International Capital Markets and Finance Essay

International Capital Markets and Finance - Essay Example In a foreign exchange contract one member agrees to sell and the other agrees to buy at a future date at an exchange rate which is prevailing at the time of agreement. Such contracts can involve a foreign currency of the party involved against the domestic currency or any other foreign currency as might be found appropriate. Generally, in a forward exchange contract the two parties in consideration are the concerned bank and the customer. While forward exchange contracts are generally accepted, currency futures are preferred more due to their innate characteristic of flexibility which we will take up subsequently. The forward currency market is comprised of the following players. "A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like delivery date, price and quantity are negotiated bilaterally by the parties to the contract" (Securities Market). (b) Critically evaluate the potential risks each of these participants face when dealing in the forward exchange markets, particularly in the current financial crisis, and discuss what strategies can be used to manage such risks. The following problems/risks are common to all forward market across the world. Lack of centralization of trading, Illiquidity, and Counterparty risk The basic problem/risk with forward contract is that they are neither standardized nor liquid. This results in too much flexibility and generality and lack of confidence among participants. A forward contract for a currency can be made by any two parties on the basis of their mutual understanding. The counter party risk arises from this non-standardized form of agreement. The high chance of counter party risk of this form of derivative made to think about alternative tools like options and futures. In a forward exchange contract, when one of the two parties to the transaction is declared bankruptcy, the other is bound to suffer. Even when forward markets trade standardized contracts, and hence avoid the problem of illiquidity, still the counterparty risk remains a very serious issue. Banks Banks play a major role in the derivative trading of a country. In a forward market for currencies, banks role is to grant short term financial arrangements to the original parties involved in the transaction. In a forward exchange market, the buyer undertakes to purchase a certain amount of a foreign currency against his/her domestic currency at an agreed exchange rate. In case the rate is not favourable to him in the future, he will incur an opportunity loss, which ultimately affects the banks from where the buyer arranged the financial resource. Speculators They are traders with a view and objective of making profits. They are willing to take risks on the anticipation of making profit out of the exchange rate fluctuations. They are making the scene most badly as their involvement will affect the genuine transactions and parties. The risk