Inter Nation Finance

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Gold specie standardADRAmerican optionAmerican quotesArbitrage

Balance of visible tradeBill of ladingBond with optionBulls and bears in foreign exchangeBulls vs beasrsContingent credit lineCrawling pegCrawling pegCrawling peg mechanismCustodian bank Depository receiptsDevaluation and revaluation of currencyDirect quoteDirty floatErrors and omissions account in the BOPEuro as a currencyEuro- as currency ofEUEuro currency bonds vs euro currency notesEuro equitiesEuropean optionFiat money

Floating exchange rateForeign aidGDRGlobal depository receipt (GDR)HedgingHot moneyHot moneyIndependent floatInflation risk Liberalized exchange rate managementLondon interbank offer rate (LIBOR)Marking to marketMonetization of goldMoney changerNostro and vostro accountsOverall balancePosition riskPut option


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RBI interventionSamurai bondStrike price

Transactions above the line in BOP Translation exposure

Treatment of goodwill in BOPUnsponsored depository receiptsValue dateVehicle currencyVehicle currencyVehicle currency

Yankee bonds

An American Depositary Receipt (or ADR) represents ownership in theshares of a non-U.S. company and trades in U.S. financial markets. The stock

of many non-US companies trade on US stock exchanges through the use of ADRs. ADRs enable U.S. investors to buy shares in foreign companies withoutthe hazards or inconveniences of cross-border & cross-currency transactions.ADRs carry prices in US dollars, pay dividends in US dollars, and can betraded like the shares of US-based companies.

Definition American option

An option which can be exercised at any time between the purchase date and the expiration date .Most options in the U.S. are of this type. This is the opposite of a European-style option , whichcan only be exercised on the date of expiration . Since an American option provides an investor with a greater degree of flexibility than a European style option , the premium for an Americanstyle option is at least equal to or higher than the premium for a European-style option whichotherwise has all the same features . also called American-style option .

[Q:] What is arbitrage? What markets do arbitrageurs usually trade on?

[A:] Terrific question! Let's start from the definition. The Economics Glossary defines arbitrageopportunity as "the opportunity to buy an asset at a low price then immediately selling it on adifferent market for a higher price." If I can buy an asset for $5, turn around and sell it for $20and make $15 for my trouble, that is arbitrage. The $15 I gain represents an arbitrage profit.

Arbitrage profits can occur in a number of different ways. We'll look at a few examples:

1. One good, Two markets
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Suppose Walmart is selling the DVD of Shaft in Africa for $10. However, I know that on eBay the last 20 copies of Shaft in Africa on DVD have sold for between $25 and $30. Then I could goto Walmart, buy copies of the movie and turn around and sell them on eBay for a profit of $15 to$20 a DVD. It is unlikely that I will be able to make a profit in this manner for too long, as oneof three things should happen:

1. Walmart runs out of copies of Shaft in Africa on DVD2. Walmart raises the price on remaining copies as they've seen an increased demand for the

movie3. The supply of Shaft in Africa DVDs skyrockets on eBay, which causes the price to fall.

The visible balance is that part of the balance of trade figures that refers to internationaltrade in physical goods, but not trade in services; it thus contrasts with the invisible

balance .

Most countries do not have a zero visible balance: they usually run a surplus or a deficit.

This will be offset by trade in services, other income transfers, investments and monetaryflows, leading to an overall balance of payments . The visible balance is affected bychanges in the volumes of imports and exports , and also by changes in the terms of trade .

In aggregate, the World often appears to have a negative visible balance with itself; i.e.imports of goods appear to exceed exports. There are numerous causes for this, such asmeasuring imports on a cost, insurance and freight basis while measuring exports on afree on board basis, or statistical errors occurring when imports are more closely recordedthan exports.

A bill of lading (sometimes referred to as a BOL ,or B/L ) is a document

issued by a carrier to a shipper, acknowledging that specified goods havebeen received on board as cargo for conveyance to a named place fordelivery to the consignee who is usually identified. A through bill of ladinginvolves the use of at least two different modes of transport from road, rail,air, and sea. The term derives from the noun "bill", a schedule of costs forservices supplied or to be supplied, and from the verb "to lade" which meansto load a cargo onto a ship or other form of transport.

Bond option

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In finance, a bond option is an OTC-traded financial instrument that facilitates an option to buyor sell a particular bond at a certain date for a particular price. It is similar to a stock option withthe difference that the underlying asset is a bond. Bond options can be valued using the Black model .
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The present market value for the bond is referred to as the spot price while the future value as per the option is referred to as the strike price.

[ edit ] Types

A European bond option is an option to buy or sell a bond at acertain date in future for a predetermined price.

An American Bond option is an option to buy or sell a bond on or before a certain date in future for a predetermined price.

[ edit ] Example

Trade Date: 1 March 2003 Maturity Date: 6 March 2006 Option Buyer: Bank A Underlyingasset: FNMA Bond. Spot Price: $101 , Strike Price: $102

On the Trade Date, Bank A enters into an option with Bank B to buy certain FNMA Bonds fromBank B for the Strike Price mentioned. Bank A pays a premium to Bank B which is the premium

percentage multiplied by the face value of the bonds.

At the maturity of the option, Bank A either exercises the option and buys the bonds from Bank B at the predetermined strike price, or chooses not to exercise the option. In either case, Bank Ahas lost the premium to Bank B.

[ edit ] Embedded option

The term "bond option" is also used for option-like features of some bonds. These are aninherent part of the bond, rather than a separately traded product. These options are not mutuallyexclusive, so a bond may have lots of options embedded.

A callable bond allows the issuer to buy back the bond at apredetermined price at certain time in future. The holder of such abond has, in effect, sold a call option to the issuer. Callable bondscannot be called for the first few years of their life. This period isknown as the lock out period .

A puttable bond allows the holder to demand early redemption at apredetermined price at certain time in future. The holder of such abond has, in effect, purchased a put option on the bond.

A convertible bond allows the holder to demand conversion of bondsinto the stock of the issuer at a predetermined price at certain timeperiod in future.
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An exchangeable bond allows the holder to demand conversion of bonds into the stock of a different company, usually a public subsidiaryof the issuer, at a predetermined price at certain time period in future.

[ edit ] Relationship with caps and floors

European Put options on zero coupon bonds can be seen to be equivalent to suitable caplets, i.e.interest rate cap components, whereas call options can be seen to be equivalent to suitablefloorlets, i.e. components of interest rate floors . See for example Brigo and Mercurio (2001),who also discuss bond options valuation with different models.

[ edit ] Uses

The major advantage of a bond option is the Locking-in price of the underlying bond for futurethereby reducing the credit risk associated with the fluctuations in the bond price.

hen the market is going up - bulls are in control. When bulls are in control -its called a bullish market.

Bulls are BUYERS - Bears are SELLERS - so when there are more BUYERS(bulls) - its called a Bullish Market - when there are more SELLERS (bears) -its called a Bearish Market.

Bullish market is also referred to as uptrend market or you can simply saythe market is bullish.

In Forex, during the bullish market - the base currency is gaining valueand the quote currency is losing value .

For EUR/USD - if this pair is bullish that means EURO is gaining value whileUSD is losing value.

Since Currencies are traded in pairs the negative effect of one currency hasbe a positive for other.

hen the market is going down - bears are in control. When bears are incontrol - its called a bearish market.

BEARS are SELLERS as opposed to BULLS who are BUYERS - when there areMORE SELLERS (bears) than BUYERS(bulls) - its called a Bearish Market.

Bearish market is also referred to as downtrend market or you can simply
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say the market is bearish.

In Forex, during the bearish market - the base currency is losing valueand the quote currency is gaining value .

For EUR/USD - if this pair is bearish that means EURO is losing value whileUSD is gaining value.

Since Currencies are traded in pairs the negative effect of one currencybecomes positive for other.

The IMF's Contingent Credit Lines (CCL)

The IMF introduced the Contingent Credit Lines (CCL) in 1999 as part of its efforts tostrengthen member countries' defenses against financial crisis. For various reasons, the facilitywas never used. In November of 2003, the CCL was allowed to expire on its scheduled sunsetdate.

The CCL as a precautionary line of defense

As part of its response to the rapid spread of turmoil through global financial markets during theAsian crisis of 1997-98, the IMF introduced the Contingent Credit Lines (CCL) in the spring of

1999. The CCL was intended to provide a precautionary line of defense for members with sound policies, who were not at risk of an external payments crisis of their own making, but werevulnerable to contagion effects from capital account crises in other countries. Under the facility,an IMF member that met the demanding eligibility criteria could draw on a large pre-specifiedamount of resources if hit by a financial crisis due to factors outside of the member's control.

In the fall of 2000, several changes were made to the terms of the CCL to make it moreattractive. These changes led to more automatic access to the first portion of the loan. Inaddition, the interest rate on the CCL was reduced relative to that applying to the SupplementalReserve Facility, a facility used to support member countries that are already experiencing acrisis. The commitment fee was also reduced.

To qualify for the CCL, an IMF member would have had to meet four criteria:

1. No expected need for IMF resources. The member must have been pursuing policies that wereconsidered unlikely to bring about a need for IMF financing-except because of contagion.

2. A positive assessment of policies and progress toward adherence to internationally acceptedstandards.
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3. Constructive relations with private creditors and progress towards limiting externalvulnerability.

4. A satisfactory macroeconomic and financial program and a commitment to adjust policies.

Commitments of funds under the CCL would have been made for up to one year on a stand-by basis. While there was no general access limit, it was expected that commitments under thefacility would typically have been in the range of 300-500 percent of the member's quota.Countries drawing under the CCL would have been expected to repay within one year to 18months of the date of each disbursement. The surcharge over the IMF's normal market-basedloan rate would have begun at 150 basis points, rising to 350 basis points, depending on theduration of the drawing.

The 2003 review of the CCL

The CCL remained unused and, in March 2003, the Executive Board began a review of the

facility. Directors considered a number of factors that may have discouraged use of the CCL.Potentially eligible countries may have lacked confidence that a CCL would be viewed as a signof strength rather than weakness. These countries may also have been concerned about the risk of negative fallout if they were to be considered ineligible at a future date. There had been someuncertainty about whether Fund resources under a CCL would in fact be readily available in theevent of need, as the release of funds would require Executive Board approval. And, finally,many potentially eligible countries had reduced their vulnerability to external shocks throughreserve accumulation, the adoption of flexible exchange rates, and other reforms, reducing the

perceived demand for insurance in the form of a CCL.

During the review, Directors gave extensive consideration to further modifications of the CCL,

as well as to alternative ways to achieve its objectives. There was strong support among manyDirectors to extend the facility beyond the sunset date built into the CCL decision, allowing timefor its design to be further improved or alternative means found to achieve its objectives. A fewDirectors felt that, even if the CCL were never used, it provided an incentive for countries to

pursue good policies. Nonetheless, support for its extension fell well short of the 85 percent of votes necessary, and the CCL was allowed to expire on November 30, 2003.

Directors highlighted a number of considerations they thought should dispel possible concernsraised by the CCL's expiration. First, as the Fund's record of helping members facing capitalaccount crises shows, the IMF stands ready to move quickly and flexibly to approve the use of Fund resources and to adjust the level and the phasing of access to the member's need when

conditions so require and permit. Second, the Fund's strengthened surveillance, support for greater transparency, and technical assistance operations are contributing to promoting sound policies, and helping to prevent crises more generally. And third, recent innovations in thefinancial architecture, improvements in market differentiation across different borrowers, andstronger policy efforts by many emerging market countries seem to have lessened the threat of contagion that the CCL was intended to avert.
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Moreover, Directors urged that efforts continue to assess the ways in which the IMF'sinstruments and policies could be further improved to strengthen their ability to prevent crises. Afuller accounting of Director's views on specific avenues for exploration can be found athttp://www.imf.org/external/np/sec/pn/2003/pn03146.htm .

g Peg

What Does Crawling Peg Mean?A system of exchange rate adjustment in which a currency with a fixedexchange rate is allowed to fluctuate within a band of rates. The par value of the stated currency is also adjusted frequently due to market factors such asinflation. This gradual shift of the currency's par value is done as analternative to a sudden and significant devaluation of the currency.

Investopedia explains Crawling PegFor example, in the 1990s, Mexico had fixed its peso with the U.S. dollar.However, due to the significant inflation in Mexico, as compared to the U.S.,it was evident that the peso would need to be severely devalued. Because arapid devaluation would create instability, Mexico put into place a crawlingpeg exchange rate adjustment system, and the peso was slowly devaluedtoward a more appropriate exchange rate.

What Does Devaluation Mean?A deliberate downward adjustment to a country's official exchange rate relative to other currencies. In a fixed exchange rate regime, only a decision by a country's government (i.ecentral bank) can alter the official value of the currency. Contrast to "revaluation".

Investopedia explains DevaluationThere are two implications for a currency devaluation. First, devaluation makes a country'sexports relatively less expensive for foreigners and second, it makes foreign products relatively

more expensive for domestic consumers, discouraging imports. As a result, this may help toreduce a country's trade deficit.

Dirty Float

What Does Dirty Float Mean?A system of floating exchange rates in which the government or the
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country's central bank occasionally intervenes to change the direction of thevalue of the country's currency. In most instances, the intervention aspect of a dirty float system is meant to act as a buffer against an external economicshock before its effects become truly disruptive to the domestic economy.

Also known as a "managed float".

Investopedia explains Dirty Float For example, country X may find that some hedge fund is speculating that itscurrency will depreciate substantially, thus the hedge fund is starting toshort massive amounts of country X's currency. Because country X uses a

dirty float system, the government decides to take swift action and buy backa large amount of its currency in order to limit the amount of devaluationcaused by the hedge fund.

A dirty float system isn't considered to be a true floating exchangerate because, theoretically, true floating rate systems don't allow forintervention.

Exchange Rate

What Does Exchange Rate Mean? The price of one country's currency expressed in another country's currency.In other words, the rate at which one currency can be exchanged foranother. For example, the higher the exchange rate for one euro in terms of one yen, the lower the relative value of the yen.

Investopedia explains Exchange RateIn most financial papers, currencies are expressed in terms of U.S. dollars,while the dollar is commonly compared to the Japanese yen, the Britishpound and the euro. As of the beginning of 2006, the exchange rate of oneU.S. dollar for one euro was about 0.84, which means that one dollar can beexchanged for 0.84 euros.

Related Terms


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Floating Exchange Rate

What Does Floating Exchange Rate Mean?A country's exchange rate regime where its currency is set by the foreign-exchange market through supply and demand for that particular currencyrelative to other currencies. Thus, floating exchange rates change freely andare determined by trading in the forex market. This is in contrast to a "fixedexchange rate" regime.

Investopedia explains Floating Exchange RateIn some instances, if a currency value moves in any one direction at a rapidand sustained rate, central banks intervene by buying and selling its owncurrency reserves (i.e. Federal Reserve in the U.S.) in the foreign-exchangemarket in order to stabilize the local currency. However, central banks arereluctant to intervene, unless absolutely necessary, in a floating regime.

n

What Does Inflation Mean? The rate at which the general level of prices for goods and services is rising,and, subsequently, purchasing power is falling. Central banks attempt tostop severe inflation, along with severe deflation, in an attempt to keep theexcessive growth of prices to a minimum.

Investopedia explains InflationAs inflation rises, every dollar will buy a smaller percentage of a good. For

example, if the inflation rate is 2%, then a $1 pack of gum will cost $1.02 in ayear.

Most countries' central banks will try to sustain an inflation rate of 2-3%.

What Does Pegging Mean?1. A method of stabilizing a country's currency by fixing its exchange rate to that of another country.


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2. A practice of and investor buying large amounts of an underlying commodity or security closeto the expiry date of a derivative held by the investor. This is done to encourage a favorablemove in market price.

Investopedia explains Pegging 1. Most countries peg their exchange rate to that of the United States.

2. An investor writing a put option would practice pegging so that he or she will not be required,due to lowering prices, to purchase the underlying security or commodity from the option holder.The goal is to have the option expire worthless so that the premium initially received by thewriter is protected.side from factors such as interest rates and inflation , the exchange rate is one of the mostimportant determinants of a country's relative level of economic health. Exchange rates play avital role in a country's level of trade, which is critical to most every free market economy in theworld. For this reason, exchange rates are among the most watched, analyzed andgovernmentally manipulated economic measures. But exchange rates matter on a smaller scale aswell: they impact the real return of an investor's portfolio. Here we look at some of the major forces behind exchange rate movements.

Before we look at these forces, we should sketch out how exchange rate movements affect anation's trading relationships with other nations. A higher currency makes a country's exports more expensive and imports cheaper in foreign markets; a lower currency makes a country'sexports cheaper and its imports more expensive in foreign markets. A higher exchange rate can

be expected to lower the country's balance of trade , while a lower exchange rate would increaseit.

Determinants of Exchange Rates Numerous factors determine exchange rates, and all are related to the trading relationship between two countries. Remember, exchange rates are relative, and are expressed as acomparison of the currencies of two countries. The following are some of the principaldeterminants of the exchange rate between two countries. Note that these factors are in no

particular order; like many aspects of economics , the relative importance of these factors issubject to much debate.

1. Differentials in inflation: As a rule of thumb, a country with a consistently lower inflationrate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the twentieth century, the countries with low inflation includedJapan, Germany and Switzerland, while the U.S. and Canada achieved low inflation only later.Those countries with higher inflation typically see depreciation in their currency in relation to thecurrencies of their trading partners. This is also usually accompanied by higher interest rates. (To
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learn more, see Cost-Push Inflation Versus Demand-Pull Inflation .)

2. Differentials in interest rates: Interest rates, inflation and exchange rates are all highlycorrelated. By manipulating interest rates, central banks exert influence over both inflation andexchange rates, and changing interest rates impact inflation and currency values. Higher interestrates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange rates. (For further reading, see What Is Fiscal Policy? )

3. Current-account deficits: The current account is the balance of trade between a country andits trading partners (see Understanding The Current Account In The Balance Of Payments ),

reflecting all payments between countries for goods, services, interest and dividends. A deficit inthe current account shows the country is spending more on foreign trade than it is earning, andthat it is borrowing capital from foreign sources to make up the deficit. In other words, thecountry requires more foreign currency than it receives through sales of exports, and it suppliesmore of its own currency than foreigners demand for its products. The excess demand for foreigncurrency lowers the country's exchange rate until domestic goods and services are cheap enoughfor foreigners, and foreign assets are too expensive to generate sales for domestic interests.

4. Public debt: Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy,nations with large public deficits and debts are less attractive to foreign investors. The reason? Alarge debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately

paid off with cheaper real dollars in the future.

In the worst case scenario, a government may print money to pay part of a large debt, butincreasing the money supply inevitably causes inflation. Moreover, if a government is not able toservice its deficit through domestic means (selling domestic bonds , increasing the moneysupply), then it must increase the supply of securities for sale to foreigners, thereby loweringtheir prices. Finally, a large debt may prove worrisome to foreigners if they believe the countryrisks defaulting on its obligations. Foreigners will be less willing to own securities denominatedin that currency if the risk of default is great. For this reason, the country's debt rating (asdetermined by Moody's or Standard & Poor's , for example) is a crucial determinant of itsexchange rate.

5. Terms of trade: A ratio comparing export prices to import prices, the terms of trade is relatedto current accounts and the balance of payments . If the price of a country's exports rises by a
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greater rate than that of its imports, its terms of trade have favorably improved. Increasing termsof trade shows greater demand for the country's exports. This, in turn, results in rising revenuesfrom exports, which provides increased demand for the country's currency (and an increase in thecurrency's value). If the price of exports rises by a smaller rate than that of its imports, thecurrency's value will decrease in relation to its trading partners.

6. Political stability and economic performance: Foreign investors inevitably seek out stablecountries with strong economic performance in which to invest their capital. A country with such

positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in acurrency and a movement of capital to the currencies of more stable countries.

ConclusionThe exchange rate of the currency in which a portfolio holds the bulk of its investments

determines that portfolio's real return. A declining exchange rate obviously decreases the purchasing power of income and capital gains derived from any returns. Moreover, the exchangerate influences other income factors such as interest rates, inflation and even capital gains fromdomestic securities. While exchange rates are determined by numerous complex factors thatoften leave even the most experienced economists flummoxed, investors should still have someunderstanding of how currency values and exchange rates play an important role in the rate of return on their investments.

Custodian bank

A custodian bank , or simply custodian , is a financial institution responsible for safeguarding afirm's or individual's financial assets. The role of a custodian in such a case would be thefollowing: to hold in safekeeping assets such as equities and bonds , arrange settlement of any

purchases and sales of such securities, collect information on and income from such assets(dividends in the case of equities and coupons in the case of bonds), provide information on theunderlying companies and their annual general meetings, manage cash transactions, performforeign exchange transactions where required and provide regular reporting on all their activitiesto their clients. Custodian banks are often referred to as global custodians if they hold assets for their clients in multiple jurisdictions around the world, using their own local branches or other local custodian banks in each market to hold accounts for their underlying clients. Assets held insuch a manner are typically owned by pension funds.

In relation to American Depositary Receipts (ADRs), a local custodian bank (also known as asub-custodian or agent bank) is a bank in a country outside the United States that holds thecorresponding amount of shares of stock trading on the home stock market represented by an
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ADR trading in the U.S, with each multiple representing some multiple of the underlying foreignshare. This multiple allows the ADRs to possess a price per share conventional for the USmarket (typically between $20 and $50 per share) even if the price of the foreign share isunconventional when converted to US dollars directly. This bank acts as custodian bank for thecompany that issues the ADRs in the U.S. stock.

A depositary receipt (DR) is a type of negotiable (transferable) financial security that is traded ona local stock exchange but represents a security, usually in the form of equity, that is issued by aforeign publicly listed company. The DR, which is a physical certificate, allows investors to holdshares in equity of other countries. One of the most common types of DRs is the Americandepositary receipt (ADR), which has been offering companies, investors and traders globalinvestment opportunities since the 1920s.

Since then, DRs have spread to other parts of the globe in the form of global depositary receipts (GDRs) (the other most common type of DR), European DRs and international DRs . ADRs aretypically traded on a U.S. national stock exchange, such as the New York Stock Exchange

(NYSE) or the American Stock Exchange , while GDRs are commonly listed on European stock exchanges such as the London Stock Exchange. Both ADRs and GDRs are usually denominatedin U.S. dollars, but can also be denominated in euros.

How Does the DR Work?The DR is created when a foreign company wishes to list its already publicly traded shares or debt securities on a foreign stock exchange. Before it can be listed to a particular stock exchange,the company in question will first have to meet certain requirements put forth by the exchange.Initial public offerings , however, can also issue a DR. DRs can be traded publicly or over-the-counter . Let us look at an example of how an ADR is created and traded:

ExampleSay a gas company in Russia has fulfilled therequirements for DR listing and now wants to list its

publicly traded shares on the NYSE in the form of anADR. Before the gas company's shares are traded freelyon the exchange, a U.S. broker , through an internationaloffice or a local brokerage house in Russia, would

purchase the domestic shares from the Russian marketand then have them delivered to the local (Russian)custodian bank of the depository bank. The depository

bank is the American institution that issues the ADRs in

America. In this example, the depository bank is theBank of New York. Once the Bank of New York's localcustodian bank in Russia receives the shares, thiscustodian bank verifies the delivery of the shares byinforming the Bank of New York that the shares cannow be issued in the United States. The Bank of NewYork then delivers the ADRs to the broker who initially
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purchased them.

Based on a determined ADR ratio, each ADR may beissued as representing one or more of the Russian localshares, and the price of each ADR would be issued inU.S. dollars converted from the equivalent Russian priceof the shares being held by the depository bank. TheADRs now represent the local Russian shares held bythe depository, and can now be freely traded equity onthe NYSE.

After the process whereby the new ADR of the Russiangas company is issued, the ADR can be traded freelyamong investors and transferred from the buyer to theseller on the NYSE, through a procedure known as intra-market trading. All ADR transactions of the Russian gascompany will now take place in U.S. dollars and aresettled like any other U.S. transaction on the NYSE. TheADR investor holds privileges like those granted toshareholders of ordinary shares, such as voting rights and cash dividends . The rights of the ADR holder arestated on the ADR certificate.

Pricing and Cross-TradingWhen any DR is traded, the broker will aim to find the best price of the share in question. He or she will therefore compare the U.S. dollar price of the ADR with the U.S. dollar equivalent price

of the local share on the domestic market. If the ADR of the Russian gas company is trading atUS$12 per share and the share trading on the Russian market is trading at $11 per share(converted from Russian rubles to dollars), a broker would aim to buy more local shares fromRussia and issue ADRs on the U.S. market. This action then causes the local Russian price andthe price of the ADR to reach parity . The continual buying and selling in both markets, however,usually keeps the prices of the ADR and the security on the home market in close range of oneanother. Because of this minimal price differential, most ADRs are traded by means of intramarket trading.

A U.S. broker may also sell ADRs back into the local Russian market. This is known as cross- border trading. When this happens, an amount of ADRs is canceled by the depository and the

local shares are released from the custodian bank and delivered back to the Russian broker who bought them. The Russian broker pays for them in roubles, which are converted into dollars bythe U.S. broker.

The Benefits of Depositary ReceiptsThe DR functions as a means to increase global trade, which in turn can help increase not onlyvolumes on local and foreign markets but also the exchange of information, technology,regulatory procedures as well as market transparency. Thus, instead of being faced with
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impediments to foreign investment, as is often the case in many emerging markets , the DR investor and company can both benefit from investment abroad. Let's take a closer a look at the

benefits:

For the Company

A company may opt to issue a DR to obtain greater exposure and raise capital in the worldmarket. Issuing DRs has the added benefit of increasing the share's liquidity while boosting thecompany's prestige on its local market ("the company is traded internationally"). Depositaryreceipts encourage an international shareholder base, and provide expatriates living abroad withan easier opportunity to invest in their home countries. Moreover, in many countries, especiallythose with emerging markets, obstacles often prevent foreign investors from entering the localmarket. By issuing a DR, a company can still encourage investment from abroad without havingto worry about barriers to entry that a foreign investor might face.

For the Investor Buying into a DR immediately turns an investors' portfolio into a global one. Investors gain the

benefits of diversification while trading in their own market under familiar settlement andclearance conditions. More importantly, DR investors will be able to reap the benefits of theseusually higher risk, higher return equities, without having to endure the added risks of goingdirectly into foreign markets, which may pose lack of transparency or instability resulting fromchanging regulatory procedures. It is important to remember that an investor will still bear someforeign-exchange risk , stemming from uncertainties in emerging economies and societies. On theother hand, the investor can also benefit from competitive rates the U.S. dollar and euro have tomost foreign currencies.

ConclusionGiving you the opportunity to add the benefits of foreign investment while bypassing the

unnecessary risks of investing outside your own borders, you may want to consider adding thesesecurities to your portfolio. As with any security, however, investing in ADRs requires anunderstanding of why they are used, and how they are issued and traded.

by Reem Heakal ,

Currency Devaluation and Revaluation

Under a fixed exchange rate system, devaluation and revaluation are officialchanges in the value of a country's currency relative to other currencies. Under a

floating exchange rate system, market forces generate changes in the value of thecurrency, known as currency depreciation or appreciation.

In a fixed exchange rate system, both devaluation and revaluation can be conductedby policymakers, usually motivated by market pressures.

The charter of the International Monetary Fund (IMF) directs policymakers toavoid "manipulating exchange rates...to gain an unfair competitive advantage over
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other members."

At the Bretton Woods Conference in July 1944, international leaders sought to insure a stable post-war international economic environment by creating a fixed exchange rate system. TheUnited States played a leading role in the new arrangement, with the value of other currencies

fixed in relation to the dollar and the value of the dollar fixed in terms of gold$35 an ounce.Following the Bretton Woods agreement, the United States authorities took actions to hold downthe growth of foreign central bank dollar reserves to reduce the pressure for conversion of official dollar holdings into gold.

During the mid- to late-1960s, the United States experienced a period of rising inflation. Becausecurrencies could not fluctuate to reflect the shift in relative macroeconomic conditions betweenthe United States and other nations, the system of fixed exchange rates came under pressure.

In 1973, the United States officially ended its adherence to the gold standard. Many other industrialized nations also switched from a system of fixed exchange rates to a system of floating

rates. Since 1973, exchange rates for most industrialized countries have floated, or fluctuated,according to the supply of and demand for different currencies in international markets. Anincrease in the value of a currency is known as appreciation, and a decrease as depreciation.Some countries and some groups of countries, however, continue to use fixed exchange rates tohelp to achieve economic goals, such as price stability.

Under a fixed exchange rate system, only a decision by a country's government or monetaryauthority can alter the official value of the currency. Governments do, occasionally, take suchmeasures, often in response to unusual market pressures. Devaluation , the deliberate downwardadjustment in the official exchange rate, reduces the currency's value; in contrast, a revaluationis an upward change in the currency's value.

For example, suppose a government has set 10 units of its currency equal to one dollar. Todevalue, it might announce that from now on 20 of its currency units will be equal to one dollar.This would make its currency half as expensive to Americans, and the U.S. dollar twice asexpensive in the devaluing country. To revalue, the government might change the rate from 10units to one dollar to five units to one dollar; this would make the currency twice as expensive toAmericans, and the dollar half as costly at home.

Under What Circumstances Might a Country Devalue?When a government devalues its currency, it is often because the interaction of market forces and

policy decisions has made the currency's fixed exchange rate untenable. In order to sustain a

fixed exchange rate, a country must have sufficient foreign exchange reserves, often dollars, and be willing to spend them, to purchase all offers of its currency at the established exchange rate.When a country is unable or unwilling to do so, then it must devalue its currency to a level that itis able and willing to support with its foreign exchange reserves.

A key effect of devaluation is that it makes the domestic currency cheaper relative to other currencies. There are two implications of a devaluation. First, devaluation makes the country'sexports relatively less expensive for foreigners. Second, the devaluation makes foreign products


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relatively more expensive for domestic consumers, thus discouraging imports. This may help toincrease the country's exports and decrease imports, and may therefore help to reduce the currentaccount deficit.

There are other policy issues that might lead a country to change its fixed exchange rate. For example, rather than implementing unpopular fiscal spending policies, a government might try touse devaluation to boost aggregate demand in the economy in an effort to fight unemployment.Revaluation, which makes a currency more expensive, might be undertaken in an effort to reducea current account surplus, where exports exceed imports, or to attempt to contain inflationary

pressures.

Effects of DevaluationA significant danger is that by increasing the price of imports and stimulating greater demand for domestic products, devaluation can aggravate inflation. If this happens, the government mayhave to raise interest rates to control inflation, but at the cost of slower economic growth.

Another risk of devaluation is psychological. To the extent that devaluation is viewed as a signof economic weakness, the creditworthiness of the nation may be jeopardized. Thus, devaluationmay dampen investor confidence in the country's economy and hurt the country's ability tosecure foreign investment.

Another possible consequence is a round of successive devaluations. For instance, trading partners may become concerned that a devaluation might negatively affect their own exportindustries. Neighboring countries might devalue their own currencies to offset the effects of their trading partner's devaluation. Such "beggar thy neighbor" policies tend to exacerbate economicdifficulties by creating instability in broader financial markets.

Since the 1930s, various international organizations such as the International Monetary Fund(IMF) have been established to help nations coordinate their trade and foreign exchange policiesand thereby avoid successive rounds of devaluation and retaliation. The 1976 revision of ArticleIV of the IMF charter encourages policymakers to avoid "manipulating exchange rates...to gainan unfair competitive advantage over other members." With this revision, the IMF also set fortheach member nation's right to freely choose an exchange rate system.

What Does Direct Quote Mean?

A foreign exchange rate quoted as the domestic currency per unit of the foreign currency. Inother words, it involves quoting in fixed units of foreign currency against variable amounts of thedomestic currency.

Investopedia explains Direct QuoteFor example, in the U.S., a direct quote for the Canadian dollar would be US$0.85 = C$1.Conversely, in Canada, a direct quote for U.S. dollars would be C$1.17 = US$1.


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A foreign exchange rate of one currency , usually the domestic currency, per unit of a different currency. In terms of U.S. dollars , a direct quote is thenumber of a foreign currency that one dollar could buy . For example, a directquote for the Euro could be US$1.50 = 1 Euro.

In economics, the balance of payments , (or BOP ) measures the payments that flow between anyindividual country and all other countries. It is used to summarize all international economic transactions for that country during a specific time period, usually a year. The BOP is determined

by the country's exports and imports of goods , services , and financial capital , as well as financialtransfers. It reflects all payments and liabilities to foreigners ( debits ) and all payments andobligations received from foreigners ( credits ). Balance of payments is one of the major indicators

of a country's status in international trade, with net capital outflow .[citation needed ]

The balance, like other accounting statements, is prepared in a single currency, usually thedomestic. Foreign assets and flows are valued at the exchange rate of the time of transaction.

o

[ edit ] IMF definition

The IMF definition: " Balance of Payments is a statistical statement that summarizestransactions between residents and nonresidents during a period." [1] The balance of payments

comprises the current account , the capital account , and the financial account . "Together,these accounts balance in the sense that the sum of the entries is conceptually zero ."[1]

The current account consists of the goods and servicesaccount , the primary income account and the secondary incomeaccount. The financial account

[ edit ] Balance of payments identity

The balance of payments identity states that:

Current Account = Capital Account + Financial Account + Net Errorsand Omissions

This is a convention of double entry accounting , where all debit entries must be booked alongwith corresponding credit entries such that the net of the Current Account will have acorresponding net of the Capital and Financial Accounts:
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where:

X = exports M = imports K i = capital inflows K o = capital outflows

Rearranging, we have:

,

yielding the BOP identity.

The basic principle behind the identity is that a country can only consume more than it can produce (a current account deficit) if it is supplied capital from abroad (a capital accountsurplus). [2]

Mercantile thought prefers a so-called balance of payments surplus where the net current accountis in surplus or, more specifically, a positive balance of trade.

A balance of payments equilibrium is defined as a condition where the sum of debits andcredits from the current account and the capital and financial accounts equal to zero; in other words, equilibrium is where

This is a condition where there are no changes in Official Reserves .[3] When there is no change inOfficial Reserves, the balance of payments may also be stated as follows:

or:

Canada's Balance of Payments currently satisfies this criterion. It is the only large monetaryauthority with no Changes in Reserves .[4]
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Business Definition for: Net Errors And Omissions

the net amount of the discrepancies that arise in calculations of balances of payments

the euro

The euro is the single currency shared by (currently) 16 of the European Union's Member States,which together make up the euro area. The introduction of the euro in 1999 was a major step inEuropean integration. It has also been one of its major successes: around 329 million EU citizensnow use it as their currency and enjoy its benefits, which will spread even more widely as other EU countries adopt the euro.

When the euro was launched on 1 January 1999, it became the new official currency of 11Member States, replacing the old national currencies such as the Deutschmark and the Frenchfranc in two stages. First introduced as a virtual currency for cash-less payments andaccounting purposes, while the old currencies continued to be used for cash payments andconsidered as 'sub-units' of the euro, it then appeared in physical form, as banknotes and coins,on 1 January 2002.

The euro is not the currency of all EU Member States. Two countries (Denmark and the UnitedKingdom) agreed an opt-out clause in the Treaty exempting them from participation, while theremainder (many of the newest EU members plus Sweden) have yet to meet the conditions for adopting the single currency. Once they do so, they will replace their national currency with theeuro.

Which countries have adopted the euro and when?

1999

Belgium, Germany, Ireland, Spain, France, Italy, Luxembourg, theNetherlands, Austria, Portugal and Finland

2001

Greece

2002

Introduction of euro banknotes and coins

2007

Slovenia

200 Cyprus, Malta


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8

2009

Slovakia

The euro and Economic and Monetary Union

All EU Member States form part of Economic and Monetary Union (EMU),which can be described as an advanced stage of economic integration basedon a single market. It involves close co-ordination of economic and fiscalpolicies and, for those countries fulfilling certain conditions, a singlemonetary policy and a single currency the euro.

The process of economic and monetary integration in the EU parallels thehistory of the Union itself. When the EU was founded in 1957, the MemberStates concentrated on building a 'common market'. However, over time itbecame clear that closer economic and monetary co-operation was desirablefor the internal market to develop and flourish further. But the goal of achieving full EMU and a single currency was not enshrined until the 1992Maastricht Treaty (Treaty on European Union), which set out the ground rulesfor its introduction. These say what the objectives of EMU are, who isresponsible for what, and what conditions Member States must meet in orderto adopt the euro. These conditions are known as the 'convergence criteria'(or 'Maastricht criteria') and include low and stable inflation, exchange ratestability and sound public finances.

Who manages it?

When the euro came into being, monetary policy became the responsibilityof the independent European Central Bank (ECB), which was created for thatpurpose, and the national central banks of the Member States havingadopted the euro. Together they compose the Eurosystem.

Fiscal policy (tax and spending) remains in the hands of individual nationalgovernments though they undertake to adhere to commonly agreed ruleson public finances known as the Stability and Growth Pact. They also retainfull responsibility for their own structural policies (labour, pension and capital


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markets), but agree to co-ordinate them in order to achieve the commongoals of stability, growth and employment.

Who uses it?

The euro is the currency of the 329 million people who live in the 16 euro-area countries. It is also used, either formally as legal tender or for practicalpurposes, by a whole array of other countries such as close neighbours andformer colonies.

It is therefore not surprising that the euro has rapidly become the secondmost important international currency after the dollar, and in some respects(e.g. the value of cash in circulation) has even overtaken it.

Why do we need it?

Apart from making travel easier, a single currency makes very goodeconomic and political sense. The framework under which the euro ismanaged makes it a stable currency with low inflation and low interest rates,and encourages sound public finances. A single currency is also a logicalcomplement to the single market which makes it more efficient. Using asingle currency increases price transparency, eliminates currency exchange

costs, oils the wheels of the European economy, facilitates internationaltrade and gives the EU a more powerful voice in the world. The size andstrength of the euro area also better protect it from external economicshocks, such as unexpected oil price rises or turbulence in the currencymarkets.

Last but not least, the euro gives the EUs citizens a tangible symbol of theirEuropean identity, of which they can be increasingly proud as the euro areaexpands and multiplies these benefits for its existing and future members.

European Option

What Does European Option Mean?An option that can only be exercised at the end of its life.


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Investopedia explains European OptionIn other words, you must ride the rollercoaster until the maturity date, and onlythen can you cash in.

What Does Fiat Money Mean?

Currency that a government has declared to be legal tender, despite the fact that it has nointrinsic value and is not backed by reserves. Historically, most currencies were based on physical commodities such as gold or silver, but fiat money is based solely on faith.

Investopedia explains Fiat MoneyMost of the world's paper money is fiat money. Because fiat money is not linked to physicalreserves, it risks becoming worthless due to hyperinflation. If people lose faith in a nation's paper currency, the money will no longer hold any value.

What Does Floating Exchange Rate Mean?

A country's exchange rate regime where its currency is set by the foreign-exchange marketthrough supply and demand for that particular currency relative to other currencies. Thus,floating exchange rates change freely and are determined by trading in the forex market. This isin contrast to a "fixed exchange rate" regime.

Investopedia explains Floating Exchange RateIn some instances, if a currency value moves in any one direction at a rapid and sustained rate,central banks intervene by buying and selling its own currency reserves (i.e. Federal Reserve inthe U.S.) in the foreign-exchange market in order to stabilize the localcurrency. However, central banks are reluctant to intervene, unless absolutely necessary, in afloating regime.

Foreign aid

the international transfer of capital , goods, or services from a country or internationalorganization for the benefit of the recipient country or its population. Aid can be economic,military, or emergency humanitarian (e.g., aid given following natural disasters ).

Global Depositary Receipt - GDR
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What Does Global Depositary Receipt - GDR Mean?1. A bank certificate issued in more than one country for shares in a foreigncompany. The shares are held by a foreign branch of an international bank. Theshares trade as domestic shares, but are offered for sale globally through thevarious bank branches.

2. A financial instrument used by private markets to raise capital denominated ineither U.S. dollars or euros.

Investopedia explains Global Depositary Receipt - GDR1. A GDR is very similar to an American Depositary Receipt.

2. These instruments are called EDRs when private markets are attempting toobtain euros.

In finance , a hedge is a position established in one market in an attempt to offsetexposure to price fluctuations in some opposite position in another market with thegoal of minimizing one's exposure to unwanted risk . There are many specificfinancial vehicles to accomplish this, including insurance policies , forward contracts ,swaps , options , many types of over-the-counter and derivative products, and

perhaps most popularly, futures contracts . Public futures markets were establishedin the 1800s to allow transparent, standardized, and efficient hedging of agriculturalcommodity prices; they have since expanded to include futures contracts forhedging the values of energy , precious metals , foreign currency , and interest rate fluctuations.

Hedging an agricultural commodity price

A typical hedger might be a commercial farmer. The market values of wheat and other cropsfluctuate constantly as supply and demand for them vary, with occasional large moves in either direction. Based on current prices and forecast levels at harvest time, the farmer might decidethat planting wheat is a good idea one season, but the forecast prices are only that - forecasts.Once the farmer plants wheat, he is committed to it for an entire growing season. If the actual

price of wheat rises a lot between planting and harvest, the farmer stands to make a lot of unexpected money, but if the actual price drops by harvest time, he could be ruined.
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If the farmer sells a number of wheat futures contracts equivalent to his crop size at plantingtime, he effectively locks in the price of wheat at that time - the contract is an agreement todeliver a certain number of bushels of wheat on a certain date in the future for a certain fixed

price. He has hedged his exposure to wheat prices; he no longer cares whether the current pricerises or falls, because he is guaranteed a price by the contract. He no longer needs to worry about

being ruined by a low wheat price at harvest time, but he also gives up the chance at makingextra money from a high wheat price at harvest times.

Hedging means reducing or controlling risk. This is done by taking a position in the futuresmarket that is opposite to the one in the physical market with the objective of reducing or limiting risks associated with price changes.

Hedging is a two-step process. A gain or loss in the cash position due to changes in price levelswill be countered by changes in the value of a futures position. For instance, a wheat farmer cansell wheat futures to protect the value of his crop prior to harvest. If there is a fall in price, the

loss in the cash market position will be countered by a gain in futures position.

How hedging is done

In this type of transaction, the hedger tries to fix the price at a certain level with the objective of ensuring certainty in the cost of production or revenue of sale.

The futures market also has substantial participation by speculators who take positions based onthe price movement and bet upon it. Also, there are arbitrageurs who use this market to pocket

profits whenever there are inefficiencies in the prices. However, they ensure that the prices of spot and futures remain correlated.

Example - case of steel

An automobile manufacturer purchases huge quantities of steel as raw material for automobile production. The automobile manufacturer enters into a contractual agreement to exportautomobiles three months hence to dealers in the East European market.

This presupposes that the contractual obligation has been fixed at the time of signing thecontractual agreement for exports. The automobile manufacturer is now exposed to risk in theform of increasing steel prices. In order to hedge against price risk, the automobile manufacturer can buy steel futures contracts, which would mature three months hence. In case of increasing or

decreasing steel prices, the automobile manufacturer is protected. Let us analyse the differentscenarios:

Increasing steel prices

If steel prices increase, this would result in increase in the value of the futures contracts, whichthe automobile manufacturer has bought. Hence, he makes profit in the futures transaction. But


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the automobile manufacturer needs to buy steel in the physical market to meet his exportobligation. This means that he faces a corresponding loss in the physical market.

But this loss is offset by his gains in the futures market. Finally, at the time of purchasing steel inthe physical market, the automobile manufacturer can square off his position in the futures

market by selling the steel futures contract, for which he has an open position.

Decreasing steel prices

If steel prices decrease, this would result in a decrease in the value of the futures contracts, whichthe automobile manufacturer has bought. Hence, he makes losses in the futures transaction. Butthe automobile manufacturer needs to buy steel in the physical market to meet his exportobligation.

This means that he faces a corresponding gain in the physical market. The loss in the futuresmarket is offset by his gains in the physical market. Finally, at the time of purchasing steel in the

physical market, the automobile manufacturer can square off his position in the futures market by selling the steel futures contract, for which he has an open position.

This results in a perfect hedge to lock the profits and protect from increase or decrease in rawmaterial prices. It also provides the added advantage of just-in time inventory management for the automobile manufacturer.

Understanding the meaning of buying/long hedge

A buying hedge is also called a long hedge. Buying hedge means buying a futures contract tohedge a cash position. Dealers, consumers, fabricators, etc, who have taken or intend to take an

exposure in the physical market and want to lock- in prices, use the buying hedge strategy.Benefits of buying hedge strategy:

To replace inventory at a lower prevailing cost. To protect uncovered forward sale of finished products.

The purpose of entering into a buying hedge is to protect the buyer against price increase of acommodity in the spot market that has already been sold at a specific price but not purchased asyet. It is very common among exporters and importers to sell commodities at an agreed-upon

price for forward delivery. If the commodity is not yet in possession, the forward delivery isconsidered uncovered.

Long hedgers are traders and processors who have made formal commitments to deliver aspecified quantity of raw material or processed goods at a later date, at a price currently agreedupon and who do not have the stocks of the raw material necessary to fulfill their forwardcommitment.

Understanding the meaning of selling/short hedge


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A selling hedge is also called a short hedge. Selling hedge means selling a futures contract tohedge.

Uses of selling hedge strategy.

To cover the price of finished products. To protect inventory not covered by forward sales. To cover the prices of estimated production of finished products.

Short hedgers are merchants and processors who acquire inventories of the commodity in thespot market and who simultaneously sell an equivalent amount or less in the futures market. Thehedgers in this case are said to be long in their spot transactions and short in the futurestransactions.

Understanding the basis

Usually, in the business of buying or selling a commodity, the spot price is different from the price quoted in the futures market. The futures price is the spot price adjusted for costs likefreight, handling, storage and quality, along with the impact of supply and demand factors.

The price difference between the spot and futures keeps on changing regularly. This pricedifference (spot - futures price) is known as the basis and the risk arising out of the difference isdefined as basis risk. A situation in which the difference between spot and futures prices reduces(either negative or positive) is defined as narrowing of the basis.

A narrowing of the basis benefits the short hedger and a widening of the basis benefits the longhedger in a market characterized by contango - when futures price is higher than spot price. In a

market characterized by backwardation - when futures quote at a discount to spot price - anarrowing of the basis benefits the long hedger and a widening of the basis benefits the shorthedger.

However, if the difference between spot and futures prices increases (either on negative or positive side) it is defined as widening of the basis. The impact of this movement is opposite tothat as in the case of narrowing.

Chiragra Chakrabarty is vice president, training, consultancy & research initiatives, MultiCommodity Exchange of India.

RISK AND return s in the case of an investment are like the two sides of the same coin. Thoughhigh returns are the basic motive behind investment, the dodgy element of risk cannot beoverlooked. Now, future is uncertain, so one has to protect oneself from future uncertainties. Soone hedges against possible uncertainties and mitigates risk by counterbalancing.
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Hedging is practised in day-to-day life. For example, when we are kids, our parents get usvaccinated against many diseases so we are not affected by the said diseases in future. Another example is insurance. When people decide to hedge, they are insuring themselves against anegative event. This doesnt prevent the negative event from happening; if it does happen but

youre properly hedged, the impact of the event is reduced. However in the financial market,hedging is more complicated than insurance; hedging against investment risk calls for usingmarket instruments strategically to offset the risks arising from any adverse price movement.

Hedging refers to a method of reducing the risk of loss caused by price fluctuation. Portfoliomanagers and corporations use hedging techniques to reduce their exposure to various risks.Before going into how hedging is done, let me brief you with the basic hedging strategies:

Options :

The right, but not the obligation, to buy or sell a specified quantity of the underlying asset at afixed price (called exercise price), on or before the expiration date. There are two kinds of options.

1. Call option : The right to buy a specified quantity of the underlying asset at a fixedexercise price on or before the expiry date.

2. Putoption : The right to sell a specified quantity of the underlying asset at a fixed exercise price on or before the expiration date.

Futures :

A contractual agreement, made only on the trading floor of a futures exchange, to buy or sell a particular commodity, financial instrument, etc, at a pre-determined price in future. Futurescontracts detail the quality and quantity of the underlying asset; they are standardised to facilitatetrading on a futures exchange. Some futures contracts may call for physical delivery of the asset,while others are settled in cash.

Mechanism of hedging :

As we know hedging is done to reduce or control risk. This can be done by taking a position in

the futures market or by buying a put option with the objective of reducing or limiting the risksassociated with price fall. Lets see examples of both.

Futures:

For a garment manufacturer and exporter, cotton is an essential raw material. The exporter entersinto a contractual agreement to export shirts three months hence to dealers in the Europeanmarket. This means that a contractual obligation has been fixed at the time of signing the
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contract for exports. The garment manufacturer is now exposed to the risk of rising cotton prices.In order to hedge against price risk, the garment manufacturer can buy futures contracts oncotton, which will mature three months hence. In case of a rise in cotton prices, the manufacturer is protected from the risk of loss. Lets analyse the different scenarios:

A rise in cotton price: If cotton prices rise, it will lead to an increase in the value of the futurescontract, which the cotton manufacturer has bought. Therefore he earns a profit in his futurestransaction. But the manufacturer has to buy cotton in the physical market in order to meet hisexport obligation. Since cotton prices have risen he faces a loss in the physical market. But hislosses will be offset by his gains in the futures market. The cotton manufacturer can recover theloss incurred in the physical market by selling the futures contract, in which he has an open

position (called closing out, technically).

A fall in cotton price: If cotton prices fall, it will lead to erosion in the value of the futurescontract, which the cotton manufacturer has bought. This way the manufacturer will incur a losson his futures contract. But the manufacturer has to buy cotton in the physical market. Since

cotton prices have declined in the physical market, he gains. Therefore the losses incurred in thefutures market will be offset by the gains made in the physical market. This way one can hedgeagainst possible losses arising from fluctuation in raw material prices.

Options: One of the other popular strategies of hedging involves the use of the options market.Lets take an example:

Suppose you buy 100 shares of ABC Company @ Rs 100 per share. Now you want to minimiseyour risk of loss. You can do this by buying a put option or writing (or selling) a call option.Buying the put option gives you the right to sell your shares at a predetermined price.

Suppose the exercise or strike price (predetermined price) is Rs 100 per share. Now if the priceof the share falls to Rs 80, being the holder (buyer) of the put option you have the right toexercise your option, which means you can sell the share @ Rs 100 per share, thereby making a

profit of Rs 20 per share. This way you can hedge against the risk of fall in the price of shares.

One can hedge against interest rate, currency, etc. Some other hedging tools apart from whathave been discussed above can also be used in hedging such as by selling short, etc. Risk is anessential yet precarious element associated with investment. Regardless of what kind of investor one aims to become, a basic knowledge of hedging strategies will lead to better awareness.Whether or not you decide to use derivatives, learning about how hedging works will helpadvance your understanding of the market. It will always help you become a better investor.

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