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    foreign exchangederivatives

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    A foreign exchange derivative is a financial

    derivative where the underlying is a particularcurrency and/or its exchange rate. Theseinstruments are used either for currencyspeculation and arbitrage or for hedging

    foreign exchange risk.

    Foreign Exchange Derivative:

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    Derivatives are used byinvestors to:

    Provide leverage

    Speculation

    HedgingExposure

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    Types of DerivativesForwardsFutures

    Options

    SwapsWarrants

    Swaptions

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    How forex derivatives work

    Derivatives can be used to restructure transactions so thatpositions can be moved off balance sheet, floating rates can be

    changed into fixed rates (and vice versa), currency

    denominations can be changed, interest or dividend income can

    become capital gains (and vice versa), liability can be turned into

    assets or revenue, payments can be moved into differentperiods in order to manipulate tax liabilities and earnings reports,

    and high yield securities can be made to look like convention

    AAA investments.

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    How forex derivatives work Companies entered into derivatives structures to reduce their interest costs. Many

    companies had gone for dollar loans.

    The appreciation of the rupee eroded the revenues and profits of exporters as theymade fewer rupees for every dollar earned abroad. On the other hand, they had toservice the dollar loans, on which they incurred a higher interest outflow.

    To offset the losses due to the rupee appreciation, corporates did derivatives trade,

    hoping to make money through them. One popular option was a currency swap in theJapanese yen or the Swiss franc, with embedded option protection.

    The option protection was structured in such a way that the option protection knockedout (disappeared) if the dollar depreciated beyond a point against the franc/yen.

    The Japanese yen or the Swiss franc was a natural choice, considered the most stable

    currencies against the dollar. In the last 25 years, for instance, the Swiss franc hasnever moved below 1.11 to the dollar and hence corporates hedged the swap bybuying options, where the knock-out will get activated if the Swiss franc moved below1.10 to a dollar. The strategy worked well for companies.

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    Danger of derivatives

    Derivatives lead to transparency problems in two basic ways- One, they distort the meaning of balance sheets as the basis for measuring the risk profile of

    firms, central banks and nation accounts.

    Two, when traded over-the-counter, derivatives lack adequate reporting requirements andgovernment surveillance. The proposed BIS Basel II Accord aims to address these problems.

    The lack of reporting and government surveillance limits the government's and marketparticipants' ability to assess the amount of open interest in the market.

    Another problem is the tendency for derivatives to be used to raise the level of riskrelative to capital.

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    Leverage is a double-edged sword. Leverage enablesderivatives to offer a more efficient use of capital for hedgingor investing, and at the same time it reduces the amount ofcapital backing a given amount of price exposure (ie, the sizeof a position).

    Another problem posed by the presence of foreign exchange

    derivatives markets is that price discovery process in thosemarkets will, under many circumstances, indicate a futuredevaluation Interest rate differential

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    This interest rate differential means that theequilibrium forward or swap rate will always be higherthan the spot rate - thus indicating that the currencywill depreciate at the rate as the interest ratedifferential.

    If the credit market in the developing country is notperfectly efficient, then foreign exchange marketmakers will not provide forward and swap contracts atrates that do not include a market risk premium. If amarket risk premium is added to the interest ratedifferential, then the forward and swap rates willindicate a greater rate of depreciation.

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    Problems faced by banks

    and corporate in 2008

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    ProblemsGrowth of the Index of Industrial Production (IIP) was

    on a downhill.

    Problems of Indian industry compounded during 2008.

    Export-oriented industries such as garments, textiles,leather and engineering have suffered a sharp fall.

    Negative Indian export for 11 consecutive months

    (October 08 to August 09).

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    Measures

    Indian government and the Reserve Bank ofIndia have initiated a number of policymeasures since September 2008.

    Banks have been encouraged to lend more,

    especially housing and automobile loans.Positive impact was visible on domestic

    demand, notably demand for consumerdurables, since April 2009.

    It contributed to the revival in the growth ofindustrial production by June 2009.