Business of Banking (volumul II).pdf

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After studying this chapter you should understand:

1.1 General concepts

1.2 The foreign exchange market

1.3 Buying and selling foreign currency

1.4 The balance of payments

1.5 The foreign exchange market in Romania

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1.1 General concepts

You know that every businessperson involved in the international trade will

have to make or receive payments in foreign currency.

What is an exchange rate?

An exchange rate1is simply the price of one currency in relation to another

(say Euros per dollar), or it is the price at which one currency can be bought

or sold in exchange for another currency. Other authors define the exchange

rate as the number of units of domestic currency required to purchase 1 unit

of the foreign currency.

E.g. If 1 sterling pound can be exchanged for 4 DM in Munchen, it will cost

you 20 pounds to purchase any article priced at 80 DM.

If the rate moves to 4,25 DM for 1 pound, the article would cost 18,82

pounds (80 DM/4,25 DM = 18,82 pounds).

The exchange rate affects the economy and our daily lives because when the

US dollar becomes less valuable relative to foreign currencies, foreign

goods become more expensive. When the US dollar rises in value, foreign

goods become cheaper.

When a currency increases in value, it experiences appreciation; when it

falls in value and its worth fewer US dollars, it undergoes depreciation.

Exchange rates are important because they affect the relative price of

domestic and foreign goods and services, and the price of financial assets

and liabilities denominated in foreign currencies, and are among the most

important prices within an economy. The dollar price of French goods to an

American is determined by the interaction of two factors: the price of

French goods in francs and the franc/dollar exchange rate.

The conclusion is: When a countrys currency appreciates (rises in value

relative to other currencies), the countrys goods abroad become moreexpensive and foreign goods in that country become cheaper (holding

domestic prices constant in two countries). Conversely, when a countrys

currency depreciates, its goods abroad become cheaper and foreign goods

in that country become more expensive.

1 Kiriescu Costin Relaii valutar-financiare internaionale, Ed. tiinific i

Enciclopedic, Bucureti, 1978


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The exchange rate can be classified,as follows:

The nominal exchange rate. It is that rate at which actual transactions

occur.

The nominal effective exchange rate. It is a measure of the value of acurrency against a weighted average of several foreign currencies.

The real exchange rate (or real effective exchange rate) equals a

nominal exchange rate or nominal effective exchange rate index divided

by measures of relative change in general price levels, the prices of

traded products, an index of changes in labour costs, or other measures

of relative competitiveness.

The official exchange rate. It is established by the monetary authority

(the Central Bank, the Treasury) through a foreign exchange law or

regulation;

The market foreign exchange rate. It is freely established in the foreign

exchange market in accordance with the supply and demand of foreign

currency;

The bid exchange rate. It is established in the stock exchange in

accordance with the offer and demand of foreign currency. It is the price

at which a dealer will buy foreign exchange.

The offered rate or asked rate. It is the price at which a dealer will sell

foreign exchange.

The black bid exchange rate. It is established in the black stock

exchange.

The single exchange rate. It is the exchange rate established by the

monetary authority for each currency;

The multiple exchange rates. It is the case when the monetary authority

establishes many exchange rates for the same currency, or

The commercial exchange rate; The non-commercial exchange rate;

The spot exchange rate. It is the rate of the day, used by banks in

carrying out the spot operations, with the settlement in 48 hours from the

date of the transaction or in two working days;

The forward exchange rate. It is utilized in the forward transactions,

with the settlement over 48 hours (1, 2, 3, 6, 9, 12 months);


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The Telegraphic Transfer exchange rate.

The fixed (or pegged) rate. It is set by law or policy to hold a specific

value or is held within a specific range compared to another currency,

basket of currencies, some commodity, or other measures of value.

The floating (or flexible) rate is allowed to vary in value against other

currencies. Many variations exist, depending on national policy; some

rates are allowed to move freely, others are subject to frequent

intervention by authorities to limit the extent or speed of movements,

others fluctuate freely within a band/an interval, others are allowed to

appreciate or depreciate at specific paces dictated by policy, etc.

The foreign currency must be freely convertible, that is, one must be able

to:

Sell it;

Swap it;

Exchange it for another currency.

Exchange rates are quoted in the financial press at middle rates (i.e.: the

difference between the buying rate and selling rate, for acceptable

currencies). Most banks have their own foreign exchange department and

provide daily sheets or screens of up-to-date rates.

1.2 The foreign exchange market

The foreign exchange rate is established in the foreign exchange market,

concentrating the supply and demand of currencies.

The foreign exchange marketallows payments to be made across national

boundaries by establishing the prices of national currencies in terms of other

currencies.

The foreign exchange market in one country is a market where foreign

currency is traded in exchange for the home currency or for currencies of

other countries. Although foreign exchange is a means of payment of

another country, this does not mean that the entire stock of that countrys

currency is foreign exchange. Rather it is only part of the money stock,

which becomes foreign exchange when it is traded in exchange for another


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currency or when residents of countries other than the country of the

currency hold it.

Like many other markets, however, the foreign exchange market is not free

of government intervention; central banks regularly engage in internationalfinancial transactions called foreign exchange interventions in order to

influence exchange rates. In our current international financial arrangement,

called a managed float regime(or a dirty float), exchange rates fluctuate

from day to day, but central banks attempt to influence their countries

exchange rates by buying and selling currencies. The first step in

understanding how central bank intervention in the foreign exchange market

affects exchange rates is to see the impact on the monetary base from central

bank sale in the foreign exchange market of some of its holdings of assets

denominated in a foreign currency, called international reserves.

A central banks purchase of domestic currency and corresponding sale of

foreign assets in the foreign exchange market leads to an equal decline in

its international reserves and the monetary base.

A central banks sale of domestic currency in order to purchase foreign

assets in the foreign exchange market results in an equal rise in its

international reserves and the monetary base.

The intervention, in which a central bank allows the purchase or sale ofdomestic currency to have an effect on the monetary base, is called an

unsterilized foreign exchange intervention2. An unsterilized foreign

exchange intervention in which domestic currency is sold to purchase

foreign assets leads to a gain in international reserves, an increase in

the money supply, and a depreciation of the domestic currency. At the

same time, an unsterilized foreign exchange intervention in which

domestic currency is purchased by selling foreign assets leads to a drop

in international reserves, a decrease in the money supply, and an

appreciation of the domestic currency.

A foreign exchange intervention with an offsetting open market operation

that leaves the monetary base unchanged is called a sterilized foreign

exchange intervention.

2Mishkin F. The economics of money, banking, and financial markets, sixth edition,

Columbia University, USA, 2001


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The main types of exchange rate regime emphasized by the specialized

literatureare:

1. flexible or floating exchange regime;

2.

fixed or pegged exchange rates;3. managed floating, and

4. exchange controls.

There are also a number of mixed or intermediate cases.

The simplest regimeis the flexibleor floating exchange rate. Under such

a regime, the demand for and supply of each currency in the foreign

exchange market are allowed to determine the exchange rate. The market

for foreign exchange can be treated as competitive, because millions ofindividuals and firms participate, foreign exchange is a homogeneous

commodity, information is good, and entry and exit are unrestricted. The

market for foreign exchange under a flexible exchange rate works much like

the market for any other good. In the case of the foreign exchange market,

the good in question is an asset in the form of a bank deposit denominated in

a foreign currency. The exchange rate adjusts until the quantity of foreign-

currency-denominated deposits that individuals wish to hold equals the

quantity available.

Under the fixedor pegged exchange rates, the demand for and supply of

foreign exchange still exist, but they are not allowed to determine the

exchange rate as in a flexible rate system. Central banks (US Federal

Reserve, the Bank of England etc.) must stand ready to absorb any excess

demand for or supply of currency to maintain the pegged rate.

It should be mentioned the types of exchange rate arrangements

according to a classification used at the International Monetary Fund.

In all cases, classifications should be based on the substance of thearrangement. For example, some countries peg their official rate against a

single currency, but most transactions are at market rates determined at

currency auctions.


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Types of exchange rate arrangements3:

Pegged rates

Pegged against a singlecurrency

Mostly pegged against the US dollar or

French franc. Also includes several smallcountries that peg to the currency of a large

neighbour and several countries in formal

currency unions

Pegged against a

currency composite

Currencies of about 25 countries are pegged

against currency composites. A small number

of other currencies are pegged against

the SDR.

Limited flexibility

Against a single currency

An arrangement for several Mid-easterncountries that formally use a flexible band

around the SDR, but do not always observe

margins in order to maintain a more stable

relationship to the US.

Cooperative

arrangements

Countries participating in the exchange rate

arrangement of the European Monetary

System.

More flexible

Adjusted according tosets of indicators Most use a band around a weighted compositeof the currencies of major trading partners.

Other managed floating

Currency may float, but authorities may

intervene or take other policy actions in order

to affect the direction and size of movements

Independently floatingCurrencies ale allowed moving freely in

markets.

In Romania, in accordance with the National Bank of Romania Act, the

central bank establishes and pursues enforcement of the foreign exchange

regime on the Romanian territory.

The following ideas are worth mentioning concerning the foreign exchange

regime in Romania:

There is no foreign exchange law, but only an foreign exchange

regulation issued by the National Bank of Romania;

3IMF - Money and Financial Statistics Manual, Washington, 1996


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On March 25 1998, Romania notified the IMFs Board of its acceptance

of Article VIII obligations, sections 2, 3 and 4 of the IMFs Articles of

Agreement;

The move involves the following:

o authorities shall abolish current account restrictions;

o no other restrictions shall be introduced;

o creation of more favourable conditions for resumption of economic

reform;

o foreign exchange policy underwent no significant changes;

The regulation on foreign exchange operations issued by the National

Bank of Romania, establishing current account convertibility, has been

in force since 30 January 1998.

The harmonization of Romanian legislation with the European Union one

involves:

Current account operations are generally performed in line with

provisions under the IMFs Articles of Agreement (Art. XXX);

Capital account operations are performed largely in line with the similar

legislation of European Union and OECD countries;

In July 1999, the National Bank of Romanias Board decided toliberalize capital inflows the decision is to be fully implemented.

Foreign exchangeconsists of: paper money, coins, and transaction balances

at banks, all denominated in foreign currency units. In addition, foreign

exchange includes other financial instruments arising from international

transactions and nearing maturity, such as near-maturity foreign drafts or

bankers acceptances, which can readily be converted into foreign means of

payment.

Under the provisions of the National Bank of Romanias Circular No.

26/20014, foreign exchange represents the national currency of another

state, the single currency of a monetary union, as well as the composite

currencies such as: the Special Drawing Rights (SDR).

4Circular issued in Monitorul Oficial al Romniei, Part I, No. 769/03.12.2001, in order to

amend and complete the Regulation No. 3/1997 concerning the foreign exchange

operations.


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The foreign exchange marketbasically performsfour major functions, such

as:

It converts the purchasing power, which can only be exercised within a

national boundary of a country to that of other countries. Such

conversions often result in transfer of purchasing power from residents

of a country to those of others.

It functions as a clearing house for foreign exchange demanded and

supplied in the course of international transactions by residents of

various countries. Without this, buyers and sellers themselves must find

their prospective counterpart sellers and buyers.

It provides facilities for hedging foreign exchange risks. This function

has become increasingly important since the International Monetary

Fund sponsored international monetary system - abandoned the fixedexchange rate regime in 1973.

It provides credit for international trade, particularly as it functions as a

secondary market for international trade finance instruments.

Market participantscan be split into five groups5:

End users of foreign exchange: firms, individuals and governments whoneed currency in order to acquire goods and services from abroad or to

move capital as part of their regular activities;

Market makers: large international banks who hold stocks of currenciesto allow the market to operate continuously and who make their profits

through the spread between buying and selling rates of exchange;

Speculators: banks, firms and individuals who attempt to profit fromoutguessing the market;

Arbitrageurs:banks that make profits from buying in one market at the

same time as selling in another, taking advantage of smallinconsistencies which develop between markets;

Central banks who, on behalf of their governments, enter the market toattempt to influence the international value of their currency.

5 Howells P.& Bain K. The Economics of Money, Banking and Finance, Pearson

Education Limited, Edinburgh Gate, Harlow Essex CM 20 2JE England.


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Other authors6 consider that the participants in the foreign exchange

marketare:

- central banks;

- specialized institutions (commercial banks and other financial

institutions);- large commercial companies and

- a few wealthy individuals, as well as

- brokers who arrange deals between banks.

The participants represent the total of the banks, companies, institutions,

individuals of a country, who order directly, or by intermediaries, the

purchase or sale of currencies on the account of the specialized institutions.

The establishment of the exchange rate of a currency against another in theforeign exchange market is called quotation7.

The exchange rate can be expressedagainst:

A monetary unit, for the US dollar, British pound, etc.

E.g. 1 USD = x FRF

1pound = y FRF.

Hundred monetary units

E.g. 100 DM = x FRF

Thousand monetary units

E.g. 1000 Lit. = x FRF.

Foreign exchange rates are frequently quoted in the following methods:

1. Direct quotation;

2. Indirect quotation.

The direct quotationis the quotation by which the foreign monetary unit is

constant (1, 100, 1000) and the national monetary unit varies.

E.g. 1 USD = x lei

1000 Lit. = z lei.

6Davies Audrey & Kearns Martin Banking Operations, Pitman Publishing, London 1994,

p.207NegruMariana Tehnici de calcul valutar-financiar, Editura Militar, Bucureti, 1992,

p. 29


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The indirect quotationshows how many foreign monetary units are equal

to one national monetary unit (English, Canadian, etc.)

E.g. 1 pound = x USD

1 pound = y FRF.

The market undertakes trade in two distinct areas:

The wholesale market: mainly for inter-banking trading or very largecommercial companies;

The retail market: for normal trading and commercial customers.

Major currencies traded were: US dollars, German marks, sterling pound,

Japanese yen, and Swiss francs. All quotations are made against the US

dollar, as it is the worlds most available currency.

Each bank or broker must be authorized to deal in foreign exchange and

they are controlled by the Central Bank.

What is the business carried out on the market?

The English literature8describesthree kinds of transactionscarried out on

the market:

-

Spot transactions;- Outright transactions;

- Swap transactions.

In the Romanian literature, Costin Kiriescu9classifies these operations into

the following:

Spot operationsare operations with the settlement within two working

days. These businesses are made using the exchange rate of the day,

meaning spot exchange rate. In the world, about 40 per cent of foreignexchange transactions are spot transactions purchases/sales of foreign

currency for immediate delivery.

8Davies Audrey & Kearns Martin Banking Operations, Pitman Publishing, London 1994,

p. 179 Kiriescu Costin Relaii valutar-financiare internaionale, Ed. tiinific i Enciclope-

dic, Bucureti, 1978, p. 230


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Forward operationsare operations with the settlement at a future time

that is over 48 hours, but less than one year. Each exchange rate is

established in advance in the moment of the negotiation of the deal.

Forward rates of exchange relate to contracts entered into force now for

promised delivery in the future. The most common periods for forwardcontracts are one-month and three-months, although longer periods are

possible especially for heavily traded currencies.

The forwardoperationscan be classified into:

simple (outright) it represents a single forward sale/purchaseoperation (settlement is at some future date).

complex - swap it represents a purchase/sale of currency in the spotmarket, combined with a simultaneous sale/purchase in the forward

market.

As a conclusion, it should be mentioned the following:

- Spot operation represents the sale of currency and the purchase of

another at spot exchange rate. So, a spot rate of exchange is a rate of

exchange for a foreign currency transaction, which is to be settled

within two working days of agreeing the rate.

The main factors that can affect the movement of spot ratesare:

(a) international interest rate differentials (e.g. If one country raises its

interest rates, this could lead to increased short-term investment in that

country, which will strengthen that countrys home country);

(b) political and economic trends (examples are balance of payments,

money supply figures, government policy changes, and industrial

relations. All these matters influence the opinions of dealers and

traders, and thus affect the supply or demand for a currency.);

(c) central bank actions (central banks may purchase or sell a particular

currency in an attempt to influence its exchange rate);

(d) formal arrangements (the European Monetary System is a prime

example of a formal arrangement. Here governments agreed that their

currencies would not be allowed to fluctuate outside certain defined

parameters.)

- Forward represents the settlement at a future date. The important thing

is that the price of the foreign exchange is agreed now for future


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delivery. So, a forward rate is a rate of exchange that is fixed now for a

deal that will take place at a fixed date, or between two dates, in the

future.

Forward rate:

100360

= zwd

NKdF , where:

d = the difference of interest rate for both currencies (spread);K = spot exchange;

Nz= number of days for the calculation period of forward.

In practice, the forward exchange rate is made from the spot exchange rate,

adding or subtracting a difference given by two terms called pips (whichcorresponds to the buying or selling exchange rate).

Thus, under direct quotation when the forward exchange rate is greater than

the spot one, the currency has a discount and the differences are added to

the spot exchange rate.

When the forward exchange rate is less than the spot one, the procedure is

reversed and the differences are subtracted from the spot exchange rate.

E.g. we want to establish the forward exchange rate for one month for the

Swiss Frank against the US dollar using the following elements:

spot exchange rate USD/CHF = 1.70;

interest rate for one month for the US dollar = 15%;

interest rate for one month for CHF = 411

16%;

0146.0000,36

303125.1070.130

100360

16

1141570.1

P =

=

=

The forward exchange rate will be:

USD 1 = CHF 1.6854 (1.70 0.0146 = 1.6854)

Spot Operations:


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E.g. the Romanian Bank X S.A. wants to sell to the Bank of Austria USD

2 million.

Beforehand, the Bank X S.A. asks which is the exchange rate USD/DM inAustria.

The spot exchange rate is 1.4150 DM/USD.

The deal is concluded.

The Bank X S.A. sells 2 million USD to ING Bank Austria (exchange rate

1.4150 DM/USD) and buys DM, meaning 2,830,000 DM (2 million USD

1.4150).

In two bank-working days, the amounts will be in the accounts of the banks.

The deal:

Deal concluded with: ING Bank;

Sold: USD 2,000,000;

Bought: DM 2,830,000;

Exchange rate: 1.4150 DM/USD;

Value date10: 15th of November 1997.

Forward Operations:

E.g. the Romanian Bank X S.A. concludes a contract with a bank from

Germany on the 15th of December 1997.

It sells USD 1 million and buys DM 1,415,000.

The exchange rate is 1.4150.

The value date is 15th of January 1998.

On the 15th of January 1998, the exchange rate USD/DM could be 1.5200.

10The date when the discounting of the transaction is made.


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So, using a forward operation under a spot exchange rate, the bank can buy

cheaper or more expensive. At the end, the bank will make the following

document:

Dealconcluded with Deutsche Bank AG Frankfurt/Main;Sold: USD 1,000,000;

Bought: DM 1,415,000;

Exchange rate: 1.4150;

Value date: 15th of January 1998.

Swap operations:

The Romanian Bank X S.A. concludes a deal with ING Bank

Vienna, on the 15th of July 1998.

Sold: USD 1,000,000;

Bought: DM 1,415,000;

Exchange rate: 1.4150;

Value date: 15th of July 1998.

At the same time,

it sells: DM 1,410,000;

it buys: USD 1,000,000;

the exchange rate: 1.4100;

the value date: 21st of July 1998.

In two working days (on 17th of July, 1998), the Bank X S.A. will deliver

the US dollars to the Chase Manhattan Bank New York, where the Austrian

Bank has an account opened in US dollars.

At the same date, Bank X S.A. will receive the amount of DM 1,415,000.

On the 21st of July, the Bank X S.A. will send in the United States for

Barclays Bank PLC London the amount of DM 1,410,000, and at the same

date the Bank X S.A. will receive (by order of The English Bank) the

amount of USD 1,000,000.

The profit of the operation is DM 5,000.


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In practice, the swap operation is used if the result of the operation is greater

or equal with the difference between the currencies.

RF

C Ns

wd

s z

= 360

, where:

Cs = spot exchange rate;

Nz = number of days.

It should be mentioned that in the foreign exchange market there is a

foreign exchange risk. A market agent bearing risk is said to have an open

position in the market. There are two types of open position an agent may

go long (take a long position) by having assets in a currency greater than hisliabilities in the same currency. The risk then is that the currency will

weaken, reducing the value of the position. An agent who goes short (takes

a short position) has liabilities in a currency to a greater amount than assets.

The risk is that the currency will strengthen, increasing the debt in that

currency. The act of moving from an open position to a closed position in

the market (that is, covering exchange rate risk) is known as hedging.

Hedging is the way to transfer the foreign exchange risk inherent in all

transactions, such as international trade, that involves two currencies. For

example, suppose you are a US importer who has just purchased 1,000

sterling pounds of goods from a British exporter; payment is due in pounds

in 30 days. You face at least two choices:

- you can enter the spot foreign exchange market now, buying a 1,000

pounds deposit at the current spot exchange rate and earning interest on

it until the payment to the exporter is due in 30 days, or

- you can hold your dollars in a deposit and earn interest for 30 days until

the payment is due, at which time you enter the spot foreign exchange

market and buy your 1,000 pounds deposit at what is then the currentspot exchange rate.

If you choose the first option, you are hedging. If you wait (take option 2),

the exchange rate might rise during the 30-day period, meaning that you

will have to pay more dollars for each of the 1,000 pounds you must buy.

During the 30-day period under option 2, you are said to be holding a short

position in pounds that is, you are short of pounds that you will need at the


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end of the 30 days. Option 1 allows you to avoid this short position and the

associated foreign exchange risk. Once you have purchased the pounds,

changes in the exchange rate no longer affect you. You are then said to be

holding a balanced or closed position in pounds. You own just as many

pounds as you need to cover your upcoming payment due in pounds.

Entering the foreign exchange market to hedge in a way to avoid foreign

exchange risk; it provides a means of insulating wealth from the effects of

changes in the exchange rate.

Speculation is just the opposite of hedging. It means taking a deliberately

risky position by:

- purchasing a deposit denominated in foreign currency (taking a long

position) in the hope that the currencys price will rise, allowing you tosell it later at a profit, or

- waiting to purchase a foreign currency deposit that you will need in the

future (taking a short position) in the hope that its price will fall.

In the OECD countries, there are no foreign exchange restrictions and there

is not a foreign exchange control. This means that a person can buy and sell

foreign currency freely and without any restrictions. Some countries

(Romania and the other former communist states) have specific regulations

that allow foreign exchange control measures to be introduced to regulate orrestrict the flow of money, to ensure that the country has sufficient reserves

of foreign currencies to pay its international debt. For example, travellers

may transfer only a certain amount in lei in or out of Romania.

According to the type of underlying transactions, banks offer different rates

of exchange, grouped into two categories:

1. Commercial rates;

2. Note rates.

All commercial rates are based on the spot market. By convention, foreign

exchange deals are arranged for settlement in two working days time. The

delay allows instructions to be given and received for the movement of

funds between the correspondent bank accounts. These deals are called

spot transactions.


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The commercial rates vary according to the size of the transactions. Some

rates will incorporate interest costs during the period that the bank is out of

funds (i.e.: for negotiation of currency cheques).

Note ratesThe rates of exchange for the purchase and sale of foreign currency notes

and coins are loaded in favour of the banks to take account of the expensive

cost of handling, transportation etc.

1.3 Buying and selling foreign currency

When a bank gives a quotation, it will give two rates:

1. A selling rate;

2. A buying rate.

The difference between these rates, called the spread, will be adjusted to

attract or deter business and represents the banks profit. All transactions are

looked at from the banks point of view. A bank sells high and buys low,

which means that it will sell you less currency in exchange for a pound, for

example, but it will expect you to pay more than a pound for that currency.

In order to avoid any possible loss for either of the participants to a foreign

exchange transaction, because of the free pressure of market forces, theywill need to act promptly on a customers instruction, which involve foreign

exchange transactions.

1.4 The balance of payments

Different countries use different currencies; therefore, international

arrangements across borders often involve currency exchanges. Doing

business in an international framework can mean using various currencies

for business transactions. To understand these transactions, it is necessary to

understand the balance of payments system currently used by countries

around the world as well as the international monetary system.

The balance of payments system is used to report monetary transactions

between countries. The international monetary system comprises the

agreements, institutions, laws, and practices governing the movement of

currency from one country to another. The international monetary system

facilitates transactions, and the balance of payments system reports them.


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The international monetary system can be seen as providing a financial

context that enables international companies to function across borders.

The balance of payments accounts provide a system for documenting

economic transactions during a given period between the residents of acountry and residents of the rest of the world, in a globally consistent

manner and following generally accepted guidelines. Governments and

international institutions, such as the World Bank publish balance of

payments information.

The balance of payments records all transactions that cross a countrys

borders. The simplest way to think about it is as a record of all payments

going out to foreigners (with the reasons for those payments), and all

payments coming into the country from foreigners (with the reasons for

those payments). A plus sign is given to the payments coming in, and a

minus sign to the payments going out.

A countrys balance of payments statement is like a companys annual cash

flow, or sources and uses of funds statement. A balance of payments

statement provides a record of a how funds were generated from abroad

(inflows from outside the home country) and used in foreign transactions

(outflows to other countries) during a particular year. The balance of

payments statements are compiled on an annual basis, but interim data are

often available on a monthly or quarterly basis.

Because the balance of payments is merely a summary of all the

transactions undertaken by residents of one country with the rest of the

world, it can be divided into sub-accounts that correspond to the various

categories of international transactions in which individuals, firms, and

governments participate.

The balance of payments is a double-entry bookkeeping system. This

means that any international transaction is entered twice, because everytransaction has two sides.

The balance of payments statements are divided into four major sections:

a) the current account, b) the capital account, c) errors and omissions, and

d) the official reserves account.


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a) The current account includes imports and exports of goods and

services, interest and dividend payments, and unilateral transfers of money

such as gifts or inheritances.

b) The capital account records investments and loans. Investments in the

home country by foreigners are considered a source of funds, andinvestments by locals in foreign countries are a use of funds. Money that is

borrowed from abroad is a source of funds and money that is lent to

foreigners is a use. Interest payments on loans are recorded in the Current

Account.

c) Errors and Omissions

The accounting system is not entirely accurate, and discrepancies can occur

because of errors and omissions. The errors and omissions section

compensates for these discrepancies.d) The official reserve account

The official reserve account is a compensatory account that changes in

response to surpluses or deficits in the current and capital accounts. A

surplus implies an inflow of funds greater than the outflow and

consequently an increase in reserves. A deficit has the reverse effect and

reduces a countrys reserves.

There are five categories of balances reported in a balance of payments

statement:1. The balance of tradereports a countrys exports and imports of goods.

The balance may be positive (a surplus) if exports are greater than

imports (the country is selling more abroad than it is buying) or

negative (a deficit) if exports are less than imports (the country is

buying more abroad than it is selling).

2. The balance of goods and servicesreports exports and imports in both

goods and services. This balance can likewise be either a surplus or a

deficit.

3. The balance of current accountreports short-term transfers of capital

in addition to trade in goods and services. This balance can also be

either a surplus or a deficit one.

4. The balance of capital accountreports long-term transfers of capital.

5. The official settlements balance reports changes in a countrys

reserves needed to balance its surplus or deficit.


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In Romania, the National Bank of Romania in accordance with the

provisions of the Balance of Payments Manual makes out the balance of

payments. The International Monetary Fund in order to issued this be a

guide for member countries, which submit regular balance of payments

reports to this institution.

The Manual provides standards for concepts, definitions, classifications, and

conventions. At the same time, it facilitates the systematic national and

international collection, organization and comparability of balance of

payments and international investment position statistics.

Under the provisions of this Manual, the balance of payments is a statistical

statement that systematically summarizes, for a specific time period, the

economic transactions of an economy with the rest of the world.

Transactions11 (between residents and non-residents) consist of those

involving goods, services, and income, and those involving financial claims

on, and liabilities to, the rest of the world.

The balance of payments of Romania (it can be seen in Annex no.1)

includes the same items as we have just been discussed.

1.5 The foreign exchange market in Romania

Before studying the foreign exchange market in Romania, it is necessarily to

define some terms under the provisions of the Romanian legal framework12,

such as:

Residents are:

Legal persons including the following categories:

Public institutions, autonomous Regies, companies, associations, clubs,

etc. registered or authorized to conduct activities in Romania;

11 A transaction itself is defined as an economic flow that reflects the creation,

transformation, exchange, transfer, or extinction of economic value and involves

changes in ownership of goods and financial assets, the provision of services, or the

provision of labor and capital.12 National Bank of Romania Regulation no. 3/1997, concerning the performing of the

foreign exchange transactions, issued in Monitorul Oficial al Romniei, Part I,

No. 395/1997, with subsequent amendments


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Individuals and family associations authorized according to the

provisions of the Decree Law no. 54/1990;

Branches, subsidiaries, representations, agencies of foreign companies

registered and authorized to conduct activities in Romania;

Embassies, consulates or other representations of Romania abroad;

Branches, subsidiaries, representations, agencies of Romanian

companies that carry out business abroad, but are not registered abroad

as legal entity.

Individualsincluding:

Individuals, Romanian citizens, domiciled in Romania, as certified byan identity card issued by the bodies entitled by law;

Individuals with other citizenship and individuals with no citizenship

domiciled in Romania certified with an identity card issued by the

bodies entitled by law;

Non-residents are:

Legal persons including:

Legal persons with their headquarters abroad and which are not

registered and authorized to conduct activities in Romania;

Embassies, consulates or other representations of other countries in

Romania, as well as the international organizations or the

representations of such organizations functioning in Romania;

Branches, subsidiaries, representations, and agencies of Romanian

companies, which conduct activities and are registered abroad as legal

persons.

Individualsincluding:

Individuals, foreign citizens, who work within embassies, consulates

and representations of other countries in Romania or within certain

international organizations or their representations which function in

Romania;


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Individual, foreign citizens, as well as individuals with no citizenship

domiciled abroad;

Individuals, Romanian citizens, domiciled.

The foreign exchange transactions represent the proceeds, payments,compensations, transfers, credits, as well as any other transactions

denominated in foreign currencies and which banking transfer, in cash, with

payment instruments or other means of payment agreed or accepted by the

banks can carry out. In this category are also included the transactions made

in the domestic currency, when performed between residents and non-

residents.

The foreign exchange transactions can be:

Current transactions the transactions performed between residents

and non residents which are not of a capital nature and which derive

from:

international trade transactions with goods and services;

other transactions which are not of a capital nature as they were defined

in the item 1.17.2 of the Regulation No. 3/1997, such as taxes, fees,

commissions, legal charges, fines, technical assistance;

amounts which derive from operational leasing, governmental

expenses, subscriptions to publications, participation fees to

organizations and clubs;

the repatriation of the net income under the form of dividends, interest,

rents, resulting from capital transactions;

remittance of moderate amounts representing current expenses for

supporting the family members;

expenses with are not of a capital nature made by residents abroad for

vocation, sport, business, visits to friends, conferences, health care,

education, religion.

Capital transactions the foreign exchange transactions carried out

between residents and non residents, resulting from:

direct investment (in Romania of non residents; abroad of residents);

real estate investments (in Romania by non residents, abroad by

residents);


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transactions with capital market securities (admission of domestic

securities on the foreign capital market for issuance by placement or

public offer or introduction on a recognised foreign capital market;

transactions in Romania with securities made by non residents;

transactions abroad with securities made by residents);

transactions with money market instruments;

transactions in collective investment securities;

international trade credits (granted by non residents to residents;

granted by residents to non residents);

financial credits and loans;

guarantees (granted by non residents in favour of residents or grantedby residents in favour of non residents);

current account operations (opened by non residents with banks or with

other entities or opened by residents abroad with banks and with other

similar institutions);

deposit account operations (opened by non residents with banks or with

other entities or opened by residents abroad with banks and with other

similar institutions);

life insurance resulting from the life insurance contracts; transfers of theindividuals (presents, donations, inheritances, etc).

Foreign exchange capital account operations of residents and non-residents

are subject to the National Bank of Romania licensing with the exception of:

most capital inflows of non-residents in Romania;

banks:

o money market-specific operations performed abroad;

o foreign exchange current account and deposit operations;

o loans and borrowings with up to 12-month maturity;

o guarantees, endorsements, and other additional financial facilities.

Since January 1st, 2002, the following transactions are not subject to the

National Bank of Romania:

direct investments abroad of the residents;

real estate investments abroad by residents;


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admission of domestic securities and admission of domestic collective

investment securities on foreign financial market;

international trade credits on medium- and long-term granted by

residents to non residents;

guarantees granted by non residents to residents;

transfers related to life insurance;

personal capital transfers meaning short-term credits granted by non

residents to residents;

personal capital transfers such as presents and donations, inheritance,

etc.

Since January 1st, 2003, the following capital transactions shall not be

subject to the National Bank of Romania: real estate transactions of residents and of foreign collective investment

securities;

financial credits and loans on short-term granted by non residents to

residents;

financial credits and loans and personal loans granted by residents to

non residents;

guarantees granted by residents to non residents.

At the same time, since January 1st, 2004, the following capital transactionsshall not be subject to the National Bank of Romania:

admission of foreign real estate transactions and collective investment

securities on the Romanian capital market;

deposit account operations in leu currency opened by non residents in

Romania

the import or export of financial assets.

The National Bank of Romanias Regulation No.3/1997 stipulates that tillthe date when Romania will become member of the European Union, the

following capital operations shall not be subject to the National Bank of

Romania:

transactions with real estate securities or other instruments marketed in

the monetary market;

current account and deposit account operations opened by residents

abroad.


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In Romania, the National Bank of Romania is responsible for the

organization and function of the foreign exchange market.

The legal framework of the foreign exchange market is set by the

Regulation no. 3/1997.

Under the provisions of the Regulation No. 3/1997, the foreign exchange

market is defined as a continuous market, where sales and purchases of

foreign currencies are carried out, for the domestic currency or other foreign

currencies at rates freely determined by intermediaries authorised by the

National Bank of Romania to operate in their own name and account and in

their own name and the account of their clients.

Only authorized intermediaries (credit institutions, exchange offices, and

other non-banking entities authorized by the National Bank of Romania tooperate in the foreign exchange market as brokers or dealers) may perform

transactions in the foreign exchange market.

Under the provisions stipulated in its statute, the National Bank of Romania:

Regulates and supervises the inter-banking foreign exchange market;

Authorizes and supervises the intermediaries of the inter-banking

foreign exchange market;

Participates in the inter-banking foreign exchange market in order to

manage its monetary policy and to protect the national currency;

Publishes a reference exchange rate for the leu currency on a daily

basis.

In order to develop the brokerage activity on the foreign exchange market,

residents legal persons from Romania must obtain the authorization from

the National Bank of Romania.

The minimum conditions, which must be fulfilled for the participation on

the foreign exchange market as an authorized broker, are the following:

a) the existence of an adequate share capital;

b) the existence of an operating authorization; the participation on the

foreign exchange market of brokers, who are undergoing a legal

procedure of reorganization and judicial liquidation may not be

authorized;


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c) the existence of a distinct organization structure and a specific space for

the activity of foreign exchange brokerage;

d) the regularization through own norms regarding:

-

procedures concerning the work with clients;- the relation with other brokers (the communication, confirmation and

settling method of transactions);

- competencies and value limits up to which any arbiter may engage

himself, as well as the limits of work with the other authorized brokers;

- the due penalties in the relation with the clients, as well as with other

brokers, in case of failure to observe the settling terms of transactions;

- the bookkeeping system of foreign exchange operations;

e) the appointing of personnel involved in the activity of foreign exchange

activity, respectively the nominal list of the arbiters, the work

experience, including the experience in the activity of foreign

exchange, as well as the appointment of the chief-arbiter;

f) the relations of a correspondent established through accounts opened

abroad, for at least 4 currencies: USD, EUR, GBP, CHF;

g) the existence of a specific operating system:

-

specific informational equipment Reuters or Dow Jones;- specific technical equipment for payments and communications

(internal and international telephone lines, a recording system of phone

conversations, telex, SWIFT, fax, etc.)

The inter banking foreign exchange market from Romania operates on every

working day from 9:00 a.m. to 2:00 p.m.

Brokers authorized to participate on the foreign exchange market must post

permanently during the hours when the inter-banking foreign exchange

market operates, both at their counter for the work with clients, and throughspreading systems of information as the Reuters or Dow Jones type, the


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Rates of Exchange

informational exchange rates of the Leu (selling/buying), spot13 and

forward14

,for at least the following currencies15

:

the American dollar (USD);

the Euro (EUR); the pound sterling (GBP);

the Swiss franc (CHF);

etc.

Thus, till February 28, 2002, the National Bank of Romania up-dated the

foreign exchange rates list daily published by eliminating the leu quotations

against each IN foreign exchange rates (e.g. the Irish pound IEP February

9th,

2002; the French Franc FRF February 17th

, 2002; German MarkDEM February 28

th, 2002).

The quotation shall be direct and it shall be based on the monetary unit of

Romania the Leu (without subdivisions).

The informational forward exchange rate shall be quoted for at least the

following deadlines:

one month (1 M);

three months (3M);

six months (6M);

nine months (9M);

twelve months (12M).

Brokers authorized to participate on the inter-banking foreign exchange

market must quote both for the clients and for the other authorized brokers,

firm or informational exchange rates, on their request.

13An operation of selling/buying foreign currency with the settlement within two days after

the date of concluding the transaction, at the exchange rate established between the

parties (spot rate).14An operation of selling/buying foreign currency with the settlement after more than two

days since the date of concluding the transaction at the exchange rate established

between the parties (forward rate).15Since the appearance of Euro, the foreign exchange rates list published by the National

Bank of Romania will include the leu rates against Euro and against IN currencies.


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Rates of Exchange

If the firm quotation meaning the amount in foreign currency and the date of

the foreign currency are accepted by the client or the authorized broker, the

transaction is considered concluded and it shall be performed

unconditioned.

The spread between the selling rates and the purchasing ones shall be freelydetermined on the inter-banking foreign exchange market.

The selling/buying orders of the clients (residents and non-residents

natural and legal persons), account owners, shall be completed according to

the attached models issued by the National Bank of Romania (forms 1 and

2 see Annex no. 2, and 3). Annexes no. 2.1 and 3.1 reflect a particular

implementation of the above mentioned forms. The spot and forward

purchase orders of the resident and non-resident legal persons shall be

accompanied by the justifying documentation (including the formDPVE/form CDA).

For capital foreign exchange operations, the documentation related to the

purchase order shall be also completed with the authorization of the

National Bank of Romania, as the case may be.

Residents may participate on the inter-banking foreign exchange market

with purchase order of foreign currency for the reimbursement of credits

and the payment of interest and commissions related to a credit or loan in

foreign currency granted by a resident bank.

The transactions among intermediaries shall be concluded on their own

behalf, by confirmation among dealers (on telephone, telex, Reuters

dealing) and re-confirmations by letters and telex or SWIFT, codified

correspondingly (letter sample of signature, telex telegraphic keys,

SWIFT SWIFT keys). The reconfirmation must include at least the

following elements:

the transaction partner;

the date of concluding the transaction;

the date of the foreign currency; the transacted foreign currency (currencies);

the transacted amounts;

the type of transaction;

the spot or forward exchange rate;

the correspondents of the parties;


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Rates of Exchange

the method of concluding the transaction (telephone, telex, Reuters

dealing).

As a conclusion, it should be mentioned the following:

Purchases and sales of foreign exchange shall be made only through

intermediaries (dealers) licensed by the National Bank of Romania; Purchases of foreign exchange by resident legal entities and non-

residents shall be made only against documents;

Purchases of foreign exchange by resident individuals via exchange

bureaus and banks are unlimited.

1. What is an exchange rate?

2. Explain what is the appreciation and depreciation of a currency.

3. List at least 8 types of foreign exchange rates and explain them.

4. Where is the exchange rate established?

5. Explain the sterilized and unsterilized foreign exchange intervention.

6. List the main types of foreign exchange rate regime and explain them.

7. What is the foreign exchange?

8. What are the major functions of the foreign exchange market?

9. List the market participants.

10. What represents the difference between a banks buying and selling

rate?

11. When is settlement made for spot deals?

12. When is settlement made for forward deals?

13. What are the swap deals?

14. What is a quotation?

15. How many types of quotations do you know? Give the definitions.

16. Which two categories of rates of exchange do banks offer?

Progress test


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17. What is the balance of payments of a country?

18. List the four major sections of the balance of payments.

19. Define the residents.

20. Define the non-residents.

21. What are the foreign exchange transactions?

22. List the transactions included in the foreign exchange transactions.

23. Identify the legal framework of the foreign exchange market in

Romania.

24. List the minimal conditions, which must be fulfilled for the

participation on the foreign exchange market as an authorized broker.

25. Describe the inter-banking foreign exchange market in Romania.

26. What is a spot rate?

27. List the main factors that affect the movement of spot rates.

28. What is a forward rate?

29. What are the main exchange rate arrangements?

30. Define a foreign exchange risk.


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ANNEX No 1

The Balance of Payments

A. Goods and Servicesa. Goods fob (exports/imports)

b. Services

Transportation

Tourism

Other services

B. Income

Compensation of employees

Direct investment income

Portfolio investment income Other capital investment (interest)

C. Current transfers

Government sector

Other sectors

A. Capital account

a. Capital transfers

Government sector

Other sectors

b. Purchases/Sales of non-produced non-financial assets

B. Financial account

a. Direct investment

Abroad

In Romania

b. Portfolio investment

Assets

Liabilitiesc. Other capital investment

Assets

1. Longterm loans and credits

2. Shortterm loans and credits

3. Longterm outstanding exports bills

4. Shortterm outstanding exports bills

5. Currency and cheques


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6. Residents' deposits abroad

7. Other assets

longterm

shortterm

Liabilities1. Credits and loans from the Fund

2. Longterm loans and credits

3. Shortterm loans and credits

4. Longterm outstanding imports bills

5. Shortterm outstanding imports bills

6. Currency and cheques

7. Nonresidents deposits in Romania

8. Other liabilities

longterm

shortterm

d. In transit accounts

e. Barter and clearing accounts

f. Reserve assets (NBR)

Monetary gold

SDRs

Reserve position with the International Monetary Fund

Foreign exchange

NET ERRORS AND OMISSIONS


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ANNEX No 2

FORM No.1

Denomination/Name of the client

..............................................................

...............................................

Address/Head

office.....................................................

Tel./telex ..........................................

Persons of contact ............................

No.from the Trade Registry .............

Fiscal

code......................................

Non-resident*

ACCEPTED/REJECTED (reason)..

..........................................................

at the FIRM QUOTATION RATE and

accepted by the client of .... Leu/

or at a LIMITED RATE requested by the

client

of..Leu/.

EXECUTED AT THE RATE

ofLeu/.

Authorized clients signature

L.S.

It must be filled in by the broker at his head office in the presence o f the client

PURCHASE ORDER OF FOREIGN CURRENCY (SPOT)/ FORWARD

Valid till the date ..................................

To ................................................................................

BUY the amount of .......................... / ..............................with the value date..

(figures) (letters)You shall recover the equivalent in Leu currency from our account of availability no.

opened with

The purchased amount in foreign currency shall be paid with the same value date in

our account no. ........................ opened with ............................................

1. We attach the following documents, which prove the nature of the foreign

currency operation:

..

..

....

2. The purpose of buying currency is:

Current foreign exchange operation;

Capital foreign exchange operation representing:

Direct investment;

Portfolio investment;

Securities investments;

Other capital foreign exchange operations.


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3. Hereby we declare that we agree that the amount in foreign exchange purchased

on basis of the present order and not used within 30 days after the expiration of

the payment term according to the initial destination or for other current foreign

operations, must be purchased through the bank, which executes the present

order.

........................................... ........................................

Issuing date Authorized signature

L.S.

Notes

1. Tick the fields, if the case.

2. Only residents, legal entities, shall fill in point 2.

3.

Points 1si 2 shall not be filled in by residents, natural persons.

4. The provisions of point 3 shall not be applied to residents and non-residents,

natural persons.

*) Non-residents from the foreign exchange point of view, according to point 1,2 of the

regulation


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ANNEX No 2.1

Ctre: THE COMMERCIAL BANK. S.A.


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ANNEX No 3

FORM NO.2

Denomination/Name of the client

.......................................

..................................................

Address/Head

office........................................

Tel./telex ..................................

Persons of contact ....................

No. from the Trade Registry ....

Fiscal code.......................................

Non-resident*

ACCEPTED/REJECTED

(reason)......................

at the FIRM QUOTATION RATE and

accepted by the client of ........ Leu/ .............

or at a LIMITED RATE requested by the

client

ofLeu/.

EXECUTED AT THE RATE

ofLeu/.

Authorized clients signature

L.S.

It must be filled in by the broker at his head office in the presence of the client

SELL ORDER OF FOREIGN CURRENCY (SPOT)/ FORWARD

Valid till the date ..................................

To ................................................................................

SELL the amount of .............. / ...............with the value date

..........

(figures) (letters)

from our foreign exchange account no........opened

with..........................

The equivalent value in Leu currency shall be paid with the same value date in our account no.

..............opened with

1. The purpose of the foreign exchange is:

Current foreign exchange operation;

Capital foreign exchange operation representing:

Direct investment;

Portfolio investment;

Securities investments;

Other capital foreign exchange operations.

.. Issuing date authorized signature

L.S.

Notes:

1. Tick the fields, if the case may be.

2. Only residents, legal entities, shall fill in point 1.

*) Non-residents from the foreign exchange point of view, according to point 1.2 of the

regulation.


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ANNEX No 3.1

Ctre: THE COMMERCIAL BANK. S.A.


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Financial Derivatives

OObbjjeeccttiivveess

After studying this chapter you should be able to understand:

2.1 Foreign exchange risk: definition, types, identification

2.2 Financial derivatives

2.2.1 General concepts

2.2.2 Forward exchange contracts

2.2.3 Currency accounts: the Eurocurrency market, loans

2.2.4 Options

2.2.5 Swaps

2.2.6 Financial futures

2.3 Comparing different types of derivatives

FINANCIAL

DERIVATIVES


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2.1 Foreign exchange risk: definition, types, identification

Foreign exchange risk has a variety of forms and can be obvious or obscure.Foreign exchange risk may exist for a company without the company even

being aware of it. One must be able to identify the existence of foreignexchange risk and its specific type before it can be effectively managed.

E.g.

1. An import company Co. from USA is buying Wedgwood china from asupplier in England and is invoiced in English pounds. Payment is dueon a net 30-day basis. Import Co. USA must buy English poundssometime between the date the china is ordered and the payment duedate.

2.

An export Co. from USA is selling its tree trimming equipment to a

company in Thailand. In order to be competitive, it must invoice itscustomer in local currency, the Thai baht. Export Co. USA will need toconvert the Thai baht into US dollars upon receipt of the payment, as ithas no accounts payable in Thailand.

3. New Products Inc. is exporting its products to Nigeria and is billing itscustomer in US dollars. Payment is on a net 10-day basis.

4.

Worldwide Corp. has subsidiaries in several different countries aroundthe world. At each quarter-end, a consolidated balance sheet must be

given to the board of directors. Each subsidiary maintains its own bank

accounts and is responsible for remitting US dollars for dividendpayments.

In each of these situations, the companies involved have foreign exchangeexposure. Each company has a different combination and varying degree ofexposure.

The main foreign exchange exposure can be defined, such as:

1.

Sovereign risk this is another name for political risk. What are the

chances that the government which is in power in the foreign countrywill remain intact and will continue to have favourable relations with

the United States, in our case? What happens if the current governmentfalls and a less-than-friendly governing is installed?

2. Exchange risk Will the foreign currency be trading freely on theopen market when the time comes to convert into or out of thecurrency? Further, are there any restrictions on the availability and


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transfer of hard currency out of the foreign country? What happens ifexchange controls are put in place?

3. Translation risk this is an accounting-based risk. When operating anoverseas operation and a consolidated statement must be filed, changesmay occur in the book value of the overseas operation without any truechanges in its balance sheet. This comes about when different currencyconversion rates are used to value the same set of assets. Since foreignexchange rates can change in seconds, a quarterly consolidated

statement will show changes in the operations value purely related tothe use of current exchange rates versus those from the previousquarter.

4. Transaction risk this is the risk associated with the potential gains

and losses on a given transaction, which is susceptible to foreignexchange movements. This relates to any transaction resulting in a netreceipt or payment, which must be made in a foreign currency.

Therefore, items such as foreign currency receivables or payables,repatriation of revenues or dividends, or foreign currency loanpayments or interest income are all subject to transaction risk.

Taking into account the connection between the above four examples offoreign exchange risk and the main foreign exchange exposures defined, it

should be mentioned the following:

In Example 1, Import Co. USA has transaction risk associated with itspurchase of china from England. The company runs the risk of the English

pound increasing in value (in relation to the US dollar) prior to the companybuying the pounds to cover the invoice. This would result in an increasedcost of the china, which the company may or may not be able to pass on toits customers.

InExample 2, Export Co. USA has sovereign risk, exchange risk, as well

as transaction risk. Is the government of Thailand stable and free ofsanctions? Is the Thai baht a freely traded currency without conversionrestrictions? Is there a forward market in the baht so Export Co. USA cansell that baht today for delivery in the future?

InExample 3, New Products Inc. has sovereign risk and exchange risk.

How stable is the Nigerian government? Is it on good terms with the USgovernment, in our case? Are their any trade sanctions covering the


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products being exported? Will the customer be able to purchase US dollarsand, if so, will it be able to transfer them out of the country? How reliable isthe exchange market in Nigeria?

InExample 4, Worldwide Corp. has translationand possibly transaction

risk. The translation risk comes from converting the foreign currency valueof the subsidiary into a US dollar value. With everything else constant, theexchange rate alone could change the value of the subsidiarys assetssignificantly. If the subsidiary has local currency payables and does notremit profits or dividends to the US parent, no transaction risk exists;however, if profits or dividends are repatriated, a transaction risk exists andmust be managed effectively in order to protect their value.

In order to identify the foreign exchange risk in a company, a lot of

departments are involved, such as: accounting, sales, legal department, bankaccount officer, foreign exchange dealer etc.

The main steps for identifying foreign exchange risk are:

1.

Determine what types of foreign exchange risk exists.

a. Sovereign

b. Exchange

c. Translation

d. Transaction

2. Determine the extent or degree of the risks identified.

a.

Is there an extreme risk of the government failing?

b.

Are there exchange controls pending?

c.

Is war or sanctions imminent?

d.

What are the tax implications of a translation profit or loss?

e. How volatile is the current foreign exchange market for thecurrencies involved?

3.

Determine the longevity of the risk.a. Is this a one-time-only transaction?

b. Will foreign denominated sales or purchases are an on-going part ofyour operation?

c. Are you dealing with an overseas subsidiary, which will continue togenerate foreign income and expenses?

d. Are you borrowing or lending a foreign currency? Short term or longterm?


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4. Determine what control procedures are in place or are needed tomonitor the identified risks.

a.

Can you adequately forecast when the extent or degree of risk willincrease or change?

b.

Who is responsible for monitoring the control process anddeveloping new controls, as they are needed?

c.

How much movements in the foreign exchange rates can be toleratedwithout adverse effects on the company?

d.

How much exchange risk will be tolerated?

5. Determine if the operation of the company has naturally offsettingforeign exchange transactions.

a.

Is an overseas subsidiary having both local currency receivables andpayables?

b.

Are imports and exports denominated in the same foreign currency?Are they in similar payment schedules?

As a conclusion, it should be said that whenever someone is involved in a

transaction in a foreign currency other than his or her home currency, anexchange risk occurs because one currency may move unfavourably againstthe other.

In Romania, the National Bank defines and regulates the maximum level of

the adjusted individual currency positions and total currency positions forbanks Romanian legal entities.

Under its provisions1 the National Bank of Romania defined the followingconcepts such as:

a) the currency position in a certain foreign exchange represents the netbalance of the patrimony in the respective foreign exchange, being the

expression of the currency risk;

b) on the balance sheet currency position in a certain foreign exchangerepresents theamount emphasized in the creditor or debtor balance ofthe account 3721 Exchange position, opened on the respective foreignexchange;

1 The National Bank of Romanias Norm No. 4/2001 concerning the supervision of theforeign exchange positions, published in Monitorul Oficial al Romniei, Part I,

No. 631/2001


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c) off balance sheet currency position in a certain foreign exchange istheamount emphasized in the creditor or debtor balance of the account 9361Exchange position, opened on the foreign exchange in cause;

d) individual currency position is the long currency position or the short

currency position on each foreign exchange, in lei equivalent;e) adjusted individual currency position represents individual currency

position adjusted with the updated equivalent in lei of the share capitalsubscribed and paid in foreign exchange and issue premiums paid inforeign exchange, calculated based on the differences in the exchangerate related to the availabilities in foreign exchange representing thecontribution to the share capital and the issue premiums paid in foreignexchange;

f) total currency position isthe highest value, in the module, between the

total of the long adjusted, individual currency positions and the total ofthe short adjusted individual currency positions.

In Romania, the supervision of the currency risk is accomplished:

g) by banks;

h) by the National Bank of Romania, on the basis of the currency positionindicators reported by banks.

Under the Romanian legal framework, banks are obliged to report to the

National Bank of Romania the level of their currency positions, according tothe form The supervision of the currency positions, provided in the Annex

No. 1.

The reporting form will include data referring to the banks global activity(the whole of the national territory and all the sub-units from abroad of thebank).

The currency position in a certain foreign exchange is calculated as analgebraic sum of the on and off balance sheet currency position.

In order to establish the total currency position, the amounts representing

long adjusted individual currency positions will be considered with the plussign (+), and the amounts representing short adjusted individual currencypositions will be considered with the minus sign (-).

The total currency position shall be long when the total of the long adjustedindividual currency positions is longer than the total of the short adjusted


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individual currency positions and it shall be short when the total of the shortadjusted individual currency positions is higher than the total of the longadjusted individual currency positions.

At the end of each working banking day the currency positions of a bank aresubmitted to the following limitations:

a) maximum 10% of the banks own funds for each of the adjustedindividual currency positions; and

b)

maximum 20% of the banks own funds for the total currency positions.

With a view to limiting the currency risk the banks have the followingobligations:

a)

to have a records system which permits permanently both the immediateregistration of the operations in foreign exchange and the calculation oftheir results, as well as the determination of the adjusted individualcurrency positions and the total currency position;

b)

to have a supervision and administration system of the currency risk onthe basis of norms and internal procedures approved of by the banks

board of directors.

2.2 Financial derivatives

2.2.1 General concepts

Exchange risk can be virtually fully removed by financial derivatives.Rather than buying or selling a currency or a commodity, a firm can nowenter into an agreement to buy or sell the future change in almost any assets

value. These derivatives can remove or reduce some risks but might alsoincrease others. There are hundreds of different derivatives. Some are verysimple, but others are very complex and risky.

Banks, companies need to know what they are doing and have good controlsin place before entering derivatives markets; otherwise, they risk disasters.

A derivative is a financial instrument based upon the performance ofseparately traded commodities or financial instruments. So, financialderivatives are financial instruments with prices determined by (derivedfrom) the prices of other financial instruments, commodities, exchange


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rates, interest rates, or other prices. Many agricultural and mining productsare traded on commodities markets by firms who are end users of thoseproducts. Equally, bond markets and foreign exchange markets allow endusers to borrow or lend funds or to obtain foreign exchange. It is possible

then to build contracts thatpromise to deliver those products at some time inthe future or give the right to buy or sell them in the future. These contractsmay then be traded in markets different from the original commodities andfinancial markets. Such contracts are known as derivatives. They are linkedto the cash market through the possibility that a delivery of the primarycommodity or instrument might occur. For example, if a trader is to carry

out a promise to deliver an instrument in three months time he will, at sometime during those three months, need to buy the instrument on the cashmarket. It follows that the value of a derivative and hence its price varies asthe price in the cash markets fluctuates. In practice, derivatives seldom leadto the exchange of the underlying instrument. Instead, contracts are closedout or allowed to lapse before the delivery.

In the International Monetary Funds opinion2, a financial derivativescontract is a financial instrument that is linked to a specific financialinstrument, indicator or commodity, and through which specific financialrisks can be traded in their own right on financial markets.

Derivatives are used for a variety of purposes, including:

Protecting against market risk of financial losses on commercialtransactions and financial instruments;

Reducing or modifying various financial risks;

Earning income by arbitraging between derivatives and cash markets;

Earning profits through trading in the instruments, and

Speculation, especially in foreign exchange and commodity markets.

Therefore, derivatives, then, are instruments that allow market agents togamble on movements in the prices of other instruments without being

required actually to trade in them. Their initial purpose was to allow tradersto hedge risks, which they faced in the cash markets as a part of their normalbusiness activity by offsetting one type of risk with the opposite risk in aderivatives market.

2IMF Manual on monetary and financial statistics, Washington 2000


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In the case of financial derivatives, the underlying instrument is financial:bonds, currencies, or stock exchange indices. The need for financialderivatives markets was not seen until the early 1970s when theglobalisation of business, which had been proceeding at pace for the

previous 20 years, confronted the increased volatility of foreign exchangerates and increasing and fluctuating rates of inflation. As companies wereexposed to increasing amounts of risk, risk management became a majorconcern of business.

The most obvious form of exchange rate risk relates to current individual

transactions the possibility that apparently profitable activities will turninto losses because of unfavourable movements in exchange rates. Moregenerally, the whole future trading performance of a foreign branch orsubsidiary may suffer as a result of exchange rate changes, depending on theimpact they have on factors such as relative inflation rates, governmentinterest rate and other policies, and a firms profit margins and market share.

To help counter foreign exchange risk, firms developed internal techniquesrelating to accounting systems, payment and invoicing procedures.Governments of developed countries became involved, providing exchangerate guarantees and other forms of insurance, in effect subsidizing theforeign activities of their exporting firms.

Developments on international capital markets allowed firms to borrowmore easily in foreign currencies. The growth of Eurocurrency marketsallowed firms to obtain foreign currency overdrafts to offset long positionsin major currencies.

Forward foreign exchange markets developed and banks began to use them

more imaginatively, offering, for example, optional date forward contractsin which a firm is given an option regarding the maturity date within aspecified period and is charged the premium or discount that applies to the

most costly of the settlement dates within the period.

The great growth in derivatives is indicated by the very rapid increase in thenumber of exchanges on which they are traded. The world market is stilldominated by the big Chicago Exchanges which started life as commoditiesmarkets, the Chicago Board of Trade and the Chicago Mercantile Exchange,

but 46 new exchanges opened between 1980 and 1993 and derivatives arenow traded on more than 60 exchanges worldwide, with almost all OECD


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countries possessing at least one such exchange. The March TermeInternational de France, which only opened in 1986, has become the leaderin the European financial derivatives markets in the world.

The most important financial derivatives that managers of financialinstitutions use to reduce risk are: forward contracts, currency accounts,financial futures, options and swaps.

2.2.2 Forward exchange contracts

Forward contractsare agreements by two parties to engage in a financialtransaction at a future (forward) specified date for a specified price. Theyare:

Firm and binding contracts between bank and customer for the

Purchase or sale of a

Specified quantity of a

Stated currency at a

Rate fixed at the time the contract is made for

Performance at a future time

Agreed at the making of the contract.

One of the parties to a forward contract assumes a long position and agreesto buy the underlying asset on a certain specified future date for a certainspecified price. The other party assumes a short position and agrees to sellthe asset on the same date for the same price. The specified price in aforward contract will be referred to as the delivery price. A forward contractis settled at maturity. The holder of the short position delivers the asset tothe holder of the long position in return of a cash amount equal to thedelivery price.

Example: a forward contract in foreign exchange

A unit enters into a forward contract to acquire yen in one month inexchange for US dollars at the current (spot) price of 95 US cents per 100yen. The amount to be purchased and the delivery date are negotiated.


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On the settlement date, delivery will take place at the forward at the forwardprice, or expiration price, of 95 US cents per 100 yen. If the spot price ofyen on the settlement date has increased to 110 US cents per 100 yen, thepurchaser will acquire yen at 15 cents below the market rate.

If, on the other hand, the spot price has fallen to 90 US cents per 100 yen,the purchaser remains committed to the contract price of 95 Us cents, 5cents above the market rate.

The calculation of forward rates is based on the difference between the

interest rates in the traders own country and the foreign country. Normally,rates are quoted for a fixed number of months ahead, e.g. 1, 2, 3, 6 and 12months. Contracts up to one month are known as short (value dates)contracts, e.g.:

a) Overnight (O/N);

b)

Tomorrow/next day (T/N);

c)

Spot/next day (S/N);

d)

Spot/week (S/W);

e)

Spot/fortnight (S/F).

Assuming that today is 1 February, overnight would be 2 February,

spot/next day would be 4 February, i.e. 2 working days plus one day;spot/fortnightwould 17 February, i.e. 2 working days p

Documents

Business of Banking (volumul II).pdf