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INTRODUCTION
The international trade and investments have grown at a tremendous pace in last
few decades. To enable free flow movement of goods and services and capital
across national boundaries, a well functioning system is needed which would
determine the amount of payments to be made in relevant currency.
The number of currencies present in the world needs to transact in them to settle
payments. For a foreign exchange to arise, either buying or selling has to be with
another country or foreign currency. For example, if an Indian exporter sells some
goods to an American resident and the price has to denominate in dollars, the
exporter (Indian) would be dealing in a foreign currency. Sometimes there might
be two way foreign transactions for example, if an Australian buys goods with
Italian denominated in US dollar both of the parties will be dealing in foreign
currency. All these transaction were dealt in an OTC market but now it is the
SWIFT system (society for worldwide interbank financial telecommunications)
THE STRUCTURE
The main players in the foreign exchange market are large commercial banks,
forex brokers, large commercial and central banks but central banks enter only to
smoothen the fluctuation in the exchange rate.
Large commercial banks deals with the market to execute their clients’ orders
.These large commercial banks stand ready to buy or sell various currencies at
specific pries at all time.
The foreign brokers do not actually buy or sell any currency. They do the work of
bringing buyers or sellers together. Though they deal in major currencies
generally they specialize in a pair of currencies and hold huge information about
it.
The Foreign Exchange Dealers Association of India (FEDAI) have classified into
three categories:
Category A: these are the offices which keep independent foreign currencies
accounts with overseas correspondent banks in their names.
Category B: These are the branches which do not maintain independent foreign
currency accounts but have the powers to operate the accounts.
Category C: The branches which fall in neither of the above categories a yet
handle forex business.
FOREIGN EXCHANGE
Merchant quote is the quote given by the bank to retail customers, and the quote
given one bank to another is called interbank quote.
Suppose a bank requires 1mn GBP. The dealer of the bank approaches another
bank and asks for a quote in the sterling, without mentioning whether he wants to
buy or sell. The market making bank gives him a two way quote. If the ask rate
for a pound is acceptable he says “One mine” and its “One yours” if it’s the other
way around, implying to buy and to sell respectively.
It is also a practice to state the same quote is Rs/$ 48.62/72 where 72 represents
the last two digits of the ask rate. And sometimes it is further shortened to Rs/$
62/72.
There are few currencies which are quoted in 10s rather than 1 or 2s.the reason is
that their value is too small to be quoted. An example is the Japanese yen
JPY/USD 124.64/68
INVERSE QUOTES
For every quote (A/B) between two currencies, there currencies, there exists an
inverse quote (B/A), where currency is being bought and sold, with its price
expressed in terms of currency B. For example for a Euro/$ quote, there exists a
$/Euro quote.
The bid rate at which the bank is ready to buy the dollars which means the rate at
which it is ready to sell Euro, which will be the ask rate in the $/Euro quote. The
calculations can be shown for example given. The direct quote given as
CROSS RATE
Rs/$: 48.62/66
3-m Rs/$:48.82/88
In the above example the dollar is expected to be more expensive in the
future and hence at premium against Rupee.
It is a kind of forward contract for a maturity which is not a whole month or for
which is a quote is not readily available. For example, if the quote is month
forward contract it will be a broken date contract. It is calculated by interpolating
the available quotes for the preceding and the succeeding maturities.
According to this theory the price levels determine the exchange rates of these
countries’ currencies. The basic tenet of this principle is that the exchange
between various currencies reflects the purchasing power of these currencies. This
is based on the LAW OF ONE PRICE.
Where
PA = S(A/B)*PB
Where PA and PB are the of the same basket of goods and services in countries A
and B respectively.
S (A/B) = PA / PB
Assumptions:
According to this form of PPP, the expecting percentage in the spot rate is equal
to the difference in the expected inflation rates. This theory assumes that the
speculators are risk neutral and markets are perfect.
Earlier the assumptions applicable the law of one price and to the various forms of
PPP.If any of these assumptions does not hold good the PPP would also not hold
good. Some of the factors which do not hold good are:
INVESTOR’S DECISION
The currencies when converted from spot rate to forward rate will give
At the same time an investment in domestic currency will at the end of the year,
give
(1+ra ) units of A, if
BORROWERS’ DECISION
When the need to borrow money arises, the borrower has the option to borrow in
domestic currency, or foreign currency. Again the decision will be based upon
cost of domestic currency borrowing as compared to the covered cost of
borrowing.
For every unit of domestic currency borrowed, the borrower will have to pay
(1+rA) units of A.
According to PPP
S*(A/B) =PA-PB
S*(A/B) = rA-rB
It follows that
rA-P*A=rB-P*B
It says that nominal interest rate minus the expected inflation rates, i.e., the real
interest rates are equal across different countries.
Interest Rate Parity does not hold good because of the following reasons
• Transaction cost
• Political risk
• Taxes
• Liquidity preferences
• Capital controls
This part of the paper deals with the Multi National Operations the accounting
issues, exposure relating to transaction and translation exposure and
hyperinflation economies.
International trade has grown significantly in various parts of the world because
various changes in the country’s policies. Many countries have established their
manufacturing units in other countries for reasons such as cheap labor or raw
materials.
Foreign currency: A currency other than the functional currency of the company.
Blended rate: It is the average of the historical rate and the average rate calculated
using the opening and closing balances of relevant accounts
ACCOUNTING ISSUES
There are three issues which effect the consolidated financial statements of the
parent company
Changes in the exchange rate result in two effects on the companies’ actual
performance and reported performance namely flow effect and holding gain or
less.
Flow Effect
YEAR 1 LC1=Re1
YEAR 2 LC1= Re 1.5
YEAR 1 2 TOTAL
REVENUE 1,00,000 1,65,000 2,65,000
Here the parent company reports 65% growth in the revenue. But the
growth is only because of 50% growth in the exchange rate. Thus the flow effect.
1. Foreign currency translations (e.g., exports, imports, & loans) which are
denominated in a currency other than a company functional currency.
2. Foreign currency financial statements of branches, divisions, subsidiary
and investments.
1. Temporal method
2. Current method
CHOICE OF CURRENCY
The choice of currency depends upon the choice of functional currency for
each subsidiary company. Before the financial statements are translated
into reporting currency.
The factors to be considered are:
1. The impact of the foreign entity’s cash flows on the parent cash
flows.
2. The responsiveness of the foreign entities sales price to exchange
rate changes.
3. The currency in which the foreign entities sales market.
4. The expenses incurred by the foreign entity.
5. The source of financing of the foreign entity
TEMPORAL METHOD
• Monetary assets and liabilities cash, B/R, B/P are translated in the
current rate.
• Non-monetary items except above mentioned are translated in the
historical rate.
• Revenues and expenses are translated at the average rate.
• The translation gain or loss is shown in the income statement
• Flow effect
HYPERINFLATIONARY ECONOMIES
It is difficult for the accountant to choose the exchange rate and translation
process for the hyperinflationary subsidiaries. Generally the following two
solutions are available:
CONCLUSION
REFERNCES: