Tag: HRM in Global Perspective Mumbai University BMS Notes

International project appraisal also known by a variety of names such as internal company analysis, profiling the organization, capability or resource audit position and strategic advantage analysis, is the process of evaluating a company’s posture relative to its business competition within and outside the country, overall performance and its capability in terms of strengths and weaknesses.

Non-DCF Techniques

Payback period and Accounting Rate of Return are the two techniques of project appraisal belonging to the non-DCF group. Under the payback period, an effort is made to determine the period it will take to recover the initial investment in the project.

DCF Techniques

Net Present Value (NPV) and the Internal Rate of Return (IRR) are the two popular DCF methods.

Steps in International Project Appraisal

With the intention of developing the strategic advantage profile of an organization the management should first collect information from external or internal sources both from formal as well as informal channels and then interpret as well as informal channels and then interpret them incisively to determine its strengths and weaknesses. The following steps involved in international project appraisal.

• Identifying strategic factors: The first step in the process of corporate analysis is the identification of all those factors which are crucial to the success of an international organization. These factors may relate to different aspects of the organization. These factors could conveniently be found in different functional areas such as marketing and finance personal, research and development.
• Determining the importance of factors: After identifying crucial factors for corporate appraisal the management will have to determine the importance of each of these factors. Since all the factors may not be of equal value to the organization for accomplishing its purpose, it will be very necessary to attach due importance to them.
• Determining strengths and weaknesses: Once the relative significance of different factors has been assessed the management should then attempt to determine the position of the organization in each of these factors. Normally the strengths and weakness of a firm can be assessed by with the firm’s own past results, comparing with accomplishment of competitors and also by comparing with what they ought to be.
• Constructing strategic advantage profile of a firm: After weighing the significance of each factor for the company in its environment, the management compiles a strategic advantage profile for the firm and compares it with profiles successful competitors of the potential of host countries to develop a pattern of the firms’ strengths and weaknesses relative to its present and proposed product market strategy.

Significance of International Project Appraisal

• The organization’s deficiency should also be compared with those of its successful competitors. Such perceptive self-appraisal when matched with environmental analysis facilities management to grasp the opportunities and combat the threats inherent in the environment.
• International project appraisal has such a vital significance in international corporate planning. Without such am-exercise it will not be possible to formulate economic strategy for an organization on the objective basis.
• It helps the management in choosing the most suitable niche for the organization.
• Economic opportunities may bound in different parts of the globe.
• Position audit of the organization highlights its distinctive capabilities on which empire of foreign business can be gainfully built. It also enables management to formulate suitable competitive strategy.
• It focuses sharply on the areas where it is strong and can operate most effectively. With this kind analysis the management can decide on the type of business, company should engage in a country and what business abandon.
• It provides an insight into the weakness of the organization; through this way the management can take steps to remove the weaknesses of the organization in the long run.

Trading is the exchange of goods or services between two or more parties. So if you need gasoline for your car, then you would trade your dollars for gasoline. In the old days, and still in some societies, trading was done by barter, where one commodity was swapped for another.

Foreign exchange risk (also known as FX risk, exchange rate risk or currency risk) is a financial risk that exists when a financial transaction is denominated in a currency other than the domestic currency of the company. The exchange risk arises when there is a risk of an unfavourable change in exchange rate between the domestic currency and the denominated currency before the date when the transaction is completed.

Foreign exchange risk also exists when the foreign subsidiary of a firm maintains financial statements in a currency other than the domestic currency of the consolidated entity.

Investors and businesses exporting or importing goods and services, or making foreign investments, have an exchange-rate risk but can take steps to manage (i.e. reduce) the risk.

A trade may have gone like this: Person A will fix Person B’s broken window in exchange for a basket of apples from Person B’s tree. This is a practical, easy to manage, day-to-day example of making a trade, with relatively easy management of risk. In order to lessen the risk, Person A might ask Person B to show his apples, to make sure they are good to eat, before fixing the window. This is how trading has been for millennia: a practical, thoughtful human process.

Foreign exchange risk, also known as exchange rate risk, is the risk of financial impact due to exchange rate fluctuations. In simpler terms, foreign exchange risk is the risk that a business’ financial performance or financial position will be impacted by changes in the exchange rates between currencies.

Types of Foreign Exchange Risk

Transaction risk

Transaction risk is the risk faced by a company when making financial transactions between jurisdictions. The risk is the change in the exchange rate before transaction settlement. Essentially, the time delay between transaction and settlement is the source of transaction risk. Transaction risk can be mitigated using forward contracts and options.

For example, a Canadian company with operations in China is looking to transfer CNY600 in earnings to its Canadian account. If the exchange rate at the time of the transaction was 1 CAD for 6 CNY, and the rate subsequently falls to 1 CAD for 7 CNY before settlement, an expected receipt of CAD100 (CNY600/6) would instead of CAD86 (CNY600/7).

Economic risk

Economic risk, also known as forecast risk, is the risk that a company’s market value is impacted by unavoidable exposure to exchange rate fluctuations. Such a type of risk is usually created by macroeconomic conditions such as geopolitical instability and/or government regulations.

Another example of an economic risk is the possibility that macroeconomic conditions will influence an investment in a foreign country. Macroeconomic conditions include exchange rates, government regulations, and political stability. When financing an investment or a project, a company’s operating costs, debt obligations, and the ability to predict economically unsustainable circumstances should be thoroughly calculated in order to produce adequate revenues in covering those economic risks. For instance, when an American company invests money in a manufacturing plant in Spain, the Spanish government might institute changes that negatively impact the American company’s ability to operate the plant, such as changing laws or even seizing the plant, or to otherwise make it difficult for the American company to move its profits out of Spain. As a result, all possible risks that outweigh an investment’s profits and outcomes need to be closely scrutinized and strategically planned before initiating the investment. Other examples of potential economic risk are steep market downturns, unexpected cost overruns, and low demand for goods.

International investments are associated with significantly higher economic risk levels as compared to domestic investments. In international firms, economic risk heavily affects not only investors but also bondholders and shareholders, especially when dealing with the sale and purchase of foreign government bonds. However, economic risk can also create opportunities and profits for investors globally. When investing in foreign bonds, investors can profit from the fluctuation of the foreign-exchange markets and interest rates in different countries. Investors should always be aware of possible changes by the foreign regulatory authorities. Changing laws and regulations regarding sizes, types, timing, credit quality, and disclosures of bonds will immediately and directly affect investments in foreign countries. For example, if a central bank in a foreign country raises interest rates or the legislature increases taxes, the return on investment will be significantly impacted. As a result, economic risk can be reduced by utilizing various analytical and predictive tools that consider the diversification of time, exchange rates, and economic development in multiple countries, which offer different currencies, instruments, and industries.

When making a comprehensive economic forecast, several risk factors should be noted. One of the most effective strategies is to develop a set of positive and negative risks that associate with the standard economic metrics of an investment. In a macroeconomic model, major risks include changes in GDP, exchange-rate fluctuations, and commodity-price and stock-market fluctuations. It is equally critical to identify the stability of the economic system. Before initiating an investment, a firm should consider the stability of the investing sector that influences the exchange-rate changes. For instance, a service sector is less likely to have inventory swings and exchange-rate changes as compared to a large consumer sector.

Translation risk

Translation risk, also known as translation exposure, refers to the risk faced by a company headquartered domestically but conducting business in a foreign jurisdiction, and of which the company’s financial performance is denoted in its domestic currency. Translation risk is higher when a company holds a greater portion of its assets, liabilities, or equities in a foreign currency.

For example, a parent company that reports in Canadian dollars but oversees a subsidiary based in China faces translation risk, as the subsidiary’s financial performance which is in Chinese yuan is translated into Canadian dollar for reporting purposes.

Contingent risk

A firm has contingent risk when bidding for foreign projects, negotiating other contracts, or handling direct foreign investments. Such a risk arises from the potential of a firm to suddenly face a transnational or economic foreign-exchange risk contingent on the outcome of some contract or negotiation. For example, a firm could be waiting for a project bid to be accepted by a foreign business or government that, if accepted, would result in an immediate receivable. While waiting, the firm faces a contingent risk from the uncertainty as to whether or not that receivable will accrue.

Managing risk

Transaction hedging

Firms with exposure to foreign-exchange risk may use a number of hedging strategies to reduce that risk. Transaction exposure can be reduced either with the use of money markets, foreign exchange derivatives such as forward contracts, options, futures contracts, and swaps or with operational techniques such as currency invoicing, leading and lagging of receipts and payments, and exposure netting. Each hedging strategy comes with its own benefits that may make it more suitable than another, based on the nature of the business and risks it may encounter.

Forward and futures contracts serve similar purposes: they both allow transactions that take place in the future for a specified price at a specified rate that offset otherwise adverse exchange fluctuations. Forward contracts are more flexible, to an extent, because they can be customized to specific transactions, whereas futures come in standard amounts and are based on certain commodities or assets, such as other currencies. Because futures are only available for certain currencies and time periods, they cannot entirely mitigate risk, because there is always the chance that exchange rates will move in your favor. However, the standardization of futures can be a part of what makes them attractive to some: they are well-regulated and are traded only on exchanges.

Two popular and inexpensive methods companies can use to minimize potential losses is hedging with options and forward contracts. If a company decides to purchase an option, it is able to set a rate that is “At-worst” for the transaction. If the option expires and it’s out-of-the-money, the company is able to execute the transaction in the open market at a favorable rate. If a company decides to take out a forward contract, it will set a specific currency rate for a set date in the future.

Currency invoicing refers to the practice of invoicing transactions in the currency that benefits the firm. It is important to note that this does not necessarily eliminate foreign exchange risk, but rather moves its burden from one party to another. A firm can invoice its imports from another country in its home currency, which would move the risk to the exporter and away from itself. This technique may not be as simple as it sounds; if the exporter’s currency is more volatile than that of the importer, the firm would want to avoid invoicing in that currency. If both the importer and exporter want to avoid using their own currencies, it is also fairly common to conduct the exchange using a third, more stable currency.

If a firm looks to leading and lagging as a hedge, it must exercise extreme caution. Leading and lagging refer to the movement of cash inflows or outflows either forward or backward in time. For example, if a firm must pay a large sum in three months but is also set to receive a similar amount from another order, it might move the date of receipt of the sum to coincide with the payment. This delay would be termed lagging. If the receipt date were moved sooner, this would be termed leading the payment.

Another method to reduce exposure transaction risk is natural hedging (or netting foreign-exchange exposures), which is an efficient form of hedging because it will reduce the margin that is taken by banks when businesses exchange currencies; and it is a form of hedging that is easy to understand. To enforce the netting, there will be a systematic-approach requirement, as well as a real-time look at exposure and a platform for initiating the process, which, along with the foreign cash flow uncertainty, can make the procedure seem more difficult. Having a back-up plan, such as foreign-currency accounts, will be helpful in this process. The companies that deal with inflows and outflows in the same currency will experience efficiencies and a reduction in risk by calculating the net of the inflows and outflows, and using foreign-currency account balances that will pay in part for some or all of the exposure.

Translation Hedging

Translation exposure is largely dependent on the translation methods required by accounting standards of the home country. For example, the United States Federal Accounting Standards Board specifies when and where to use certain methods. Firms can manage translation exposure by performing a balance sheet hedge, since translation exposure arises from discrepancies between net assets and net liabilities solely from exchange rate differences. Following this logic, a firm could acquire an appropriate amount of exposed assets or liabilities to balance any outstanding discrepancy. Foreign exchange derivatives may also be used to hedge against translation exposure.

A common technique to hedge translation risk is called balance-sheet hedging, which involves speculating on the forward market in hopes that a cash profit will be realized to offset a non-cash loss from translation. This requires an equal amount of exposed foreign currency assets and liabilities on the firm’s consolidated balance sheet. If this is achieved for each foreign currency, the net translation exposure will be zero. A change in the exchange rates will change the value of exposed liabilities to an equal degree but opposite to the change in the value of exposed assets.

Companies can also attempt to hedge translation risk by purchasing currency swaps or futures contracts. Companies can also request clients to pay in the company’s domestic currency, whereby the risk is transferred to the client.

Strategies other than financial hedging

Firms may adopt strategies other than financial hedging for managing their economic or operating exposure, by carefully selecting production sites with a mind for lowering costs, using a policy of flexible sourcing in its supply chain management, diversifying its export market across a greater number of countries, or by implementing strong research and development activities and differentiating its products in pursuit of less foreign-exchange risk exposure.

By putting more effort into researching alternative methods for production and development, it is possible that a firm may discover more ways to produce their outputs locally rather than relying on export sources that would expose them to the foreign exchange risk. By paying attention to currency fluctuations around the world, firms can advantageously relocate their production to other countries. For this strategy to be effective, the new site must have lower production costs. There are many factors a firm must consider before relocating, such as a foreign nation’s political and economic stability.

An international portfolio is a selection of stocks and other assets that focuses on foreign markets rather than domestic ones. If well designed, an international portfolio gives the investor exposure to emerging and developed markets and provides diversification.

An international portfolio appeals to investors who want to diversify their assets by moving away from a domestic-only portfolio. This type of portfolio can carry increased risks due to potential economic and political instability in some emerging markets, There also is the risk that a foreign market’s currency will slip in value against the U.S. dollar.

Over the recent past, the growth of the economies of China and India greatly exceeded those of the U.S. That created a rush to invest in the stocks of those countries. Both are still growing fast, but an investor in the stocks of either nation now would have to do some research to find stocks that have not already seen their best days.

The search for new fast-growing countries has led to some winners and losers. Not long ago, investors going for fast growth were looking to the CIVETS nations. They were Colombia, Indonesia, Vietnam, Egypt, Turkey, and South Africa. Not all of those countries would still be on any investor’s list of promising economies.

Advantages

Diversifies Currency Exposure: When investors buy stocks for an international portfolio, they are also effectively buying the currencies in which the stocks are quoted. For example, if an investor purchases a stock that is listed on the London Stock Exchange, the value of that stock may rise and fall with the British pound. If the U.S. dollar falls, the investor’s international portfolio helps to neutralize currency fluctuations.

International credit: Investors may be able to access an increased amount of credit in foreign countries, allowing the investor to utilize more leverage and generate a higher return on their equity investment.

May Reduce Risk: Having an international portfolio can be used to reduce investment risk. If U.S. stocks underperform, gains in the investor’s international holdings can smooth out returns. For example, an investor may split a portfolio evenly between foreign and domestic holdings. The domestic portfolio may decline by 10% while the international portfolio could advance 20%, leaving the investor with an overall net return of 10%. Risk can be reduced further by holding a selection of stocks from developed and emerging markets in the international portfolio.

Market Cycle Timing: An investor with an international portfolio can take advantage of the market cycles of different nations. For instance, an investor may believe U.S. stocks and the U.S. dollar are overvalued and may look for investment opportunities in developing regions, such as Latin America and Asia, that are believed to benefit from capital inflow and demand for commodities.

Limitations

Increased Transaction Costs: Investors typically pay more in commission and brokerage charges when they buy and sell international stocks, which reduces their overall returns. Taxes, stamp duties, levies, and exchange fees may also need to be paid, which dilute gains further. Many of these costs can be significantly reduced or eliminated by gaining exposure to an international portfolio using ETFs or mutual funds.

Political and Economic Risk: Many developing countries do not have the same level of political and economic stability that the United States does. This increases risk to a level that many investors don’t feel they can tolerate. For example, a political coup in a developing country may result in its stock market declining by 40%.

Manipulation of Security Prices: Government and powerful brokers can influence the security prices. Governments can heavily influence the prices by modifying their monetary and fiscal policies. Moreover, public sector institutions and banks swallow a big share of securities traded on stock exchanges.

Unequal Access to Information: Wide cross-cultural differences may be a barrier to GPM. It is difficult to disseminate and acquire the information by the international investors beforehand. If information is tough to obtain, it is difficult to act rationally and in a prudent manner.

Floating Exchange Rate System:

Floating exchange rates are neither characterized by par values, nor by official exchange rates. This allows complete flexibility of exchange rates unlike the rigidity of currency movements under the fixed rate system.

Independently floating:

Under the ‘independent’ or ‘free’ float, the exchange rates are market-determined and central banks intervene only to moderate the speed of change or to prevent excessive fluctuations without any attempt to maintain it or drive it to a particular level.

About 35 countries, including the US, the UK, Japan, Switzerland, Germany, France, New Zealand, Mexico, Australia, Canada, and Brazil have adopted independently floating exchange rate regimes.

Managed float with no pre-determined path for the exchange rate:

Although currencies are allowed to fluctuate on a daily basis with no official boundaries, national governments may and sometimes do intervene so as to prevent their currencies from moving too far in a certain direction.

Such a system is known as ‘managed’ or ‘dirty’ float contrary to ‘free’ or ‘clean’ float wherein currencies are allowed to move freely without government intervention. Such exchange rate arrangements prevail in about 48 countries, including India, Singapore, the Russian Federation, Malaysia, Kenya, Thailand, Indonesia, Tanzania, Bangladesh, and Mauritius.

The managed float system is criticized on the ground that it allows governments to manipulate exchange rates for the benefit of their countries at the expense of others. For instance, a government may weaken its currency to attract foreign demand with an objective to stimulate its stagnant economy.

Pegged Exchange Rate System:

Pegging value of home currency to a foreign currency or a basket of currencies is known as pegged exchange rate system. Although the home currency value is fixed in terms of a foreign currency or unit of account to which it is pegged, it is allowed to move in line with that currency against other currencies. IMF classifies pegging exchange rate system as soft and hard pegs.

Soft pegs:

Conventional fixed peg:

The currency fluctuates for at least three months within a band of less than 2 per cent or ±1 per cent against another currency or a basket of currencies. The basket of currencies is formed from the geographical distribution of trade, services, or capital flows.

The monetary authority stands ready to maintain the fixed parity through direct intervention (i.e., via sales or purchase of foreign exchange in the market) or indirect intervention (i.e., via aggressive use of interest rate policy, imposition of foreign exchange regulations, exercise of moral suasion that constrains foreign exchange activity, or through intervention by other public institutions).

About 70 countries follow the conventional fixed peg arrangements, out of which 63 countries are pegged against a single currency whereas seven countries are pegged against other currency composites. The United Arab Emirates, Saudi Arabia, Qatar, Argentina, Egypt, Ethiopia, Kuwait, Oman, Syria, Venezuela, Vietnam, and Zimbabwe are among the 40 countries that peg their currencies to the US dollar.

The currencies of 19 countries, including Senegal, Niger, Gabon, Cameroon, and Malta, are pegged to the euro. Nepal and Bhutan peg their currencies to the Indian rupee, whereas the currencies of Swaziland, Namibia, and Lesotho are pegged to the South African Rand. Fiji, Iran, Morocco, Samoa, Seychelles, and Vanuatu peg their currencies against other currency composites.

Intermediate pegs:

Pegs within horizontal bands:

Currencies are generally not allowed to fluctuate beyond ±1 per cent of the central parity. Denmark, Slovak Republic, and Cyprus follow such an exchange rate system within a cooperative arrangement, whereas Hungary and Tonga adopt other band arrangements.

Crawling peg:

Under the crawling peg system, a currency is pegged to a single currency or a basket of currencies, but the peg is periodically adjusted with a range of less than 2 per cent in response to changes in selective micro-economic indicators, such as inflation differentials vis-a-vis major trading partners.

Maintaining a crawling peg imposes constraints on the monetary policy in a manner similar to a fixed peg system. China is among the six countries following such an exchange rate system, apart from Botswana, Azerbaijan, Iraq, Nicaragua, and Sierra Leone.

Crawling bands:

The currency is adjusted periodically at a fixed rate or in response to changes in selective quantitative macroeconomic indicators, with a range of fluctuation of 2 per cent or more. The degree of exchange rate flexibility is a function of the bandwidth.

The commitment to maintain the exchange rate within the band imposes constraints on monetary policy making, with the degree of policy independence being a function of the bandwidth. Costa Rica is the only country following the crawling bands exchange rate system.

Hard pegs:

Currency board arrangements:

Currency board arrangements refer to a monetary regime based on an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate. It combines restrictions on the issuing authority to ensure the fulfilment of its legal obligations.

The board must maintain foreign currency reserves for all the currency that it has printed. A currency board facilitates the stabilization of a country’s currency and maintains the confidence of foreign investors. About 13 countries have such arrangements. For instance, Hong Kong SAR, Djibouti, and Dominica have such an arrangement with the US dollar.

The currency board of a country maintains a reserve of the US dollar for every unit of home currency circulated. Bulgaria, Estonia, Lithuania, and Bosnia have such arrangements with euro, and Brunei Darussalam with Singapore dollars. Since 1983, Hong Kong has tied the value of the Hong Kong dollar with the US dollar.

Arrangements with no separate legal tender:

Replacement of a country’s local currency with US dollars is termed as ‘dollarization’. It may be formal or informal. Under this regime, the currency of another country circulates as the sole legal tender (formal dollarization) or the member belongs to a monetary or currency union in which the same legal tender is shared by the members of the union.

Adopting such an exchange rate regime implies the complete surrender of the monetary authority’s independent control over domestic policies. Ecuador, El Salvador, Marshall Islands, Micronesia, Palau, Panama, and Timor-Leste do not have their own separate legal tender, and instead use the US dollars, whereas the euro is used in Montenegro and San Marino, and the Australian dollar in Kiribati.

Consequent to the sharp depreciation of about 97 per cent in the Sucre, Ecuador’s currency, against the US dollar from 1990 to 2000, due to unstable trade conditions, high inflation, and volatile interest rates, Ecuador decided to replace its currency with the US dollar. As a result, dollarization showed positive effects as the economic growth increased and the inflation declined by November 2000.

The European Monetary System (EMS) was a multilateral adjustable exchange rate agreement in which most of the nations of the European Economic Community (EEC) linked their currencies to prevent large fluctuations in relative value. It was initiated in 1979 under then President of the European Commission Roy Jenkins as an agreement among the Member States of the EEC to foster monetary policy co-operation among their Central Banks for the purpose of managing inter-community exchange rates and financing exchange market interventions.

The European Monetary System (EMS) was an adjustable exchange rate arrangement set up in 1979 to foster closer monetary policy cooperation between members of the European Community (EC). The European Monetary System (EMS) was later succeeded by the European Economic and Monetary Union (EMU), which established a common currency, the euro.

The EMS functioned by adjusting nominal and real exchange rates, thus establishing closer monetary cooperation and creating a zone of monetary stability. As part of the EMS, the ECC established the first European Exchange Rate Mechanism (ERM) which calculated exchange rates for each currency and a European Currency Unit (ECU): an accounting currency unit that was a weighted average of the currencies of the 12 participating states. The ERM let exchange rates to fluctuate within fixed margins, allowing for some variation while limiting economic risks and maintaining liquidity.

The European Monetary System lasted from 1979 to 1999, when it was succeeded by the Economic and Monetary Union (EMU) and exchange rates for Eurozone countries were fixed against the new currency the Euro. The ERM was replaced at the same time with the current Exchange Rate Mechanism (ERM II).

History of the European Monetary System (EMS)

The early years of the EMS were marked by uneven currency values and adjustments that raised the value of stronger currencies and lowered those of weaker ones. After 1986, changes in national interest rates were specifically used to keep all the currencies stable.

A new crisis for the EMS emerged in the early 1990s. Differing economic and political conditions of member countries, notably the reunification of Germany, led to Britain permanently withdrawing from the EMS in 1992. Britain’s withdrawal foreshadowed its later insistence on independence from continental Europe; Britain refused to join the eurozone, along with Sweden and Denmark.

During this time, efforts to form a common currency and cement greater economic alliances were ramped up. In 1993, most EC members signed the Maastricht Treaty, establishing the European Union (EU). One year later, the EU created the European Monetary Institute, which became the European Central Bank (ECB) in 1998. The primary responsibility of the ECB was to institute a single monetary policy and interest rate.

At the end of 1998, the majority of EU nations simultaneouslyy cut their interest rates to promote economic growth and prepare for the implementation of the euro. In January 1999, a unified currency, the euro, was created; the euro is used by most EU member countries. The European Economic and Monetary Union (EMU) was also established, succeeding the EMS as the new name for the common monetary and economic policy organization of the EU.

Criticism of the European Monetary System (EMS)

Under the EMS, exchange rates could only be changed if both member countries and the European Commission were in agreement. This was an unprecedented move that attracted a lot of criticism.

In the aftermath of the global economic crisis of 2008-2009, significant tension between the principles of the EMS and the policies of national governments became evident.

Certain member states Greece, in particular, but also Ireland, Spain, Portugal, and Cyprus pursued policies that created high national deficits. This phenomenon was later referred to as the European sovereign debt crisis. These countries could not resort to the devaluation of their currencies and were not allowed to spend to offset unemployment rates.

From the beginning, the European Monetary System (EMS) policy intentionally prohibited bailouts to ailing economies in the eurozone. Despite vocal resistance from EU members with stronger economies, the EMU finally established bailout measures to provide relief to struggling members.

Benefits of the European Monetary System

Working towards a single market

The EMS was considered an important step towards the establishment of the EU and the single market in Europe.

Ensuring currency stability

The EMS ensured currency stability in Europe during times of international market volatility.

Unity in Europe

The EMS promoted political and economic unity across Europe at a pivotal time in European history.

Drawbacks of the European Monetary System

Common monetary policy

The EMS promoted a common monetary policy; therefore, raising or decreasing interest rates affected all economies differently just like the exchange rate system.

Fixed exchange rates

Fixed exchange rates affected different members of the EMS in different ways, which were not beneficial to all economies. It became evident in the 1992 crisis.

Forex quotations can be quite complex for the average person. It takes some training and knowledge to understand that these quotations can be provided in more than one way! Also, it takes a little getting used to before a person can quickly comprehend these quotes and take quick decisions based on the same. In this article, we will explain the two types of Forex quotations as well as the abbreviations which are used in them.

Nomenclature

Any Foreign exchange market quotation always uses the abbreviation of the currency under question. There are standard currency keys or currency codes that have been created by International Standards Organization (ISO). These keys are used for transactions worldwide.

The key is made up of 3 alphabets. The first two alphabets of the key denote the country to which the currency belongs whereas the third alphabet of the key is the first alphabet of the currency. Hence, United States dollar is referred to as the USD, Indian Rupee is referred to as INR, Great Britain Pound is referred to as GBP and the Japanese Yen is abbreviated as JPY.

The exceptions to this rule would be currencies like Euro which is abbreviated as EUR and most importantly the Swiss Franc which is abbreviated as CHF.

Direct Quotation

Under this method, the quote is expressed in terms of domestic currency. This means that the rate expresses how one unit of domestic currency relates to the foreign currency. Therefore, if unit of the domestic currency were to be exchanged, how many units of the foreign currency would it beget? This method is also alternatively referred to as the price quotation method.

Therefore, if the value of the domestic currency increases, a smaller amount of it would have to be exchanged. Conversely a decline in value would create a situation where a large amount of the domestic currency would have to be exchanged. Hence, it can be said that the quotation rate has an inverse relationship with the value of the domestic currency.

The value of the domestic currency is assumed to be 1 in case of a direct quotation. The price being quoted explains the number of units of foreign currency that can be exchanged for a single unit of domestic currency.

Example: An example of direct quotation would be

USD/JPY: 113.15/18

This quote suggests that roughly 113.15 units of Japanese Yen can be exchanged for 1 unit of United States Dollar. The two rates provided are bid and ask rates i.e. the different rates at which the market maker is willing to buy and sell the currency.

Usage: The direct quote method is one of the most widely used quotation methods across the world. This is the norm for quoting Forex prices and is assumed de facto until another method has been explicitly mentioned.

Indirect Quotation

This method is the opposite of the direct quotation method. Under this method, the quote is expressed in terms of foreign currency. Therefore this rate assumes one unit of foreign currency. It then expresses how many units of domestic currency are required to obtain a single unit of a foreign currency. Sometimes this quote is also expressed in terms of 100 units of foreign currency. This method is often referred to as the quantity quotation method.

Since this method is quoted in terms of foreign currency, the quoted rate has a direct correlation with the domestic rate. If the quote goes up, so does the value of the domestic currency and vice versa.

Example: An example of indirect quotation would be:

EUR/USD: 1.275/79

In this case, the first currency i.e. EUR is the domestic currency. Therefore, the indirect quote refers to approximately 0.875 EUR being exchanged for 1 unit of USD. Once again the two rates provided are the bid ask rate i.e. the two different rates at which market makers are willing to buy and sell the currency.

Usage: The usage of indirect currency quotation is extremely rare. It is only in the Commonwealth countries like United Kingdom and Australia that the indirect quotation method is used as a result of convention.

Direct Quote and Indirect Quote

The direct quote and indirect quote can be expressed in relation to each other, as follows:

Direct Quote = 1 / Indirect Quote

Spread & Spread

In forex trading, the spread is the difference between the bid (sell) price and the ask (buy) price of a currency pair. There are always two prices given in a currency pair, the bid and the ask price. The bid price is the price at which you can sell the base currency, whereas the ask price is the price you would use to buy the base currency.

The base currency is shown on the left of the currency pair, and the variable, quote or counter currency, on the right. The pairing tells you how much of the variable currency equals one unit of the base currency. The buy price quoted will always be higher than the sell price quoted, with the underlying market price being somewhere in-between.

There are two types of spreads:

• Fixed
• Variable (also known as “floating”)

Fixed spreads are usually offered by brokers that operate as a market maker or “dealing desk” model while variable spreads are offered by brokers operating a “non-dealing desk” model.

Advantages

Fixed spreads have smaller capital requirements, so trading with fixed spreads offers a cheaper alternative for traders who don’t have a lot of money to start trading with.

Trading with fixed spreads also makes calculating transaction costs more predictable. Since spreads never change, you’re always sure of what you can expect to pay when you open a trade.

Disadvantages

Requotes can occur frequently when trading with fixed spreads since pricing is coming from just one source (your broker).

There will be times when the forex market is volatile and prices are rapidly changing. Since spreads are fixed, the broker won’t be able to widen the spread to adjust for current market conditions.

So if you try to enter a trade at a specific price, the broker will “block” the trade and ask you to accept a new price. You will be “re-quoted” with a new price.

The requote message will appear on your trading platform letting you know that price has moved and asks you whether or not you are willing to accept that price. It’s almost always a price that is worse than the one you ordered.

Slippage is another problem. When prices are moving fast, the broker is unable to consistently maintain a fixed spread and the price that you finally end up after entering a trade will be totally different than the intended entry price.

Slippage is similar to when you swipe right on Tinder and agree to meet up with that hot gal or guy for coffee and realize the actual person in front of you looks nothing like the photo.

A flexible exchange-rate system is a monetary system that allows the exchange rate to be determined by supply and demand.

Every currency area must decide what type of exchange rate arrangement to maintain. Between permanently fixed and completely flexible however some take heterogeneous approaches. They have different implications for the extent to which national authorities participate in foreign exchange markets. According to their degree of flexibility, post-Bretton Woods-exchange rate regimes are arranged into three categories: currency unions, dollarized regimes, currency boards and conventional currency pegs are described as “fixed-rate regimes”; horizontal bands, crawling pegs and crawling bands are grouped into “intermediate regimes”; and managed and independent floats are described as flexible regimes. All monetary regimes except for the permanently fixed regime experience the time inconsistency problem and exchange rate volatility, albeit to different degrees.

Flexible exchange rate

These systems do not particularly reduce time inconsistency problems nor do they offer specific techniques for maintaining low exchange rate volatility.

A crawling peg attempts to combine flexibility and stability using a rule-based system for gradually altering the currency’s par value, typically at a predetermined rate or as a function of inflation differentials. A crawling peg is similar to a fixed peg; however, it can be adjusted based on clearly defined rules. A crawling peg is often used by (initially) high-inflation countries or developing nations who peg to low inflation countries in attempt to avoid currency appreciation. At the margin a crawling peg provides a target for speculative attacks. Among variants of fixed exchange rates, it imposes the least restrictions, and may hence yield the smallest credibility benefits. The credibility effect depends on accompanying institutional measures and record of accomplishment.

Exchange rate bands allow markets to set rates within a specified range; edges of the band are defended through intervention. It provides a limited role for exchange rate movements to counteract external shocks while partially anchoring expectations. This system does not eliminate exchange rate uncertainty and thus motivates development of exchange rate risk management tools. On the margin a band is subject to speculative attacks. It does not by itself place hard constraints on policy, and thus provides only a limited solution to the time inconsistency problem. The credibility effect depends on accompanying institutional measures, a record of accomplishment and whether the band is firm or adjustable, secret or public, band width and the strength of the intervention requirement.

Managed float exchange rates are determined in the foreign exchange market. Authorities can and do intervene, but are not bound by any intervention rule. They are often accompanied by a separate nominal anchor, such as an inflation target. The arrangement provides a way to mix market-determined rates with stabilizing intervention in a non-rule-based system. Its potential drawbacks are that it does not place hard constraints on monetary and fiscal policy. It suffers from uncertainty from reduced credibility, relying on the credibility of monetary authorities. It typically offers limited transparency.

In a pure float, the exchange rate is determined in the market without public sector intervention. Adjustments to shocks can take place through exchange rate movements. It eliminates the requirement to hold large reserves. However, this arrangement does not provide an expectations anchor. The exchange rate regime itself does not imply any specific restriction on monetary and fiscal policy.

Fixed exchange rate regime

A fixed exchange rate regime, sometimes called a pegged exchange rate regime, is one in which a monetary authority pegs its currency’s exchange rate to another currency, a basket of other currencies or to another measure of value (such as gold), and may allow the rate to fluctuate within a narrow range. To maintain the exchange rate within that range, a country’s monetary authority usually needs to intervenes in the foreign exchange market. A movement in the peg rate is called either revaluation or devaluation.

Currency board

Currency board is an exchange rate regime in which a country’s exchange rate maintain a fixed exchange rate with a foreign currency, based on an explicit legislative commitment. It is a type of fixed regime that has special legal and procedural rules designed to make the peg “Harder that is, more durable”. Examples include the Hong Kong dollar against the U.S dollar and Bulgarian lev against the Euro.

Dollarisation

Dollarisation, also currency substitution, means a country unilaterally adopts the currency of another country.

Most of the adopting countries are too small to afford the cost of running its own central bank or issuing its own currency. Most of these economies use the U.S dollar, but other popular choices include the euro, and the Australian and New Zealand dollars.

Currency union

A currency union, also known as monetary union, is an exchange regime where two or more countries use the same currency. Under a currency union, there is some form of transnational structure such as a single central bank or monetary authority that is accountable to the member states.

Examples of currency unions are the Eurozone, CFA and CFP franc zones. One of the first known examples is the Latin Monetary Union that existed between 1865 and 1927. The Scandinavian Monetary Union existed between 1873 and 1905.

History:

The Bretton Woods Conference, which established a gold standard for currencies, took place in July 1944. A total of 44 countries met, with attendees limited to the Allies in World War II. The Conference established the International Monetary Fund (IMF) and the World Bank, and it set out guidelines for a fixed exchange rate system. The system established a gold price of $35 per ounce, with participating countries pegging their currency to the dollar. Adjustments of plus or minus one percent were permitted. The U.S. dollar became the reserve currency through which central banks carried out intervention to adjust or stabilize rates.

The first large crack in the system appeared in 1967, with a run on gold and an attack on the British pound that led to a 14.3% devaluation. President Richard Nixon took the United States off the gold standard in 1971.

By late 1973, the system had collapsed, and participating currencies were allowed to float freely.

Failed Attempt to Intervene in a Currency

In floating exchange rate systems, central banks buy or sell their local currencies to adjust the exchange rate. This can be aimed at stabilizing a volatile market or achieving a major change in the rate. Groups of central banks, such as those of the G-7 nations (Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States), often work together in coordinated interventions to increase the impact.

An intervention is often short-term and does not always succeed. A prominent example of a failed intervention took place in 1992 when financier George Soros spearheaded an attack on the British pound. The currency had entered the European Exchange Rate Mechanism (ERM) in October 1990; the ERM was designed to limit currency volatility as a lead-in to the euro, which was still in the planning stages. Soros believed that the pound had entered at an excessively high rate, and he mounted a concerted attack on the currency. The Bank of England was forced to devalue the currency and withdraw from the ERM. The failed intervention cost the U.K. Treasury a reported £3.3 billion. Soros, on the other hand, made over $1 billion.

Central banks can also intervene indirectly in the currency markets by raising or lowering interest rates to impact the flow of investors’ funds into the country. Since attempts to control prices within tight bands have historically failed, many nations opt to free float their currency and then use economic tools to help nudge it one direction or the other if it moves too far for their comfort.

India was the one of the largest economies in the world, for about two and a half millennia starting around the end of 1st millennium BC and ending around the beginning of British rule in India.

Around 500 BC, the Mahajanapadas minted punch-marked silver coins. The period was marked by intensive trade activity and urban development. By 300 BC, the Maurya Empire had united most of the Indian subcontinent except Tamilakam, which was ruled by Three Crowned Kings, who were allies of Mauryas. The resulting political unity and military security allowed for a common economic system and enhanced trade and commerce, with increased agricultural productivity.

The Maurya Empire was followed by classical and early medieval kingdoms, including the Cholas, Pandyas, Cheras, Guptas, Western Gangas, Harsha, Palas, Rashtrakutas and Hoysalas. The Indian subcontinent had the largest economy of any region in the world for most of the interval between the 1st century and 18th century. Though it is to be noted that, up until 1000 AD,its GDP per capita was higher than subsistence level.

India experienced per-capita GDP growth in the high medieval era during the gupta empire and, during the Delhi Sultanate in the north and Vijayanagara Empire in the south, but was not as productive as Ming China until the 16th century. By the late 17th century, most of the Indian subcontinent had been reunited under the Mughal Empire, which became the largest economy and manufacturing power in the world, producing about a quarter of global GDP, before fragmenting and being conquered over the next century. Bengal Subah, the empire’s wealthiest province, that solely accounted for 40% of Dutch imports outside the west, had an advanced, productive agriculture, textile manufacturing and shipbuilding, in a period of proto-industrialization.

By the 18th century, the Mysoreans had embarked on an ambitious economic development program that established the Kingdom of Mysore as a major economic power. Sivramkrishna analyzing agricultural surveys conducted in Mysore by Francis Buchanan in 1800-1801, arrived at estimates, using “subsistence basket”, that aggregated millet income could be almost five times subsistence level. The Maratha Empire also managed an effective administration and tax collection policy throughout the core areas under its control and extracted chauth from vassal states.

The Indus Valley Civilisation, the first known permanent and predominantly urban settlement, flourished between 3500 BCE and 1800 BCE. It featured an advanced and thriving economic system. Its citizens practised agriculture, domesticated animals, made sharp tools and weapons from copper, bronze and tin, and traded with other cities. Evidence of well-laid streets, drainage systems and water supply in the valley’s major cities, Dholavira, Harappa, Lothal, Mohenjo-daro and Rakhigarhi, reveals their knowledge of urban planning.

Along with the family- and individually-owned businesses, ancient India possessed other forms of engaging in collective activity, including the gana, pani, puga, vrata, sangha, nigama and Shreni. Nigama, pani and Shreni refer most often to economic organisations of merchants, craftspeople and artisans, and perhaps even para-military entities. In particular, the Shreni shared many similarities with modern corporations, which were used in India from around the 8th century BCE until around the 10th century CE. The use of such entities in ancient India was widespread, including in virtually every kind of business, political and municipal activity.

The Shreni was a separate legal entity that had the ability to hold property separately from its owners, construct its own rules for governing the behaviour of its members and for it to contract, sue and be sued in its own name. Ancient sources such as Laws of Manu VIII and Chanakya’s Arthashastra provided rules for lawsuits between two or more Shreni and some sources make reference to a government official (Bhandagarika) who worked as an arbitrator for disputes amongst Shreni from at least the 6th century BCE onwards. Between 18 and 150 Shreni at various times in ancient India covered both trading and craft activities. This level of specialisation is indicative of a developed economy in which the Shreni played a critical role. Some Shreni had over 1,000 members.

The Shreni had a considerable degree of centralised management. The headman of the Shreni represented the interests of the Shreni in the king’s court and in many business matters. The headman could bind the Shreni in contracts, set work conditions, often received higher compensation and was the administrative authority. The headman was often selected via an election by the members of the Shreni, and could also be removed from power by the general assembly. The headman often ran the enterprise with two to five executive officers, also elected by the assembly.

India experienced deindustrialisation and cessation of various craft industries under British rule, which along with fast economic and population growth in the Western world, resulted in India’s share of the world economy declining from 24.4% in 1700 to 4.2% in 1950, and its share of global industrial output declining from 25% in 1750 to 2% in 1900. Due to its ancient history as a trading zone and later its colonial status, colonial India remained economically integrated with the world, with high levels of trade, investment and migration.

The Republic of India, founded in 1947, adopted central planning for most of its independent history, with extensive public ownership, regulation, red tape and trade barriers. After the 1991 economic crisis, the central government began policy of economic liberalisation. While this has made it one of the world’s fastest growing large economies.

Economy in the Indian Subcontinent performed just as it did in ancient times, though now it would face the stress of extensive regional tensions. Like earlier, the economy of Indian Subcontinent in medieval era was also performing in disparate units, limits of which were determined by multiple political entities which existed during this period. India during this era had multiple and divergent political units in form of Mughal Empire, Maratha Empire, Vijayanagara Empire, Ahom kingdom and several others which were all prosperous in the early 18th century. Parthasarathi estimated that 28,000 tonnes of bullion (mainly from the New World) flowed into the Indian subcontinent between 1600 and 1800, equating to 30% of the world’s production in the period.

An estimate of the annual income of Emperor Akbar’s treasury, in 1600, is $90 million (in contrast to the tax take of Great Britain two hundred years later, in 1800, totaled $90 million). The South Asia region, in 1600, was estimated to be the largest in the world followed by China.

During the time of Akbar, the Mughal Empire was at its peak as it controlled vast region of North India and had entered into alliances with Deccan States. It enforced a uniform customs and tax-administration system. In 1700, the exchequer of the Emperor Aurangzeb reported an annual revenue of more than £100 million, or $450 million, more than ten times that of his contemporary Louis XIV of France, while controlling just 7 times the population.

By 1700, the Indian Subcontinent had become the world’s largest economy, ahead of Qing China and Western Europe, containing approximately 24.2% of the World’s population, and producing about a quarter of world output. India produced about 25% of global industrial output into the early 18th century. India’s GDP growth increased under the Mughal Empire, exceeding growth in the prior 1,500 years. The Mughals were responsible for building an extensive road system, creating a uniform currency, and the unification of the country. The Mughals adopted and standardized the rupee currency introduced by Sur Emperor Sher Shah Suri. The Mughals minted tens of millions of coins, with purity of at least 96%, without debasement until the 1720s. The empire met global demand for Indian agricultural and industrial products.

Manufacturing

Until the 18th century, Mughal India was the most important manufacturing center for international trade. Key industries included textiles, shipbuilding and steel. Processed products included cotton textiles, yarns, thread, silk, jute products, metalware, and foods such as sugar, oils and butter. This growth of manufacturing has been referred to as a form of proto-industrialization, similar to 18th-century Western Europe prior to the Industrial Revolution.

Early modern Europe imported products from Mughal India, particularly cotton textiles, spices, peppers, indigo, silks and saltpeter (for use in munitions). European fashion, for example, became increasingly dependent on Indian textiles and silks. From the late 17th century to the early 18th century, Mughal India accounted for 95% of British imports from Asia, and the Bengal Subah province alone accounted for 40% of Dutch imports from Asia.[8] In contrast, demand for European goods in Mughal India was light. Exports were limited to some woolens, ingots, glassware, mechanical clocks, weapons, particularly blades for Firangi swords, and a few luxury items. The trade imbalance caused Europeans to export large quantities of gold and silver to Mughal India to pay for South Asian imports. Indian goods, especially those from Bengal, were also exported in large quantities to other Asian markets, such as Indonesia and Japan.

The largest manufacturing industry was cotton textile manufacturing, which included the production of piece goods, calicos and muslins, available unbleached in a variety of colours. The cotton textile industry was responsible for a large part of the empire’s international trade. The most important center of cotton production was the Bengal Subah province, particularly around Dhaka. Bengal alone accounted for more than 50% of textiles and around 80% of silks imported by the Dutch. Bengali silk and cotton textiles were exported in large quantities to Europe, Indonesia Japan, and Africa, where they formed a significant element in the exchange of goods for slaves, and treasure. In Britain protectionist policies, such as 1685-1774 Calico Acts, imposed tariffs on imported Indian textiles.

Mughal India had a large shipbuilding industry, particularly in the Bengal Subah province. Economic historian Indrajit Ray estimates shipbuilding output of Bengal during the sixteenth and seventeenth centuries at 223,250 tons annually, compared with 23,061 tons produced in nineteen colonies in North America from 1769 to 1771.

A foreign exchange spot transaction, also known as FX spot, is an agreement between two parties to buy one currency against selling another currency at an agreed price for settlement on the spot date. The exchange rate at which the transaction is done is called the spot exchange rate. As of 2010, the average daily turnover of global FX spot transactions reached nearly US$1.5 trillion, counting 37.4% of all foreign exchange transactions. FX spot transactions increased by 38% to US$2.0 trillion from April 2010 to April 2013.

The spot market is where financial instruments, such as commodities, currencies, and securities, are traded for immediate delivery. Delivery is the exchange of cash for the financial instrument. A futures contract, on the other hand, is based on the delivery of the underlying asset at a future date.

Exchanges and over-the-counter (OTC) markets may provide spot trading and/or futures trading.

Execution methods

Common methods of executing a spot foreign exchange transaction include the following:

• Direct: Executed between two parties directly and not intermediated by a third party. For example, a transaction executed via direct telephone communication or direct electronic dealing systems such as Reuters Conversational Dealing
• Electronic broking systems: Executed via automated order matching system for foreign exchange dealers. Examples of such systems are EBS and Reuters Matching 2000/2
• Electronic trading systems: Executed via a single-bank proprietary platform or a multibank dealing system. These systems are generally geared towards customers. Examples of multibank systems include Fortex Technologies, Inc., 360TGTX, FXSpotStream LLC, Integral, FXall, HotSpotFX, Currenex, LMAX Exchange, FX Connect, Prime Trade, Globalink, Seamless FX, and eSpeed
• Voice broker: Executed via telephone with a foreign exchange voice broker.

The forex rate is the rate at which a currency is exchanged. For example, if the Indian rupee trades at Rs 74.46 to one dollar, the forex rate for the US dollar for the Indian rupee is 74.46. This rate can change depending on many factors. Therefore, forex rates are closely watched by currency traders and governments, who take steps to keep the rate advantageous to the country’s economic health. These exchange rates can have a tangible impact on investor portfolios on a granular level in terms of genuine returns.

Factors affecting

Speculation

If a country’s currency value is expected to rise, investors will demand more of that currency in order to make a profit in the near future. As a result, the value of the currency will rise due to the increase in demand. With this increase in currency value comes a rise in the exchange rate as well.

Inflation Rates

Changes in market inflation cause changes in currency exchange rates. A country with a lower inflation rate than another’s will see an appreciation in the value of its currency. The prices of goods and services increase at a slower rate where the inflation is low. A country with a consistently lower inflation rate exhibits a rising currency value while a country with higher inflation typically sees depreciation in its currency and is usually accompanied by higher interest rates

Political Stability & Performance

A country’s political state and economic performance can affect its currency strength. A country with less risk for political turmoil is more attractive to foreign investors, as a result, drawing investment away from other countries with more political and economic stability. Increase in foreign capital, in turn, leads to an appreciation in the value of its domestic currency. A country with sound financial and trade policy does not give any room for uncertainty in value of its currency. But, a country prone to political confusions may see a depreciation in exchange rates.

Government Debt

Government debt is public debt or national debt owned by the central government. A country with government debt is less likely to acquire foreign capital, leading to inflation. Foreign investors will sell their bonds in the open market if the market predicts government debt within a certain country. As a result, a decrease in the value of its exchange rate will follow.

Interest Rates

Changes in interest rate affect currency value and dollar exchange rate. Forex rates, interest rates, and inflation are all correlated. Increases in interest rates cause a country’s currency to appreciate because higher interest rates provide higher rates to lenders, thereby attracting more foreign capital, which causes a rise in exchange rates.

Recession

When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to acquire foreign capital. As a result, its currency weakens in comparison to that of other countries, therefore lowering the exchange rate.

Terms of Trade

Related to current accounts and balance of payments, the terms of trade is the ratio of export prices to import prices. A country’s terms of trade improves if its exports prices rise at a greater rate than its imports prices. This results in higher revenue, which causes a higher demand for the country’s currency and an increase in its currency’s value. This results in an appreciation of exchange rate.

Country’s Current Account / Balance of Payments

A country’s current account reflects balance of trade and earnings on foreign investment. It consists of total number of transactions including its exports, imports, debt, etc. A deficit in current account due to spending more of its currency on importing products than it is earning through sale of exports causes depreciation. Balance of payments fluctuates exchange rate of its domestic currency.