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EMPIRICAL STUDY OF FOREIGN

CURRENCY CONVERSION (AS-11)

TABLES OF CONTENTS
SERIAL
NO

CONTENTS

PAGE
NO

CHAPTER-I

8-10

FOREIGN CURRENCY
CONVERSION
INTRODUCTION
BACKGROUND

CHAPTER-II

11-21

HISTORY OF FOREIGN
CURRENCY CONVERSION
TYPES OF INTERVENTION

CHAPTER-III

22-27

PARTICIPANTS BANK IN FOREIGN


CURRENCY OPERATION

CHAPTER-IV

28-41

FOCUS ON EUROPEAN CENTRAL


BANK
Advantage And Disadvantage
LIMITATION

CHAPTER-V

42-44

CASE STUDY

CHAPTER-VI

45

CONCLUSION

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BIBLIOGRAPHY

CHAPTER-I
FOREIGN EXCHANGE CURRENCY CONVERSION

INTRODUCTION
The European Central Bank (ECB) is the central bank for the nineteen-nation
eurozone, with a mandate to maintain price stability by setting key interest rates
and controlling the union's money supply. After the emergence of the eurozone's
sovereign debt crises between 2009 and 2011, the ECB sparked controversy by
undertaking a range of unorthodox monetary policiesincluding a program of
unlimited bond-buying, the use of negative interest rates, and a $1.2 trillion
quantitative easing planthat divided policymakers and economists between those
who thought it overstepped its authority and those who argued for it to take more
aggressive action. Meanwhile, the ECB has been placed at the center of the
initiative to create a eurozone-wide banking union, granting the bank new powers
of supervision over Europe's largest financial institutions, even as the 2015
resurgence of Greece's debt crisis has renewed questions over the future of the
common euro currency.

DEFINITION:
The exchange of one currency for another, or the conversion of one currency into
another currency. Foreign exchange also refers to the global market where

currencies are traded virtually around-the-clock. The term foreign exchange is


usually abbreviated as "forex" and occasionally as "FX."

Background:
Historically, Forex has been dominated by inter-world investment and commercial
banks, money portfolio managers, money brokers, large corporations, and very few
private traders. Lately this trend has changed. With the advances in internet
technology, plus the industry's unique leveraging options, more and more
individual traders are getting involved in the market for the purposes of
speculation. While other reasons for participating in the market include facilitating
commercial transactions (whether it is an international corporation converting its
profits, or hedging against future price drops), speculation for profit has become
the most popular motive for Forex trading for both big and small participants.
PURPOSE
There are many reasons why a country's monetary and/or fiscal authority may want
to intervene in the foreign exchange market.
Central banks are in a general consensus in regard to the primary objective of
foreign exchange market intervention: to adjust the volatility or changing the level
of the exchange rate. Governments prefer to stabilize the exchange rate because
excessive short-term volatility erodes market confidence and affects both the
financial market and the real goods market. When there is an inordinate instability,
exchange rate uncertainty generates extra costs and reduces profits for firms. As a
result, investors are unwilling to make investment in foreign financial assets. Firms
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are reluctant to engage in the international trade. Moreover, the exchange rate
fluctuation would spill over into the financial markets. If the exchange rate
volatility increases the risk of holding domestic assets, then prices of these assets
would also become more volatile. The increased volatility of financial markets
would threaten the stability of the financial system and make monetary policy
goals more difficult to attain. Therefore, authorities conduct currency intervention.
In addition, when economic condition changes or when the market misinterprets
economic signals, authorities use foreign exchange intervention to correct
exchange rates, in order to avoid overshooting of either direction.
Today, forex market intervention is largely used by the central banks of developing
countries, and less so by developed countries. There are a few reasons why most
developed countries no longer actively intervene:

Research and experience suggest that the instrument is only effective (at
least beyond the very short term) if seen as foreshadowing interest rate or other
policy adjustments. Without a durable and independent impact on the nominal
exchange rate, intervention is seen as having no lasting power to influence the
real exchange rate and thus competitive conditions for the tradable sector.

Large-scale intervention can undermine the stance of monetary policy.

Private financial markets have enough capacity to absorb and manage


shocks - so that there is no need to guide the exchange rate.

Developing countries, on the other hand, do sometimes intervene, presumably


because they believe the instrument to be an effective tool in the circumstances and
for the situations they face. Objectives include: to control inflation, to achieve
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external balance or enhance competitiveness to boost growth, or to prevent


currency crises, such as large depreciation/appreciation swings.

CHAPTER-II
HISTORY OF FOREIGN CURRENCY CONVERSION
In the 1960s, under the Bretton Woods system of fixed exchange rates, intervention
was used to help maintain the exchange rate within prescribed margins the Bretton
Woods system between 1968 and 1973 was largely due to President Richard
Nixons temporary suspension of the dollars convertibility to gold in 1971, after
the dollar struggled throughout the late 1960s in light of large increases in the price
of gold. An attempt to revive the fixed exchange rates failed, and by March 1973
the major currencies began to float against each other. Since the end of the
traditional Bretton Woods system, IMF members have been free to choose any
form of exchange arrangement they wish (except pegging their currency to gold),
such as: allowing the currency to float freely, pegging it to another currency or a
basket of currencies, adopting the currency of another country, participating in a
currency bloc, or forming part of a monetary union. The end of the traditional

Bretton Wood system in the early 1970s and the move to managed currencies led to
a large scale increase in currency intervention throughout the 1970s and 80s.

TYPES OF INTERVENTION:
Direct intervention:
Direct currency intervention is generally defined as foreign exchange transactions
that are conducted by the monetary authority and aimed at influencing exchange
rate. Depending on whether it changes the monetary base or not, currency
intervention could be distinguished between sterilized intervention and nonsterilized intervention, respectively.

Sterilized intervention
Sterilized intervention is a policy that attempts to influence the exchange
rate without changing the monetary base. The procedure is a combination of
two transactions. First, the central bank conducts a nonsterilized intervention
by buying (selling) foreign currency bonds using domestic currency that it
issues. Then the central bank sterilizes the effects on the monetary base by
selling (buying) a corresponding quantity of domestic-currency-denominated
bonds to soak up the initial increase (decrease) of the domestic currency. The
net effect of the two operations is the same as a swap of domestic-currency
bonds for foreign-currency bonds with no change in the money supply. With
sterilization, any purchase of foreign exchange is accompanied by an equalvalued sale of domestic bonds, and vice versa.

For example, desiring to decrease the exchange rate/price of domestic


currency without changing the monetary base, authorities purchase foreigncurrency bonds, the same action as in the last section. After this action, in
order to keep the monetary base, governments conduct a new transaction,
selling an equal amount of domestic-currency bonds, so that the total money
supply is back to the original level.
Non-sterilized intervention
Non-sterilized intervention is a policy that alters the monetary base.
Specifically, authorities affect the exchange rate through purchasing or
selling foreign money or bonds with domestic currency.
For example, aiming at decreasing the exchange rate/price of the domestic
currency, authorities could purchase foreign currency bonds. During this
transaction, extra supply of domestic currency will drag down domestic
currency price, and extra demand of foreign currency will push up foreign
currency price. As a result, the exchange rate drops.
Indirect intervention:
Indirect currency intervention is a policy that influences the exchange rate
indirectly. Some examples are capital controls (taxes or restrictions on international
transactions in assets), and exchange controls (the restriction of trade in
currencies). Those policies may lead to inefficiencies or reduce market confidence,
but can be used as an emergency damage control.

EFFECTIVENESS:

Non sterilization intervention:


In general, there is a consensus in the profession that non-sterilized intervention is
effective. Similarly to the monetary policy, nonsterilized intervention influences
the exchange rate by inducing changes in the stock of the monetary base, which, in
turn, induces changes in broader monetary aggregates, interest rates, market
expectations and ultimately the exchange rate. As we have shown in the previous
example, the purchase of foreign-currency bonds leads to the increase of homecurrency money supply and thus a decrease of the exchange rate.

Sterilization intervention
On the other hand, the effectiveness of sterilized intervention is more controversial
and ambiguous. By definition, the sterilized intervention has little or no effect on
domestic interest rates, since the level of the money supply has remained constant.
However, according to some literature, sterilized intervention can influence the
exchange rate through two channels: the portfolio balance channel and the
expectations or signaling channel.

The Portfolio Balance Channel


In the portfolio balance approach, domestic and foreign bonds are not perfect
substitutes. Agents balance their portfolios among domestic money and bonds, and
foreign currency and bonds. Whenever aggregate economic condition changes,
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agents adjust their portfolios to a new equilibrium, based on a variety of


considerations, i.e., wealth, tastes, expectation, etc. Thus, these actions to balance
portfolios will influence exchange rates.

The Expectations or Signaling Channel


Even if domestic and foreign assets are perfect substitutability of each other,
sterilized intervention is still effective. According to the signaling channel theory,
agents may view exchange rate intervention as a signal about the future stance of
policy. Then the change of expectation will affect the current level of the exchange
rate.

MODERN EXAMPLES
Today, there are four groups that stand out as frequent currency manipulators:
Longstanding advanced and developed economies, such as Japan and Switzerland,
newly industrialized economies such as Singapore, developing Asian economies
such as China, and oil exporters, such as Russia.
It is not unusual for countries to manage their exchange rate via central bank in
order to make their exports cheap. This method is being used extensively by the
emerging markets of Southeast Asia, in particular. The American dollar is generally
the primary target for these currency managers. The dollar is the global trading
systems premier reserve currency, meaning dollars are freely traded and
confidently accepted by international investors.
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Swiss Franc
As the financial crisis of 200708 hit Switzerland, the Swiss franc appreciated,
owing to a flight to safety and to the repayment of Swiss franc liabilities funding
carry trades in high yielding currencies. On March 12, 2009, the Swiss National
Bank (SNB) announced that it intended to buy foreign exchange to prevent the
Swiss franc from further appreciation. Affected by the SNB purchase of Euros and
U.S. dollars, Swiss franc weakened from 1.48 against the euro to 1.52 in a single
day. At the end of 2009, the currency risk seemed to be solved; the SNB changed
its attitude to preventing substantial appreciation. Unfortunately, the Swiss franc
began to appreciate again. Thus, the SNB stepped in one more time and intervened
at a rate of more than CHF 30 billion per month. By the end of June 17, 2010,
when the SNB announced the end of intervening, it had purchased an equivalent of
$179 billion of Euros and U.S. dollars, amounting to 33% of Swiss
GDP. Furthermore, in September 2011, the SNB influenced the foreign exchange
market again, and set a minimum exchange rate target of SFr 1.2 to the Euro.
On January 15, 2015, the SNB suddenly announced that it would no longer hold
the Swiss Franc at the fixed exchange rate with the euro it had set in 2011. The
franc soared in response; the euro fell roughly 40 percent in value in relation to the
franc, falling as low as 0.85 francs (from the original 1.2 francs).
As investors flocked to the franc during the financial crisis, they dramatically
pushed up its value. An expensive franc may have large adverse effects on the
Swiss economy; the Swiss economy is heavily reliant on selling things abroad.
Exports of goods and services are worth over 70% of Swiss GDP. In order to
maintain price stability and lower the francs value, the SNB created new francs
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and used them to buy euros. Increasing the supply of francs relative to euros on
foreign-exchange markets caused the francs value to fall (ensuring the euro was
worth 1.2 francs). This policy resulted in the SNB amassing roughly $480 billionworth of foreign currency, a sum equal to about 70% of Swiss GDP.
The Economist asserts that the SNB dropped the cap for the following reasons:
first, rising criticisms among Swiss citizens regarding the large build-up of foreign
reserves. Fears of runaway inflation underlie these criticisms, despite inflation of
the franc being too low, according to the SNB. Second, in response to the European
Central Bank's decision to initiate a quantitative easing program to combat euro
deflation. The consequent devaluation of the euro would require the SNB to further
devalue the franc had they decided to maintain the fixed exchange rate. Third, due
to recent euro depreciation in 2014, the franc lost roughly 12% of its value against
the USD and 10% against the rupee (exported goods and services to the U.S. and
India account for roughly 20% Swiss exports).
Following the SNB's announcement, the Swiss stock market sharply declined; due
to a stronger franc, Swiss companies have a more difficult time selling goods and
services to neighboring European citizens.
Japanese Yen
From 1989 to 2003, Japan was suffering from a long deflationary period. After
experiencing economic boom, the Japanese economy slowly declined in the early
1990s and entered a deflationary spiral in 1998. Within this period, Japanese output
activities were stagnating; the deflation, in the sense of a negative inflation rate,
was getting continuing to fall, and the unemployment rate was increasing.
Simultaneously, confidence in the financial sector waned, and several banks failed.
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During the period, the Bank of Japan, having become legally independent in March
1998, aimed at stimulating the economy by ending deflation and stabilizing the
financial system. The "availability and effectiveness of traditional policy
instruments was severely constrained as the policy interest rate was already
virtually at zero, and the nominal interest rate could not become negative (the zero
bound problem)."
In response of deflationary pressures, the Bank of Japan, in coordination with the
Ministry of Finance, launched a reserve targeting program. The BOJ increased the
commercial bank current account balance to 35 trillion. Subsequently, the MoF
used those funds to purchase $320 billion in U.S. treasury bonds and agency debt.
Today, like the case with China, critics of Japanese currency intervention assert
that the central bank of Japan has been artificially and intentionally devaluing the
yen. Some state that the US-Japan trade deficit (as of 2014, the deficit equates to
$261.7 billion) as a result of this devaluation is costing the United States economy
jobs. Bank of Korea Governor Kim Choong Soo has urged Asian countries to work
together to defend themselves against the side-effects of Japanese Prime Minister
Shinzo Abes reflation campaign. Some have stated that this campaign is in
response to Japans stagnant economy and potential deflationary spiral.
In 2013, Japanese Finance Minister Taro Aso stated that Japan planned to use its
foreign exchange reserves to buy bonds issued by the European Stability
Mechanism and euro-area sovereigns, in order to weaken the yen. The U.S.
criticized Japan for undertaking unilateral sales of the yen in 2011, after Group of
Seven economies jointly intervened to weaken the currency in the aftermath of the
record earthquake and tsunami that year. As of 2013, Japan holds $1.27 trillion in
foreign reserves according to finance ministry data.
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Chinese Yuan
China has provided the most controversy within the United States due to the large
increase in American imports of Chinese goods in the 1990s and 2000s. Chinas
central bank has allegedly devalued yuan by buying large amounts of US dollars
with yuan, thus increasing the supply of the yuan in the foreign exchange market,
while increasing the demand for US dollars, thus increasing the price of USD. As
of the end of 2012, Chinas foreign exchange reserve holds roughly $3.3 trillion,
making it the highest foreign exchange reserve in the world. Roughly 60% of this
reserve is composed of US government bonds and debentures.
There has been much disagreement on how the United States should respond to
Chinese devaluation of the yuan. This is partly due to disagreement over the actual
effects of the undervalued yuan on capital markets, trade deficits, and the US
domestic economy.
Some economists, such as Paul Krugman, argue that Chinese currency devaluation
helps China by boosting its exports, and hurts the United States by widening its
trade deficit. In other words, China intentionally devalues its currency in order to
keep its exports cheap, thus facilitating countries like the United States to buy
more Chinese goods. Krugman has suggested that the United States should impose
tariffs on Chinese goods as a way of undermining the efforts of the Chinese to
make their goods cheaper in relativity to the U.S. dollars. Krugman stated:
The more depreciated Chinas exchange rate the higher the price of the dollar
in yuan* the more dollars China earns from exports, and the fewer dollars it
spends on imports. (Capital flows complicate the story a bit, but dont change it in
any fundamental way). By keeping its current artificially weak a higher price of
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dollars in terms of yuan China generates a dollar surplus; this means that the
Chinese government has to buy up the excess dollars.
Greg Mankiw, on the other hand, asserts that U.S. protectionism via tariffs will
hurt the U.S. economy far more than Chinese devaluation. Similarly, others have
stated that the undervalued yuan has actually hurt China more in the long run
insofar that the undervalued yuan doesnt subsidize the Chinese exporter, but
subsidizes the American importer. Thus, importers within China have been
substantially hurt due to the Chinese governments intention to continue to grow
exports.
Russian Ruble
On November 10, 2014, the Central Bank of Russia decided to fully float the ruble
in response to its biggest weekly drop in 11 years (roughly 6 percent drop in value
against USD). In doing so, the central bank abolished the dual-currency trading
band within which the ruble had previously traded. The central bank also ended
regular interventions that had previously limited sudden movements in the
currency's value. Earlier steps to raise interest rates by 150 basis points to 9.5
percent failed to stop the ruble's decline. The central bank sharply adjusted its
macroeconomic forecasts. It stated that Russia's foreign exchange reserves, then
the fourth largest in the world at roughly $480 billion, were expected to decrease to
$422 billion by the end of 2014, $415 billion in 2015, and under $400 billion in
2016, in an effort to prop up the ruble.
On December 11, the Russian central bank raised the key rate by 100 basis points,
from 9.5 percent to 10.5 percent.

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Declining oil prices and economic sanctions imposed by the West in response to
the Russian annexation of Crimea led to worsening Russian recession. On
December 15, 2014,the ruble dropped as much as 19 percent, the worst single-day
drop for the ruble in 16 years.
The Russian central bank response was twofold: first, continue using Russia's large
foreign currency reserve to buy rubles on the forex market in order to maintain its
value through artificial demand on a larger scale. The same week of the December
15 drop, the Russian central bank sold an additional $700 million in foreign
currency reserves, in addition to the nearly $30 billion spent over previous months
to stave off decline. Russia's reserves then sat at $420 billion, down from $510
billion in January 2014.
Second, increase interest rates dramatically. The central bank increased the key
interest rate 650 basis points from 10.5 percent to 17 percent, the world's largest
increase since 1998, when Russian rates soared past 100 percent and the
government defaulted on its debt. The central bank hoped that higher rates would
provide incentives to the forex market to maintain rubles.
From February 12 to 19, 2015, the Russian central bank spent an additional $6.4
billion in reserves. Russian foreign reserves at this point stood at $368.3 billion,
greatly below the central bank's initial forecast for 2015. Since the collapse in
global oil prices in June 2014, Russian reserves have fell by over $100 billion.
As oil prices began to stabilize in FebruaryMarch 2015, the ruble likewise
stabilized. The Russian central bank has decreased the key rate from its high of 17
percent to its current 15 percent as of February 2015. Russian foreign reserves
currently sit at $360 billion.
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In March and April 2015, with the stabilization of oil prices, the ruble has made a
surge, which Russian authorities have deemed a "miracle". Over three months, the
ruble gained 20 percent against the US dollar, and 35 percent against the euro. The
ruble is thus far the best performing currency of 2015 in the forex market. Despite
being far from its pre-recession levels (in January 2014, 1 USD equaled roughly 33
Russian rubles), it is currently trading at roughly 52 rubles to 1 USD (an increase
in value from 80 rubles to 1 USD in December 2014).
Current Russian foreign reserves sit at $360 billion. In response to the ruble's
surge, the Russian central bank lowered its key interest rate further to 14 percent in
March 2015. The ruble's recent gains have been largely accredited to oil price
stabilization and the calming of conflict in Ukraine.

CHAPTER-III

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Some of the main participants in the market are INTERNATIONAL


banks in the foreign currency operation
The worlds central banks possess similar forms of operation and structure
although their long term goals may vary.
There are eight major central banks within the world economy today:
1. US Federal Reserve Bank (USD)
2. European Central Bank (EUR)
3. Bank of England (GBP)
4. Bank of Japan (JPY)
5. Swiss National Bank (CHF)
6. Bank of Canada (CAD)
7. Reserve Bank of Australia (AUD)
8. Reserve Bank of New Zealand (NZD)

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Federal Reserve Bank- United States


The Federal Reserve The most influential bank is the US Federal Reserve Bank
because the US dollar is the most heavily traded currency. The Federal Reserves
Federal Open Markets Committee (FOMC) decides on interest rates and is made
up of 7 governors of the Reserve Board and 5 of the 12 district reserve presidents.
The Federal Reserve meets 8 times a year and its key official is Ben Bernanke, the
chairman of the Federal Reserve. Twelve regional Federal Reserve Banks were
created so that the economic operations of the United States can be monitored
efficiently.
The FOMC committee meets about every six weeks. The FOMC is comprised of
members from the Federal Reserve Board that are both appointed and approved
through joint efforts of the President, Congress and regional Federal Reserve Bank
presidents. The decisions made by the FOMC are closely watched by investors
both within and outside of the US because it gives traders an idea of the economic
sentiment, which can be used to predict possible interest rate movements.

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The European Central Bank


European Central Bank The European Central Bank was established after the
creation of the Euro in 1998. It oversees the actions of the other member European
central banks such as the Banque de France or Ufficio Italiano dei Cambi. The
European Central Bank has a group similar to the Federal Open Markets
Committee that helps decide on the changes that may need to be made to monetary
policy. The committee is known as the Governing Council and is comprised of 6
members of the executive board of the European Central Bank in addition to all the
governors of the national central banks from the countries which use the Euro. The
Governing Council meets twice a week but only changes policy at 11 of these
meetings. The key official associated with the Governing Council is Jean-Claude
Trichet, who is the President of European Central Bank.

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The Bank of England


Bank of EnglandThe Bank of England consists of a committee known as the
Monetary Policy Committee. It is comprised of 9 members, which include a
governor, 2 deputy governors, 2 executive directors and 4 outside experts. The
main official associated with the Bank of England is a man by the name of Mervyn
King who is the governor of the Bank of England. The Monetary Policy
Committee meets once every month in order to discuss any policy changes.

The Bank of Japan


Bank of Japan The Bank of Japan also has a committee that consists of the Bank of
Japan governor, two deputy governors along with 6 other members.
It meets once or twice a month and the key official associated with the Bank of
Japan is Toshihiko Fukui who is the governor of the Bank of Japan.

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The Swiss National Bank


Swiss BankThe Swiss National Bank has a very small committee that consists of
just 3 people and is typically more conservative as far as interest rate movements
are concerned.
The committee meets quarterly and the key official associated with the Swiss Bank
is Jean-Pierre Roth who is the Chairman of the Swiss National Bank.

The Royal Bank of Canada


The Bank of Canada also has a committee which is known as the governing
council. The governing council consists of the governor of the Bank of Canada, the
senior deputy governor and four deputy governors. The committee meets about 8
times a year and the key official associated with the bank is David Dodge, who is
the governor of the Bank of Canada.

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The Reserve Bank of Australia


The Reserve Bank of Australia consists of a monetary policy committee which
contains a central bank governor, deputy governor, the secretary to the treasurer
and 6 independent members appointed by the government. The committee meets
about eleven times a year and the key official for the Reserve Bank is Ian
Macfarlane, who is the Governor of the Reserve Bank of Australia.

The National Bank of New Zealand


Finally, the National Bank of New Zealand unlike all the other banks has no
committee. In fact, all the power of monetary policy lies in the hands of one
individual: the central bank governor. The decision is made about 8 times a year by
Alan Bollard who is the governor.

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CHAPTER-IV
How European central bank operate their foreign currency?

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Introduction
The European Central Bank (ECB) is the central bank for the nineteen-nation
eurozone, with a mandate to maintain price stability by setting key interest rates
and controlling the union's money supply. After the emergence of the eurozone's
sovereign debt crises between 2009 and 2011, the ECB sparked controversy by
undertaking a range of unorthodox monetary policiesincluding a program of
unlimited bond-buying, the use of negative interest rates, and a $1.2 trillion
quantitative easing planthat divided policymakers and economists between those
who thought it overstepped its authority and those who argued for it to take more
aggressive action. Meanwhile, the ECB has been placed at the center of the
initiative to create a eurozone-wide banking union, granting the bank new powers
of supervision over Europe's largest financial institutions, even as the 2015
resurgence of Greece's debt crisis has renewed questions over the future of the
common euro currency.
Interest rates play the most important role in moving the prices of currencies in the
foreign exchange market. As the institutions that set interest rates, central banks are
therefore the most influential actors. Interest rates dictate flows of investment.
Since currencies are the representations of a countrys economy, differences in
interest rates affect the relative worth of currencies in relation to one another.
When central banks change interest rates they cause the forex market to experience
movement and volatility. In the realm of Forex trading, accurate speculation of
central banks actions can enhance the trader's chances for a successful trade.

Powers and objectives during the European banking crisis


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The European debt crisis has revealed some relative weaknesses in the sovereign
debt of such member countries as Portugal, Ireland, Greece and Spain.
Rescue operations involving sovereign debt have included temporarily moving bad
or weak assets off the balance sheets of the weak member banks into the balance
sheets of the European Central Bank. Such action is viewed as monetisation and
can be seen as an inflationary threat, whereby the strong member countries of the
ECB shoulder the burden of monetary expansion (and potential inflation) to save
the weak member countries. Most central banks prefer to move weak assets off
their balance sheets with some kind of agreement as to how the debt will continue
to be serviced. This preference has typically led the ECB to argue that the weaker
member countries must:

Allocate considerable national income to servicing debts.

Scale back a wide range of national expenditures (such as education,


infrastructure, and welfare transfer payments) to make their payments.

The European Central Bank had stepped up the buying of member nations debt. In
response to the crisis of 2010, some proposals have surfaced for a collective
European bond issue that would allow the central bank to purchase a European
version of US Treasury bills. To make European sovereign debt assets more similar
to a US Treasury, a collective guarantee of the member states' solvency would be
necessary. But the German government has resisted this proposal, and other
analyses indicate that "the sickness of the euro" is due to the linkage between
sovereign debt and failing national banking systems. If the European central bank
were to deal directly with failing banking systems sovereign debt would not look
as leveraged relative to national income in the financially weaker member states.

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On 17 December 2010, the ECB announced that it was going to double its
capitalisation. (The ECB's most recent balance sheet before the announcement
listed capital and reserves at 2.03 trillion.) The 16 central banks of the member
states would transfer assets to the ledger of the ECB.
In 2011, the European member states may need to raise as much as US$2 trillion in
debt. Some of this will be new debt and some will be previous debt that is "rolled
over" as older loans reach maturity. In either case, the ability to raise this money
depends on the confidence of investors in the European financial system. The
ability of the European Union to guarantee its members' sovereign debt obligations
have direct implications for the core assets of the banking system that support the
Euro.
The bank must also co-operate within the EU and internationally with third bodies
and entities. Finally, it contributes to maintaining a stable financial system and
monitoring the banking sector. The latter can be seen, for example, in the bank's
intervention during the subprime mortgage crisis when it loaned billions of euros
to banks to stabilise the financial system. In December 2007, the ECB decided in
conjunction with the Federal Reserve System under a programme called Term
auction facility to improve dollar liquidity in the eurozone and to stabilise the
money market.
In late May 2012, looking ahead to further challenges with Greece, Bundesbank
chief and ECB council member Jens Weidmann pointed out that the council could
veto "emergency liquidity assistance" (ELA) to, for instance, Greece through a
twothird majority of the council. If Greece chose to default on its debts yet
wanted to stay in the Euro, the ELA would be one of the ways to accommodate the
country's and its banks' liquidity needs or, alternatively, to precipitate departure.

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On 31 October 2012, the ECB announced it had phased out as pllaned the Covered
Bond Purchase programme, which was one of the crisis measures aimed at
supporting the shaky banking system of the 17-country eurozone.
Businesses involved in international trade often execute a sale or purchase at one
point in time but the transfer of funds takes place at a different point in time. This
results in an uncertainty about the about the amount of revenue or expenditure
involved in the transaction in the business' home currency.
For example, suppose an American company sells electrical equipment to a buyer
in France for one million euros. The equipment is to be delivered 90 days before
the payment is made. At the time the sale agreement was made the exchange rate
was $1.25 euros per dollar. This meant that the company was counting on receiving
something in the neighborhood of $1.25 million in the transaction. Suppose the
American company's cost for producing and delivering the equipment was $1.15
million and it was counting on making a $100,000 profit on the transaction.
However if the value of the euro fell to $1.10 by the time the American company
received payment then it would find that it had a $50,000 loss instead of a
$100,000 profit.
Suppose the American company required the French company to make the
payment in dollars instead of euros. Then the French company would be bearing
the risk. If the exchange rate fell from $1.25 per euro to $1.10 then what it had
been expecting to pay one million euros for would cost it about 1.136 million
euros.
Foreign currency or transactions risk is the risk that is the consequence of
fluctuations of exchange rates. It can strongly affect businesses in a variety of
ways. Even if a company does not engage in foreign sales or purchases it can still
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be subject to a risk because of exchange rate fluctuations. This is because the price
of its foreign competition's products may be affected by a change in the exchange
rate.
THE SOURCE OF THE RISK
Exchange rates fluctuate due to a great many factors. Some may be strictly
financial but political events can also affect the exchange rates. If there is the threat
of military conflict in some part of the world those holding funds there may want
to transfer their holdings to the U.S. They consequently exchange their currency
for dollars thus driving up the value of the dollar.
When Japan was hit by a major earthquake at Kobe, Japanese businesses began
transferring funds back into Japanese yen for the rebuilding process. This had the
effect of increasing the value of the yen with respect to other currencies.
In the early 1980's the tight monetary policy of the Fed resulted in high real interest
rates in the U.S. compared to other countries. This in turn resulted in a high value
of the dollar compared to other currencies.

Strategies for Dealing with the Foreign Currency


Transaction Risk
There exist organized markets for foreign currencies. The trading in foreign
currencies now is called the spot market. There are also forward and futuremarkets
for currency transfers which will occur sometime in the future. This means that a
company can enter into a contract with another party to transfer its right to receive
foreign currency payments a specified time in the future. The contract may involve
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payment now or payment of a definite amount in the future when the foreign funds
become available.
A company can also engage in speculation in an organized futures market for the
foreign currency. In this strategy the company mades up in profit on its futures
market transaction whatever loss it might have on it foreign trade transaction risk.
Some companies decide that they have no expertise in the foreign currencies
markets and immediate sell on the forward market any foreign currency funds they
are to receive. They then know exactly what profit they are making on a foreign
trade transaction. Other companies decided to try their hand at foreign currency
speculation. Some found that they made a profit on such speculation. Sometimes
the profit on currency speculation offset losses on these companies' main
operations. This resulted in those companies seriously committing themselves to
such currency speculation. They set up separate division to handle their currency
market operations. When these divisions had losses instead of profits the
companies' financial stabilities were put at risk.

The

Empirical

Evidence

of

How

Companies

Handle

Their Foreign Currency Transaction Risk

Gregory Millman, the author of The Floating Battlefield, interviewed the


executives in a number of companies and put the information together with
information from published studies to give those of us interested in finance and
economics an inside look at risk strategies and some empirical facts to compare
with theory. Mr. Millman does not want the details of his studies displayed on the
internet.

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Interest Rates Dictate Investment


Interest rates can be simply defined as the amount of money a borrower must pay
to a lender in order to hold their money. In a simple representation of the foreign
exchange market, the lender is an investor holding cash or assets and the borrower
is a bank inside a particular country. The lender (investor) provides money to the
borrower (the bank) and will receive, after a specific time period, interest in
conjunction with the original sum he or she put in. Typically, interest is applied as
an annual rate or percentage of the amount being lent. In forex trading interest is
credited on a daily basis.
A simple example:
A US investor, Jane, wants to place 100 dollars into a savings account with either a
domestic or a foreign bank. The US banks interest rate is 5.25%. In Japan, the
interest rate for a savings account is 0.25% and in New Zealand it is 7.25%. In
considering the best investment after a year, Jane can get back $105.25 investing in
the US, $100.25 in Japan, and $107.25 in New Zealand. Opening an account and
lending money to a New Zealand bank is the investment option that achieves the
biggest return for Jane.
Janes investment decision shows that higher interest rates attract capital. As a
result central banks may attempt to draw foreign investment to their countries
through higher interest rates.

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How Interest Rates Play a Role in the Currency Markets


An increase in interest rates encourages traders to invest within that market and
causes the demand for the currency to rise. As demand rises, the currency becomes
scarcer and consequently more valuable. Investors are drawn to the currency,
causing it to appreciate, because they will gain a higher yield on their investments,
as in the Jane example. In order to purchase the country's assets (stocks or bonds),
Jane will have to convert her domestic currency to the target country's currency
also increasing demand. Conversely, a fall in interest rates dissuades investors from
purchasing assets in that economy, as the return on their investment is now smaller.
The economy's currency will depreciate as a result of the weaker demand.

Advantages and Disadvantages


Fiat currency doesnt imply a fixed exchange rate. In fact, fiat currencies are
compatible with a floating exchange rate regime, in which the value of a currency
is determined in foreign exchange markets.

ADVANTAGES:

No need for international management of exchange rates: Unlike fixed


exchange rates based on a metallic standard, floating exchange rates dont
require an international manager such as the International Monetary Fund to
look over current account imbalances. Under the floating system, if a country
has large current account deficits, its currency depreciates.
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No need for frequent central bank intervention: Central banks frequently


must intervene in foreign exchange markets under the fixed exchange rate
regime to protect the gold parity, but such is not the case under the floating
regime. Here theres no parity to uphold.

No need for elaborate capital flow restrictions: It is difficult to keep the


parity intact in a fixed exchange rate regime while portfolio flows are moving
in and out of the country. In a floating exchange rate regime, the
macroeconomic fundamentals of countries affect the exchange rate in
international markets, which, in turn, affect portfolio flows between countries.
Therefore, floating exchange rate regimes enhance market efficiency.

Greater insulation from other countries economic problems: Under a


fixed exchange rate regime, countries export their macroeconomic problems to
other countries. Suppose that the inflation rate in the U.S. is rising relative to
that of the Euro-zone.
Under a fixed exchange rate regime, this scenario leads to an increased U.S.
demand for European goods, which then increases the Euro-zones price level.
Under a floating exchange rate system, however, countries are more insulated
from other countries macroeconomic problems. A rising U.S. inflation instead
depreciates the dollar, curbing the U.S. demand for European goods.

DISADVANTAGES:

Higher volatility: Floating exchange rates are highly volatile. Additionally,


macroeconomic fundamentals cant explain especially short-run volatility in
floating exchange rates.
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Use of scarce resources to predict exchange rates: Higher volatility in


exchange rates increases the exchange rate risk that financial market
participants face. Therefore, they allocate substantial resources to predict the
changes in the exchange rate, in an effort to manage their exposure to exchange
rate risk.

Tendency to worsen existing problems: Floating exchange rates may


aggravate existing problems in the economy. If the country is already
experiencing economic problems such as higher inflation or unemployment,
floating exchange rates may make the situation worse.
For example, if the country suffers from higher inflation, depreciation of its
currency may drive the inflation rate higher because of increased demand for
its goods; however, the countrys current account may also worsen because of
more expensive imports.

LIMITATION
Whether you plan to go abroad for studies, holiday, business travel or any other
purpose like making investment in shares and property, you need foreign currency
conversion in the local currency. Budget can go haywire if you are unaware of the
relevant limits under foreign exchange regulations. The Reserve Bank of India
(RBI), the nodal body for managing foreign exchange, has prescribed limits up to
which a resident individual can remit or spend foreign exchange freely i.e. without
34

any approval requirement.


Holiday: Holidaying abroad may require spending in foreign currency for hotel
accommodation, tour arrangements, shopping, etc. Under this category, an
individual is allowed to draw foreign exchange up to $10,000 in a year for one or
more private visits abroad.
Business trip: If you are going abroad for business travel, attending conference or
specialised training, you can apply to your bank for release of foreign exchange up
to $25,000.
Employment: RBI has allowed drawing foreign exchange up to $100,000 for
taking up employment abroad.
Education: You can draw up to $100,000 equivalent per academic year for
studying abroad. Studying abroad covers all expenses relating to education
including admission fee, tuition fee and purchase of study material. However, if
you require funds in excess of $100,000, you need to produce an estimate from the
institute you intend to study to the concerned bank.
Medical treatment: An individual willing to travel abroad for getting medical
treatment is allowed to withdraw foreign exchange up to $100,000 based on selfdeclaration of essential details without providing any estimate from a doctor or
hospital. However, if the individual wishes to take money over the prescribed limit,
s/he will have to provide an estimate from a hospital or doctor. In addition, a
maintenance expense of up to $25,000 is allowed.

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Emigration facilities: RBI has allowed drawal of foreign exchange for emigration
facilities up to $100,000 based on self-declaration or an amount prescribed by the
country of emigration.
Liberalised Remittance Scheme (LRS): In addition to these limits there is a
scheme known as Liberalised Remittance Scheme in force since 2004 which
allows resident individuals to draw foreign exchange up to a specified limit. The
remittance limits under LRS keep changing and under the present limit an
individual can draw up to $250,000 per year for the transaction permissible under
the scheme. Under this scheme, an individual can freely acquire and hold shares,
debentures, units of mutual funds, venture capital funds, unrated debt securities,
promissory notes or any other instrument of like nature. Further, the resident can
invest in such securities out of the bank account opened abroad under the Scheme.
He can also set up a company, enter into joint venture or buy immovable properties
abroad provided the law of the host country allows such transactions. Apart from
the above, this scheme allows an individual to make remittance as gift or loan to
his relative abroad who is a non-resident Indian i.e. an Indian
Citizen who resides outside India. Further, where an individual has availed of a
loan at a time when he was non-resident, he can take the benefit of this scheme to
make remittance for repayment of loans.
Bank Accounts: The RBI has allowed resident individuals to open, hold and
maintain foreign currency accounts with their banks. The amount standing in these
accounts can be utilised for making remittances abroad for permissible
transactions.
Exchange Earners' Foreign Currency Account (EEFC): The balance in this
36

account represents earnings in foreign exchange and can be utilised towards


current and capital account transactions like private visits, business visits, purchase
of property, and payment of custom duty. There is no restriction on withdrawal in
rupees of funds held in an EEFC account. However, the amount withdrawn in
rupees shall not be eligible for conversion into foreign currency and for re-credit to
the account.
Resident Foreign Currency Account: An individual can open, hold and maintain
with a bank in India a Foreign Currency Account, known as a Resident Foreign
Currency (RFC) Account, out of foreign exchange received as pension, gift,
proceeds from sale of property outside India, maturity proceeds of insurance
policy, etc. The funds in this account are free from all restrictions towards
utilisation including investments.
Resident Foreign Currency (Domestic) Account: Resident individuals have
another option by opening and operating an account with a bank known as
Resident Foreign Currency (Domestic) Account. The credits in this account are
allowed to be out of foreign exchange acquired in the form of currency notes, bank
notes and travellers' cheques while on a visit to any place outside India by way of
payment for services, gift from close relatives or unspent amount of foreign
exchange acquired for travel abroad. The balance held in this account can be
utilised for permissible current and capital account transactions like private visits,
business visits, and purchase of property.
Documentation: RBI has not prescribed any documents except self-declaration
satisfying the banker that the foreign exchange will be utilised only for the
transaction for which request to the banker for the release of foreign exchange is
37

made and Form A2. However, practically, banks may ask for some additional
documents as per its internal policies. Therefore, it will be better to carry all
important documents with you while applying for release of foreign exchange.

CHAPTER-V
CASE STUDY

The case study: How BMW dealt with exchange rate risk
Carmaker moved production overseas

38

AP

The story. BMW Group, owner of the BMW, Mini and Rolls-Royce brands, has
been based in Munich since its founding in 1916. But by 2011, only 17 per cent of
the cars it sold were bought in Germany.
In recent years, China has become BMWs fastest-growing market, accounting for
14 per cent of BMWs global sales volume in 2011. India, Russia and eastern
Europe have also become key markets.

The Challenge:

Despite rising sales revenues, BMW was conscious that its

profits were often severely eroded by changes in exchange rates. The companys
own calculations in its annual reports suggest that the negative effect of exchange
rates totalled 2.4bn between 2005 and 2009.
BMW did not want to pass on its exchange rate costs to consumers through price
increases. Its rival Porsche had done this at the end of the 1980s in the US and
sales had plunged.

The Strategy: BMW

took a two-pronged approach to managing its foreign

exchange exposure.
One strategy was to use a natural hedge meaning it would develop ways to
spend money in the same currency as where sales were taking place, meaning
revenues would also be in the local currency.
39

However, not all exposure could be offset in this way, so BMW decided it would
also use formal financial hedges. To achieve this, BMW set up regional treasury
centres in the US, the UK and Singapore.
How The Strategy Was Implemented: The natural hedge strategy was
implemented in two ways. The first involved establishing factories in the markets
where it sold its products; the second involved making more purchases
denominated in the currencies of its main markets.
BMW now has production facilities for cars and components in 13 countries. In
2000, its overseas production volume accounted for 20 per cent of the total. By
2011, it had risen to 44 per cent.
In the 1990s, BMW had become one of the first premium carmakers from overseas
to set up a plant in the US in Spartanburg, South Carolina. In 2008, BMW
announced it was investing $750m to expand its Spartanburg plant. This would
create 5,000 jobs in the US while cutting 8,100 jobs in Germany.
This also had the effect of shortening the supply chain between Germany and the
US market.
The company boosted its purchasing in US dollars generally, especially in the
North American Free Trade Agreement region. Its office in Mexico City made
$615m of purchases of Mexican auto parts in 2009, expected to rise significantly in
following years.
A joint venture with Brilliance China Automotive was set up in Shenyang, China,
where half the BMW cars for sale in the country are now manufactured. The
carmaker also set up a local office to help its group purchasing department to select
competitive suppliers in China. By the end of 2009, Rmb6bn worth of purchases
were from local suppliers. Again, this had the effect of shortening supply chains
and improving customer service.
40

At the end of 2010, BMW announced it would invest 1.8bn rupees in its production
plant in Chennai, India, and increase production capacity in India from 6,000 to
10,000 units. It also announced plans to increase production in Kaliningrad,
Russia.
Meanwhile, the overseas regional treasury centres were instructed to review the
exchange rate exposure in their regions on a weekly basis and report it to a group
treasurer, part of the group finance operation, in Munich. The group treasurer team
then consolidates risk figures globally and recommends actions to mitigate foreign
exchange risk.

The Lessons: By moving production to foreign markets the company not only
reduces its foreign exchange exposure but also benefits from being close to its
customers.
In addition, sourcing parts overseas, and therefore closer to its foreign markets,
also helps to diversify supply chain risks.

CHAPTER-VI
CONCLUSION
This article has presented the European System of Central Banks as a two-level
system, comprising the European Central Bank and the national central banks. It
has a twolevel organisational structure, in which the ESCB oversees the joint
existence of the ECB and the national central banks. The ECB has a legal
41

personality status, which enables it to realise the aims and tasks of monetary policy
and to use a range of monetary instruments for achieving them. For achieving its
aims the ESCB has available a whole range of monetary policy instruments,
including open market operations, the provision of standing facilities and the
creation of minimum reserves, and others. The aim of these is to influence market
interest rates and liquidity in the banking system and guide monetary policy. The
ECB has decisionmaking power, but realisation lies in the competence of the
national central banks. In connection with the accession of Slovakia and other
countries to the European Union, it is essential to analyse the development of this
institutional system, the aims and instruments of monetary policy, taking account
of the tasks and possibilities of appropriate incorporation into the ESCB.

42

BIBLIOGRAHY
www.cmsfx.com/en/forex-education/online-forexcourse/chapter-2-fundamental-focus/central-bank-interestrates/major-central-banks/

www.cmsfx.com/en/forex-education/online-forexcourse/chapter-2-fundamental-focus/central-bank-interestrates/role-of-central-banks/

www.cmsfx.com/en/forex-education/online-forexcourse/chapter-2-fundamental-factors/exchange-ratessupply-and-demand/supply-and-demand/

www.cmsf.com/en/forex-education/online-forexcourse/chapter-1-forex-basics/introduction-to-forexexchange/

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