Forex Market Projct

8/11/2019 Forex Market Projct

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1. INTRODUCTION

The foreign exchange market is the market in which individuals, firms and banks buy and sell foreign

currencies or foreign exchange. The purpose of the foreign exchange market is to permit transfers ofpurchasing power denominated in one currency to another i.e. to trade one currency for another. For

example, a Japanese exporter sells automobiles to a U.S. dealer for dollars, and a U.S. manufacturer sells

machine tools to Japanese company for yen. Ultimately, however, the U.S. company will be interested in

receiving dollars, whereas the Japanese exporter will want yen. ecause it would be inconvenient for the

individual buyers and sellers of foreign exchange to seek out one another, a foreign exchange market has

developed to act as an intermediary.

About foreign exchange market:

!articularly for foreign exchange market there is no market place called the foreign exchange market. "t

is mechanism through which one country#s currency can be exchange i.e. bought or sold for the currency

of another country. The foreign exchange market does not have any geographic location. Foreign

exchange market is described as an $T% &over the counter' market as there is no physical place where

the participant meets to execute the deals, as we see in the case of stock exchange. The largest foreign

exchange market is in (ondon, followed by the )ew *ork, Tokyo, +urich and Frankfurt. The markets

are situated throughout the different time one of the globe in such a way that one market is closing theother is beginning its operation. Therefore it is stated that foreign exchange market is functioning

throughout - hours a day. "n most market US dollar is the vehicle currency, vi., the currency sued to

dominate international transaction. "n "ndia, foreign exchange has been given a statutory definition.

Section - &b' of foreign exchange regulation /%T, 0123 states4 Foreign exchange means foreign

currency and includes4

All deposits, credits and balance payable in any foreign currency and any draft, travelers

cheques, letter of credit and bills of exchange. Expressed or drawn in India currency but payable

in any foreign currency.

/ny instrument payable, at the option of drawee or holder thereof or any other party thereto, either in

"ndian currency or in foreign currency or partly in one and partly in the other. "n order to provide

facilities to members of the public and foreigners visiting "ndia, for exchange of foreign currency into

"ndian currency and vice5versa 6" has granted to various firms and individuals, license to undertake

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money5changing business at seas7airport and tourism place of tourist interest in "ndia. esides certain

authoried dealers in foreign exchange &banks' have also been permitted to open exchange bureaus.

Following are the ma8or bifurcations4

Full flege mone!changer"9 they are the firms and individuals who have been authoried to take both,

purchase and sale transaction with the public.

Re"tricte mone!changer9 they are shops, emporia and hotels etc. that have been authoried only to

purchase foreign currency towards cost of goods supplied or services rendered by them or for

conversion into rupees.

Authori#e ealer"9 they are one who can undertake all types of foreign exchange transaction. anks

are only the authoried dealers. The only exceptions are Thomas cook, western union, U/: exchange

which though, and not a bank is an /;. :ven among the banks 6" has categoried them as follows4

ranch / 9 They are the branches that have )ostro and


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$. FOR%& 'AR(%T: A )I*TORICA+ ,%R*,%CTI-%

%arl! *tage": 1/0100

The evolution of "ndia#s foreign exchange market may be viewed in line with the shifts in "ndia#s

exchange rate policies over the last few decades from a par value system to a basket5peg and further to a

managed float exchange rate system. ;uring the period from 012 to 0120, "ndia followed the par value

system of exchange rate. "nitially the rupee#s external par value was fixed at .0> grains of fine gold.

The 6eserve ank maintained the par value of the rupee within the permitted margin of ?0 per cent

using pound sterling as the intervention currency. Since the sterling5dollar exchange rate was kept stable

by the US monetary authority, the exchange rates of rupee in terms of gold as well as the dollar and

other currencies were indirectly kept stable. The devaluation of rupee in September 011 and June 01@@

in terms of gold resulted in the reduction of the par value of rupee in terms of gold to -.AA and 0.A3

grains of fine gold, respectively. The exchange rate of the rupee remained unchanged between 01@@ and

0120.

Biven the fixed exchange regime during this period, the foreign exchange market for all practical

purposes was defunct. anks were re=uired to undertake only cover operations and maintain a Cs=uare#

or Cnear s=uare# position at all times. The ob8ective of exchange controls was primarily to regulate the

demand for foreign exchange for various purposes, within the limit set by the available supply. The

Foreign :xchange 6egulation /ct initially enacted in 012 was placed on a permanent basisin 01>2. "n

terms of the provisions of the /ct, the 6eserve ank, and in certain cases, the %entral Bovernmentcontrolled and regulated the dealings in foreign exchange payments outside "ndia, export and import of

currency notes and bullion, transfers of securities between residents and non5residents, ac=uisition of

foreign securities, etc3 .

Dith the breakdown of the retton Doods System in 0120 and the floatation of ma8or currencies, the

conduct of exchange rate policy posed a serious challenge to all central banks world wide as currency

fluctuations opened up tremendous opportunities for market players to trade in currencies in a borderless

market. "n ;ecember 0120, the rupee was linked with pound sterling. Since sterling was fixed in terms

of US dollar under the Smithsonian /greement of 0120, the rupee also remained stable against dollar. "n

order to overcome the weaknesses associated with a single currency peg and to ensure stability of the

exchange rate, the rupee, with effect from September 012>, was pegged to a basket of currencies. The

currency selection and weights assigned were left to the discretion of the 6eserve ank. The currencies

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included in the basket as well as their relative weights were kept confidential in order to discourage

speculation. "t was around this time that banks in "ndia became interested in trading in foreign exchange

Formati2e ,erio: 1031$

The impetus to trading in the foreign exchange market in "ndia came in 012A when banks in "ndia were

allowed by the 6eserve ank to undertake intra5day trading in foreign exchange and were re=uired to

comply with the stipulation of maintaining Cs=uare# or Cnear s=uare# position only at the close of

business hours each day. The extent of position which could be left uncovered overnight &the open

position' as well as the limits up to which dealers could trade during the day were to be decided by the

management of banks. The exchange rate of the rupee during this period was officially determined by

the 6eserve ank in terms of a weighted basket of currencies of "ndia#s ma8or trading partners and the

exchange rate regime was characterised by daily announcement by the 6eserve ank of its buying and

selling rates to the /uthorised ;ealers &/;s' for undertaking merchant transactions. The spread between

the buying and the selling rates was E.> per cent and the market began to trade actively within this range.

/;s were also permitted to trade in cross currencies &one convertible foreign currency versus another'.

owever, no Cposition# in this regard could originate in overseas markets.

/s opportunities to make profits began to emerge, ma8or banks in "ndia started =uoting two way prices

against the rupee as well as in cross currencies and, gradually, trading volumes began to increase. This

led to the adoption of widely different practices &some of them being irregular' and the need was felt for

a comprehensive set of guidelines for operation of banks engaged in foreign exchange business.

/ccordingly, the CBuidelines for "nternal %ontrol over Foreign :xchange usiness#, were framed for

adoption by the banks in 01A0. The foreign exchange market in "ndia till the early 011Es, however,

remained highly regulated with restrictions on external transactions, barriers to entry, low li=uidity and

high transaction costs. The exchange rate during this period was managed mainly for facilitating "ndia#s

imports. The strict control on foreign exchange transactions through the Foreign :xchange 6egulations

/ct &F:6/' had resulted in one of the largest and most efficient parallel markets for foreign exchange in

the world, i.e., the hawala &unofficial' market.

y the late 01AEs and the early 011Es, it was recognied that both macroeconomic policy and structural

factors had contributed to balance of payments difficulties. ;evaluations by "ndia#s competitors had

aggravated the situation. /lthough exports had recorded a higher growth during the second half of the

01AEs &from about .3 per cent of B;! in 01A25AA to about >.A per cent of B;! in 011E510', trade

imbalances persisted at around 3 percent of B;!. This combined with a precipitous fall in invisible


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receipts in the form of private remittances, travel and tourism earnings in the year 011E510 led to further

widening of current account deficit. The weaknesses in the external sector were accentuated by the Bulf

crisis of 011E510. /s a result, the current account deficit widened to 3.- per cent of B;! in 011E510 and

the capital flows also dried up necessitating the adoption of exceptional corrective steps. "t was against

this backdrop that "ndia embarked on stabilisation and structural reforms in the early 011Es.

,o"tReform ,erio: 1$ on4ar"

This phase was marked by wide ranging reform measures aimed at widening and deepening the foreign

exchange market and liberalisation of exchange control regimes. / credible macroeconomic, structural

and stabiliation programme encompassing trade, industry, foreign investment, exchange rate, public

finance and the financial sector was put in place creating an environment conducive for the expansion of

trade and investment. "t was recognised that trade policies, exchange rate policies and industrial policies

should form part of an integrated policy framework to improve the overall productivity, competitiveness

and efficiency of the economic system, in general, and the external sector, in particular. /s a stabilsation

measure, a two step downward exchange rate ad8ustment by 1 per cent and 00 per cent between July 0

and 3, 0110 was resorted to counter the massive drawdown in the foreign exchange reserves, to instill

confidence among investors and to improve domestic competitiveness. / two5step ad8ustment of

exchange rate in July 0110 effectively brought to close the regime of a pegged exchange rate. /fter the

Bulf crisis in 011E510, the broad framework for reforms in the external sector was laid out in the 6eport

of the igh (evel %ommittee on alance of !ayments &%hairman4 ;r. %. 6angara8an'. Following the

recommendations of the %ommittee to move towards the market5determined exchange rate, the

(iberalised :xchange 6ate Ganagement System &(:6GS' was put in place in Garch 011- initially

involving a dual exchange rate system. Under the (:6GS, all foreign exchange receipts on current

account transactions &exports, remittances, etc.' were re=uired to be surrendered to the /uthorised

;ealers &/;s' in full. The rate of exchange for conversion of @E per cent of the proceeds of these

transactions was the market rate =uoted by the /;s, while the remaining E percent of the proceeds

were converted at the 6eserve ank#s official rate. The /;s, in turn, were re=uired to surrender these E

per cent of their purchase of foreign currencies to the 6eserve ank. They were free to retain the balance

@E per cent of foreign exchange for selling in the free market for permissible transactions. The (:6GS

was essentially a transitional mechanism and a downward ad8ustment in the official exchange rate took

place in early ;ecember 011- and ultimate convergence of the dual rates was made effective from

Garch 0, 0113, leading to the introduction of a market5determined exchange rate regime.

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The dual exchange rate system was replaced by a unified exchange rate system in Garch 0113, whereby

all foreign exchange receipts could be converted at market determined exchange rates. $n unification of

the exchange rates, the nominal exchange rate of the rupee against both the US dollar as also against a

basket of currencies got ad8usted lower, which almost nullified the impact of the previous inflation

differential. The restrictions on a number of other current account transactions were relaxed. The

unification of the exchange rate of the "ndian rupee was an important step towards current account

convertibility, which was finally achieved in /ugust 011, when "ndia accepted obligations under

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5.6A*IC CONC%,T* IN FOR%& TRADIN7 4

6i an A"k Rate:

The bid7ask spread is the difference between the price at which a bank or market maker will sell &HaskH,

or HofferH' and the price at which a market taker will buy &HbidH' from a wholesale or retail customer.

The customer will buy from the market5maker at the higher HaskH price, and will sell at the lower HbidH

price, thus giving up the HspreadH as the cost of completing the trade.

'argin Traing:

Foreign exchange is normally traded on margin. / relatively small deposit can control much larger

positions in the market. For trading the main currencies, Saxo ank re=uires a 0I margin deposit. This

means that in order to trade one million dollars, you need to place 8ust US; 0E,EEE by way of security.

"n other words, you will have obtained a gearing of up to 0EE times. This means that a change of, say

-I, in the underlying value of your trade will result in a -EEI profit or loss on your deposit.

*to8lo"" i"ci8line:

There are significant opportunities and risks in foreign exchange markets. /ggressive traders might

experience profit7loss swings of -E53EI daily. This calls for strict stop5loss policies in positions that are

moving against you.

Fortunately, there are no daily limits on foreign exchange trading and no restrictions on trading hours

other than the weekend. This means that there will nearly always be an opportunity to react to moves in

the main currency markets and a low risk of getting caught without the opportunity of getting out. $fcourse, the market can move very fast and a stop5loss order is by no means a guarantee of getting out at

the desired level. For speculative trading, it is recommended to place protective stop5loss orders.

*8ot an for4ar traing:

Dhen you trade foreign exchange you are normally =uoted a spot price. This means that if you take no

further steps, your trade will be settled after two business days. This ensures that your trades are

undertaken sub8ect to supervision by regulatory authorities for your own protection and security. "f you

are a commercial customer, you may need to convert the currencies for international payments. "f you

are an investor, you will normally want to swap your trade forward to a later date. This can be

undertaken on a daily basis or for a longer period at a time. $ften investors will swap their trades

forward anywhere from a week or two up to several months depending on the time frame of the

investment.

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/lthough a forward trade is for a future date, the position can be closed out at any time 5 the closing part

of the position is then swapped forward to the same future value date.

Currenc! Trae Acro"" 7lobe 9 Inia

The FOUR maor currenc! 8air"

:U67US;

US;7J!*

US;7%F

B!7US;

Currenc! Cro""e"

:U67%F

:U67J!*

B!7J!*

:U67B!

Currencie" trae in Inia:

US;7")6

:U67")6

B!7")6

J!*7")6

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Currenc! %xchange" in Inia:

0. G% Stock :xchange &G% 9 S'-. )ational Stock :xchange &)S:'3. United Stock :xchange &US:'

The daily turnover of )S: and G% 9 S together is around 3E,EEE cr.

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Speculative activities by traders worldwide also affect exchange rate movements. For example, if

speculators think that the currency of a country is overvalued and will devalue in near future, they will

pull out their money from that country resulting in reduced demand for that currency and depreciating its

value.

FOR%I7N %&C)AN7% 'ANA7%'%NT ACT= 1

The change in the entire approach towards exchange control regulation has been the result of the

replacement of the Foreign :xchange 6egulation /ct, 0123, by the Foreign :xchange Ganagement /ct,

0111. The latter came into effect from June 0, -EEE. The change in the preamble itself signifies the

dramatic change in approach 55 from Hfor the conservation of the foreign exchange resourcesH in F:6/

0123, to Hfacilitate external trade and paymentsH under F:G/ 0111. /ny F:G/ violations are civil, not

criminal, offences, attracting monetary penalties, and not arrests or imprisonment.

The scheme of F:G/ and the notifications issued thereunder take into the account the convertibility of

the rupee for all current account transactions. "ndeed, there is now general freedom to authorised dealers

to sell currency for most current account transactions. $ne old limitation continues. /ll transactions in

foreign exchange have to be with authorised dealers, i.e. banks authorised to act as dealers in foreign

exchange by the 6eserve ank. The original rules, regulations, notifications, etc., under F:G/ are

contained in the /.;. &G./. series' %ircular )o. 00 of Gay 0@, -EEE. Subse=uent circulars have been

issued under the /.!. &;"6 series' nomenclature. "t is obviously impossible to incorporate all the current

regulations in a book of this type, particularly since the regulations keep changing. /n outline of the

basic framework of exchange control under F:G/ is in /nnexure >.3. ut its contents should not be

considered as either definitive or current and those interested need to keep up with the various circulars

and other communications on the sub8ect.

,artici8ant" in foreign exchange market

'arket ,la!er"

!layers in the "ndian market include &a' /;s, mostly banks who are authorised to deal in foreign

exchange, &b' foreign exchange brokers who act as intermediaries, and &c' customers 9 individuals,

corporates, who need foreign exchange for their transactions. Though customers are ma8or players in the

foreign exchange market, for all practical purposes they depend upon /;s and brokers. "n the spot

foreign exchange market, foreign exchange transactions were earlier dominated by brokers.

)evertheless, the situation has changed with the evolving market conditions, as now the transactions are

dominated by /;s. rokers continue to dominate the derivatives market.

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The main players in foreign exchange market are as follows4

0. Cu"tomer"4

The customers who are engaged in foreign trade participate in foreign exchange market by availing of

the services of banks. :xporters re=uire converting the dollars in to rupee and importers re=uire

converting rupee in to the dollars, as they have to pay in dollars for the goods7services they have

imported.

-.Commercial 6ank:

They are most active players in the forex market. %ommercial bank dealings with international

transaction offer services for conversion of one currency in to another. They have wide network of

branches. Typically banks buy foreign exchange from exporters and sells foreign exchange to the

importers of goods. /s every time the foreign exchange bought or oversold position. The balance

amount is sold or bought from the market.

3. Central 6ank:

"n all countries %entral bank have been charged with the responsibility of maintaining the external value

of the domestic currency. Benerally this is achieved by the intervention of the bank.

. %xchange 6roker":

Forex brokers play very important role in the foreign exchange market. owever the extent to which

services of foreign brokers are utilied depends on the tradition and practice prevailing at a particular

forex market center. "n "ndia as per F:;/" guideline the /ds are free to deal directly among themselves

without going through brokers. The brokers are not among to allowed to deal in their own account

allover the world and also in "ndia.

>.O2er"ea" Forex 'arket:

Today the daily global turnover is estimated to be more than US L 0.> trillion a day. The international

trade however constitutes hardly > to 2 I of this total turnover. The rest of trading in world forex market

is constituted of financial transaction and speculation. /s we know that the forex market is -5hour

market, the day begins with Tokyo and thereafter Singapore opens, thereafter "ndia, followed by

ahrain, Frankfurt, !aris, (ondon, )ew *ork, Sydney, and back to Tokyo.

@.*8eculator":

The speculators are the ma8or players in the forex market. ank dealing are the ma8or speculators in the

forex market with a view to make profit on account of favorable movement in exchange rate, take

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position i.e. if they feel that rate of particular currency is likely to go up in short term. They buy that

currency and sell it as soon as they are able to make =uick profit.

Cor8oration>" particularly multinational corporation and transnational corporation having business

operation beyond their national frontiers and on account of their cash flows being large and in multi

currencies get in to foreign exchange exposures. Dith a view to make advantage of exchange rate

movement in their favor they either delay covering exposures or do not cover until cash flow

materialie.

Ini2iuallike share dealing also undertake the activity of buying and selling of foreign exchange for

booking short term profits. They also buy foreign currency stocks, bonds and other assets without

covering the foreign exchange exposure risk. This also results in speculations.

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?.%&C)AN7% RAT% *@*T%'

%ountries of the world have been exchanging goods and services amongst themselves. This has been

going on from time immemorial. The world has come a long way from the days of barter trade. Dith theinvention of money the figures and problems of barter trade have disappeared. The barter trade has given

way ton exchanged of goods and services for currencies instead of goods and services. The rupee was

historically linked with pound sterling. "ndia was a founder member of the "GF. ;uring the existence of

the fixed exchange rate system, the intervention currency of the 6eserve ank of "ndia &6"' was the

ritish pound, the 6" ensured maintenance of the exchange rate by selling and buying pound against

rupees at fixed rates. The inter bank rate therefore ruled the 6" band. ;uring the fixed exchange rate

era, there was only one ma8or change in the parity of the rupee5 devaluation in June 01@@. ;ifferent

countries have adopted different exchange rate system at different time.

The following are some of the exchange rate system followed by various countries.

The 7ol *tanar

Gany countries have adopted gold standard as their monetary system during the last two decades of the

01he century. This system was in vogue till the outbreak of Dorld Dar 0. Under this system the parties

of currencies were fixed in term of gold. There were two main types of gold standard4

1 7ol "8ecie "tanar

Bold was recognied as means of international settlement for receipts and payments amongst countries.

Bold coins were an accepted mode of payment and medium of exchange in domestic market also. /

country was stated to be on gold standard if the following condition were satisfied4

Gonetary authority, generally the central bank of the country, guaranteed to buy and sell gold in

unrestricted amounts at the fixed price.

Gelting gold including gold coins, and putting it to different uses was freely allowed.

"mport and export of gold was freely allowed.

The total money supply in the country was determined by the =uantum of gold available for monetary

purpose.

$ 7ol 6ullion *tanar:

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Under this system, the money in circulation was either partly of entirely paper and gold served as

reserve asset for the money supply. owever, paper money could be exchanged for gold at any time. The

exchange rate varied depending upon the gold content of currencies. This was also known as M Gint

!arity Theory M of exchange rates..

6retton Boo" *!"tem

;uring the world wars, economies of almost all the countries suffered. "n order to correct the balance of

payments dise=uilibrium, many countries devalued their currencies. %onse=uently, the international

trade suffered a deathblow. "n 01, following Dorld Dar "", the United States and most of its allies

ratified the retton Doods /greement, which set up an ad8ustable parity exchange5rate system under

which exchange rates were fixed &!egged' within narrow intervention limits &pegs' by the United States

and foreign central banks buying and selling foreign currencies. This agreement, fostered by a new spirit

of international cooperation, was in response to financial chaos that had reigned before and during the

war. "n addition to setting up fixed exchange parities &par values' of currencies in relationship to gold,

the agreement established the "nternational Gonetary Fund &"GF' to act as the McustodianN of the

system. Under this system there were uncontrollable capital flows, which lead to ma8or countries

suspending their obligation to intervene in the market and the retton Dood System, with its fixed

parities, was effectively buried..

Floating Rate *!"tem

"n a truly floating exchange rate regime, the relative prices of currencies are decided entirely by the

market forces of demand and supply. There is no attempt by the authorities to influence exchange rate.

Dhere government interferes# directly or through various monetary and fiscal measures in determining

the exchange rate, it is known as managed of dirty float. !U6%/S")B !$D:6 !/6"T* &!!!'.

Therefore, under this theory the exchange rate was to be determined and the sole criterion being the

purchasing power of the countries. /s per this theory if there were no trade controls, then the balance of

payments e=uilibrium would always be maintained. Thus if 0>E ")6 buy a fountain pen and the same

fountain pen can be bought for US; -, it can be inferred that since - US; or 0>E ")6 can buy the same

fountain pen, therefore US; - O ")6 0>E.For example "ndia has a higher rate of inflation as compared

to country US then goods produced in "ndia would become costlier as compared to goods produced in

US. This would induce imports in "ndia and also the goods produced in "ndia being costlier would lose

in international competition to goods produced in US. This decrease in exports of "ndia as compared to

exports from US would lead to demand for the currency of US and excess supply of currency of "ndia.

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This in turn, cause currency of "ndia to depreciate in comparison of currency of US that is having

relatively more exports.

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0.FOR%I7N %&C)AN7% 'AR(%T *TRUCTUR%

'arket *egment"

Foreign exchange market activity in most :G:s takes place onshore with many countries prohibitingonshore entities from undertaking the operations in offshore markets for their currencies. Spot market is

the predominant form of foreign exchange market segment in developing and emerging market

countries. / common feature is the tendency of importers7exporters and other end5users to look at

exchange rate movements as a source of return without adopting appropriate risk management practices.

This, at times, creates uneven supplydem and conditions, often based on CCnews and views##. The lack of

forward market development reflects many factors, including limited exchange rate flexibility, the de

facto exchange rate insurance provided by the central bank through interventions, absence of a yield

curve on which to base the forward prices and shallow money markets, in which market5making banks

can hedge the maturity risks implicit in forward positions &%anales5Pril8enko, -EE'.

Gost foreign exchange markets in developing countries are either pure dealer markets or a combination

of dealer and auction markets. "n the dealer markets, some dealers become market makers and play a

central role in the determination of exchange rates in flexible exchange rate regimes. The bidoffer spread

reflects many factors, including the level of competition among market makers. "n most of the :G:s, a

code of conduct establishes the principles that guide the operations of the dealers in the foreign

exchange markets.

The "ndian foreign exchange market is a decentralised multiple dealership market comprising two

segments 9 the spot and the derivatives market. "n the spot market, currencies are traded at the

prevailing rates and the settlement or value date is two business days ahead. The two5day period gives

ade=uate time for the parties to send instructions to debit and credit the appropriate bank accounts at

home and abroad. The derivatives market encompasses forwards, swaps and options. Though forward

contracts exist for maturities up to one year, ma8ority of forward contracts are for one month, three

months, or six months. Forward contracts for longer periods are not as common because of the

uncertainties involved and related pricing issues. / swap transaction in the foreign exchange market is a

combination of a spot and a forward in the opposite direction. /s in the case of other :G:s, the spot

market is the dominant segment of the "ndian foreign exchange market. The derivative segment of the

foreign exchange market is assuming significance and the activity in this segment is gradually rising.

Funamental" in %xchange Rate

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:xchange rate is a rate at which one currency can be exchange in to another currency, say US; O 6s.A.

This rate is the rate of conversion of US dollar in to "ndian rupee and vice versa.

'etho" of uoting Rate

There are two methods of =uoting exchange rates.

0' Direct metho:

Foreign currency is kept constant and home currency is kept variable. "n direct =uotation, the principle

adopted by bank is to buy at a lower price and sell at higher price.

-' Inirect metho:

ome currency is kept constant and foreign currency is kept variable. ere the strategy used by bank is

to buy high and sell low. "n "ndia with effect from august -, 0113, all the exchange rates are =uoted in

direct method. "t is customary in foreign exchange market to always =uote two rates means one for

buying and another rate for selling. This helps in eliminating the risk of being given bad rates i.e. if a

party comes to know what the other party intends to do i.e. buy or sell, the former can take the letter for

a ride. There are two parties in an exchange deal of currencies. To initiate the deal one party asks for

=uote from another party and other party =uotes a rate. The party asking for a =uote is known as# asking

party and the party giving a =uotes is known as =uoting party. The advantage of two9way =uote is as

under

The market continuously makes available price for buyers or sellers

Two way prices limit the profit margin of the =uoting bank and comparison of one =uotewith another =uote can be done instantaneously.

/s it is not necessary any player in the market to indicate whether he intends to buy or

sale foreign currency, this ensures that the =uoting bank cannot take advantage by

manipulating the prices.

"t automatically insures that alignment of rates with market rates.

Two way =uotes lend depth and li=uidity to the market, which is so very essential for

efficient market. "n two way =uotes the first rate is the rate for buying and another forselling.

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A. FACTOR* AFF%CTIN7 %&C)AN7% RAT%*

"n free market, it is the demand and supply of the currency which should determine the exchange rates

but demand and supply is the dependent on many factors, which are ultimately the cause of the exchange

rate fluctuation, some times wild. The volatility of exchange rates cannot be traced to the single reason

and conse=uently, it becomes difficult to precisely define the factors that affect exchange rates.

owever, the more important among them are as follows4

Q*trength of %conom!

:conomic factors affecting exchange rates include hedging activities, interest rates, inflationary

pressures, trade imbalance, and euro market activities. "rving fisher, an /merican economist, developed

a theory relating exchange rates to interest rates. This proposition, known as the fisher effect, states that

interest rate differentials tend to reflect exchange rate expectation. $n the other hand, the purchasing5

power parity theory relates exchange rates to inflationary pressures. "n its absolute version, this theory

states that the e=uilibrium exchange rate e=uals the ratio of domestic to foreign prices. The relative

version of the theory relates changes in the exchange rate to changes in price ratios.

Q,olitical Factor

The political factor influencing exchange rates include the established monetary policy along with

government action on items such as the money supply, inflation, taxes, and deficit financing. /ctive

government intervention or manipulations, such as central bank activity in the foreign currency market,also have an impact. $ther political factors influencing exchange rates include the political stability of a

country and its relative economic exposure &the perceived need for certain levels and types of imports'.

Finally, there is also the influence of the international monetary fund.

Q %x8ectation of the Foreign %xchange 'arket

!sychological factors also influence exchange rates. These factors include market anticipation,

speculative pressures, and future expectations. / few financial experts are of the opinion that in today#s

environment, the only Ctrustworthy# method of predicting exchange rates by gut feel. ob :veling, vice

president of financial markets at SB, is corporate finance#s top foreign exchange forecaster for 0111.

eveling#s gut feeling has, defined convention, and his method proved uncannily accurate in foreign

exchange forecasting in 011A.SB ended the corporate finance forecasting year with a -.@@I error

overall, the most accurate among 01 banks. The secret to eveling#s intuition on any currency is keeping

abreast of world events. /ny event, from a declaration of war to a fainting political leader, can take its

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toll on a currency#s value. Today, instead of formal modals, most forecasters rely on an amalgam that is

part economic fundamentals, part model and part 8udgment.

Fiscal policy

"nterest rates

Gonetary policy

alance of payment

:xchange control

%entral bank intervention

Speculation

Technical factors

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23/41

1.CURR%NC@ RI*( 'ANA7%'%NT

Currenc! Ri"k

So, what precisely is currency riskR There is no point in focusing on an issue if one cannot first define it./lthough definitions vary within the academic community, a practical description of currency risk

would be4

The impact that unexpected exchange rate changes have on the value of the corporation

%urrency risk is very important to a corporation as it can have a ma8or impact on its cash flows, assets

and liabilities, net profit and ultimately its stock market value. /ssuming the corporation has accepted

that currency risk needs to be managed specifically and separately, it has three initial priorities4

0. ;efine what kinds of currency risk the corporation is exposed to

-. ;efine a corporate Treasury strategy to deal with these currency risks

3. ;efine what financial instruments it allows itself to use for this purpose

%urrency risk is simple in concept, but complex in reality. /t its most basic, it is the possible gain or loss

resulting from an exchange rate move. "t can affect the value of a corporation directly as a result of an

unhedged exposure or more indirectly.

;ifferent types of currency risk can also offset each other. For instance, take a US citien who owns

stock in a Berman auto manufacturer and exporter to the US. "f the :uro falls against the US dollar, the

US dollar value of the :uro5denominated stock falls and therefore on the face of it the individual sees

the US dollar value of their holding decline. owever, the Berman auto exporter should in fact benefit

from a weaker :uro as this makes the company#s exports to

the US cheaper, allowing them the choice of either maintaining US prices to maintain margin or cutting

them further to boost market share. Sooner or later, the stock market will realie this and mark up the

stock price of the auto exporter. Thus, the stock owner may lose on the currency translation, but gain on

the higher stock price. This is of course a very simple example and life unfortunately is rarely that

simple. For 8ust as a weaker :uro makes exports from the :uro5one cheaper, so it makes imports more

expensive. Thus, an exporter may not in fact feel the benefit of the currency translation through to

market share because higher import prices force it to raise export prices from where they would

otherwise would be according to the exchange rate.

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The first step in successfully managing currency ris is to acnowledge that such ris actually exists and

that it has to be managed in the general interest of the corporation and the corporation#s shareholders.

For some, this is of itself a difficult hurdle as there is still ma8or reluctance within corporate

management to undertake what they see as straying from their core, underlying business into the

speculative world of currency markets. The truth however is that the corporation is a participant in the

currency market whether it likes it or not if it has foreign currency5denominated exposure, that exposure

should be managed. To do anything else is irresponsible. The general trend within the corporate world

has however been in favour of recogniing the existence of and the need to manage currency risk. That

recognition does not of itself entail speculation. "ndeed, at its best, prudent currency hedging can be

defined as the elimination of speculation4

The real speculation is in fact not managing currency ris

The next step, however, is slightly more complex and that is to identify the nature and extent of the

currency risk or exposure. "t should be noted that the emphasis here is for the most part on non5financial

corporations, on manufacturers and service providers rather than on banks or other types of financial

institutions. )on5financial corporations generally have only a small amount of their total assets in the

form of receivables and other types of transaction. Gost of their assets are made up of inventory,

buildings, e=uipment and other forms of tangible MrealN assets. "n order to measure the effect of

exchange rate moves on a corporation, one first has to define the type and then the amount of risk

involved, or the Mvalue at riskN &


25/41

Translation risk is slightly more complex and is the result of the consolidation of parent company and

foreign subsidiary financial statements. This consolidation means that exchange rate impact on the

balance sheet of the foreign subsidiaries is transmitted or translated to the parent company#s balance.

Translation ris is thus balance sheet currency ris. Dhile most large multinational corporations

actively manage their transaction currency risk, many are less aware of the potential dangers of

translation risk.

The actual translation process in consolidating financial statements is done either at the average

exchange rate of the period or at the exchange rate at the period end, depending on the specific

accounting regulations affecting the parent company. /s a direct result, the consolidated results will vary

as either the average or the end5of5period exchange rate varies. Thus, all foreign currency5denominated

profit is exposed to translation currency risk as exchange rates vary. "n addition, the foreign currency

value of foreign subsidiaries is also consolidated on the parent company#s balance sheet, and that value

will vary accordingly. Translation risk for a foreign subsidiary is usually measured by the net assets

&assets less liabilities' that are exposed to potential exchange rate moves.

!roblems can occur with regard to translation risk if a corporation has subsidiaries whose accounting

books are local currency5denominated. For consolidation purposes, these books must of course be

translated into the currency of the parent company, but at what exchange rateR "ncome statements are

usually translated at the average exchange rate over the period. owever, deciding at what exchange rate

to translate the balance sheet is slightly trickier. There are generally three methods used by ma8or

multinational corporations for translating balance sheet risk, varying in how they separate assets and

liabilities between those that need to be translated at the McurrentN exchange rate at the time of

consolidation and those that are translated at the historical exchange rate4

The all current &closing rate' method

The monetary7non5monetary method

The temporal method

/s the name might suggest, the all current &closing rate' method translates all foreign currency

exposures at the closing exchange rate of the period concerned. Under this method, translation risk

relates to net assets or shareholder funds. This has become the most popular method of translating

balance exposure of foreign subsidiaries, both in the US and worldwide

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$n the other hand, the monetary7non5monetary method translates monetary items such as assets,

liabilities and capital at the closing rate and non5monetary items at the historical rate. Finally, the

temporal method breaks balance sheet items down in terms of whether they are firstly stated at

replacement cost, realiable value, market value or expected future value, or secondly stated at historic

cost. For the first group, these are translated at the closing exchange rate of the period concerned, for the

second, at the historical exchange rate.

The US accounting standard F/S >- and the UP#s SS/! -E apply to translation risk. Under

F/S >-, the translation of foreign currency revenues and costs is made at the average exchange rate of

the period. F/S >- generally uses the all current method for translation purposes, though it does have

several important provisions, notably regarding the treatment of currency hedging contracts. Under

SS/! -E, the corporation can use either the current or average rate. Benerally, there has been a shift

among multinational corporations towards using the average rather than the closing rate bec

ause this is seen as a truer reflection of the translation risk faced by the corporation during the period.

%conomic Ri"k

The translation of foreign subsidiaries concerns the consolidated group balance sheet. owever, this

does not affect the real MeconomicN value or exposure of the subsidiary. :conomic risk focuses on how

exchange rate moves change the real economic value of the corporation, focusing on the present value of

future operating cash flows and how this changes in line with exchange rate changes. Gore specifically,

the economic risk of a corporation reflects the effect of exchange rate changes on items such as export

and domestic sales, and the cost of domestic and imported inputs. /s with translation risk, calculating

economic risk is complex, but clearly necessary to be able to assess how exchange rate changes can

affect the present value of foreign subsidiaries. :conomic risk is usually applied to the present value of

future operating cash flows of a corporation#s foreign subsidiaries. owever, it can also be applied to the

parent company#s operations and how the present value of those change in line with exchange rate

changes.

Summariing this part, transaction risk deals with the effect of exchange rate moves on transactional

exposure such as accounts receivable7payable or dividends. Translation risk focuses on how exchange

rate moves can affect foreign subsidiary valuation and therefore the valuation of the consolidated group

balance sheet. Finally, economic risk deals with the effect of exchange rate changes to the present value

of future operating cash flows, focusing on the Mcurrency of determinationN of revenues and operating

expenses. ere it is important to differentiate between the currency in which cash flows are denominated

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and the currency that may determine the nature and sie of those cash flows. The two are not necessarily

the same. To complicate the issue further, there is the small matter of the parent company#s currency,

which is used to consolidate the financial statements. "f a parent company has foreign currency5

denominated debt, this is recorded in the parent company#s currency, but the value of its legal obligation

remains in the currency denomination of the debt. "n sum, transaction risk is 8ust the tip of the iceberg

$f necessity, the reality of currency risk is very case5specific. That said, there has been an attempt by the

academic and economic communities to apply the traditional exchange rate models to the corporate

world for the purpose of demonstrating how exchange rates impact a corporation.

!!! &or the law of one price' suggests that price differentials of the same good in different countries

re=uire an exchange rate ad8ustment to offset them. The international Fisher effect suggests that the

expected change in the exchange rate is e=ual to the interest rate differential. The unbiased forward rate

theory suggests that the forward exchange rate is e=ual to the expected exchange rate.

Benerally, these theories are grounded in the efficient market hypothesis and therefore flawed at best.

$ver the long term, these traditional MrulesN of exchange rate theory suggest that competition and

arbitrage should neutralie the effect of exchange rate changes on returns and on the valuation of the

corporation. :=ually, locking into the forward rate should, according to the unbiased forward rate theory,

offer the same return as remaining exposed to currency risk, as this theory suggests that the distribution

of probability should be e=ual on either side of the forward rate.

The unfortunate thing about such models, however worthy the attempt, is that they do not and cannot

deal with the practical realities of managing currency risk. Dhat academics regard as Mtemporary

deviationsN from where the model suggests the exchange rate should be can be sufficient and substantial

enough to cause painful and intolerable deterioration to both the !V( and the balance sheetR

To conclude this part, a corporation should define and seek to =uantify the types of currency risk to

which it is exposed in order then to be able to go about creating a strategy for managing that currency

risk.

Core ,rinci8le" for 'anaging Currenc! Ri"k

0.Determine the t!8e" of currenc! ri"k to 4hich the cor8oration i" ex8o"e 9 reak these down into

transaction, translation and economic risk, making specific reference to what currencies are related to

each type of currency risk.

-. %"tabli"h a "trategic currenc! ri"k management 8olic! 9 $nce currency risk types have been

agreed on, corporate Treasury should establish and document a strategic currency risk Wmanagement

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policy to deal with these types of risks. This policy should include the corporation#s general approach to

currency risk, whether it wants to hedge or trade that risk and its core hedging ob8ectives.

3. Create a mi""ion "tatement for Trea"ur!9 "t is crucial to create a set of values and principles which

embody the specific approach taken by the Treasury towards managing currency risk, agreed upon by

senior management at the time of establishing and documenting the risk management policy.

. Detail currenc! heging a88roach 9 aving established the overall currency risk management

policy, the corporation should detail how that policy is to be executed in practice, including the types of

financial instruments that could be used for hedging, the process by which currency hedging would be

executed and monitored and procedures for monitoring and reviewing existing currency hedges.

>. Centrali#ing Trea"ur! o8eration" a" a "ingle centre of excellence 9 Treasury operations can be

more effectively and efficiently managed if they are centralied. This makes it easier to ensure all

personnel are clear about the Treasury#s mission statement and hedging approach. Thus, the Treasury

can be run as a single centre of excellence within the corporation, ensuring the =uality of individual

members. (arge multinational corporations should consider creating a position of chief dealer to manage

the dealing team, as the demands of a Treasurer often exceed the ability to manage all positions and

exposures on a real5time basis. The currency dealing team must have the same level of expertise as their

counterparty banks.

@. Ao8t uniform "tanar" for accounting for currenc! ri"k 9 "n line with the centraliing of

Treasury operations, uniform accounting procedures with regard to currency risk should be adopted,

creating and ensuring transparency of risk. %reate benchmarks for measuring the performance of

currency hedging.

2. )a2e inhou"e moelling an foreca"ting ca8acit! 9 %urrency forecasting is as important as

execution. Dhile Treasury may rely on its core banks for forecasting exchange rates relative to its needs,

it should also have its own forecasting ability, linked in with its operational observations which are

fre=uently more real time than any bank is capable of. Treasury should also be able to model all its

hedging positions using


29/41

1.FOR%I7N %&C)AN7% RI*( 'ANA7%'%NT: ,ROC%** 9 N%C%**IT@

Firms dealing in multiple currencies face a risk &an unanticipated gain7loss' on account of

sudden7unanticipated changes in exchange rates, =uantified in terms of exposures. :xposure is defined

as a contracted, pro8ected or contingent cash flow whose magnitude is not certain at the moment and

depends on the value of the foreign exchange rates. The process of identifying risks faced by the firm

and implementing the process of protection from these risks by financial or operational hedging is

defined as foreign exchange risk management. This paper limits its scope to hedging only the foreign

exchange risks faced by firms.

(in" of Foreign %xchange %x8o"ure

6isk management techni=ues vary with the type of exposure &accounting or economic' and term of

exposure. /ccounting exposure, also called translation exposure, results from the need to restate foreign

subsidiaries# financial statements into the parent#s reporting currency and is the sensitivity of net income

to the variation in the exchange rate between a foreign subsidiary and its parent. :conomic exposure is

the extent to which a firmXs market value, in any particular currency, is sensitive to unexpected changes

in foreign currency. %urrency fluctuations affect the value of the firm#s operating cash flows, income

statement, and competitive position, hence market share and stock price. %urrency fluctuations also

affect a firmXs balance sheet by changing the value of the firmXs assets and liabilities, accounts payable,

accounts receivables, inventory, loans in foreign currency, investments &%;s' in foreign banks this type

of economic exposure is called balance sheet exposure. Transaction :xposure is a form of short termeconomic exposure due to fixed price contracting in an atmosphere of exchange5rate volatility. The most

common definition of the measure of exchange5rate exposure is the sensitivity of the value of the firm,

proxied by the firm#s stock return, to an unanticipated change in an exchange rate. This is calculated by

using the partial derivative function where the dependant variable is the firm#s value and the

independent variable is the exchange rate &/dler and ;umas, 01A'.

Nece""it! of managing foreign exchange ri"k

/ key assumption in the concept of foreign exchange risk is that exchange rate changes are not

predictable and that this is determined by how efficient the markets for foreign exchange are. 6esearch

in the area of efficiency of foreign exchange markets has thus far been able to establish only a weak

form of the efficient market hypothesis conclusively which implies that successive changes in exchange

rates cannot be predicted by analying the historical se=uence of exchange rates.&Soenen, 0121'.

owever, when the efficient markets theory is applied to the foreign exchange market under floating

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exchange rates there is some evidence to suggest that the present prices properly reflect all available

information.&Biddy and ;ufey, 011-'. This implies that exchange rates react to new information in an

immediate and unbiased fashion, so that no one party can make a profit by this information and in any

case, information on direction of the rates arrives randomly so exchange rates also fluctuate randomly. "t

implies that foreign exchange risk management cannot be done away with by employing resources to

predict exchange rate changes.

)eging a" a tool to manage foreign exchange ri"k:

There is a spectrum of opinions regarding foreign exchange hedging. Some firms feel hedging

techni=ues are speculative or do not fall in their area of expertise and hence do not venture into hedging

practices. $ther firms are unaware of being exposed to foreign exchange risks. There are a set of firms

who only hedge some of their risks, while others are aware of the various risks they face, but are

unaware of the methods to guard the firm against the risk. There is yet another set of companies who

believe shareholder value cannot be increased by hedging the firm#s foreign exchange risks as

shareholders can themselves individually hedge themselves against the same using instruments like

forward contracts available in the market or diversify such risks out by manipulating their portfolio.

There are some explanations backed by theory about the irrelevance of managing the risk of change in

exchange rates. For example, the "nternational Fisher effect states that exchange rates changes are

balanced out by interest rate changes, the !urchasing !ower !arity theory suggests that exchange rate

changes will be offset by changes in relative price indices7inflation since the (aw of $ne !rice should

hold. oth these theories suggest that exchange rate changes are evened out in some form or the other.

/lso, the Unbiased Forward 6ate theory suggests that locking in the forward exchange rate offers the

same expected return and is an unbiased indicator of the future spot rate. ut these theories are perfectly

played out in perfect markets under homogeneous tax regimes. /lso, exchange rate5linked changes in

factors like inflation and interest rates take time to ad8ust and in the meanwhile firms stand to lose out on

adverse movements in the exchange rates.

The existence of different kinds of market imperfections, such as incomplete financial markets, positive

transaction and information costs, probability of financial distress and agency costs and restrictions on

free trade make foreign exchange management an appropriate concern for corporate management.

&Biddy and ;ufey, 011-' "t has also been argued that a hedged firm, being less risky can secure debt

more easily and this en8oy a tax advantage &interest is excluded from tax while dividends are taxed'.

This would negate the Godigliani5Giller proposition as shareholders cannot duplicate such tax

3E


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advantages. The GG argument that shareholders can hedge on their own is also not valid on account of

high transaction costs and lack of knowledge about financial manipulations on the part of shareholders.

There is also a vast pool of research that proves the efficacy of managing foreign exchange risks and a

significant amount of evidence showing the reduction of exposure with the use of tools for managing

these exposures. "n one of the more recent studies, /llayanis and $fek &-EE0' use a multivariate analysis

on a sample of SV! >EE non5financial firms and calculate a firms exchange5rate exposure using the ratio

of foreign sales to total sales as a proxy and isolate the impact of use of foreign currency derivatives

&part of foreign exchange risk management' on a firm#s foreign exchange exposures. They find a

statistically significant association between the absolute value of the exposures and the &absolute value'

of the percentage use of foreign currency derivatives and prove that the use of derivatives in fact reduce

exposure.

Ri"k 'anagement an *ettlement of Tran"action" in the Foreign %xchange 'arket

The foreign exchange market is characteried by constant changes and rapid innovations in trading

methods and products. Dhile the innovative products and ways of trading create new possibilities for

profit, they also pose various kinds of risks to the market. %entral banks all over the world, therefore,

have become increasingly concerned of the scale of foreign exchange settlement risk and the importance

of risk mitigation measures. ehind this growing awareness are several events in the past in which

foreign exchange settlement risk might have resulted in systemic risk in global financial markets,

including the failure of ankhaus erstatt in 012 and the closure of %%" S/ in 0110.

The foreign exchange settlement risk arises because the delivery of the two currencies involved in a

trade usually occurs in two different countries, which, in many cases are located in different time ones.

This risk is of particular concern to the central banks given the large values involved in settling foreign

exchange transactions and the resulting potential for systemic risk. Gost of the banks in the :G:s use

some form of methodology for measuring the foreign exchange settlement exposure. Gany of these

banks use the single day method, in which the exposure is measured as being e=ual to all foreign

exchange receipts that are due on the day. Some institutions use a multiple day approach for measuring

risk. Gost of the banks in :G:s use some form of individual counterparty limit to manage their

exposures. These limits are often applied to the global operations of the institution. These limits are

sometimes monitored by banks on a regular basis. "n certain cases, there are separate limits for foreign

exchange settlement exposures, while in other cases, limits for aggregate settlement exposures are

created through a range of instruments. ilateral obligation netting, in 8urisdictions where it is legally

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certain, is an important way for trade counterparties to mitigate the foreign exchange settlement risk.

This process allows trade counterparties to offset their gross settlement obligations to each other in the

currencies they have traded and settle these obligations with the payment of a single net amount in each

currency.

Several emerging markets in recent years have implemented domestic real time gross settlement &6TBS'

systems for the settlement of high value and time critical payments to settle the domestic leg of foreign

exchange transactions. /part from risk reduction, these initiatives enable participants to actively manage

the time at which they irrevocably pay away when selling the domestic currency, and reconcile final

receipt when purchasing the domestic currency. !articipants, therefore, are able to reduce the duration of

the foreign exchange settlement risk.

6ecognising the systemic impact of foreign exchange settlement risk, an important element in the

infrastructure for the efficient functioning of the "ndian foreign exchange market has been the clearing

and settlement of inter5bank US;5")6 transactions. "n pursuance of the recommendations of the

Sodhani %ommittee, the 6eserve ank had set up the %learing %orporation of "ndia (td. &%%"(' in -EE0

to mitigate risks in the "ndian financial markets. The %%"( commenced settlement of foreign exchange

operations for inter5bank US;5")6 spot and forward trades from )ovember A, -EE- and for inter5bank

US;5")6 cash and tom trades from February >, -EE. The %%"( undertakes settlement of foreign

exchange trades on a multilateral net basis through a process of novation and all spot, cash and tom

transactions are guaranteed for settlement from the trade date.

/n issue related to the guaranteed settlement of transactions by the %%"( has been the extension of this

facility to all forward trades as well. Gember banks currently encounter problems in terms of huge

outstanding foreign exchange exposures in their books and this comes in the way of their doing more

trades in the market. 6isks on such huge outstanding trades were found to be very high and so were the

capital re=uirements for supporting such trades. ence, many member banks have expressed their desire

in several fora that the %%"( should extend its guarantee to these forward trades from the trade date

itself which could lead to significant increase in the li=uidity and depth in the forward market. The risks

that banks today carry in their books on account of large outstanding forward positions will also be

significantly reduced. This has also been one of the recommendations of the %ommittee on Fuller

%apital /ccount %onvertibility. /part from managing the foreign exchange settlement risk, participants

also need to manage market risk, li=uidity risk, credit risk and operational risk efficiently to avoid future

losses. /s per the guidelines framed by the 6eserve ank for banks to manage risk in the inter5bank

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34/41

11.FOR%I7N %&C)AN7% RI*( 'ANA7%'%NT FRA'%BOR(

$nce a firm recognies its exposure, it then has to deploy resources in managing it. / heuristic for firms

to manage this risk effectively is presented below which can be modified to suit firm5specific needs i.e.

some or all the following tools could be used.

Foreca"t": /fter determining its exposure, the first step for a firm is to develop a forecast on the

market trends and what the main direction7trend is going to be on the foreign exchange rates. The

period for forecasts is typically @ months. "t is important to base the forecasts on valid assumptions.

/long with identifying trends, a probability should be estimated for the forecast coming true as well

as how much the change would be.

Ri"k %"timation: ased on the forecast, a measure of the "alue at #is &the actual profit or loss for a

move in rates according to the forecast' and the probability of this risk should be ascertained. The

risk that a transaction would fail due to maret$specific problems% should be taken into account.

Finally, the Systems 6isk that can arise due to inade=uacies such as reporting gaps and

implementation gaps in the firms# exposure management system should be estimated.

6enchmarking: Biven the exposures and the risk estimates, the firm has to set its limit for handling

foreign exchange exposure. The firm also has to decide whether to manage its exposures on a cost

centre or profit centre basis. / cost centre approach is a defensive one and the main aim is ensure

that cash flows of a firm are not adversely affected beyond a point. / profit centre approach on the

other hand is a more aggressive approach where the firm decides to generate a net profit on its

exposure over time.

)eging: ased on the limits a firm set for itself to manage exposure, the firms then decides an

appropriate hedging strategy. There are various financial instruments available for the firm to choose

from4 futures, forwards, options and swaps and issue of foreign debt. edging strategies and

instruments are explored in a section.

*to8 +o"": The firms risk management decisions are based on forecasts which are but estimates of

reasonably unpredictable trends. "t is imperative to have stop loss arrangements in order to rescue the

firm if the forecasts turn out wrong. For this, there should be certain monitoring systems in place to

detect critical levels in the foreign exchange rates for appropriate measure to be taken.

Re8orting an Re2ie4: 6isk management policies are typically sub8ected to review based on

periodic reporting. The reports mainly include profit7 loss status on open contracts after marking to

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market, the actual exchange7 interest rate achieved on each exposure, and profitability vis5Y5vis the

benchmark and the expected changes in overall exposure due to forecasted exchange7 interest rate

movements. The review analyses whether the benchmarks set are valid and effective in controlling

the exposures, what the market trends are and finally whether the overall strategy is working or

needs change.

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1$.)%D7IN7 *TRAT%7I%*E IN*TRU'%NT*

/ derivative is a financial contract whose value is derived from the value of some other financial asset,

such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices.The main role of derivatives is that they reallocate risk among financial market participants, help to

make financial markets more complete. This section outlines the hedging strategies using derivatives

withforeign exchange being the only risk assumed.

For4ar"

/ forward is a made5to5measure agreement between two parties to buy7sell a specified amount of a

currency at a specified rate on a particular date in the future. The depreciation of the receivable

currency is hedged against by selling a currency forward. "f the risk is that of a currency appreciation

&if the firm has to buy that currency in future say for import', it can hedge by buying the currency

forward. :.g if 6"( wants to buy crude oil in US dollars six months hence, it can enter into a forward

contract to pay ")6 and buy US; and lock in a fixed exchange rate for ")65US; to be paid after @

months regardless of the actual ")65;ollar rate at the time. "n this example the downside is an

appreciation of ;ollar which is protected by a fixed forward contract. The main advantage of a

forward is that it can be tailored to the specific needs of the firm and an exact hedge can be obtained.

$n the downside, these contracts are not marketable, they can#t be sold to another party when they

are no longer re=uired and are binding.

Future"

/ futures contract is similar to the forward contract but is more li=uid because it is traded in an

organied exchange i.e. the futures market. ;epreciation of a currency can be hedged by selling

futures and appreciation can be hedged by buying futures. /dvantages of futures are that there is a

central market for futures which eliminates the problem of double coincidence. Futures re=uire a

small initial outlay &a proportion of the value of the future' with which significant amounts of money

can be gained or lost with the actual forwards price fluctuations. This provides a sort of leverage.The previous example for a forward contract for 6"( applies here also 8ust that 6"( will have to go

to a US; futures exchange to purchase standardised dollar futures e=ual to the amount to be hedged

as the risk is that of appreciation of the dollar. /s mentioned earlier, the tailorability of the futures

contract is limited i.e. only standard denominations of money can be bought instead of the exact

amounts that are bought in forward contracts.

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O8tion"

/ currency $ption is a contract giving the right, not the obligation, to buy or sell a specific =uantity

of one foreign currency in exchange for another at a fixed price called the :xercise !rice or Strike

!rice. The fixed nature of the exercise price reduces the uncertainty of exchange rate changes and

limits the losses of open currency positions. $ptions are particularly suited as a hedging tool for

contingent cash flows, as is the case in bidding processes. %all $ptions are used if the risk is an

upward trend in price &of the currency', while !ut $ptions are used if the risk is a downward trend.

/gain taking the example of 6"( which needs to purchase crude oil in US; in @ months, if 6"( buys

a %all option &as the risk is an upward trend in dollar rate', i.e. the right to buy a specified amount of

dollars at a fixed rate on a specified date, there are two scenarios. "f the exchange rate movement is

favourable i.e the dollar depreciates, then 6"( can buy them at the spot rate as they have become

cheaper. "n the other case, if the dollar appreciates compared to today#s spot rate, 6"( can exercise

the option to purchase it at the agreed strike price. "n either case 6"( benefits by paying the lower

price to purchase the dollar

*4a8"

/ swap is a foreign currency contract whereby the buyer and seller exchange e=ual initial principal

amounts of two different currencies at the spot rate. The buyer and seller exchange fixed or floating

rate interest payments in their respective swapped currencies over the term of the contract. /t

maturity, the principal amount is effectively re5swapped at a predetermined exchange rate so that the

parties end up with their original currencies. The advantages of swaps are that firms with limited

appetite for exchange rate risk may move to a partially or completely hedged position through the

mechanism of foreign currency swaps, while leaving the underlying borrowing intact. /part from

covering the exchange rate risk, swaps also allow firms to hedge the floating interest rate risk.

%onsider an export oriented company that has entered into a swap for a notional principal of US; 0

mn at an exchange rate of -7dollar.

The company pays US @months ("$6 to the bank and receives 00.EEI p.a. every @ months on 0st

January V 0st July, till > years. Such a company would have earnings in ;ollars and can use the

same to pay interest for this kind of borrowing &in dollars rather than in 6upee' thus hedging its

exposures.

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Foreign Debt

Foreign debt can be used to hedge foreign exchange exposure by taking advantage of the

"nternational Fischer :ffect relationship. This is demonstrated with the example of an exporter who

has to receive a fixed amount of dollars in a few months from present. The exporter stands to lose if

the domestic currency appreciates against that currency in the meanwhile so, to hedge this, he could

take a loan in the foreign currency for the same time period and convert the same into domestic

currency at the current exchange rate. The theory assures that the gain realised by investing the

proceeds from the loan would match the interest rate payment &in the foreign currency' for the loan.

%hoice of hedging instruments

The literature on the choice of hedging instruments is very scant. /mong the available studies, BZcy et

al. &0112' argues that currency swaps are more cost5effective for hedging foreign debt risk, while

forward contracts are more cost5effective for hedging foreign operations risk. This is because foreign

currency debt payments are long5term and predictable, which fits the long5term nature of currency swap

contracts. Foreign currency revenues, on the other hand, are short5term and unpredictable, in line with

the short5term nature of forward contracts. / survey done by Garshall &-EEE' also points out that

currency swaps are better for hedging against translation risk, while forwards are better for hedging

against transaction risk. This study also provides anecdotal evidence that pricing policy is the most

popular means of hedging economic exposures.

These results however can differ for different currencies depending in the sensitivity of that currency tovarious market factors. 6egulation in the foreign exchange markets of various countries may also skew

such results.

Determinant" of )eging Deci"ion"

The management of foreign exchange risk, as has been established so far, is a fairly complicated

process. / firm, exposed to foreign exchange risk, needs to formulate a strategy to manage it, choosing

from multiple alternatives. This section explores what factors firms take into consideration when

formulating these strategies.

,rouction an Trae 2". )eging Deci"ion"

/n important issue for multinational firms is the allocation of capital among different countries

production and sales and at the same time hedging their exposure to the varying exchange rates.

6esearch in this area suggests that the elements of exchange rate uncertainty and the attitude toward risk

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are irrelevant to the multinational firmXs sales and production decisions &'roll,())*+. $nly the revenue

function and cost of production are to be assessed, and, the production and trade decisions in multiple

countries are independent of the hedging decision.

The implication of this independence is that the presence of markets for hedging instruments greatly

reduces the complexity involved in a firm#s decision making as it can separate production and sales

functions from the finance function. The firm avoids the need to form expectations about future

exchange rates and formulation of risk preferences which entails high information costs.

Co"t of )eging

edging can be done through the derivatives market or through money markets &foreign debt'. "n either

case the cost of hedging should be the difference between value received from a hedged position and the

value received if the firm did not hedge. "n the presence of efficient markets, the cost of hedging in the

forward market is the difference between the future spot rate and current forward rate plus any

transactions cost associated with the forward contract. Similarly, the expected costs of hedging in the

money market are the transactions cost plus the difference between the interest rate differential and the

expected value of the difference between the current and future spot rates. "n efficient markets, both

types of hedging should produce similar results at the same costs, because interest rates and forward and

spot exchange rates are determined simultaneously. The costs of hedging, assuming efficiency in foreign

exchange markets result in pure transaction costs. The three main elements of these transaction costs are

brokerage or service fees charged by dealers, information costs such as subscription to 6euter reports

and news channels and administrative costs of exposure management.

Factor" affecting the eci"ion to hege foreign currenc! ri"k

6esearch in the area of determinants of hedging separates the decision of a firm to hedge from that of

how much to hedge. There is conclusive evidence to suggest that firms with larger sie, 6V;

expenditure and exposure to exchange rates through foreign sales and foreign trade are more likely to

use derivatives. &Allayanis and fe,-(+ First, the following section describes the factors that affect

the decision to hedge and then the factors affecting the degree of hedging are considered.

Firm "i#e

Firm sie acts as a proxy for the cost of hedging or economies of scale. 6isk management involves

fixed costs of setting up of computer systems and training7hiring of personnel in foreign exchange

management. Goreover, large firms might be considered as more creditworthy counterparties for

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forward or swap transactions, thus further reducing their cost of hedging . The boo value of assets is

used as a measure of firm si!e.

+e2erage

/ccording to the risk management literature, firms with high leverage have greater incentive to

engage in hedging because doing so reduces the probability, and thus the expected cost of financial

distress. ighly levered firms avoid foreign debt as a means to hedge and use derivatives.

+i;uiit! an 8rofitabilit!:

Firms with highly li=uid assets or high profitability have less incentive to engage in hedging because

they are exposed to a lower probability of financial distress. /iquidity is measured by the quicratio,

i.e. quic assets divided by current liabilities+. 0rofitability is measured as E'IT divided by boo

assets.

*ale" gro4th

Sales growth is a factor determining decision to hedge as opportunities are more likely to be affected

by the underinvestment problem. For these firms, hedging will reduce the probability of having to

rely on external financing, which is costly for information asymmetry reasons, and thus enable them

to en8oy uninterrupted high growth. The measure of salesgrowth is obtained using the *$year

geometric average of yearly sales growthrates.

/s regards the degree of hedging /llayanis and $fek &-EE0' conclude that the sole determinants of the

degree of hedging are exposure factors &foreign sales and trade'. "n other words, given that a firm

decides to hedge, the decision of how much to hedge is affected solely by its exposure to foreign

currency movements.

R6I guieline"

6" guidelines except with the general or special permission of the reserve bank of "ndia, no person can4

;eal in or transfer any foreign exchange or foreign security to any person not being an

authoried person

Gake any payment to or for the credit of any person resident outside "ndia in any manner

6eceive otherwise through an authoried person, any payment by order or on behalf of any

person resident outside "ndia in any manner

6easonable restrictions for current account transactions as may be prescribed.

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15.CONC+U*ION

"n "ndia, regulation has been steadily eased and turnover and li=uidity in the foreign currency derivative

markets has increased, although the use is mainly in shorter maturity contracts of one year or less.

Forward and option contracts are the more popular instruments. 6egulators had initially only allowed

certain banks to deal in this market however now corporates can also write option contracts. There are

many variants of these derivatives which investment banks across the world specialie in, and as the

awareness and demand for these variants increases, 6" would have to revise regulations.

For now, "ndian companies are actively hedging their foreign exchanges risks with forwards, currency

and interest rate swaps and different types of options such as call, put, cross currency and range5barrier

options. The high use of forward contracts by "ndian firms also highlights the absence of a rupee futures

exchange in "ndia.

owever, the ;ubai Bold and %ommodities :xchange in June, -EE2 introduced 6upee5 ;ollar futures

that could be traded on its exchanges and had provided another route for firms to hedge on a transparent

basis. There are fears that 6"#s ability to control the partially convertible currency will be subdued by

this introduction but this issue is beyond the scope of this study. The partial convertibility of the 6upee

will be difficult to control if many exchanges offer such instruments and that will be factor to consider

for the 6".

.

Forex Market Projct

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