Factors that influence exchange rates | Features of Swap
Measuring exchange rate movements
Exchange rates respond quickly to all sorts of events – both economic and non-economic. The movement of exchange rates is the result of the combined effect of a number of factors that are constantly at play. Economic factors, also called fundamentals, are better guides as to how a currency moves in the long run. Short-term changes are affected by a multitude of factors which may also have to be examined carefully.
In recent years, global interdependence has increased to an unprecedented degree. Changes in one nation’s economy are rapidly transmitted to that nation’s trading partners. These fluctuations in economic activity are reflected almost immediately in fluctuations of currency values.
These changes in exchange rates expose all those firms having export-import operations as also multinationals with integrated cross-border production and marketing operations. It is useful to be aware of the various factors that influence exchanges rates. By a study of these factors and the trend of movements in the value of the particular currency, an experienced businessman may be able to forecast the possible future movement of that currency.
Factors that influence exchange rates
In foreign exchange trading, technical indicators such as charts and moving average lines are very significant in the determination of the movement of the prices of various currencies.
- The demand factor: At the most primary level, a change in the price of a currency will occur because of more or less demand for it. High demand signifies a higher price experience of the currency pair.
- The supply-side factor: A basic economic principle of supply says that a currency’s value will change with the rise and fall of the levels of supply.
- Long term vs. short term: A time period of a year or more signifies a long-term supply and demand. Short-term is generally thirty days or less than that. The currency prices in both time periods can be affected by the same factors.
- Factors affecting Currency Trading: A number of factors affect the rates of exchange. In the end, the costs of currency result from the supply of currency.
- Economic factors: These include the economic policy of the government which is made known through various government agencies and the central bank of the country, and economic conditions, generally revealed through economic reports.
- Political conditions: Internal, regional, and international political conditions and issues can profoundly affect currency markets; for instance, political upheaval and instability can negatively impact the economy of a nation.
Managing transaction exposure
Transaction exposure is concerned with the impact of change in the exchange rate on present cash flows. Transaction exposure emerges mainly on account of the export and import of commodities on open account, borrowing, and lending in a foreign currency and intra-firm flows within an international company.
Transaction exposure measures profits or losses that occur once the existing financial obligations as per the terms of reference are settled. Given that the transaction will result in a future foreign currency cash inflow or outflow, any unanticipated changes in the exchange rate between the time the transaction is entered into and the time it is settled in cash will lead to a change value of the net cash flow in terms of the home currency.
Examples of a transaction exposure of an Indian company would be the account receivable associated with a sale denominated in US dollars or the obligation of an account payable in Euro debt.
Managing operating exposure
Operating exposure has an impact on the firm’s future operating costs and cash flows. Since the firm is valued as a going concern entity, its future revenues and costs are to be affected by the exchange rate changes. If the firm succeeds in passing on the impact of higher input costs fully by increasing the selling price, it does not have any operating risk exposure as its operating future cash flows are likely to remain unaffected. In addition to supply and demand elasticity, the firm’s ability to shift production and sourcing of inputs is another major factor affecting operating risk exposure.
The word “operating” means the change in the operating cash flow which leads to a change in the value of the firm. It is not very easy to measure real operating exposure as far as the measurement of the inflation rate differential is not easy, more so when countries are going through a phase when they experience a highly volatile rate of exposure.
Operating exposure analysis assesses the impact of changing exchange rates on a firm’s own operations over the coming months and years and on its competitive position vis-à-vis other firms. The goal is to identify strategic moves or operating techniques that the firm might wish to adopt to enhance its value in the face of unexpected exchange rate changes.
Introduction of swap
A swap is an agreement between two or more parties to exchange sets of cash flows over a period in the future. The parties that agree to swap are known as counterparties. It is a combination of purchases with a simultaneous sale for an equal amount but on different dates. Swaps are used by corporate houses and banks as an innovative financing instrument that decreases borrowing costs and increases control over other financial instruments.
Features of swap
- Basically a forward: A swap is nothing but a combination of forwards. So, it has all the properties of a forward contract discussed above.
- Double coincidence of wants: Swap requires that two parties with equal and opposite needs must come into contact with each other.
- The necessity of an intermediary: Swap requires the existence of two counterparties with opposite but matching needs.
- Swaps are contracts of exchanging cash flows and are tailored to the needs of counterparties. Swaps can meet the specific needs of customers.
- Counterparties can select amounts, currencies, maturity dates, etc.
- Exchange trading involves the loss of some privacy but in the swap market privacy exists and only the counterparties know the transactions.
- There is no regulation in the swap market.
- There are some limitations like
a) Each party must find a counterparty that wishes to take the opposite position.
b) Determination requires to be accepted by both parties.
c) Since swaps are bilateral agreements the problem of potential default exists.
Kinds of swap
- Interest Rate Swap: An interest rate swap is a contractual agreement between two counterparties to exchange cash flows on particular dates in the future.
- Credit Default Swap: A credit default swap is a contract that provides protection against credit loss on an underlying reference entity as a result of a specific credit event.
- Asset Swap: An asset swap is a combination of a default table bond with a fixed-for-floating interest rate swap that swaps the coupon of the bond into the cash flows of LIBOR plus a spread.
- Trigger Swap: A Trigger Swap is an interest rate swap in which payments are knocked out if the reference rate is above a given trigger rate.
- Commodity Swap: A commodity swap is a swap in which one of the payment streams for a commodity is fixed and the other is floating.
- Foreign-Exchange (FX) Swaps: An FX swap is where one leg’s cash flows are paid in one currency, while the other leg’s cash flows are paid in another currency.
Various types of interest rate swap
The following are the most important types of interest rate swaps:
- Fixed for Floating: Investors call the parts of interest swap agreements “legs.” In a fixed-for-floating swap agreement, one party agrees to pay the fixed leg of the swap, with the other party agreeing to pay the floating leg of the swap.
- Floating for Floating: In a floating-for-floating interest rate swap agreement, both parties agree to pay a floating rate on their respective legs of the swap. The floating rates for each leg of the swap generally come from different reference rate indexes, but can also come from the same index.
- Fixed for Fixed: In fixed-for-fixed interest rate swaps, both parties agree to a fixed interest for their respective legs of the swap. The interest rate does not change over the life of the loan for both parties.
- Plain vanilla swap: This swap involves the periodic exchange of fixed-rate payments for floating-rate payments. It is sometimes referred to as fixed for floating swaps.
- Forward swap: This involves an exchange of interest rate payments that does not begin until a specified future point in time. It is a swap involving fixed floating interest rates.
- Putable swap: It provides the party making the floating rate payments with a right to terminate the swap.
- Extendable swap: It contains an extendable feature that allows fixed for the floating parties to extend the swap period.
- Zero-coupon for floating swap: In this swap, the fixed-rate pair makes a bullet payment at the end and the floating rate pair makes the periodic payment throughout the swap period.
- Rate-capped swaps: This involves the change of fixed-rate payments for floating-rate payments whereby the floating-rate payments are capped. An upfront fee is paid by the floating rate party to the fixed-rate party for the cap.
- Equity swaps: An equity swap is a financial derivative contract where a set of future cash flows are agreed to be exchanged between two counterparties at set dates in the future.