Sivakamy Vadivelu , Professor at Associate Professor. Embeds 0 No embeds. No notes for slide. Foreign exchange management notes 1. Payment cards, credit transfers, directdebits and cheques are non-cash payment instruments with which end-users of payment systemstransfer funds between accounts at banks or other financial institutions. The safety and efficiency of payment instruments are important for both maintaining confidence in thecurrency and keeping the economy running smoothly.
The risks in the provision and use of paymentinstruments have not generally been considered to be of systemic concern. Relatively easy to stoppayment if necessaryMail or courier delivery canbe slowGood funds must still becollected from the draweebankIf payable in foreigncurrency, value may changeduring the collection periodStale dating rules differ invarious countriesCommercialLetters ofCreditBanks credit replaces BuyerscreditPayment made againstcompliant documentsForeign bank risk can beeliminated via confirmation of abank in Beneficiarys countryAcceptance credits offer built-infinancing opportunityRights and risks of Buyerand Seller are balancedSeller is assured ofpayment when conditionsare metBuyer is reasonablyassured of receiving thegoods orderedConfirmation eliminatescountry risk andcommercial riskMore costly than otherpayment alternativesIssuance and ammendmentscan take timeStrict documentarycompliance by Seller isrequiredReduces applicants creditfacilities 2.
Every Business Manager would need to know thenuances of the trade even though he may or may not be involved in the micro management of theprocesses. Any Import or Export entails commercial transaction and payment. When an import is made into the US,the foreign supplier would have to be paid in the currency in which he has raised the invoice.
Normallyinternational transactions are made using USD as the currency. However in many cases of transactionswith Europe, the Euro Dollar is used as the currency too. When an Export originates out of US to another country, the Exporter would have to receive paymentfrom the End Customer.
In Exports we have several types of trade or export transactions and the nature of the businessdetermines the payment terms. Advance PaymentWhen a new customer approaches and places an order on the Exporter, normally might insist onadvance payment for executing the order. This method normally continues for a few times until mutualtrust is built between the two parties and they get to know each other. Letters of CreditAn Exporter if dealing with an unknown customer at the other end may not have any prior exposure tothe credit worthiness of the Customer and would normally insist on Confirmed Letter of Credit to beopened by the Customer before shipping the goods.
In such cases the Exporter may not be extendingany credit. Also in case of high value transactions with known customers too; exporters prefer to getpaid through Letter of Credit. Normally LargeMulti Nationals demand such credit worthiness reports as a part of their policy.
This system is also called as Documentary Drafts. Open or Ongoing AccountWhen there is a huge volume of continuous business transactions between the Exporter and Importerand exports continue to happen on ongoing basis, the Exporter can simply export on the basis of apurchase order and expect the Importer to pay promptly on due date. This is the usual method adoptedby most of the Multi National Companies as well as the large organizations that have sufficient importvolumes spread across various countries and are dealing with multiple vendors on ongoing basis.
In suchcases they just determine the annual volumes to be supplied by each vendor, issue an open purchaseorder and keep reviewing only the delivery schedule. They offer standard payment commitment on aparticular date to all vendors as a global policy. The payment process will be set and determined as apart of their business agreement. Other Types of Trade and Related Payment MechanismsBesides the above types of payment mechanisms based on normal Exports and Imports, there are othertypes of business models which work on various other modes of payment terms too.
Consignment SaleAn exporter might sign up a contractor with a distributor overseas to import, hold stock and sell thegoods on his behalf. In such a situation, the distributor may not own the stocks and the ownership mightcontinue to lie with the exporter.
The distributor would only be an intermediary to sell the stocks andrepatriate the money realized back to the exporter and get remunerated in terms of service charges orcommission.
In such cases there may be a business agreement in place but no fixed payment mechanismmay be adopted. The paymentmay also involve services other than products. This kind of trade becomes a necessity while dealing withcountries that do not have sufficient foreign currency. There is also another system of internationalbarter which is not very commonly practiced in the commercial world.
The membercurrencies of the ERM were fixed against each other within a narrow band of fluctuation based on acentral European Currency Unit ECU rate, but floating against non-member countries. If a currencydeviated significantly from the central ECU rate, the European Monetary Cooperation Fund and thecentral banks concerned stepped in to stabilize the currency. The ERM was revised from 1 January , with the launch of the single European currency euro , andGreece and Denmark became members of ERM II a structure linking the currencies of some non-participating member states to the euro.
Greece then became a full member of the eurozone on 1January The United Kingdom which had withdrawn from the mechanism in turbulentcircumstances in October and Sweden were, in , not members of the ERM. When you are in Germany and you buy rice froma shop, you will naturally pay in Euros, and of course, the shop will be willing to accept Euros. This tradecan be conducted in Euros.
Trading of goods within a country is relatively simple. However, things get complicated if you want to buy a US-made computer. You might have paid in Eurosat the shop. However, through transactions in banks and financial institutions, the final payment will bemade in US dollars and not Euros.
Similarly, when Americans want to buy German products, they willhave to eventually pay in Euros. From this example of international trading, we introduce the concept of foreign exchange rate.
For example, the current foreign exchange rate for Euros is: Methods of Quoting Foreign Exchange RatesCurrently, domestic banks will determine their exchange rates based on international financial markets. There are two common ways to quote exchange rates, direct and indirect quotation. This is also known as price quotation. The exchange rate of the domestic currency isexpressed as equivalent to a certain number of units of a foreign currency.
It is usually expressed as theamount of domestic currency that can be exchanged for 1 unit or units of a foreign currency. Themore valuable the domestic currency, the smaller the amount of domestic currency needed to exchangefor a foreign currency unit and this gives a lower exchange rate. When the domestic currency becomesless valuable, a greater amount is needed to exchange for a foreign currency unit and the exchange ratebecomes higher.
Under the direct quotation, the variation of the exchange rates are inversely related to the changes inthe value of the domestic currency. When the value of the domestic currency rises, the exchange ratesfall; and when the value of the domestic currency falls, the exchange rates rise. Most countries usesdirect quotation.
This is also known as the quantity quotation. The exchange rate of a foreign currencyis expressed as equivalent to a certain number of units of the domestic currency. This is usuallyexpressed as the amount of foreign currency needed to exchange for 1 unit or units of domesticcurrency.
The more valuable the domestic currency, the greater the amount of foreign currency it canexchange for and the lower the exchange rate. When the domestic currency becomes less valuable, itcan exchange for a smaller amount of foreign currency and the exchange rate drops.
Under indirect quotation, the rise and fall of exchange rates are directly related to the changes in valueof the domestic currency. When the value of the domestic currency rises, the exchange rates also rise;and when the value of the domestic currency falls, the exchange rates fall as well.
Since the difference between the buyprice and sell price is not large, only the last 2 digits of the sell price are shown. The two digits in frontare the same as the buy price. This is the smallest unit ofmovement in the exchange rate. For exchange rate types, you can define fixed exchange rate spreads between average rate and buyingrate, as well as between average rate and bank selling rate. You then only have to enter exchange rates for the average rate.
The system then calculates theexchange rates for the buying rate and bank selling rate by adding and subtracting the exchange ratespread for the average rate. It is calculated as an annual average based onmonthly averages local currency units relative to the U. This phrase is also sometimes used to refer tocurrency quotes which do not involve the U.
For example, if an exchange rate between the Euro and the Japanese Yen was quoted in an Americannewspaper, this would be considered a cross rate in this context, because neither the euro or the yen isthe standard currency of the U.
However, if the exchange rate between the euro and the U. Forward rates are based onthe spot rate, adjusted for the cost of carry and refer to the rate that will be used to deliver a currency,bond or commodity at some future time. It may also refer to the rate fixed for a future financialobligation, such as the interest rate on a loan payment. In forex, the forward rate specified in an agreement is a contractual obligation that must behonored by the parties involved.
For example, consider an American exporter with a large exportorder pending for Europe, and undertakes to sell 10 million euros in exchange for dollars at a rateof 1. The exporter is obligated to deliver 10 millioneuros at the specified rate on the specified date, regardless of the status of the export order or theexchange rate prevailing in the spot market at that time. Forward rates are widely used forhedging purposes in the currency markets, since currency forwards can be tailored for specific 8.
In the context of bonds, forward rates are calculated to determine future values. For example, aninvestor can purchase a one-year Treasury bill or buy a six-month bill and roll it into another six-month bill once it matures. The investor will be indifferent if they both produce the same result. The investor will know the spot rate for the six-month bill and the one-year bond, but he or shewill not know the value of a six-month bill that is purchased six months from now.
Given thesetwo rates though, the forward rate on a six-month bill will be the rate that equalizes the dollarreturn between the two types of investments mentioned earlier.More...