Executive Summary

This project gives an in-depth analysis and understanding of Foreign Exchange Markets

in India. It helps to understand the History and the evolution of the foreign market in

India.

It gives an overview of the conditions existing in the current global economy. It gives an

overview of the Foreign exchange market.

It talks about the foreign exchange management act applicable and also gives details

about the participants in the forex markets.

It also talks about what are the sources of demand and supply of foreign exchange in

the market all over the world.

The report also talks about the Foreign Exchange trading platform and how the

efficiency and the transparency is maintained.

The report focuses on corporate hedging for foreign exchange risk in India. The report

contains details about some companies Foreign Exposure and how they have

maintained it.

It also talks about the determinants to be taken care of while taking corporate hedging

decisions. It gives insights about the Regulatory guidelines for the use of Foreign

Exchange derivatives, Development of Derivatives markets in India and also the

Hedging instruments for Indian firms.

The report gives an in-depth analysis of the currency risk management by talking about

what currency risk is, the types of currency risk – Transaction risk ,Translation risk and

Economic risk. It also contains details about the companies in the index sensex and

nifty showing their transaction is foreign currency like the imports, exports, Loans,

Interst payments and the other expenses. It then shows the sensitivity analysis of how

the currency rates impact the gains/ profits of the company.

Contents

Foreign Exchange Market Overview................................................................................5

.........................................................................................................................................9

Basic Concepts in Forex Trading...................................................................................13

Currency Traded Across Globe & India..........................................................................14

Trading Platforms...........................................................................................................15

Factors Affecting Foreign Exchange..............................................................................17

Foreign Exchange Management Act, 1999....................................................................18

Participants in foreign exchange market........................................................................19

Exchange rate System...................................................................................................22

Foreign Exchange Market Structure...............................................................................24

Fundamentals in Exchange Rate...................................................................................25

Factors Affecting Exchange Rates.................................................................................26

Sources of Supply and Demand in the Foreign exchange.............................................28

Corporate Hedging for Foreign Exchange Risk in India.................................................32

Foreign Exchange Risk Management Framework.........................................................38

Hedging Strategies/ Instruments....................................................................................40

Determinants of Hedging Decisions...............................................................................43

An Overview of Corporate Hedging in India...................................................................45

Currency Risk Management...........................................................................................50

Foreign Exchange Market

The foreign exchange market (forex or FX for short) is one of the most exciting, fast-

paced markets around. Until recently, forex trading in the currency market had been the

domain of large financial institutions, corporations, central banks, hedge funds and

extremely wealthy individuals. The emergence of the internet has changed all of this,

and now it is possible for average investors to buy and sell currencies easily with the

click of a mouse through  online brokerage accounts.

Daily currency fluctuations are usually very small. Most currency pairs move less than

one cent per day, representing a less than 1% change in the value of the currency. This

makes foreign exchange one of the least volatile financial markets around. Therefore,

many currency speculators rely on the availability of enormous leverage to increase the

value of potential movements. In the retail forex market, leverage can be as much as

250:1. Higher leverage can be extremely risky, but because of round-the-clock trading

and deep liquidity, foreign exchange brokers have been able to make high leverage an

industry standard in order to make the movements meaningful for currency traders.

Extreme liquidity and the availability of high leverage have helped to spur the market’s

rapid growth and made it the ideal place for many traders. Positions can be opened and

closed within minutes or can be held for months. Currency prices are based on

objective considerations of supply and demand and cannot be manipulated easily

because the size of the market does not allow even the largest players, such as central

banks, to move prices at will.

 There are several  avenues for retail customers to make investments. Individuals can

use investments instruments in financial markets by using long term goals or short term

trading i.e. shares, options, derivatives, swaps, commodity, real estate, gold, silver,

bonds etc., some of these instruments give an opportunity for people to make money.

Indian financial market is still only 2+ decades old and requires lot of maturity.

 Recently some of trading instruments are available in the market because of the online

facility and many folks are using the technology to make additional money by trading in

futures or cash market along with commodity. There are bound to be many changes

going to happen in the coming years because of the stake taken in BSE and NSE by

foreign exchanges and substantial developments are going to happen with technology

and access to retail investors.

 There are many new products will be launched in the financial market, which provides

easy access for retail investors to benefit from the same. One such trading activity is

FOREX, which is now accessible for many retail investors. Most of the folks are not

aware of how to use this trading avenue to make additional money and the beauty of

this product is that you can trade 24hrs which provides opportunity for folks who can do

some bit of trading during later hours or after work or early in the morning. As we all

know that FOREX trading is the biggest market globally and there are so many

combinations individuals can hedge.

Overview

Globally, operations in the foreign exchange market started in a major way after the

breakdown of the Bretton Woods system in 1971, which also marked the beginning of

floating exchange rate regimes in several countries. Over the years, the foreign

exchange market has emerged as the largest market in the world. The decade of the

1990s witnessed a perceptible policy shift in many emerging markets towards

reorientation of their financial markets in terms of new products and instruments,

development of institutional and market infrastructure and realignment of regulatory

structure consistent with the liberalized operational framework. The changing contours

were mirrored in a rapid expansion of foreign exchange market in terms of participants,

transaction volumes, decline in transaction costs and more efficient mechanisms of risk

transfer.

The origin of the foreign exchange market in India could be traced to the year 1978

when banks in India were permitted to undertake intra-day trade in foreign exchange.

However, it was in the 1990s that the Indian foreign exchange market witnessed far

reaching changes along with the shifts in the currency regime in India. The exchange

rate of the rupee, that was pegged earlier was floated partially in March 1992 and fully

in March 1993 following the recommendations of the Report of the High Level

Committee on Balance of Payments (Chairman: Dr.C. Rangarajan). The unification of

the exchange rate was instrumental in developing a market-determined exchange rate

of the rupee and an important step in the progress towards current account

convertibility, which was achieved in August 1994. 6.3 A further impetus to the

development of the foreign exchange market in India was provided with the setting up of

an Expert Group on Foreign Exchange Markets in India (Chairman: Shri O.P. Sodhani),

which submitted its report in June 1995. The Group made several recommendations for

deepening and widening of the Indian foreign exchange market. Consequently,

beginning from January 1996, wide-ranging reforms have been undertaken in the Indian

foreign exchange market. After almost a decade, an Internal Technical Group on the

Foreign Exchange Market (2005) was constituted to undertake a comprehensive review

of the measures initiated by the Reserve Bank and identify areas for further

liberalization or relaxation of restrictions in a medium-term framework.

The momentous developments over the past few years are reflected in the enhanced

risk-bearing capacity of banks along with rising foreign exchange trading volumes and

finer margins. The foreign exchange market has acquired depth (Reddy, 2005). The

conditions in the foreign exchange market have also generally remained orderly (Reddy,

2006c). While it is not possible for any country to remain completely unaffected by

developments in international markets, India was able to keep the spillover effect of the

Asian crisis to a minimum through constant monitoring and timely action, including

recourse to strong monetary measures, when necessary, to prevent emergence of self

fulfilling speculative activities

In today’s world no economy is self sufficient, so there is need for exchange of goods

and services amongst the different countries. So in this global village, unlike in the

primitive age the exchange of goods and services is no longer carried out on barter

basis. Every sovereign country in the world has a currency that is legal tender in its

territory and this currency does not act as money outside its boundaries. So whenever a

country buys or sells goods and services from or to another country, the residents of

two countries have to exchange currencies. So we can imagine that if all countries have

the same currency then there is no need for foreign exchange.

Need for Foreign Exchange:

Let us consider a case where Indian company exports cotton fabrics to USA and

invoices the goods in US dollar. The American importer will pay the amount in US

dollar, as the same is his home currency. However the Indian exporter requires rupees

means his home currency for procuring raw materials and for payment to the labor

charges etc. Thus he would need exchanging US dollar for rupee. If the Indian

exporters invoice their goods in rupees, then importer in USA will get his dollar

converted in rupee and pay the exporter. From the above example we can infer that in

case goods are bought or sold outside the country, exchange of currency is necessary.

Sometimes it also happens that the transactions between two countries will be settled in

the currency of third country. In that case both the countries that are transacting will

require converting their respective currencies in the currency of third country. For that

also the foreign exchange is required.

About foreign exchange market:

Particularly for foreign exchange market there is no market place called the foreign

exchange market. It 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 OTC (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 London, followed by the New York, Tokyo, Zurich and

Frankfurt. The markets are situated throughout the different time zone of the globe in

such a way that one market is closing the other is beginning its operation. Therefore it is

stated that foreign exchange market is functioning throughout 24 hours a day. In most

market US dollar is the vehicle currency, viz., the currency sued to dominate

international transaction. In India, foreign exchange has been given a statutory

definition. Section 2 (b) of foreign exchange regulation ACT, 1973 states: Foreign

exchange means foreign currency and includes:

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

traveler’s cheques, letter of credit and bills of exchange. Expressed or drawn in

India currency but payable in any foreign currency.

Any instrument payable, at the option of drawee or holder thereof or any other party

thereto, either in Indian currency or in foreign currency or partly in one and partly in the

other. In order to provide facilities to members of the public and foreigners visiting

India, for exchange of foreign currency into Indian currency and vice-versa RBI has

granted to various firms and individuals, license to undertake money-changing business

at seas/airport and tourism place of tourist interest in India. Besides certain authorized

dealers in foreign exchange (banks) have also been permitted to open exchange

bureaus. Following are the major bifurcations:

Full fledge moneychangers – they are the firms and individuals who have been

authorized to take both, purchase and sale transaction with the public.

Restricted moneychanger – they are shops, emporia and hotels etc. that have been

authorized only to purchase foreign currency towards cost of goods supplied or services

rendered by them or for conversion into rupees.

Authorized dealers – they are one who can undertake all types of foreign exchange

transaction. Banks are only the authorized dealers. The only exceptions are Thomas

cook, western union, UAE exchange which though, and not a bank is an AD. Even

among the banks RBI has categorized them as follows:

Branch A – They are the branches that have Nostro and Vostro account.

Branch B – The branch that can deal in all other transaction but do not maintain Nostro

and Vostro a/c’s fall under this category. For Indian we can conclude that foreign

exchange refers to foreign money, which includes notes, cheques, bills of exchange,

bank balance and deposits in foreign currencies.

Foreign Exchange Market: An Assessment

The continuous improvement in market infrastructure has had its impact in terms of

enhanced depth, liquidity and efficiency of the foreign exchange market. The turnover in

the Indian foreign exchange market has grown significantly in both the spot and

derivatives segments in the recent past. Along with the increase in onshore turnover,

activity in the offshore market has also assumed importance. With the gradual opening

up of the capital account, the process of price discovery in the Indian foreign exchange

market has improved as reflected in the bid-ask spread and forward premia behaviour.

Foreign Exchange Market Turnover

As per the Triennial Central Bank Survey by the Bank for International Settlements

(BIS) on

“Foreign Exchange and Derivatives Market Activity”, global foreign exchange market

activity rose markedly between 2001 and 2004 (Table 6.4). The strong growth in

turnover may be attributed to two related factors. First, the presence of clear trends and

higher volatility in foreign exchange markets between 2001 and 2004 led to trading

momentum, where investors took large positions in currencies that followed persistent

appreciating trends. Second, positive interest rate differentials encouraged the so-called

“carry trading”, i.e., investments in high interest rate currencies financed by positions in

low interest rate currencies. The growth in outright forwards between 2001 and 2004

reflects heightened interest in hedging. Within the EM countries, traditional foreign

exchange trading in Asian currencies generally recorded much faster growth than the

global total between 2001 and 2004. Growth rates in turnover for Chinese renminbi,

Indian rupee, Indonesian rupiah, Korean won and new Taiwanese dollar exceeded 100

per cent between April 2001 and April 2004 (Table 6.5). Despite significant growth in the

foreign exchange market turnover, the share of most of the EMEs in total global

turnover, however, continued to remain low.

The Indian foreign exchange market has grown manifold over the last several years.

The daily average turnover impressed a substantial pick up from about US $ 5 billion

during 1997-98 to US $ 18 billion during 2005-06. The turnover has risen considerably

to US $ 23 billion during 2006-07 (up to February 2007) with the daily turnover crossing

US $ 35 billion on certain days during October and November 2006. The inter-bank to

merchant turnover ratio has halved from 5.2 during 1997-98 to 2.6 during 2005-06,

reflecting the growing participation in the merchant segment of the foreign exchange

market (Table 6.6 and Chart VI.2). Mumbai alone accounts for almost 80 per cent of the

foreign exchange turnover.

6.60 Turnover in the foreign exchange market was 6.6 times of the size of India’s

balance of payments during 2005-06 as compared with 5.4 times in 2000-01 (Table

6.7). With the deepening of the foreign exchange market and increased turnover,

income of commercial banks through treasury operations has increased considerably.

Profit from foreign exchange transactions accounted for more than 20 per cent of total

profits of the scheduled commercial banks during 2004-05 and 2005-06

Basic Concepts in Forex Trading

:

Bid and Ask Rate:

The bid/ask spread is the difference between the price at which a bank or market

maker will sell ("ask", or "offer") and the price at which a market taker will buy ("bid")

from a wholesale or retail customer. The customer will buy from the market-maker at the

higher "ask" price, and will sell at the lower "bid" price, thus giving up the "spread" as

the cost of completing the trade.

Margin Trading:

Foreign exchange is normally traded on margin. A relatively small deposit can control

much larger positions in the market. For trading the main currencies, Saxo Bank

requires a 1% margin deposit. This means that in order to trade one million dollars, you

need to place just USD 10,000 by way of security.

In other words, you will have obtained a gearing of up to 100 times. This means that a

change of, say 2%, in the underlying value of your trade will result in a 200% profit or

loss on your deposit.

Stop-loss discipline:

There are significant opportunities and risks in foreign exchange markets. Aggressive

traders might experience profit/loss swings of 20-30% daily. This calls for strict stop-loss

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. Of course, the market can move very fast

and a stop-loss order is by no means a guarantee of getting out at the desired level. For

speculative trading, it is recommended to place protective stop-loss orders.

Spot and forward trading:

When you trade foreign exchange you are normally quoted 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 subject to supervision by regulatory authorities

for your own protection and security. If you are a commercial customer, you may need

to convert the currencies for international payments. If 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. Often investors will swap their trades forward

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

investment.

Although a forward trade is for a future date, the position can be closed out at any time -

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

FOREX TRADING EXAMPLES

Example 1

An investor has a margin deposit with Saxo Bank of USD100,000.

The investor expects the US dollar to rise against the Swiss franc and therefore decides

to buy USD2,000,000 - his maximum possible exposure.

The Saxo Bank dealer quotes him 1.5515-20. The investor buys USD at 1.5520.

Day 1: Buy USD2,000,000 vs CHF 1.5520 = Sell CHF3,104,000.

Four days later, the dollar has actually risen to CHF1.5745 and the investor decides to

take his profit.

Upon his request, the Saxo Bank dealer quotes him 1.5745-50. The investor sells at

1.5745.

Day 5: Sell USD2,000,000 vs CHF 1.5745 = Buy CHF3,149,000.

As the dollar side of the transaction involves a credit and a debit of USD2,000,000, the

investor's USD account will show no change. The CHF account will show a debit of

CHF3,104,000 and a credit of CHF3,149,000. Due to the simplicity of the example and

the short time horizon of the trade, we have disregarded the interest rate swap that

would marginally alter the profit calculation.

This results in a profit of CHF45,000 = approx. USD28,600 = 28.6% profit on the deposit

of USD100,000.

Example 2:

The investor follows the cross rate between the Euro and the Japanese yen. He

believes that this market is headed for a fall. As he is less confident of this trade, he

does not fully use the leverage available on his deposit. He chooses to ask the dealer

for a quote in EUR1,000,000. This requires a margin of EUR1,000,000 x 5% =

EUR50,000 = approx. USD52,500 (EUR/USD1.05).

The dealer quotes 112.05-10. The investor sells EUR at 112.05.

Day 1: Sell EUR1,000,000 vs JPY 112.05 = Buy JPY112,050,000.

He protects his position with a stop-loss order to buy back the euro at 112.60. Two days

later, this stop is triggered as the euro strengthens short term in spite of the investor's

expectations.

Day 3: Buy EUR1,000,000 vs JPY 112.60 = Sell JPY112,600,000.

The EUR side involves a credit and a debit of EUR1,000,000. Therefore, the EUR

account shows no change. The JPY account is credited JPY112.05m and debited

JPY112.6m for a loss of JPY0.55m. Due to the simplicity of the example and the short

time horizon of the trade, we have disregarded the interest rate swap that would

marginally alter the loss calculation.

This results in a loss of JPY0.55m = approx.USD5,300 (USD/JPY 105) = 5.3% loss on

the original deposit of USD100,000.

Currency Traded Across Globe & India

The FOUR major currency pairs

EUR/USD

USD/JPY

USD/CHF

GBP/USD

Currency Crosses

EUR/CHF

EUR/JPY

GBP/JPY

EUR/GBP

Currencies traded in India:

USD/INR

EUR/INR

GBP/INR

JPY/INR

Currency Exchanges in India:

1. MCX Stock Exchange (MCX – SX)

2. National Stock Exchange (NSE)

3. United Stock Exchange (USE)

The daily turnover of NSE and MCX – SX together is around 30,000 cr.

Factors Affecting Foreign Exchange

There are various factors affecting the exchange rate of a currency. They can be

classified as fundamental factors, technical factors, political factors and speculative

factors.

Fundamental factors:

The fundamental factors are basic economic policies followed by the government in

relation to inflation, balance of payment position, unemployment, capacity utilization,

trends in import and export, etc. Normally, other things remaining constant the

currencies of the countries that follow sound economic policies will always be stronger.

Similarly, countries having balance of payment surplus will enjoy a favorable exchange

rate. Conversely, for countries facing balance of payment deficit, the exchange rate will

be adverse.

Technical factors:

Interest rates: Rising interest rates in a country may lead to inflow of hot money in the

country, thereby raising demand for the domestic currency. This in turn causes

appreciation in the value of the domestic currency.

Inflation rate: High inflation rate in a country reduces the relative competitiveness of the

export sector of that country. Lower exports result in a reduction in demand of the

domestic currency and therefore the currency depreciates.

Exchange rate policy and Central Bank interventions: Exchange rate policy of the

country is the most important factor influencing determination of exchange rates. For

example, a country may decide to follow a fixed or flexible exchange rate regime, and

based on this, exchange rate movements may be less/more frequent. Further,

governments sometimes participate in foreign exchange market through its Central

bank in order to control the demand or supply of domestic currency.

Political factors:

Political stability also influences the exchange rates. Exchange rates are susceptible to

political instability and can be very volatile during times of political crises.

Speculation:

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.

Participants in foreign exchange market

Market Players

Players in the Indian market include (a) ADs, mostly banks who are authorised to deal

in foreign exchange, (b) foreign exchange brokers who act as intermediaries, and (c)

customers – individuals, corporates, who need foreign exchange for their transactions.

Though customers are major players in the foreign exchange market, for all practical

purposes they depend upon ADs and brokers. In the spot foreign exchange market,

foreign exchange transactions were earlier dominated by brokers. Nevertheless, the

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

dominated by ADs. Brokers continue to dominate the derivatives market.

The Reserve Bank intervenes in the market essentially to ensure orderly market

conditions. The Reserve Bank undertakes sales/purchases of foreign currency in

periods of excess demand/supply in the market. Foreign Exchange Dealers’ Association

of India (FEDAI) plays a special role in the foreign exchange market for ensuring

smooth and speedy growth of the foreign exchange market in all its aspects. All ADs are

required to become members of the FEDAI and execute an undertaking to the effect

that they would abide by the terms and condition stipulated by the FEDAI for transacting

foreign exchange business. The FEDAI is also the accrediting authority for the foreign

exchange brokers in the interbank foreign exchange market.

The licences for ADs are issued to banks and other institutions, on their request, under

Section 10(1) of the Foreign Exchange Management Act, 1999. ADs have been divided

into different categories. All scheduled commercial banks, which include public sector

banks, private sector banks and foreign banks operating in India, belong to category I of

ADs. All upgraded full fledged money changers (FFMCs) and select regional rural banks

(RRBs) and co-operative banks belong to category II of ADs. Select financial institutions

such as EXIM Bank belong to category III of ADs. Currently, there are 86 (Category I)

Ads operating in India out of which five are co-operative banks (Table 6.3). All merchant

transactions in the foreign exchange market have to be necessarily undertaken directly

through ADs. However, to provide depth and liquidity to the inter-bank segment, Ads

have been permitted to utilise the services of brokers for better price discovery in their

inter-bank transactions. In order to further increase the size of the foreign exchange

market and enable it to handle large flows, it is generally felt that more ADs should be

encouraged to participate in the market making. The number of participants who can

give two-way quotes also needs to be increased.

The customer segment of the foreign exchange market comprises major public sector

units, corporates and business entities with foreign exchange exposure. It is generally

dominated by select large public sector units such as Indian Oil Corporation, ONGC,

BHEL, SAIL, Maruti Udyog and also the Government of India (for defence and civil debt

service) as also big private sector corporates like Reliance Group, Tata Group and

Larsen and Toubro, among others. In recent years, foreign institutional investors (FIIs)

have emerged as major players in the foreign exchange market.

The main players in foreign exchange market are as follows:

1. Customers:

The customers who are engaged in foreign trade participate in foreign exchange market

by availing of the services of banks. Exporters require converting the dollars in to rupee

and importers require converting rupee in to the dollars, as they have to pay in dollars

for the goods/services they have imported.

2. Commercial Bank:

They are most active players in the forex market. Commercial 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. As every time the

foreign exchange bought or oversold position. The balance amount is sold or bought

from the market.

3. Central Bank:

In all countries Central bank have been charged with the responsibility of maintaining

the external value of the domestic currency. Generally this is achieved by the

intervention of the bank.

4. Exchange Brokers:

Forex brokers play very important role in the foreign exchange market. However the

extent to which services of foreign brokers are utilized depends on the tradition and

practice prevailing at a particular forex market center. In India as per FEDAI guideline

the Ads 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 India.

5. Overseas Forex Market:

Today the daily global turnover is estimated to be more than US $ 1.5 trillion a day. The

international trade however constitutes hardly 5 to 7 % of this total turnover. The rest of

trading in world forex market is constituted of financial transaction and speculation. As

we know that the forex market is 24-hour market, the day begins with Tokyo and

thereafter Singapore opens, thereafter India, followed by Bahrain, Frankfurt, Paris,

London, New York, Sydney, and back to Tokyo.

6. Speculators:

The speculators are the major players in the forex market. Bank dealing are the major

speculators in the forex market with a view to make profit on account of favorable

movement in exchange rate, take 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 quick profit.

Corporation’s 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. With a

view to make advantage of exchange rate movement in their favor they either delay

covering exposures or do not cover until cash flow materialize.

Individual like 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.

Exchange rate System

Countries 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. With the invention 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. India was a founder member of the IMF. During the existence of the

fixed exchange rate system, the intervention currency of the Reserve Bank of India

(RBI) was the British pound, the RBI ensured maintenance of the exchange rate by

selling and buying pound against rupees at fixed rates. The inter bank rate therefore

ruled the RBI band. During the fixed exchange rate era, there was only one major

change in the parity of the rupee- devaluation in June 1966. Different countries have

adopted different exchange rate system at different time.

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

The Gold Standard

Many countries have adopted gold standard as their monetary system during the last

two decades of the 19he century. This system was in vogue till the outbreak of World

War 1. Under this system the parties of currencies were fixed in term of gold. There

were two main types of gold standard:

1) Gold specie standard

Gold was recognized as means of international settlement for receipts and payments

amongst countries. Gold coins were an accepted mode of payment and medium of

exchange in domestic market also. A country was stated to be on gold standard if the

following condition were satisfied:

Monetary authority, generally the central bank of the country, guaranteed to buy

and sell gold in unrestricted amounts at the fixed price.

Melting gold including gold coins, and putting it to different uses was freely

allowed.

Import and export of gold was freely allowed.

The total money supply in the country was determined by the quantum of gold available

for monetary purpose.

2) Gold Bullion Standard:

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

served as reserve asset for the money supply. However, 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 “ Mint Parity Theory “ of exchange rates.

The gold bullion standard prevailed from about 1870 until 1914, and intermittently

thereafter until 1944. World War I brought an end to the gold standard.

Bretton Woods System

During the world wars, economies of almost all the countries suffered. In order to

correct the balance of payments disequilibrium, many countries devalued their

currencies. Consequently, the international trade suffered a deathblow. In 1944,

following World War II, the United States and most of its allies ratified the Bretton

Woods Agreement, which set up an adjustable parity exchange-rate system under

which exchange rates were fixed (Pegged) 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. In addition to setting up

fixed exchange parities (par values) of currencies in relationship to gold, the agreement

established the International Monetary Fund (IMF) to act as the “custodian” of the

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

countries suspending their obligation to intervene in the market and the Bretton Wood

System, with its fixed parities, was effectively buried. Thus, the world economy has

been living through an era of floating exchange rates since the early 1970.

Floating Rate System

In 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. Where government interferes’ directly or through

various monetary and fiscal measures in determining the exchange rate, it is known as

managed of dirty float. PURCHASING POWER PARITY (PPP) Professor Gustav

Cassel, a Swedish economist, introduced this system. The theory, to put in simple terms

states that currencies are valued for what they can buy and the currencies have no

intrinsic value attached to it. Therefore, under this theory the exchange rate was to be

determined and the sole criterion being the purchasing power of the countries. As per

this theory if there were no trade controls, then the balance of payments equilibrium

would always be maintained. Thus if 150 INR buy a fountain pen and the same fountain

pen can be bought for USD 2, it can be inferred that since 2 USD or 150 INR can buy

the same fountain pen, therefore USD 2 = INR 150.For example India has a higher rate

of inflation as compared to country US then goods produced in India would become

costlier as compared to goods produced in US. This would induce imports in India and

also the goods produced in India being costlier would lose in international competition to

goods produced in US. This decrease in exports of India as compared to exports from

US would lead to demand for the currency of US and excess supply of currency of

India. This in turn, cause currency of India to depreciate in comparison of currency of

US that is having relatively more exports.

Fundamentals in Exchange Rate

Exchange rate is a rate at which one currency can be exchange in to another currency,

say USD = Rs.48. This rate is the rate of conversion of US dollar in to Indian rupee and

vice versa.

Methods of Quoting Rate

There are two methods of quoting exchange rates.

1) Direct method:

Foreign currency is kept constant and home currency is kept variable. In direct

quotation, the principle adopted by bank is to buy at a lower price and sell at higher

price.

2) Indirect method:

Home currency is kept constant and foreign currency is kept variable. Here the strategy

used by bank is to buy high and sell low. In India with effect from august 2, 1993, all the

exchange rates are quoted in direct method. It is customary in foreign exchange market

to always quote 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

quote from another party and other party quotes a rate. The party asking for a quote is

known as’ asking party and the party giving a quotes is known as quoting party. The

advantage of two–way quote is as under

The market continuously makes available price for buyers or sellers

Two way prices limit the profit margin of the quoting bank and comparison

of one quote with another quote can be done instantaneously.

As it is not necessary any player in the market to indicate whether he

intends to buy or sale foreign currency, this ensures that the quoting bank

cannot take advantage by manipulating the prices.

It automatically insures that alignment of rates with market rates.

Two way quotes lend depth and liquidity to the market, which is so very

essential for efficient market. In two way quotes the first rate is the rate for

buying and another for selling.

We should understand here that, in India the banks, which are authorized dealer,

always, quote rates. So the rates quoted- buying and selling is for banks point of view

only. It means that if exporters want to sell the dollars then the bank will buy the dollars

from him so while calculation the first rate will be used which is buying rate, as the bank

is buying the dollars from exporter. The same case will happen inversely with importer

as he will buy dollars from the bank and bank will sell dollars to importer.

Factors Affecting Exchange Rates

In 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 consequently, it becomes

difficult to precisely define the factors that affect exchange rates. However, the more

important among them are as follows:

• Strength of Economy

Economic factors affecting exchange rates include hedging activities, interest rates,

inflationary pressures, trade imbalance, and euro market activities. Irving fisher, an

American 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. On the other hand, the purchasing- power parity

theory relates exchange rates to inflationary pressures. In its absolute version, this

theory states that the equilibrium exchange rate equals the ratio of domestic to foreign

prices. The relative version of the theory relates changes in the exchange rate to

changes in price ratios.

• Political 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. Active government intervention or manipulations, such as central bank

activity in the foreign currency market, also have an impact. Other 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.

• Expectation of the Foreign Exchange Market

Psychological factors also influence exchange rates. These factors include market

anticipation, speculative pressures, and future expectations. A few financial experts are

of the opinion that in today’s environment, the only ‘trustworthy’ method of predicting

exchange rates by gut feel. Bob Eveling, vice president of financial markets at SG, is

corporate finance’s top foreign exchange forecaster for 1999. eveling’s gut feeling has,

defined convention, and his method proved uncannily accurate in foreign exchange

forecasting in 1998.SG ended the corporate finance forecasting year with a 2.66% error

overall, the most accurate among 19 banks. The secret to eveling’s intuition on any

currency is keeping abreast of world events. Any event, from a declaration of war to a

fainting political leader, can take its 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 judgment.

Fiscal policy

Interest rates

Monetary policy

Balance of payment

Exchange control

Central bank intervention

Speculation

Technical factors

Foreign Exchange Risk Management Framework

Once a firm recognizes its exposure, it then has to deploy resources in managing it. A

heuristic for firms to manage this risk effectively is presented below which can be

modified to suit firm-specific needs i.e. some or all the following tools could be used.

Forecasts: After determining its exposure, the first step for a firm is to develop a

forecast on the market trends and what the main direction/trend is going to be on the

foreign exchange rates. The period for forecasts is typically 6 months. It is important

to base the forecasts on valid assumptions. Along with identifying trends, a

probability should be estimated for the forecast coming true as well as how much the

change would be.

Risk Estimation: Based on the forecast, a measure of the Value at Risk (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 market-

specific problems4 should be taken into account. Finally, the Systems Risk that can

arise due to inadequacies such as reporting gaps and implementation gaps in the

firms’ exposure management system should be estimated.

Benchmarking: Given 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. A 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. A 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.

Hedging: Based 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 from: futures, forwards, options and swaps and issue

of foreign debt. Hedging strategies and instruments are explored in a section.

Stop Loss: The firms risk management decisions are based on forecasts which are

but estimates of reasonably unpredictable trends. It 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.

Reporting and Review: Risk management policies are typically subjected to review

based on periodic reporting. The reports mainly include profit/ loss status on open

contracts after marking to market, the actual exchange/ interest rate achieved on

each exposure, and profitability vis-à-vis the benchmark and the expected changes

in overall exposure due to forecasted exchange/ 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.

TOOLS FOR MANAGING RISK IN FOREX MARKET

THE SPOT MARKET

1. Introduction

The spot market accounts for nearly a third of global foreign exchange turnover. It can

be broadly divided into two tiers:

• The interbank market where currency is bought and sold for delivery and settlement

within two days, with the banks acting as “wholesalers” or “market makers”.

• The retail market made up of private traders, who deal over the telephone or the

internet through intermediaries (brokers).

The forex market has no centralized exchanges. All trades are over-the-counter deals,

agreed and settled by individual counterparties known to one another. The forex market

is truly global and operates 24 hours a day, Monday to Friday. Daily trading commences

in Wellington, New Zealand and follows the sun to (inter alia) Sydney, Tokyo, Hong

Kong, Singapore, Bahrain, Frankfurt, Geneva, Zurich, Paris, London, New York,

Chicago and Los Angeles before starting again.

2. Currency pairs and the rate of exchange

Every foreign exchange transaction is an exchange between a pair of currencies. Each

currency is denoted by a unique three-character International Standardization

Organization (ISO) code (e.g. GBP represents sterling and USD the US dollar).

Currency pairings are expressed as two ISO codes separated by a division symbol (e.g.

GBP/USD), the first representing the “base currency” and the other the “secondary

currency”.

The rate of exchange is simply the price of one currency in terms of another. For

example GBP/USD = 1.5545 denotes that one unit of sterling (the base currency) can

be exchanged for 1.5545 US dollars (the secondary currency). The base currency is the

one that you are buying or selling. This elementary point is often lost on beginners.

Exchange rates are usually written to four decimal places, with the exception of

Japanese yen which is written to two decimal places. The rate to two (out of four)

decimal places is known as the “big figure” while the third and fourth decimal places

together measure the “points” or “pips”. For instance, in GBP/USD = 1.5545 the “big

figure” is 1.55 while the 45 (i.e. the third and fourth decimal places) represents the

points.

2.1. Bid offer spread

As with other financial commodities, there is a buying price (“offer” or “ask” price) and a

selling price (“bid” price). The difference is known as the “bid-offer spread” or “the

spread”.

The spread is written in a particular format, best demonstrated by way of an example.

GBP/USD = 1.5545/50 means that the bid price of GBP is 1.5545 USD and the offer

price is 1.5550 USD. The spread in this case is 5 points.

2.2.The major pairings

All pairings with the US dollar are known as the “majors”. The “big four” majors are: -

EUR/USD denoting euro/USdollar

GBP/USD denoting sterling/US dollar (known as “cable”)

USD/JPY denoting US dollar /Japanese yen

USD/CHF denoting US dollar/Swiss franc.

2.3.Crossrates

Pairings of non-US dollar currencies are known as “crosses”. We can derive cross

exchange rates for GPB, EUR, JPY and CHF from the aforementioned major pairs.

Exchange rates must be consistent across all currencies, or else it will be possible to

“roundtrip”and make riskless profits.

The following “major” exchange rates (red) imply the “cross rates” (blue). An illustration

of how cross rates are computed is given in Appendix A.

3. Buying equals selling

Every purchase of the base currency implies a reciprocal sale of the secondary

currency. Likewise, sale of the base currency implies the simultaneous purchase of the

secondary currency.

For example, when I sell 1 GBP, I am simultaneously buying 1.5545 USD. Likewise,

when I buy 1 GBP, I am simultaneously selling 1.5550 USD.

We can express this equivalence by inverting the GBP/USD exchange rate and rotating

the bid and offer reciprocals, to derive the USD/GBP rate i.e.

USD/GBP = (1/1.5550) bid; (1/1.5545) offer = 0.6431/33

This means that the bid price of one USD is 0.6431 GBP (or 64.31p) and the offer price

of one USD is 0.6433 GBP (or 64.33p). Note that USD has now become the base

currency and that the spread is 2 points.

4. Practical spot trading

4.1 Units of trading – lots

As we have already seen, every forex transaction is an exchange of one currency for

another. The basic unit of trading for private investors is known as a “lot” which consists

of 100,000 units of the base currency (although some brokers may arrange trading in

mini-lots).

• Using the data in Table A, the purchase of a single lot of GBP/USD will involve the

purchase of 100,000 GBP at a price of 1.5852 USD = 158,520 USD.

• Similarly, the sale of a single lot of GBP/USD entails the sale of 100,000 GBP at

1.5847 USD = 158,470 USD.

4.2 Margin

A private investor who purchases a GBP/USD lot does not have to put down the full

value of the trade (158,520 USD). Instead, the buyer is required to put down a deposit

known as “margin” which enables the investor to gear up the trade size to institutional

level.

Since the sale of one currency involves the simultaneous purchase of another, the seller

of a GBP/USD lot will have bought a volume of USD, and will also have to put down

margin for the value of the deal (158,470 USD).

The normal margin requirement is between 1% and 5% of the underlying value of the

trade.

The currency denomination depends on the brokerage through which you execute your

trade. If you are dealing through an American broker (say online), then it is likely that

you will have to deposit margin in USD even if you are resident in the UK.

With 5,000 USD in your margin account and with margin requirement of 2.5%, you can

open positions worth 200,000 USD. Your positions will be valued continuously. If the

funds in your margin account drop below the minimum required to support your open

positions, then you may be asked to provide additional funds. This is known as a

“margin call”.

If your trade is denominated in a currency other than that accepted by the

broker, you will have to convert your gains and losses back into an acceptable currency.

For example, if you trade a USD/JPY pair, then your gains and losses will be

denominated in JPY. If your broker’s home currency is USD, then your profits and

losses will be converted back to USD at the relevant USD/JPY offer rate.

4.3 Closing out

An open position is one that is live and ongoing. As long as the position is open, its

value will fluctuate in accordance with the exchange rate in the market. Any profits and

losses will exist on paper only and will be reflected in your margin account.

To close out your position, you conduct an equal and opposite trade in the same

currency pair. For example, if you have gone long in one lot of GBP/USD (at the

prevailing offer price) you can close out that position by subsequently going short in one

GBP/USD lot (at the prevailing bid price).

Your opening and closing trades must the conducted through the same intermediary.

You cannot open a GBP/USD position with Broker A and close it out through Broker B.

5. Worked example

5.1 Betting on a rise

Assume that you start with a clean slate and that the current GPB/USD rate is

1.5847/52.

• You expect the pound to appreciate against the US dollar, so you buy a single lot of

100,000 GBP at the offer price of 1.5852 USD.

• The value of the contract is 100,000 X $1.5852 = $158, 520.

The broker wants margin of 2.5% in USD, so you must ensure that you deposit at least

2.5% of 158,520 USD = 3,963 USD in your margin account

• GBP/USD duly appreciates to 1.6000/05 and you decide to close out your position by

selling your sterling for US dollars at the bid rate. Your gain is:

100,000 X (1.6000 – 1.5852) USD = 1,480 USD, the equivalent of 10 USD per point

• Your rate of return is 1,480/3,963 = 37.35%, on an exchange rate movement of less

than 1%. This illustrates the positive effect of buying on margin.

• Had GBP/USD fallen to 1.5700/75, your loss would have been:

100,000 X (1.5852 – 1.5700) USD = 1,520 USD, a return of –38.35%

The lesson is that margin trading magnifies your rate of profit or loss.

6. Screen-based spot trading

The technology for trading forex has evolved from the telephone and telex (not

forgetting voice dealing) through to the modern Electronic Broking System (EBS) that

enables “straight through processing” (STP) with integrated quotation, transactional and

administrative functionality.

EBS-type technology is now available to individual, private investors who can receive

live, streaming data from and transact directly through their chosen brokers. The private

dealer, however, does not deal on the highly competitive inter-bank market with its tight

spreads. In practice, brokers add points to the price spread in lieu of dealing

commission.

A private trader requires:

• A margin account broker with internet access and a fast connection

• A computer terminal capable of running several programmes simultaneously

• Proprietary software to open and manage positions and to display technical analysis

tools.

• Sufficient monitors to handle market data, submit dealing instructions, display

technical analysis; and for keeping tabs on open positions, managing orders (e.g. stop

loss, TPO, limit etc.) and viewing the state of the margin account. For demonstrations of

the kind of proprietary software available, visit Pronet Analytics

(www.pronetanalytics.com) and Nostradamus (www.nostradamus.co.uk)

Pronet Analytics provides the only chart-based software package approved by

Association of Cambistes Internationale, the governing body of professional forex

trading.

From early 2003, a new spot trading software package from US provider Gain Capital

will be available through the UK online margin broker Easy2Trade

(www.easy2trade.com), better known for its futures online global trading platform. “We

will build our required margin into the bid-offer spread,” says Easy2Trade chief

executive David Wenman. “It will be free to use after that.”

Before you splash out on the full kit, why not does a test drive by renting a dealing desk

at an organization like TraderHouse (www.traderhouse.net).

Fundamental and technical analysis

Without the apparatus for making sense of the currency market, any trade represents a

pure gamble. There are two broad schools of analysis, which are not mutually exclusive.

Fundamentalanalysis

Fundamental analysis is the application of micro and macroeconomic theory to markets,

with the aim of predicting future trends. So what fundamental forces drive currency

markets?

(a). The balance of trade: Currencies that are associated with long term trade

surpluses will tend to strengthen against those associated with persistent deficits -

simply because there is net buying of surplus currencies corresponding to the excess of

exports over imports.

Trends are important too. An improving balance of trade should cause the relevant

currency to appreciate relative to those associated with a deteriorating or stable balance

of trade.

(b). Relative inflation rates: If country A is suffering a higher rate of price inflation than

country B, then A’s currency ought to weaken relative to B’s in order to restore

“purchasing power parity”.

(c). Interest rates: International capital flows seek the highest inflation-adjusted returns,

creating additional demand for high real interest-rate currencies and pushing up their

rates of exchange.

(d). Expectations and speculation: Markets anticipate events. Speculation on, say,

the future rate of inflation may be enough to move the exchange rate - long before the

actual trend becomes apparent.

It should be understood that these economic forces act in concert. It is a supremely

difficult task, however, to establish where the sum of interacting economic forces will

take the market. The solution, some argue, lies in technical analysis.

Technical analysis

Technical analysis is concerned with predicting future price trends from historical price

and volume data. The underlying axiom of technical analysis is that all fundamentals

(including expectations) are factored into the market and are reflected in exchange

rates.

The tools of technical analysis are now freely available to private investors in support of

their trading decisions. It cannot be stressed too heavily, however, that such tools are

only estimators and are not infallible.

The following is the briefest of introductions to the technical analytical tools used to

identify trends and recurring patterns in a volatile marketplace. Aspiring forex dealers

are advised to undergo proper training in technical analysis, although true proficiency

comes with practice, endurance and experience.

Hedging Strategies/ Instruments

A 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 with foreign exchange

being the only risk assumed.

Forwards

A forward is a made-to-measure agreement between two parties to buy/sell 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. If 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. E.g if

RIL wants to buy crude oil in US dollars six months hence, it can enter into a forward

contract to pay INR and buy USD and lock in a fixed exchange rate for INR-USD to

be paid after 6 months regardless of the actual INR-Dollar rate at the time. In this

example the downside is an appreciation of Dollar 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. On the downside,

these contracts are not marketable, they can’t be sold to another party when they

are no longer required and are binding.

Futures

A futures contract is similar to the forward contract but is more liquid because it is

traded in an organized exchange i.e. the futures market. Depreciation of a currency

can be hedged by selling futures and appreciation can be hedged by buying futures.

Advantages of futures are that there is a central market for futures which eliminates

the problem of double coincidence. Futures require 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 RIL applies here also just that RIL

will have to go to a USD futures exchange to purchase standardised dollar futures

equal to the amount to be hedged as the risk is that of appreciation of the dollar. As

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.

Options

A currency Option is a contract giving the right, not the obligation, to buy or sell a

specific quantity of one foreign currency in exchange for another at a fixed price;

called the Exercise Price or Strike Price. The fixed nature of the exercise price

reduces the uncertainty of exchange rate changes and limits the losses of open

currency positions. Options are particularly suited as a hedging tool for contingent

cash flows, as is the case in bidding processes. Call Options are used if the risk is

an upward trend in price (of the currency), while Put Options are used if the risk is a

downward trend. Again taking the example of RIL which needs to purchase crude oil

in USD in 6 months, if RIL buys a Call 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. If the exchange rate movement is favourable i.e the

dollar depreciates, then RIL can buy them at the spot rate as they have become

cheaper. In the other case, if the dollar appreciates compared to today’s spot rate,

RIL can exercise the option to purchase it at the agreed strike price. In either case

RIL benefits by paying the lower price to purchase the dollar

Swaps

A swap is a foreign currency contract whereby the buyer and seller exchange equal

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. At maturity, the principal amount is

effectively re-swapped 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. Apart from covering the exchange rate risk, swaps also

allow firms to hedge the floating interest rate risk. Consider an export oriented

company that has entered into a swap for a notional principal of USD 1 mn at an

exchange rate of 42/dollar.

The company pays US 6months LIBOR to the bank and receives 11.00% p.a. every

6 months on 1st January & 1st July, till 5 years. Such a company would have

earnings in Dollars and can use the same to pay interest for this kind of borrowing

(in dollars rather than in Rupee) thus hedging its exposures.

Foreign Debt

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

of the International Fischer Effect 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.

Determinants of Hedging Decisions

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

complicated process. A 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.

Production and Trade vs. Hedging Decisions

An 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. Research in this area suggests that the elements of exchange

rate uncertainty and the attitude toward risk are irrelevant to the multinational firm's

sales and production decisions (Broll,1993). Only 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.

Cost of Hedging

Hedging can be done through the derivatives market or through money markets (foreign

debt). In 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. In 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. In 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 Reuter reports and news channels and administrative costs of

exposure management.

Factors affecting the decision to hedge foreign currency risk

Research 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 size, R&D expenditure and exposure to exchange rates through foreign

sales and foreign trade are more likely to use derivatives. (Allayanis and Ofek, 2001)

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 size

Firm size acts as a proxy for the cost of hedging or economies of scale. Risk

management involves fixed costs of setting up of computer systems and

training/hiring of personnel in foreign exchange management. Moreover, large firms

might be considered as more creditworthy counterparties for forward or swap

transactions, thus further reducing their cost of hedging. The book value of assets is

used as a measure of firm size.

Leverage

According 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. Highly levered firms avoid foreign debt as a

means to hedge and use derivatives.

Liquidity and profitability:

Firms with highly liquid assets or high profitability have less incentive to engage in

hedging because they are exposed to a lower probability of financial distress.

Liquidity is measured by the quick ratio, i.e. quick assets divided by current

liabilities). Profitability is measured as EBIT divided by book assets.

Sales growth

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 enjoy uninterrupted high

growth. The measure of sales growth is obtained using the 3-year geometric

average of yearly sales growth rates.

As regards the degree of hedging Allayanis and Ofek (2001) conclude that the sole

determinants of the degree of hedging are exposure factors (foreign sales and trade). In

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.

This discussion highlights how risk management systems have to be altered according

to characteristics of the firm, hedging costs, nature of operations, tax considerations,

regulatory requirements etc. The next section discusses these issues in the Indian

context and regulatory environment.

BIBLIOGRAPHY

o www.google.com GOOGLE SEARCH ENGINE

o Dr. G. KOTRESHWAR, RISK MANAGEMENT, HIMALAYA PUBLISHING

HOUSE, MUMBAI.

o A.K.SETH, INTERNATIONAL FINANCIAL MANAGEMENT.

o LEVY, INTERNATIONAL FINANCIAL MANAGEMENT.

o V.K.BHALLA, INTERNATIONAL FINANCIAL MANAGEMENT.

o SHAPIRO, INTERNATIONAL FINANCIAL MANAGEMENT.