.

The foreign brokers do not actually buy or sell any currency. They do the work of

bringing buyers or sellers together. Though they deal in major currencies

generally they specialize in a pair of currencies and hold huge information about

it.

The world-wide market is a 24 hour market it is open virtually open 24 hours of

the day, in at least one of the financial markets of the world.

The Foreign Exchange Dealers Association of India (FEDAI) have classified into

three categories:

Category A: these are the offices which keep independent foreign currencies

accounts with overseas correspondent banks in their names.

Category B: These are the branches which do not maintain independent foreign

currency accounts but have the powers to operate the accounts.

Category C: The branches which fall in neither of the above categories a yet

handle forex business.

FOREIGN EXCHANGE

Foreign exchange is defined in terms of Section 2 of FEMA 1999 as

I. All deposits, credits, balances payable in any foreign currency;

II. Any drafts, travelers’ cheques, letters of credit and bills of exchange expressed or

drawn in Indian currency payable in foreign currency;

III. Any instrument giving anyone the option of making it payable either partly or

fully in a foreign currency.

EXCHANGE RATE QUOTATIONS

An exchange rate quotation is the price of a currency stated in terms of another.

American vs. European quote

An American quote is the number of dollars expressed per unit of any other

currency, while a European quote is the number of units any other currency

expressed in terms of dollar. For example Rs.48.28/$ is a European quote and

$1.6698/ is an American quote.

BID AND ASK RATE

The single rate at which the currencies were being bought and sold.

For example, the rupee-dollar exchange rates were given as Rs/$48.9.

In reality at which a bank is ready to buy a currency will be different from the rate

at which it stands to sell the same currency .The difference in these rates

represents the cost of the bank in these transactions, a small return on the capital

employed, and the compensation for the risk it takes.

The difference between the bid rate and ask rate is called bid-ask spread.

Some of the useful conventions:

The bid rate always precedes the ask rate.

The bid rate and ask rate is separated by (/) or (-)

The quote is always seen in the bank’s point of view

Interbank Quote vs. Merchant Quote

Merchant quote is the quote given by the bank to retail customers, and the quote

given one bank to another is called interbank quote.

MARKET MECHANISM AND CONVENTIONS

Suppose a bank requires 1mn GBP. The dealer of the bank approaches another

bank and asks for a quote in the sterling, without mentioning whether he wants to

buy or sell. The market making bank gives him a two way quote. If the ask rate

for a pound is acceptable he says “One mine” and its “One yours” if it’s the other

way around, implying to buy and to sell respectively.

The quote is generally given in the market as: Rs/$ 48.62/48.72

It is also a practice to state the same quote is Rs/$ 48.62/72 where 72 represents

the last two digits of the ask rate. And sometimes it is further shortened to Rs/$

62/72.

There are few currencies which are quoted in 10s rather than 1 or 2s.the reason is

that their value is too small to be quoted. An example is the Japanese yen

JPY/USD 124.64/68

INVERSE QUOTES

For every quote (A/B) between two currencies, there currencies, there exists an

inverse quote (B/A), where currency is being bought and sold, with its price

expressed in terms of currency B. For example for a Euro/$ quote, there exists a

$/Euro quote.

The bid rate at which the bank is ready to buy the dollars which means the rate at

which it is ready to sell Euro, which will be the ask rate in the $/Euro quote. The

calculations can be shown for example given. The direct quote given as

Euro/$1.06601/1.0665 is $/Euro 0.9376/0.9380

Implied ($/Euro) bid= 1/ (Euro/$) ask

Implied ($/Euro) ask= 1/ (Euro/$) bid

CROSS RATE

In the foreign exchange markets, it is a practice to quote most of the currencies

against the dollar and to calculate the exchange rates between other currencies

with the dollar as the intermediate currency. For example, the Euro/GBP rate will

be calculated through the Euro/$ quote and the $/GBP. The Euro/GBP rate are

thus calculated is called cross rates or the synthetic rate.

DISCOUNT AND PREMIUM

A currency is said be at premium against anther currency if it is more expensive

in the forward market than the spot market. In this case, it is forward which will

be greater than the spot rate. Conversely a currency is to be in discount if it is

more in the spot rate than the forward rate.\

Let us assume the following quote

Rs/$: 48.62/66

3-m Rs/$:48.82/88

In the above example the dollar is expected to be more expensive in the

future and hence at premium against Rupee.

BROKEN DATE FORWARD CONTRACT

It is a kind of forward contract for a maturity which is not a whole month or for

which is a quote is not readily available. For example, if the quote is month

forward contract it will be a broken date contract. It is calculated by interpolating

the available quotes for the preceding and the succeeding maturities.

PURCHASING POWER PARITY PRINCIPLE

According to this theory the price levels determine the exchange rates of these

countries’ currencies. The basic tenet of this principle is that the exchange

between various currencies reflects the purchasing power of these currencies. This

is based on the LAW OF ONE PRICE.

According to this principle in equilibrium conditions, the price of a commodity

has to be same across the world. If it were not so arbitrageurs would drive the

price towards equality by buying the product in the cheaper market and selling in

the dearer one.

The equation can be generalized as:

PxA =S (A/B)* PB

X

Where

PxA the price of the commodity ‘x’ in country A.

S (A/B) is the spot exchange rate of the two countries’ currency.

PBX is the price of commodity x in the country B.

THE ABSOLUTE FORM OF PPP

If the law of one price were to hold good for each and every commodity, then it

will follow:

PA = S(A/B)*PB

Where PA and PB are the of the same basket of goods and services in countries A

and B respectively.

S (A/B) = PA / PB

Assumptions:

No transaction costs in the foreign currency markets

Basket of commodities are assumed in both countries with the components being

used in the same proportions

THE EXPECTATIONS FORM OF PPP

According to this form of PPP, the expecting percentage in the spot rate is equal

to the difference in the expected inflation rates. This theory assumes that the

speculators are risk neutral and markets are perfect.

REASONS FOR PPP NOT HOLDING GOOD

Earlier the assumptions applicable the law of one price and to the various forms of

PPP.If any of these assumptions does not hold good the PPP would also not hold

good. Some of the factors which do not hold good are:

Constraints on movement of commodities.

Price index constraints.

Effect on statistical method employed

INTEREST RATE PARITY

According to this theory the cost of money when the adjusted for the cost foreign

exchange risk, is equal across different countries. This is so because in the

absence of any transactions costs, taxes, and capital controls investors and

borrowers will tend to transact in those currencies which provide attractive prices.

INVESTOR’S DECISION

Any individual or corporate is unlikely to have a fully matched income and

expenditure in each and every period, where the current requirement to borrow,

there are also periods where the opposite holds good giving rise to a chance to

invest.

The currencies when converted from spot rate to forward rate will give

1/SF (A/B)*(1+ra) units of A

At the same time an investment in domestic currency will at the end of the year,

give

(1+ra ) units of A, if

(1+ra)>F (A/B)/S (A/B)*(1+rB)

In such a case investors would prefer to invest in securities denominated in

currency A rather than B. If it is other way around the investors would prefer to

invest in currency B than A.

BORROWERS’ DECISION

When the need to borrow money arises, the borrower has the option to borrow in

domestic currency, or foreign currency. Again the decision will be based upon

cost of domestic currency borrowing as compared to the covered cost of

borrowing.

For every unit of domestic currency borrowed, the borrower will have to pay

(1+rA) units of A.

Borrowing 1 unit of A is equivalent to borrowing 1/S (A/B) units of currency B

1/S (A/B)* (1+rB) units of B

When converted to forward rate gives

F (A/B)/S (A/B)*(1+rB) units of A

THE RELATION BETWEEN PPP &IRP

According to PPP

S*(A/B) =PA-PB

According to the uncovered IRP

S*(A/B) = rA-rB

It follows that

rA-P*A=rB-P*B

It says that nominal interest rate minus the expected inflation rates, i.e., the real

interest rates are equal across different countries.

REASONS FOR IRP NOT HOLDING GOOD

Interest Rate Parity does not hold good because of the following reasons

Transaction cost

Political risk

Taxes

Liquidity preferences

Capital controls

MULTI NATIONAL OPERATIONS

This part of the paper deals with the Multi National Operations the accounting

issues, exposure relating to transaction and translation exposure and

hyperinflation economies.

International trade has grown significantly in various parts of the world because

various changes in the country’s policies. Many countries have established their

manufacturing units in other countries for reasons such as cheap labor or raw

materials.

MNCs conduct business activities where local reporting regulations may be

different from those governing company financial statements. Foreign

transactions are done in different countries in different economic condition these

variations effect actual reported operating performance, financial position & cash

flows.

SOME OF THE IMPORTANT TERMS

Foreign currency: A currency other than the functional currency of the company.

Foreign currency transaction: When a company buys or sells on credit goods or

services whose prices are denominated in foreign currency.

Historical rate: It is rate at which the transaction was actually settled.

Current rate: It is the rate at prevailing on the date of translation of accounts.

Blended rate: It is the average of the historical rate and the average rate calculated

using the opening and closing balances of relevant accounts

ACCOUNTING ISSUES

There are three issues which effect the consolidated financial statements of the

parent company

I. Choice of exchange rate: In case all the transactions denominated in other

currency has to be translated into the parent reporting currency for the

preparation of consolidated balance sheet. The problem faced is the choice

of exchanges rates namely current rate or the historical rate.

II. Definition exposure: The selection of assets and liabilities that should be

adjusted for exchange rate changes. If the exchange rate changes, financial

data recorded in reporting currency also change even though there is no

change in subsidiary co. currency.

III. Disposition of resulting translation adjustment: The third issue is resulting

translation adjustment i.e. is gain or loss in translation. Any loss or gain

resulting from foreign currency translation should be accounted and it

should be recognized in the same accounting period.

EFFECT OF THE EXCHANGE RATE CHANGES

Changes in the exchange rate result in two effects on the companies’ actual

performance and reported performance namely flow effect and holding gain or

less.

Suppose A ltd is a foreign subsidiary company & prepared its financial

statements in local currency (LC).A ltd reported revenue is LC 1 lakh in the 1st

year and LC 110000 in 2nd year. So A Ltd reports a 10% growth in its revenue,

if the LC and Re is constant 1 LC = 1Re then the parent consolidates the

subsidiary 10% growth in the revenue is also reflects in the consolidated

financial statements.

Flow Effect

Assume the following

YEAR 1 LC1=Re1

YEAR 2 LC1= Re 1.5

Then company results will be

YEAR 1 2 TOTAL

REVENUE 1,00,000 1,65,000 2,65,000

Here the parent company reports 65% growth in the revenue. But the

growth is only because of 50% growth in the exchange rate. Thus the flow effect.

Growth due to exchange rate =Rs 55000(50% of Rs 1, 10,000)

Growth in revenue is 10,000

TRANLATION OF FINANCIAL STEATEMENTS

SFAS 52 deals with the translation of financial statements of foreign entity.

1. Foreign currency translations (e.g., exports, imports, & loans) which are

denominated in a currency other than a company functional currency.

2. Foreign currency financial statements of branches, divisions, subsidiary

and investments.

According to US GAAP, two translation methods are used for converting

1. Temporal method

2. Current method

CHOICE OF CURRENCY

The choice of currency depends upon the choice of functional currency for

each subsidiary company. Before the financial statements are translated

into reporting currency.

The factors to be considered are:

1. The impact of the foreign entity’s cash flows on the parent cash

flows.

2. The responsiveness of the foreign entities sales price to exchange

rate changes.

3. The currency in which the foreign entities sales market.

4. The expenses incurred by the foreign entity.

5. The source of financing of the foreign entity

TEMPORAL METHOD

This method is used when the functional currency of the foreign

subsidiary is the reporting currency. This method classifies items on the

basis of whether they are valued at historical basis or market basis. All the

items in the balance sheet that are valued on the historical cost basis are

translated at the historical rate, and those valued at current value are

valued at closing rate

Monetary assets and liabilities cash, B/R, B/P are translated in the

current rate.

Non-monetary items except above mentioned are translated in the

historical rate.

Revenues and expenses are translated at the average rate.

The translation gain or loss is shown in the income statement

CURRENT RATE METHOD

As per US GAAP this method is required when the functional currency is

the local currency. In this case the subsidiary company is deemed as

independent of the parent’s company and viewed as an investment of the

parent...Under this method

All income statement elements are translated at the average

rate.

All the assets and liabilities are translated at current rate

except inventory which is translated at historical rate.

Dividends are translated at the rate that applied when they are

paid.

Calculation of translation gain or loss

Under current method

Assets-liabilities (or stock holder’s equity)

Under temporal method

(cash+B/R)-(B/P=current debt+long term debt)

Flow effect

Change in exposure(LC)*(Ending rate-Avg rate)

HYPERINFLATIONARY ECONOMIES

SFAS 52 defines a hyperinflationary economy as one that experiences a

cumulative 3 year inflation rate of more than100% example,

Zimbabwe .These economies create problems for both accountants and

financial analysts. The purchasing power of money diminishes rapidly in

the hyper inflationary economies and it is necessary to depreciate the

assets at a rapid rate.

Selecting exchange rate is another problem with hyperinflationary

economies. If the current rate is used to translate the assets and the

liabilities of the subsidiaries in these countries they become insignificant.

ACCOUNTING METHOD OF HYPERINFLATIONARY

SUBSIDIARIES

It is difficult for the accountant to choose the exchange rate and translation

process for the hyperinflationary subsidiaries. Generally the following two

solutions are available:

The parent currency can be the functional currency for all

operations of hyperinflationary subsidiaries. Non-monetary assets and

liabilities of the subsidiary are accounted for the parent company.

The value of non-monetary assets and liabilities are translated at

the current exchange rate. The carrying amount of assets and liabilities of

the subsidiary are shown in the reporting currency.

In US the first method is used. Temporal method is followed for

translation of assets and liabilities and parent currency is treated as

functional currency. Cost of goods sold & depreciation also measured

in the reporting currency. Companies operating in the high inflation

countries generally try to balance their exposure to the local currency

by borrowing locally if necessary.

IAS recommends the second method for accounting for subsidiaries

in hyperinflationary economies. Both the methods are broadly similar

as they eliminate the problem of disappearing assets and liabilities.

CONCLUSION

This paper primarily gave an introduction to structure of a foreign

exchange market. It spoke about different types of quotes involved in the

foreign market and how the transaction takes place. This paper also dealt

with problems arising of foreign transactions such as choice of foreign

rate, exposure, disposition of translation. Choice of the rate depends upon

the management, exposure and the translation depends on the methods

used for translation. This paper also spoke about the hyperinflationary

economies which will undergo a cumulative 3 year inflation rate more

than 100%. These will create a problem for accountants, analysts and also

for the companies

REFERNCES:

ICFAI University Publications (IUP) 2009 Edition Financial Management for Analyst.

ICFAI University Publications (IUP) 2009 Edition Financial markets

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