project report s
TRANSCRIPT
CORPORATE HEDGING IN INDIA
With Special Reference to
COCHIN STOCK EXCHANGE LTD
Project Report
Submitted by
SURYA.S
(Reg.No.1019)
In partial fulfillment of requirement for the award of
POST GRADUATE DIPLOMA IN MANAGEMENT
to
BHAVAN’S ROYAL INSTITUTE OF MANAGEMENT
(Approved by All India Council for Technical Education, New Delhi)
TIRUVANKULAM, KOCHI – 682305
2008-2010
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CORPORATE HEDGING IN INDIA
With Special Reference to
COCHIN STOCK EXCHANGE LTD
Project Report
Submitted by
SURYA.S
(Reg.No.1019)
Under the Guidance of
Prof. Samuel Thomas
In partial fulfillment of requirement for the award of
POST GRADUATE DIPLOMA IN MANAGEMENT
to
BHAVAN’S ROYAL INSTITUTE OF MANAGEMENT
(Approved by All India Council for Technical Education, New Delhi)
TIRUVANKULAM
KOCHI – 682305
2008-2010
2
DECLARATION
I SURYA.S, hereby declare that this report on “CORPORATE HEDGING IN INDIA
” is the record of my project work done for COCHIN STOCK EXCHANGE LTD, under the
supervision of Dr. Thomas George, Cochin Stock Exchange Ltd. I also declare that this
project report is my original work and that it has not previously formed the basis for award of
any degree or diploma.
Date: 15/09/10 SURYA.S
Place: Cochin
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CERTIFICATE
I do hereby certify that this Project report on “CORPORATE HEDGING IN INDIA”
submitted to Bhavan’s Royal Institute of Management is a bonafide record of project work
done under my guidance by Ms. Surya.s for COCHIN STOCK EXCHANGE Ltd in partial
fulfillment of requirements for the award of Post Graduate Diploma in Management . It is also
certified that this report has not been previously formed the basis for the award of any degree,
diploma or any other similar titles.
Date:-15-09-10 PROF. (DR) B.HAREENDRAN
Thiruvamkulam DEAN
CHAPTER 1
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INTRODUCTION
1.1Introduction
Derivatives are one of the most important classes of financial instruments that are central
to today’s financial markets. They offer various types of risk protection and allow innovative
investment strategies. In India the derivatives market was small and domestic just a few years
back. Since then it has grown impressively and had reached to a sizable volume, for example on
an average providing 3,500 crores of volume in the national stock exchange in daily currency
derivative trade. No other class of financial instruments has experienced as much innovation.
Product and technology innovation together with competition have fuelled the impressive growth
that has created many new jobs both at exchanges and intermediaries as well as at related service
providers.
Given the derivatives market’s global nature, users can trade round the clock and make
use of currency derivatives that offer exposure to the investor in almost any “Underlying
Currency” across all markets. The Currency derivatives market is growing at a fast pace and
providing all different investing horizons to the investors like Hedging, Speculation, Arbitrage
and investment. There are two competing segments in the currency market: the off-exchange or
over-the-counter (OTC) segment and the on-exchange segment. From a customer perspective,
OTC trading is approximately less expensive than on-exchange trading. By and large, the
currency derivatives market is safe and efficient. Risks are particularly well controlled in the
exchange segment, where central counterparties (CCPs) operate very efficiently and mitigate the
risks for all market participants.
The currency derivatives market has successfully developed under an effective
regulatory regime in India. All three prerequisites for a well-functioning market – safety,
efficiency and innovation – are fulfilled. While there is no need for structural changes in the
framework under which OTC players and exchanges operate today, improvements are possible.
Particularly in the OTC segment, increasing operating efficiency, market transparency and
enhancing counterparty risk mitigation would help the global derivatives market to function even
more effectively. At the end of the day, currency derivatives market opens up new window for
the investors in India to go beyond the stereotype equity and commodity market and enjoy the
Currency market.
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1.2 Statement of the problem
Risk is unavoidable. Hedging is a tool that helps to avoid the risk due to the price
fluctuations of an underlying asset. Due to the volatility in the currency market the price changes
very frequently. So derivatives play a role. This study mainly covers the area of hedging. The
main aim of the study was to prove how corporate houses reduce their foreign exchange
exposure and risk by using derivatives product. Corporates use hedging as a tool to avoid risk
and so it can be said to be a precautionary measure. They use mainly two types of hedging-
forward and futures. Based on the volatility of the market, the risk may either increase or
decrease. Future is uncertain and unpredictable. But hedging helps the corporates to avoid the
huge risk facing them and all these are done based on assumptions. Indian corporates also mainly
uses hedging as a tool to avoid risk. The corporates who involve in transactions with foreign
corporates use hedging as the main tool for avoiding foreign exchange risks. This study aims to
provide a perspective on managing the risk that firm’s face due to fluctuating exchange rates. It
investigates the prudence in investing resources towards the purpose of hedging and then
introduces the tools for risk management. These are then applied in the Indian context. The
relevance of this study came from the recent rise in volatility in the money markets of the world
and particularly in the US Dollar, due to which Indian exports are fast gaining a cost
disadvantage. Hedging with derivative instruments is a feasible solution to this situation.
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1.3Objective of the study
Major objective
1. To analyses whether hedging is an effective tool to managing exchange rate risk.
Other objectives
1. To find out the better hedging strategy for managing exchange rate risk.
2. To study the foreign exchange market.
3. To give an overview about useful derivatives products used for managing risk.
1.4Scope of the study
The present study provided the researcher an opportunity to conduct a detailed study
about the foreign exchange market, which is the largest financial market in the world. The
researcher could scan through literature on derivatives products which is emerging in India
markets also. The study enabled the researcher to examine and prove that hedging is very
effective in containing the exchange rate risk. The relative influvance of futures and forwards in
containing the risk involved in foreign currency operation will be highly useful to the researcher
and the stock exchange operators.
1.5Research Methodology
1.5.1 Research design- The study about "Corporate Hedging for Foreign Exchange Risk in
India” was an empirical study to compile a theoretical perspective and bring clarity in this field
of study
1.5.2 Research approach – Historical data analysis is the research approach in this study. Desk
research is an effective method of past data analysis and past data analysis is attempted here.
Desk research is a process of gathering and analysing information, already available in print or
published or on the internet or in the company records. Desk research was attempted to reduce
the time and cost involved in collecting costing primary information.
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1.6 Sources of Data
Researcher depends two types of sources for collecting the relevant information for
conducting research. They are primary source and secondary source .
1. Primary data
Data observed or collected directly from first-hand experience. Primary data is collected
through interviews, surveys, observations or through experiments.
2. Secondary data
The present study being a past data analysis used only secondary data .the secondary
data is data, which was collected and compiled previously for different purpose. The present
study depends solely on secondary sources for collecting all the required information for the
successful completion of the study. The secondary data include material collected from:
1. Historical Values for BSE Indices: - http://www.bseindia.com/index_op.htm
2. World Interest Rates Table :- http://www.fxstreet.com
3. Exchange rate history:- http://www.exchangerates.org.uk/currency-tools.html
4. BIS Survey 2010:- www.bis.org/statistics/derstats.htm
5. Newspaper
6. Magazine
7. Internet
8. Website
9. Books
10. Journals
1.5.3 Research instrument– Mathematical and statistical tools were used to compute the effect
of hedging strategies and for comparing the relative benefit of a hedger and a non-hedger. The
secondary data on spot rate, market rate, interest rate and the BSE Sensex and the like were
extracted from different sources using structured tables.
1.7 Research period
To study the hedging strategies of corporate houses for the period of three years starting
from 2007 to 2010.
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1.8 Limitation of the study
The limitations of the study were
1. The analysis was purely based on the secondary data. So, any error in the secondary data might
affect the result of the present study also.
2. While applying the strategies, transaction cost and impact cost are not taken into consideration
so, it will reflect in the profit calculation on each month of the study.
3. Hedging strategy was applied on historical data. So the direction of each trend in the
stock market is known before hand for the period selected. As a result, some bias may
creep in the section of the application of hedging strategy.
4. There was no organized information available on how the corporate enterprises in India
are facing this challenge
1.9 CHAPTER SCHEME
This project report contains 6 chapters.
i. First chapter contains introduction which includes statement of the problem, objectives of
the study, scope of the study, research methodology, limitations of the study and chapter
scheme.
ii. Second chapter provides the industry profile which contains international scenario,
national scenario and the state scenario.
iii. Third chapter gives an overview about the profile of Cochin Stock Exchange which
includes the history and growth of the company till now, future plans, financial
performance of the company and the details of Finance department etc.
iv. Fourth chapter discusses the theoretical background and it gives an overview about the
concept of Corporate Hedging.
v. Fifth chapter includes data analysis and interpretation of data collected for this study.
vi. Sixth chapter contains the findings, suggestions and conclusion of the research.
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CHAPTER II
INDUSTRY PROFILE
2.1 Foreign Exchange Market
The foreign exchange (FX) market is the largest financial market in the world. It is the
largest and most liquid financial market in the world. Globally, operations in the foreign
exchange market started in a major way after the breakdown of the Britton Woods system in
1971, which also marked the beginning of floating exchange rate regimes in several countries.
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. Thus over the years, the foreign exchange
market has emerged as the largest market in the world.
The foreign exchange market runs 24 hours a day from Monday 5:00 am Australian
Eastern Standard Time (AEST), to Friday 5:00pm New York time. It is a place where global
currencies are bought and sold against one another however, unlike the commodity and stock
markets, it is not a physical market based on one building or location. Rather, it is an
organizational framework within which participants, linked by telephone and computers, buy and
sell global currencies. Actual currencies are not physically traded; instead, they are transferred
electronically from one back account to another.
The Forex market has historically been dominated by banks including central banks,
commercial banks, and investment banks. However the number of other participants is growing
rapidly and now includes large multinational corporations, global money managers, registered
dealers, international money brokers, futures and options traders, small businesses and private
speculators. The Forex market is an over-the-counter (OTC) market. This means that the size of
the "deal" and the "settlement date" are negotiable between the two counterparties in the market.
Currency prices are affected by a variety of economic and political conditions, but the most
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important factors are interest rates, inflation and political stability. Any of these factors, as well
as large market orders, can cause high volatility in currency prices. However, the size and
volume of the FX market makes it impossible for any one entity to affect the market significantly
for any length of time
2.2Global Foreign Exchange Market
Measured by the daily turnover the foreign exchange market is the largest financial
market in the world. The most commonly traded, or "liquid", currencies are those from countries
with stable governments, respected central banks, and low inflation. Today, over 85% of all daily
transactions involve trading of the major currencies which include the US Dollar (USD),
Japanese Yen (JPY), Euro (EUR), British Pound (GBP), Swiss Franc (CHF), Canadian Dollar
(CAD) and the Australian Dollar (AUD). The higher global foreign exchange market turnover in
2010 is largely due to the increased trading activity of “other financial institutions” – a category
that includes no reporting banks, hedge funds, pension funds, mutual funds, insurance companies
and central banks, among others. Turnover by this category grew by 42%, increasing to $1.9
trillion in April 2010 from $1.3 trillion in April 2007. For the first time, activity with other
financial institutions surpassed transactions between reporting dealers.
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Global foreign exchange market turnover was 20% higher in April 2010 than in April
2007. This increase brought average daily turnover to $4.0 trillion (from $3.3 trillion) at current
exchange ratesOver the long term the US stock market has always gone up giving stocks in the
US an upward bias when trading. As currencies are traded in pairs when the value of one
currency is falling this automatically means that the value of another currency is rising. This is
an advantage from the standpoint of there is equal opportunity for profit from both long and short
trades. This is a disadvantage from the standpoint of not having that upward bias working for
you when you are in a long trade
2.3 Foreign exchange market turnover
The April 2007 data on turnover in traditional foreign exchange markets highlight several
important features of the evolution of these markets. The average daily turnover has grown by an
unprecedented 69% since April 2004, to $3.2 trillion. This increase was much stronger than the
one observed between 2001 and 2004. Even abstracting from the valuation effects arising from
exchange rate movements, average daily turnover rose by 63%. Second, growth in turnover was
broad-based across instruments. More than half of the increase in turnover can be accounted for
by the growth in foreign exchange swaps, which rose 80% compared with 45% over the previous
three-year period. Changes in hedging activity may have been one factor underlying the
increasing importance of foreign exchange swap instruments. Growth in the turnover of outright
forward contracts also picked up significantly to 73%. In contrast, turnover in spot markets
increased by 59%, which is somewhat lower than the growth in turnover in the previous three-
year period.
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Third, the composition of turnover by counterparty changed substantially. Transactions
between reporting dealers and non-reporting financial institutions, such as hedge funds, mutual
funds, pension funds and insurance companies, more than doubled between April 2004 and April
2007 and contributed more than half of the increase in aggregate turnover. Factors underlying the
strength of this segment include strong investor activity in an environment of trending exchange
rates and low levels of financial market volatility, a trend shift among institutional investors with
a longer-term investment horizon towards holding more internationally diversified portfolios and
a marked increase in the levels of technical trading. Turnover between reporting dealers and non-
financial customers also more than doubled. Consequently, the share of turnover resulting from
transactions between reporting dealers, ie the interbank market, fell to 43%, despite growth in
this segment being slightly lower than in the previous three-year period. Fourth, the currency
composition of turnover has become more diversified over the past three years. The share of the
four largest currencies fell, although the US dollar/euro continued to be the most traded currency
pair. The most notable increases in share were for the Hong Kong dollar, which has benefited
from being associated with the economic expansion of China, and the New Zealand dollar, which
has attracted attention from investors as a high yielding currency. More broadly, the share of
emerging market currencies in total turnover has increased, to almost 20% in April 2007. Finally,
the geographical distribution of foreign exchange trading did not change significantly. Among
countries with major financial centres, 2 Triennial Central Bank Survey 2007 Singapore,
Switzerland and the United Kingdom gained market share, while the shares of Japan and the
United States dropped. In some cases, changing shares reflected the relocation of desks. Global
foreign exchange market turnover was 20% higher in April 2010 than in April 2007, with
average daily turnover of $4.0 trillion compared to $3.3 trillion. The increase was driven by the
48% growth in turnover of spot transactions, which represent 37% of foreign exchange market
turnover. Spot turnover rose to $1.5 trillion in April 2010 from $1.0 trillion in April 2007. The
increase in turnover of other foreign exchange instruments was more modest at 7%, with average
daily turnover of $2.5 trillion in April 2010. Turnover in outright forwards and currency swaps
grew strongly. Turnover in foreign exchange swaps was flat relative to the previous survey,
while trading in currency options decreased. As regards counterparties, the higher global foreign
exchange market turnover is associated with the increased trading activity of “other financial
institutions” – a category that includes non-reporting banks, hedge funds, pension funds, mutual
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funds, insurance companies and central banks, among others. Turnover by this category grew by
42%, increasing to $1.9 trillion in April 2010 from $1.3Mtrillion in April 2007. For the first
time, activity of reporting dealers with other financial institutions surpassed inter-dealer
transactions (ie transactions between reporting dealers).Foreign exchange market activity became
more global, with cross-border transactions representing 65% of trading activity in April 2010,
while local transactions account for 35%. The percentage share of the US dollar has continued its
slow decline witnessed since the April 2001 survey, while the euro and the Japanese yen gained
relative to April 2007. Among the 10 most actively traded currencies, the Australian and
Canadian dollars both increased market share, while the pound sterling lost ground and the Swiss
franc declined marginally. The market share of emerging market currencies increased, with the
biggest gains for the Turkish lira and the Korean won. The relative ranking of foreign exchange
trading centres has changed slightly from the previous survey. Banks located in the United
Kingdom accounted for 36.7%, against 34.6% in 2007, of all foreign exchange market turnover,
followed by the United States (18%), Japan (6%), Singapore (5%), Switzerland (5%), Hong
Kong SAR (5%) and Australia (4%).
2.4 24 Hour Liquidity
Probably the biggest advantages that traders of the forex market will cite is that main
currencies can be traded actively 24 hours a day. The huge amount of volume traded in the
world’s main currencies each day the volume traded in the equities and the futures markets many
times over. This combined with the 24 hour trading day gives traders the ability to determine
their own trading hours instead of having to trade within set hours as they would have to when
trading stocks and/or futures. More importantly than this however is that as the market is more
liquid than the futures and equities markets, price slippage (the difference between where you
click to enter or exit a trade and where you actually get in or out) in the forex market is normally
much smaller than in the stock and futures market.
Geographical distribution of turnover
The geographical distribution of foreign exchange trading typically changes slowly over
time, and the 2010 results are no exception (Table 5). Banks located in the United Kingdom
accounted for 37% of global foreign exchange market turnover, followed by the United States
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(18%), Japan (6%), Singapore (5%), Switzerland (5%), Hong Kong SAR (5%) and Australia
(4%). Japan has recovered its third place ranking, which it lost in the 2007 survey. Singapore has
moved up ahead of Switzerland in 2010. In dollar terms, the greatest increases in trading activity
were in the United Kingdom ($371 billion), the United States ($159 billion), Japan ($62 billion)
and Hong Kong SAR ($57 billion). Other countries that saw significant survey include Denmark,
France, Singapore, Finland, Turkey and Spain.
Source -BIS Quarterly Review, December 2010
2.5 Exchange Traded and Over the Counter Markets
When trading stocks or futures you normally do so via a centralized exchange such as the
New York Stock Exchange, Bombay stock exchange, or the Chicago Mercantile Exchange. In
addition to providing a centralized place where all trades are conducted, exchanges such as these
also play the key role of acting as the counterparty to all trades. What this means is that while
you may be buying for example 100 shares of Infosys stock at the same time someone else is
selling those shares, you do not buy those shares directly from the seller but instead from the
exchange. The fact that the exchange stands on the other side of all trades in exchange traded
markets is one of their key advantages as this removes counterparty risk, or the chance that the
person who you are trading with will default on their obligations relating to the trade. A second
key advantage of exchange traded markets is that as all trades flow through one central place, the
price that is quoted for a particular instrument is always the same regardless of the size or
sophistication of the person or entity making the trade.
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2.6 Over the counter market
Unlike the stock market and the futures market which trade on centralized exchanges, the
spot Forex market and many debt markets trade in what’s known as the over the counter market.
What this means is that there is no centralized place where trades are made, instead the market is
made up of all the participants in the market trading among themselves .The biggest advantage to
over the counter markets is that because there is no centralized exchange and little regulation,
you have heavy competition between different providers to attract the most traders and trading
volume to their firm. This being the case transaction costs are normally lower in over the counter
markets when compared to similar products that trade on an exchange. As there is no centralized
exchange the firms that make prices in the instrument that is trading over the counter can make
whatever price they want, and the quality of execution varies from firm to firm for the same
instrument. While this is less of a problem in liquid markets such as Forex market where there
are multiple price reference sources, it can be a problem in less traded instruments
Activity in OTC derivatives markets was vibrant. Average daily turnover in OTC foreign
exchange and interest rate contracts went up by 73% relative to the previous survey in 2004, to
reach $4,198 billion. This corresponds to an annual compound rate of growth of 20%, which is
higher than the 14% growth recorded since the derivatives part of triennial survey was started in
1995. Activity in foreign exchange derivatives rose by 78%, slightly above the rate of increase
reported for the spot market (59%). More moderate growth was recorded in the interest rate
segment, where turnover went up by 64%.
.
2.7 The Global Foreign Exchange Market: Growth and Transformation
The foreign exchange market is known to be the largest financial market in the world, as
measured by daily turnover. The most recent BIS Triennial Survey (BIS 2007) estimates that the
total turnover in global foreign exchange markets is US$3.2 trillion a day—more than 6 times
larger than trading in U.S. Treasury bonds and 30 times larger than trading on the New York
Stock Exchange (SIFMA 2007; NYSEData.com 2007). What may be less apparent is how
quickly this market has grown over the past few years and why it is growing so quickly. By most
estimates, the trading volumes in the foreign exchange market are continuing to grow rapidly.
The Tower Group, for example, recently estimated that daily global trading volumes would
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likely reach US$5 trillion by 2010 (Profit & Loss Magazine 2007). Should this happen, foreign
exchange trading volumes will have more than tripled in this decade. As the market expands, it is
undergoing a remarkable transformation that is changing who is trading foreign exchange and
how they are doing it. In turn, these changes are accelerating market growth. An increasing
proportion of overall foreign exchange trading volume is being transacted on electronic trading
platforms, both in the interbank market as well as between banks and clients; by large global
investment dealers and non-bank market participants; and by computer driven algorithmic
trading strategies. Together, these closely related and mutually reinforcing elements are defining
a new paradigm for the foreign exchange market and, indeed, for global financial markets in
general.
Foreign Exchange and Derivatives Market Activity shows that turnover in traditional
foreign exchange markets increased significantly to $3.2 trillion in April 2007. The growth since
April 2004, the previous survey date, was an unprecedented 71% at current exchange rates and
65% at constant exchange rates. Although this growth was broadly based across traditional
foreign exchange instruments, the pickup in the growth of foreign exchange swaps was
particularly strong, increasing to 82% from 44% over the previous three years. Turnover in
foreign exchange derivatives, such as currency swaps and foreign exchange options, increased
even more rapidly, albeit from a very small base. Trends in the growth of turnover by different
types of counterparty established in earlier surveys have continued. The increase in trading
between reporting dealers, typically commercial and, to a lesser extent, investment banks, and
other financial institutions, including hedge funds and pension funds, was particularly notable:
the share of this trade in total turnover increased from 33% to 40% . The share of trading
between reporting dealers and non-financial customers also rose, reaching 17%, recovering to the
level it held in 1992–98. Correspondingly, the share of interbank trading continued to fall. In
April 2007, trading between reporting dealers captured 43% of the total market, compared to
53% in 2004 and 64% in 1998. This trend is present across instruments.
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Source -BIS Quarterly Review, December 2010
There have been small but significant changes in the currency composition of foreign
exchange turnover. In particular, the presence of emerging market currencies has increased. This
potentially points to significant longer-term trends that may have implications for the
geographical distribution of foreign exchange sales, given differences in the importance of these
currencies for different financial centres first focuses on the factors underlying the increase in
turnover with other financial institutions. In particular, it looks at the contribution made by
leveraged investors exploiting short-term profit opportunities through strategies such as the carry
trade, by investors with a longer-term horizon diversifying their portfolios and by algorithmic
traders secondly explores the growing importance of emerging market currencies and the
implications this has had for different financial centres.
2.8 Rapid growth in turnover with financial customers
Financial customers were the main drivers of the strong rise in global turnover. Growth in this
segment has accounted for half of the increase in total turnover over the past three years,
compared with 29% for interbank trading and 21% for the non-financial customer segment. This
growth can be explained by several factors, many of which were noted in previous surveys and,
as such, can be regarded as a continuation of earlier trends (Galati and Melvin (2004). First,
foreign exchange markets have offered leveraged investors with relatively short investment
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horizons attractive returns. Second, investors with a longer term investment horizon have been
actively diversifying their portfolios, which have created direct and indirect demand for foreign
exchange. Finally, an increase in high-frequency algorithmic trading by some investors, mostly
investment banks, has also increased turnover, particularly in the spot market.
2.9 Global Average Daily Trading Volume in Foreign Exchange
Market commentary has suggested that leveraged investors such as hedge funds have
been primary players in foreign exchange market activity in recent years. In addition, leveraged
retail investors also appear to be a growing presence in foreign exchange markets, although the
impact of these investors on global turnover is still relatively small and the degree of leverage is
not likely to be large (Galati et al (2007)). One of the factors driving this trend is that retail
investors have had significantly more access to margin accounts through online trading services
targeted at retail traders, such as Deutsche Bank’s dbFX. Indeed, strategies such as the carry
trade, which use leverage to exploit interest rate differentials and exchange rate trends in an
environment of low financial market volatility, have been profitable over the past three years
(Galati et al (2007),The triennial survey statistics show that several currencies identified as carry
trade targets, such as the Australian and New Zealand dollars, experienced particularly strong
growth in turnover between April 2004 and April 2007 More broadly, there is a positive
correlation between growth in turnover and the level of domestic interest rates across instruments
The contribution of these investment strategies to overall turnover has been amplified by the
increase in the funds managed by leveraged investors. Although it is difficult to obtain precise
numbers, it is clear that hedge fund activity, measured by either estimates of assets under
management or the number of funds, has increased significantly over the past six years left-hand
and centre panels). The growth in hedge fund activity has been concentrated in the United States
and London. In addition to access to relatively cheap funding and benign conditions in financial
markets, hedge fund growth in foreign exchange markets has benefited from the development of
prime brokerage services Institutional investors, such as pension funds and investment trust
managers with a longer-term investment horizon, have also been more active in their cross-
currency investment activities. This reflects a number of driving forces. First, similarly to
investors with a shorter-term horizon, these investors have increasingly viewed foreign exchange
as a distinct asset class and have taken a more active approach to the management of currency
19
exposure with a view to improving returns on international investments. Second, the portfolios
these institutions manage have become increasingly diversified internationally (CGFS (2007)),
encouraged by developments in financial markets, the greater availability of instruments that
allow foreign exchange risk to be hedged and regulatory changes. A third driving force is that the
value of funds managed by these investors has grown significantly. Data on Japanese investment
trusts provide a specific example of the latter two factors at work, right-hand panel).
Another factor likely to have been important for the increase in turnover between
reporting dealers and other financial institutions, particularly hedge funds and investment banks,
is the growing role of algorithmic trading (The Economist (2007), Pengelly (2007)). This style of
trading is designed to exploit high-frequency movements in exchange rate quotes that are
available electronically, based on a set of predetermined rules. For example, algorithmic traders
have tried to exploit changes in carry trade profitability at very high frequencies. Algorithmic
trading generates high turnover relative to the underlying size of the positions. The growth in this
market segment owes much to advances in technology in electronic trading systems, particularly
in the spot market there is also anecdotal evidence that algorithmic traders have contributed to a
significant rise in futures market activity
Currency distribution and turnover by currency pair
The currency composition of turnover changed only slightly over the past three years, with the
relative share of the main currencies diverging somewhat. The market share of the top three currencies
(the US dollar, euro and Japanese yen) increased by 3 percentage points, with the market share of the top
10 increasing by only 1.4 percentage points. The biggest increases were seen for the euro and Japanese
yen, and the biggest decline for the pound sterling. The market share of the 23 emerging market
currencies listed in Table 3 increased to 14.0% in April 2010 from 12.3% in April. 2007. The most
significant increases were seen for the Turkish lira and the Korean won, followed by the Brazilian real
and the Singapore dollar9. The US dollar continued a slow retreat from its 90% peak share of all
transactions, reached in the 2001 survey just after the introduction of the euro. The share of foreign
exchange transactions involving the US dollar has fallen slowly, reaching 85% in April 2010. This
decline benefited the euro, which gained 2 percentage points in market share since the last survey and
accounts for 39% of all transactions. The Japanese yen also increased its market share by 2 percentage
points to 19%, a recovery relative to the 2007 survey but still below its peak of 23.5% reached in 2001.
The pound sterling gave up most of its post-euro gains, with its share returning to the immediate post-
euro level of around 13%. Trading in the Swiss franc also declined marginally to 6.4% from 6.8% in
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April 2007. The Australian and Canadian dollars both increased their share by around 1 percentage point,
to 7.6% and 5.3%, respectively. Turnover by currency pair in April 2010 did not show major changes
from three years earlier. USD/EUR remained by far the dominant pair (with a 28% share), followed at
some distance by USD/JPY with a slight increase to 14% of turnover. The USD/GBP pair continued to
retreat from its peak of 2004 to a 9% share or about the level reached in pre-euro 1998.
2.10 Innovations in Electronic Dealing Technology
Through the mid-1990s, the foreign exchange market was primarily reliant on phone-
based technology. A client needing to deal in foreign exchange would phone a bank with which
it had a line of credit and ask for a two-sided price, i.e., a bid and offer on the specified Amount
of foreign exchange to be transacted. Banks would quote prices for their clients on demand,
serving as market-makers. The market-maker bank would have typically transferred, or laid-off,
the risk created by the deal in the interbank market by phoning other banks with which it had
established a dealing relationship and conducting an offsetting transaction. (These interbank
dealing relationships were mutual obligations between banks to quote each other two-sided
prices on demand for wholesale amounts of foreign exchange —typically US$5 million or
larger.) This phone-based network of direct relationships between banks was the principal
component of the interbank market, the central source of liquidity in the foreign exchange
market. Frequently, banks’ participation in these interbank dealing relationships was motivated
solely by price discovery. Because the wholesale price apparent to a dealer consisted only of the
two-sided quotes provided on demand by other banks (and even then, only for the duration of the
phone call) and because they were faced with a constantly changing foreign exchange rate, banks
were forced to make frequent calls to each other throughout the business day to learn the current
wholesale price. Banks would typically “pay away the spread” (the difference between bid and
offer quotes) on price-discovery transactions as a necessary cost of doing business. During the
past decade, these interbank dealing arrangements began to shift to electronic protocols. Reuters
Dealing and EBS (Electronic Broking Services) both introduced electronic interbank trading
platforms in the early 1990s. Although uptake of electronic broking was relatively slow at first,
by the late 1990s these platforms came to dominate interbank trading flows. By most estimates,
their combined market share now accounts for about 90 per cent of interbank trading in most
major currency pairs; voice broking accounts for most of the rest, while direct dealing among
major banks has all but disappeared.
21
The price-discovery process on Reuters Dealing and EBS differs from the phone-based
model of direct dealing in several key aspects. First, banks participating on these platforms are
not obliged to provide two-sided price quotes to other banks on demand. A bank can post a one-
sided price (either a bid or an offer) and only when it chooses to. Second, the minimum deal size
allowed on these portals is much smaller than the standard wholesale amounts used in the
traditional direct-dealing relationships between banks. This allows any dealer with a smaller
amount to transact to enter the market without the obligation of making or accepting delivery of
unwanted, larger amounts. Third, and perhaps most importantly, these electronic portals provide
a live price stream that aggregates all bids and offers posted on the system. This interbank price
is visible at all times to all participating dealers. The same technology that enabled electronic
price delivery in the interbank market was relatively easily
Extended to bank-to-client (B2C) relationships as well. Single-bank portals are bank-owned
trading platforms that establish an electronic communications link between the dealer and its
end-user clients, supplying that dealer’s price quotes and trade details electronically. Multi-bank
portals are third-party platforms that connect an end-user client with price quotes from several
banks simultaneously. (Examples of multibank portals include FX Connect and FX all; average
daily trading volumes on these two platforms are shown in Chart 4, below.) The technology for
both single and multi-bank portals now makes live, deal able, streaming price quotes (similar to
those available on electronic interbank platforms) available to end-user accounts.
2.11 A Changing Mix of Market Participants
Technological innovation dramatically reduced trading costs and has created new
opportunities, as well as new challenges, for a broad range of market participants. This has
occurred in several principal ways. First, the ability to transact in relatively small amounts on
fully transparent prices on these global electronic dealing platforms has led to fundamental
changes in the operation of the interbank market. Since banks no longer need to engage in costly
price-discovery transactions and mutual dealing relationships with other dealers, the foreign
exchange market has been opened up to much broader global participation among banks in the
provision of liquidity. The electronic aggregation of a multitude of worldwide orders and
transparency in pricing has also led to sharp compression in the typical interbank bid/offer
spread. Second, heightened competition between dealers and the much greater degree of price
transparency has led to interbank spread tightening being passed along to end-user accounts in
22
the B2C market. As dealing costs for end-user clients have declined, new accounts entered the
foreign exchange market, and existing market participants were able to profitably transact more.
Increased trading by end-user clients was further facilitated by the cost efficiencies of using B2C
dealing portals. The use of electronic foreign exchange trading by buy-side accounts has been
growing steadily: it is estimated that in 2006, for the first time, more than half of all foreign
exchange transactions by end-user clients were executed electronically (Greenwich Associates
2007).
Third, many of the market-making banks that previously dominated the market have been
forced to re-examine their business model as dealing spreads in both the interbank and B2C
markets compress. The result has been a changing mix of large and smaller banks in the
interbank market. Technology is expensive. In addition to considerable start-up costs, it requires
continuous upgrades. Given the tighter bid/ offer spreads in both the interbank and B2C markets,
most successful dealing banks have therefore implemented a low-margin, high-volume business
model that amortizes these higher technology costs through continually building trading
volumes. This gives a competitive advantage to those banks with the size and large global
distribution networks needed to sustain on going technological innovation and to provide
competitive, profitable price quotes. The result has been consolidation in the foreign exchange
market, with the largest banks accounting for a growing percentage of the overall global trading
volume. For example, in the May 2007 Euro money foreign exchange poll, five banks accounted
for over 60 per cent of client trading activity. In the 2006 poll, the top five had a 54 per cent
market share; a decade ago, the top five accounted for less than one-third of market volume.
Fourth, as a result of deal flow in the global foreign exchange market consolidating among the
largest global banks, the role of second-tier dealers has been evolving. For smaller banks, the
level of technological commitment needed to remain competitive in such a low margin
environment or to operate in all currency pairs and all time zones is no longer feasible. It often
makes more economic sense for them to outsource this function to large global institutions. For
some second-tier dealers, this outsourcing has taken the form of “white-labelling” (or white-
boarding), whereby the smaller bank will act as an intermediary between an end-user client
buying foreign exchange and another larger bank that supplies it. Essentially, the smaller bank
becomes a liquidity retailer, maintaining its single-bank B2C portal for servicing client orders
but using a larger bank to provide the wholesale liquidity. The smaller bank is thus able to
23
specialize in managing the client’s credit risk. The larger bank provides the liquidity and
manages the market risk. Generated by the client’s order. This institutional division of labour and
specialization in areas of comparative advantage supports better pricing for the end-user client.
2.13 Increasingly automated trading functions
Through the mid-1990s, most trading functions were done manually. This implied that
dealers’ market making and proprietary trading activities were, in general, not systematically
implemented. Traders had wide latitude when quoting prices to clients and other banks, using
their best judgment to manage the various risks generated by the market-making process and to
assume proprietary risk positions. As a result, there was often little distinction between market
making and proprietary trading, since market making involved warehousing imbalances (and
thus price risks) in the client order flow, as well as trading in and out of the market in a
continuous price-discovery process. Moreover, to manage the bank’s position in the currency,
traders were typically expected to have an opinion on the market and to express that bias when
quoting prices to clients. Thus, a close relationship existed between agency trading functions
(executing client orders) and principal functions (proprietary trading and the management of
price risk). At many banks, one trader performed both functions. With the technological
innovations of the past decade, many trading functions once performed exclusively by traders are
now increasingly performed by specialized computer programs. What distinguishes recent
developments in this area is the use of application programming interface (API), the protocols
that connect trading algorithms directly with the live price feeds on electronic trading platforms.
With API, a trader can program the computer-based trading model to receive data from the
market, process this information according to predetermined rules, and then generate buy and
sell orders that are transmitted directly and immediately to the market without human
intermediation. The development of API has transformed all aspects of the trading process;
specialized computer programs now initiate trades, manage trade execution and order flow, and
use complex algorithms to handle dealers’ market-making functions. API and algorithmic trading
have had a marked impact on trading volume. The immediacy of computerized trading programs
can produce a staggering number of trades, particularly for active-trading PTC accounts. Hedge
funds already control a very large and rapidly growing pool of capital (estimated to be almost
US$2.5 trillion in 2007 (Hedge Fund Intelligence 2007), and, like other PTC accounts, typically
apply leverage to amplify their trading capacity. This extremely large pool of capital can then be
24
rapidly traded through the market. The combination of PTC penetration into the interbank market
and computer-based trading has led to a surge in the proportion of algorithmically sourced
foreign exchange volume. It is estimated that, since its introduction, algorithmic trading has
achieved an approximate market share of 30 per cent on interbank platforms. Some analysts
predict that algorithmic trading will eventually account for up to 70 per cent or more of foreign
exchange volume, similar to what has occurred in equity markets (West 2007). The widespread
availability of retail electronic trading portals and inexpensive computer power has enabled even
smaller speculative accounts (such as day traders) to participate in the foreign exchange market.
2.14 A New, Hybrid Market
These three interrelated factors—electronic dealing platforms, a changing mix of market
participants, and algorithmic trading—are rapidly changing the cost structure of the foreign
exchange market. Reflecting this, foreign exchange is in a period of transition as global
competition forces market participants to focus on areas where they have a clear comparative
advantage. This is leading to a more distinct separation of principal and agency trading functions
in the new paradigm foreign exchange market. On one hand, a growing proportion of global
market liquidity is supplied by large global dealers acting as principals, accepting and managing
market risk for profit. Their client lists generate a significant order flow (especially through their
PTC accounts), but these dealers will nonetheless warehouse temporary imbalances in the market
and use client order flow to manage proprietary trading positions. In many respects, these top-tier
dealers duplicate the market-making functions of local banks under the previous market
structure, with one significant difference: their market-making activity is increasingly
algorithmic in order to cope with the high speed and volume of modern foreign exchange
markets. These market-making algorithms will often analyse client order flow and use the
information gathered to guide the dealer’s risk positioning, defining a form of automated, flow-
based proprietary trading. On the other hand, the new paradigm market structure also contains
significant agency elements, since many dealers also execute the orders of other market
participants, but without assuming market risk themselves. There are two sources of agency
operations that between them appear to account for a growing proportion of foreign exchange
trading volume. First, an increasing proportion of the overall deal flow passing through the larger
banks represents non-bank PTC accounts using prime brokered market access. Second, smaller
(often domestic) banks that lack a comparative advantage in liquidity provision are increasingly
25
outsourcing this function to larger banks via white labelling or prime brokerage arrangements.
Both prime brokerage and white-labelling are flow-based, low margin commodity-like business
models that succeed by keeping operating costs down, transactions volumes high, and exposure
to market risk low. As these agency functions grow in relative importance, the new paradigm
foreign exchange market is adopting some characteristics of an “exchange” model. This model
already exists for several other asset classes— notably equities and commodities—where
standardized financial products are traded on formal public exchanges by exchange members
(e.g., the New York Stock Exchange).
An exchange-based market model is no longer defined by the existence of a trading floor
(many stock and commodity exchanges are moving towards electronic trading platforms).
Rather, an exchange model has certain defining characteristics, including:
1. End-user accounts trade with each other through dealers (exchange members) who act only as
their agents. Dealers do not act as principals by accepting or warehousing price risk, but provide
only market access, credit-risk management, and other fee based ancillary trading services.
2. This client-to-client (C2C) market is totally anonymous because end-user accounts trade
though agents; there is no need for end-user accounts to know the identity of their ultimate
counterparty as long as their agents (credit-risk managers) provide surety of settlement.
3. With total trading anonymity and surety of settlement, all end users face the same price on the
exchange without discrimination. As the foreign exchange market evolves, some of the
exchange-like characteristics are being integrated into its structure in several ways.
2.14 Currency composition
Over the past three years, the share of turnover accounted for by currency pairs among the US
dollar, euro and yen has declined by 6 percentage points. Most of this fall can be explained by
the decline in the share of the US dollar/yen pair. The offsetting increase was mainly for
transactions involving currencies with relatively low turnover, classified as “other” in The
increase in the dispersion of foreign exchange turnover by currency is also apparent In 2007, the
four most traded currencies, the US dollar, the euro, the yen and sterling, are involved in 8
percentage points fewer foreign exchange transactions than they were in 2004. Taking into
account the valuation effects arising from the appreciation or deprecation of a currency relative
to the US dollar, ie at constant exchange rates, yields a similar conclusion: while the share of the
US dollar in total turnover increases, this is offset by larger declines in the shares of the euro and
26
sterling. Among the currencies with lower levels of turnover, the Hong Kong dollar, the New
Zealand dollar, the Swiss franc, the Norwegian krone, the Australian dollar, the Swedish krona,
the Polish zloty, the Chinese renminbi and the Indian rupee have all experienced a significant
increase in their share of aggregate turnover at current exchange rates. In general, this remains
true in constant exchange rate terms, although the share of the Australian dollar rises by 0.3
percentage points rather than by 0.8 percentage points and the share of the Canadian dollar falls
by 0.5 percentage points rather than staying steady
For the first time since 1995, growth in turnover in the OTC market outstripped that in
exchange-traded interest rate and currency derivatives (36%). As a consequence, the ratio of
OTC turnover to that in listed contracts rebounded to 0.7, from a low of 0.5 recorded in April
2004. However, it remained far below the level of around 1.5 seen in the first survey in 1995.
The narrowing of the gap between the two markets resulted from comparatively low growth in
exchange-traded interest rate contracts (35%). Turnover in listed FX derivatives went up by
222%, far outstripping growth in the OTC market, but at less than $0.1 trillion it was dwarfed by
the interest rate segment of the international derivatives exchanges.
27
Foreign exchange market in India
Liberalization has radically changed India’s foreign exchange sector. Indeed the
liberalization process itself was sparked by a severe Balance of Payments and foreign exchange
crisis. Since 1991, the rigid, four-decade old, fixed exchange rate system replete with severe
import and foreign exchange controls and a thriving black market is being replaced with a less
regulated, “market driven” arrangement. While the rupee is still far from being “fully floating”
(many studies indicate that the effective pegging is no less marked after the reforms than before),
the nature of intervention and range of independence tolerated have both undergone significant
changes. With an overabundance of foreign exchange reserves, imports are no longer viewed
with fear and skepticism. The Reserve Bank of India and its allies now intervene occasionally in
the foreign exchange markets not always to support the rupee but often to avoid an appreciation
in its value. Full convertibility of the rupee is clearly visible in the horizon. The effects of this
development s are palpable in the explosive growth in the foreign exchange market in India.
The foreign exchange market in India started in earnest less than three decades ago when
in 1978 the government allowed banks to trade foreign exchange with one another. Today over
70% of the trading in foreign exchange continues to take place in the inter-bank market. The
market consists of over 90 Authorized Dealers (mostly banks) who transact currency among
themselves and come out “square” or without exposure at the end of the trading day. Trading is
regulated by the Foreign Exchange Dealers Association of India (FEDAI), a self-regulatory
association of dealers. Since 2001, clearing and settlement functions in the foreign exchange
market are largely carried out by the Clearing Corporation of India Limited (CCIL) that handles
transactions of approximately 3.5 billion US dollars a day, about 80% of the total transactions.
The liberalization process has significantly boosted the foreign exchange market in the country
by allowing both banks and corporations greater flexibility in holding and trading foreign
currencies. The growth of the foreign exchange market in the last few years has been nothing
less than momentous.
History of Forex Market in India
28
Until the early seventies, given the fixed rate regime, the foreign exchange market was
perceived as a mechanism merely to put through merchant transactions. With the collapse of the
Breton Woods agreement and the floatation of major currencies, the conduct of exchange rate
policy posed a great challenge to central banks as currency fluctuations opened up tremendous
opportunities for market players to trade in currency volatilities in a borderless market. The
market in Indian, however, remained insulated as exchange rate controls inhibited capital
movements and the banks were required to undertake cover operations and maintain a square
position at all times.
Slowly a demand began to build up that banks in India be permitted to trade in FOREX.
In response to this demand the RBI, as a first step, permitted banks to undertake intra-day trade
in FOREX in 1978. As a consequence, the stipulation of maintaining square or near square
position was to be complied with only at close of business each day. The extent of position
which conduct be left uncovered overnight (the open position) as well as the limit up to which
dealers conduct trade during the day was to be decided by the management of the banks.
As opportunities to make profit began to emerge, the major banks started quoting two-
way prices against the Rupee as well as in cross-currencies (Non-rupee) and gradually, trading
volumes began to increase. This was enabled by a major change in the exchange rate regime in
1975 whereby the Rupee was delinked from the Pound Sterling and under a managed floating
arrangement; the external value of the rupee was determined by the RBI in terms of a weighted
basket of currencies of India’s major trading partners. Given the RBI’s obligation to buy and sell
unlimited amounts of Pound Sterling (the intervention currency), arising from the bank’s
merchant trades, its quotes for buying/selling effectively became the fulcrum around which the
market moved.
As volumes increased, the appetite for profits was found to lead to the observance of
widely different practices (some of which were irregular) dictated largely by the size of the
players, their location, expertise of the dealing staff, and availability of communications
facilities, it was thought necessary to draw up a comprehensive set of guidelines covering the
entire gamut of dealing operations to be observed by banks engaged in FOREX business.
Accordingly, in 1981 the “Guidelines for Internal Control over Foreign Exchange Business” was
framed for adoption by banks. During the eighties, deterioration in the macro-economic situation
29
set in, ultimately warranting a structural change in the exchange rate regime, which in turn had
an impact on the FOREX market. Large and persistent external imbalances were reflected in
rising level of internal indebtedness. The graduated depreciation of the rupee could not
compensate for the widening inflation differentials between India and the rest of the world and
the exchange rate of the Rupee was getting increasingly overvalued. The Gulf problems of
August 1990, given the fragile state of the economy, triggered off an unprecedented crisis of
liquidity and confidence. This unprecedented crisis called for the adoption of exceptional
corrective steps. The country simultaneously embarked upon measures of adjustment to stabilize
the economy and got in motion structural reforms to generate renewed impetus for stable growth.
As a first step in this direction, the RBI effected a two-step downward adjustment of the
Rupee in July 1991. Simultaneously, in order to provide a closer alignment between exports and
imports, the EXIM scrip scheme was introduced. The scheme provide a boost to exports and
with the experience gained in the working of the scheme, it was thought prudent to
institutionalize the incentive component and convey it through the price mechanism, while
simultaneously insulating essential imports from currency fluctuations. Therefore, with effect
from March 1, 1992, RBI instituted a system of dual exchange rates under the Liberalized
Exchange Rate Management System (LERMS). Under this, 40% of the exchange earnings had to
be surrendered at a rate determined by the RBI and the RBI was obliged to sell foreign exchange
only for imports of essential commodities such as oil, fertilizers, lifesaving drugs etc., besides the
government’s debt servicing. The balance 60% could be converted at rates determined by the
market. The scheme worked satisfactorily preparing the market for its emerging role and the
Rupee remained fairly stable with the spread between the official and market rate hovering
around 17%.
Even through the dual exchange rate system worked well, it however, implied an implicit tax on
exporters and remittances. Moreover it distorted the efficient allocation of resources. The
LERMS was essentially a transitional mechanism and in March 1993, the two legs of the
exchange rates were unified and christened Modified LERMS. It stipulated that form March 2nd
1993, all FOREX receipt could be converted at market determined rates of exchange. Over the
next eighteen months restrictions on a number of other current account transactions were relaxed
and on August 20th 1994, the Rupee was made fully convertible for all current account
30
transactions and the country formally accepted obligations under Article VIII of the IMF’s
Article of Agreement.
1. 1966 -The Rupee was devalued by 57.5% against on June 6
2. 1967 -Rupee-Sterling parity change as a result of devaluation of the sterling
3. 1971 - Bretton Wood system broke down in August. Rupee briefly pegged to the USD @
Rs 7.50 before reneging to Sterling at Rs. 18.8672 with a 2.25% margin on either side
4. 1972 -Sterling floated on June 23. Rupee sterling parity revalued to Rs 18.95 and the in
October to Rs 18.80
5. 1975 -Rupee pegged to an undisclosed basket with a margin of 2.25%on either side.
Sterling the intervention currency with a central bank rate of Rs 18.3084
6. 1979 - Margins around basket parity widened to 5% on each side in January
7. 1991 - Rupee devalued by 22% July 1st and 3rd. Rupee dollar rate depreciated from
21.20 to 25.80. A version of dual exchange rate introduced through EXIM scrip scheme,
given exporters freely tradable import entitlements equivalent to 30-40% of export
earnings.
8. 1992 - LERMS introduced with a 40-60 dual rate converting export proceeds, market
determined rate for all but specified imports and market rate for approved capital
transaction. US Dollar became the intervention currency from March 4th. EXIM scrip
scheme abolished.
9. 1993 - Unified market determined exchange rate introduced for all transactions. RBI
would buy/sell US Dollars for specified purposes. It will not buy or sell forward Dollars
though it will enter into Dollar swaps.
10. 1994 - Rupee made fully convertible on current account from August 20th.
11. 1998 - Foreign Exchange Management Act – FEM Bill 1998, which was placed in the
Parliament to replace FERA.
31
12. 1999 - Implication of FEMA start.
Relative Size of the Foreign Exchange Market in India
Foreign Exchange turnover segment wise
In the derivatives market, foreign exchange swaps account for the largest share of the
total derivatives turnover in India, followed by forwards and options. Options have remained
Insignificant despite being in existence for four years. With restrictions on the issue of foreign
exchange swaps and options by corporate in India, the turnover in these segments (swap and
options) essentially reflects inter-bank transactions.
Where Does India Stand in Global Forex Market?
The daily turnover of the Global Forex market is presently estimated at US$ 3 trillion.
Presently the Indian Forex market is the 16th largest Forex market in the world in terms of daily
turnover as the BIS Triennial Survey report. As per this report the daily turnover of the Indian
Forex market is US$ 34 billion in the year 2007. Besides the OTC derivative segment of the
Indian Forex market has also increased significantly since its commencement in the year 2007.
During the year 2007-08 the daily turnover of the derivative segment in the Indian Forex market
stands at US$ 48 billion.
The growth of the Indian Forex market owes to the tremendous growth of the Indian
economy in the last few years. Today India holds a significant position in the Global economic
scenario and it is considered to be one of the emerging economies in the World. The steady
32
growth of the Indian economy and diversification of the industrial sectors in India has
contributed significantly to the rapid growth of the Indian Forex market.
The Forex trading history of India dates back to 1978, when Reserve Bank of India took a step
towards allowing the banks to undertake intra-day trading in Foreign exchange. It is during the
period of 1975-1992 when Reserve Bank of India, officially determined the exchange rate of
rupee according to the weighted basket of currencies with the significant business partners of
India. But it needs to be mentioned that there are too many restrictions on these banks during this
period for trading in the Forex market.
The introduction of the open market policy in the year 1991 and implementation of the
new economic policy by the Govt. of India brought a comprehensive change in the Forex market
of India. It is during the month of July 1991, that the rupee undergone a twofold downward
adjustment and this was in line with inflation differential to ensure competitiveness in exports.
Then as per the recommendation of a high level committee set up to review the Balance of
Payment position, the Liberalized Exchange Rate Management System or the LERMS was
introduced in 1992. The method of dual exchange rate mechanism that was part of the LERMS
also came into effect 1993. It is during this time that uniform exchange rate came into effect and
that started demand and supply controlled exchange rate regime in Indian. This ultimately
progressed towards the current account convertibility that was a part of the Articles of
Agreement with the International Monetary Fund.
It was the report and recommendations of the Expert Group on Foreign Exchange,
formed to judge the Forex market in India that actually helped to widen the Forex trading
practices in the country. As per the recommendations of the expert committee, Reserve bank of
India and the Government took so many significant steps that ultimately gave freedom to the
banks in many ways. Apart from the banks corporate bodies were also given certain relaxation
that also played an instrumental role in spread of Forex trading in India.
It is during the year 2008 that Indian Forex market has seen a great advancement that
took the Indian Forex trading at par with the global Forex markets. It is the introduction of future
derivative segment in Forex trading through the largest stock exchange in country – National
33
Stock Exchange. This step not only increased the Indian Forex market volume too many folds
also gave the individual and retail investor a chance to trade at the Forex market, that was till this
time remained a forte of the banks and large corporate.
Traded volumes on all exchanges for USD-INR pair (data: SEBI)
Indian Forex market got yet another boost recently when the SEBI and Reserve Bank of
India permitted the trade of derivative contract at the leading stock exchanges NSE and MCX for
three new currency pairs. In its recent circulars Reserve Bank of India accepting the proposal of
SEBI, permitted the trade of INRGBP (Indian Rupee and Great Britain Pound), INREUR (Indian
Rupee and Euro) and INRYEN (Indian Rupee and Japanese Yen). This was in addition with the
existing pair of currencies that is US$ and INR. From inclusion of these three currency pairs in
the Indian Forex circuit the Indian Forex scene is expected to boost even further as these are
some of the most widely traded currency pairs in the world.
Foreign exchange regulatory regimes in India
Soon after independence, a complex web of controls were imposed for all external
transactions through a legislation i.e. Foreign Exchange Regulation Act (FERA), 1947. These
were put into more rigorous framework of controls through FERA, 1973. Severe restrictions on
current account transactions had continued till mid-1990‟s when relaxations were made in the
operations of FERA, 1973. The control framework was essentially transaction based in terms of
34
which all transaction in foreign exchange including those between residents and non-residents
were prohibited, unless specifically permitted. A sequence of events started in the subsequent
years generally followed by the recommendations made by different committees such as the high
level committee on Balance of Payments under Chairman Dr. C. Rangarajan, 1993. In 1993,
exchange rate of rupee was made market determined. In 1994 India accepted article VIII of the
Articles of Agreement of the International Monetary Fund in August 1994 and adopted current
account convertibility. In June 2000 a legal framework, with implementation of FEMA, has also
has also being put into effect to ensure convertibility on the current account. This consistent
approach has lent credibility to the liberalization process of both current and capital account
transactions. As evident from various economic indicators, the liberalization process has been
underway for some time created a more competitive environment for Indian Industry vis-a-vis
what existed earlier. Consequently the Indian companies have upgraded their technology and
expanded to more efficient scales of production and refocused their activities to areas of
competence. Increasingly, Indian companies are looking to become global players. Reform
measures is external sectors, including dismantling of exchange control have been a contributor
to this development.
Participants in Forex Market
The participants in the foreign exchange market comprise;
1. Corporates
2. Commercial banks
3. Exchange brokers
4. Central banks
1. Corporates:
The business houses, international investors, and multinational corporations may operate
in the market to meet their genuine trade or investment requirements. They may also buy or sell
currencies with a view to speculate or trade in currencies to the extent permitted by the exchange
control regulations. They operate by placing orders with the commercial banks. The deals
between banks and their clients form the retail segment of foreign exchange market.
35
In India the Foreign Exchange Management (Possession and Retention of Foreign Currency)
Regulations, 2000 permits retention, by resident, of foreign currency up to USD 2,000. Foreign
Currency Management (Realization, Repatriation and Surrender of Foreign Exchange)
Regulations, 2000 requires a resident in India who receives foreign exchange to surrender it to an
authorized dealer:
1. Within seven days of receipt in case of receipt by way of remuneration, settlement of
lawful obligations, income on assets held abroad, inheritance, settlement or gift: and
2. Within ninety days in all other cases.
Any person who acquires foreign exchange but could not use it for the purpose or for any other
permitted purpose is required to surrender the unutilized foreign exchange to authorized dealers
within sixty days from the date of acquisition. In case the foreign exchange was acquired for
travel abroad, the unspent foreign exchange should be surrendered within ninety days from the
date of return to India when the foreign exchange is in the form of foreign currency notes and
coins and within 180 days in case of travellers cheques. Similarly, if a resident required foreign
exchange for an approved purpose, he should obtain from and authorized dealer.
2. Commercial Banks
Commercial Banks are the major players in the Forex market. They buy and sell
currencies for their clients. They may also operate on their own. When a bank enters a market to
correct excess or sale or purchase position in a foreign currency arising from its various deals
with its customers, it is said to do a cover operation. Such transactions constitute hardly 5% of
the total transactions done by a large bank. A major portion of the volume is accounted buy
trading in currencies indulged by the bank to gain from exchange movements. For transactions
involving large volumes, banks may deal directly among themselves. For smaller transactions,
the intermediation of foreign exchange brokers may be sought.
3. Exchange brokers
36
Exchange brokers facilitate deal between banks. In the absence of exchange brokers,
banks have to contact each other for quotes. If there are 150 banks at a center, for obtaining the
best quote for a single currency, a dealer may have to contact 149 banks. Exchange brokers
ensure that the most favorable quotation is obtained and at low cost in terms of time and money.
The bank may leave with the broker the limit up to which and the rate at which it wishes to buy
or sell the foreign currency concerned. From the intends from other banks, the broker will be
able to match the requirements of both. The names of the counter parties are revealed to the
banks only when the deal is acceptable to them. Till then anonymity is maintained. Exchange
brokers tend to specialize in certain exotic currencies, but they also handle all major currencies.
In India, banks may deal directly or through recognized exchange brokers. Accredited exchange
brokers are permitted to contract exchange business on behalf of authorized dealers in foreign
exchange only upon the understanding that they will conform to the rates, rules and conditions
laid down by the FEDAI. All contracts must bear the clause “subject to the Rules and
Regulations of the Foreign Exchanges Dealers ‘Association of India’.
4. Central Bank
Central Bank may intervene in the market to influence the exchange rate and change it
from that would result only from private supplies and demands. The central bank may transact in
the market on its own for the above purpose. Or, it may do so on behalf of the government when
it buys or sell bonds and settles other transactions which may involve foreign exchange payments
and receipts. In India, authorized dealers have recourse to Reserve Bank to sell/buy US dollars to
the extent the latter is prepared to transact in the currency at the given point of time. Reserve
Bank will not ordinarily buy/sell any other currency from/to authorized dealers. The contract can
be entered into on any working day of the dealing room of Reserve Bank. No transaction is
entered into on Saturdays. The value date for spot as well as forward delivery should be in
conformity with the national and international practice in this regard. Reserve Bank of India does
not enter into the market in the ordinary course, where the exchanges rates are moving in a
detrimental way due to speculative forces, the Reserve Bank may intervene in the market either
directly or through the State Bank of India.
37
CHAPTER -III
COMPANY PROFILE
Origin of Indian Stock Market
The origin of the stock market in India goes back to the end of the eighteenth century
when long-term negotiable securities were first issued. However, for all practical purposes, the
real beginning occurred in the middle of the nineteenth century after the enactment of the
companies Act in 1850, which introduced the features of limited liability and generated investor
interest in corporate securities. An important early event in the development of the stock market
in India was the formation of the native share and stock brokers 'Association at Bombay in 1875,
the precursor of the present day Bombay Stock Exchange. This was followed by the formation of
associations/exchanges in Ahmadabad (1894), Calcutta (1908), and Madras (1937). In addition, a
large number of ephemeral exchanges emerged mainly in buoyant periods to recede into oblivion
during depressing times subsequently.
Stock exchanges are intricacy inter-woven in the fabric of a nation's economic life.
Without a stock exchange, the saving of the community- the sinews of economic progress and
productive efficiency- would remain underutilized. The task of mobilization and allocation of
savings could be attempted in the old days by a much less specialized institution than the stock
exchanges. But as business and industry expanded and the economy assumed more complex
nature, the need for 'permanent finance' arose. Entrepreneurs needed money for long term
whereas investors demanded liquidity – the facility to convert their investment into cash at any
given time. The answer was a ready market for investments and this was how the stock exchange
came into being. Stock exchange means anybody of individuals, whether incorporated or not,
constituted for the purpose of regulating or controlling the business of buying, selling or dealing
in securities. These securities include:
1. Shares, scrip, stocks, bonds, debentures stock or other marketable securities of a like
nature in or of any incorporated company or other body corporate;
2. Government securities; and
3. Rights or interest in securities.
38
The Bombay Stock Exchange (BSE) and the National Stock Exchange of India Ltd
(NSE) are the two primary exchanges in India. In addition, there are 22 Regional Stock
Exchanges. However, the BSE and NSE have established themselves as the two leading
exchanges and account for about 80 per cent of the equity volume traded in India. The NSE and
BSE are equal in size in terms of daily traded volume. The average daily turnover at the
exchanges has increased from Rs 851 crore in 1997-98 to Rs 1,284 crore in 1998-99 and further
to Rs 2,273 crore in 1999-2000 (April - August 1999). NSE has around 1500 shares listed with a
total market capitalization of around Rs 9, 21,500 crore. The BSE has over 6000 stocks listed
and has a market capitalization of around Rs 9, 68,000 crore. Most key stocks are traded on both
the exchanges and hence the investor could buy them on either exchange. Both exchanges have a
different settlement cycle, which allows investors to shift their positions on the bourses. The
primary index of BSE is BSE Sensex comprising 30 stocks. NSE has the S&P NSE 50 Index
(Nifty) which consists of fifty stocks. The BSE Sensex is the older and more widely followed
index. Both these indices are calculated on the basis of market capitalization and contain the
heavily traded shares from key sectors. The markets are closed on Saturdays and Sundays. Both
the exchanges have switched over from the open outcry trading system to a fully automated
computerized mode of trading known as BOLT (BSE on Line Trading) and NEAT (National
Exchange Automated Trading) System. It facilitates more efficient processing, automatic order
matching, faster execution of trades and transparency; the scrip's traded on the BSE have been
classified into 'A', 'B1', 'B2', 'C', 'F' and 'Z' groups. The 'A' group shares represent those, which
are in the carry forward system (Badla). The 'F' group represents the debt market (fixed income
securities) segment. The 'Z' group scrip's are the blacklisted companies. The 'C' group covers the
odd lot securities in 'A', 'B1' & 'B2' groups and Rights renunciations. The key regulator
governing Stock Exchanges, Brokers, Depositories, Depository participants, Mutual Funds, FIIs
and other participants in Indian secondary and primary market is the Securities and Exchange
Board of India (SEBI) Ltd.
Brief History of Stock Exchanges
Do you know that the world's foremost marketplace New York Stock Exchange (NYSE),
started its trading under a tree (now known as 68 Wall Street) over 200 years ago? Similarly,
India's premier stock exchange Bombay Stock Exchange (BSE) can also trace back its origin to
as far as 125 years when it started as a voluntary non-profit making association. News on the
39
stock market appears in different media every day. You hear about it any time it reaches a new
high or a new low, and you also hear about it daily in statements like 'The BSE Sensitive Index
rose 5% today'. Obviously, stocks and stock markets are important. Stocks of public limited
companies are bought and sold at a stock exchange. But what really are stock exchanges? Known
also as the stock market or bourse, a stock exchange is an organized marketplace for securities
(like stocks, bonds, options) featured by the centralization of supply and demand for the
transaction of orders by member brokers, for institutional and individual investors. The exchange
makes buying and selling easy. For example, you don't have to actually go to a stock exchange,
say, BSE - you can contact a broker, who does business with the BSE, and he or she will buy or
sell your stock on your behalf.
Market Basics
1. Electronic trading
Electronic trading eliminates the need for physical trading floors. Brokers can trade from
their offices, using fully automated screen-based processes. Their workstations are connected to
a Stock Exchange's central computer via satellite using Very Small Aperture Terminus (VSATs).
The orders placed by brokers reach the Exchange's central computer and are matched
electronically.
2. Exchanges in India
The Stock Exchange, Mumbai (BSE) and the National Stock Exchange (NSE) are the
country's two leading Exchanges. There are 20 other regional Exchanges, connected via the
Inter- Connected Stock Exchange (ICSE). The BSE and NSE allow nationwide trading via their
VSAT systems.
3. Index
An Index is a comprehensive measure of market trends, intended for investors who are
concerned with general stock market price movements. An Index comprises stocks that have
large liquidity and market capitalization. Each stock is given a weight age in the Index equivalent
to its market capitalization. At the NSE, the capitalization of NIFTY (fifty selected stocks) is
taken as a base capitalization, with the value set at 1000. Similarly, BSE Sensitive Index or
Sensex comprises 30 selected stocks. The Index value compares the day's market capitalization
40
vis-a-vis base capitalization and indicates how prices in general have moved over a period of
time.
4. Execute an order
Select a broker of your choice and enter into a broker-client agreement and fill in the
client registration form. Place your order with your broker preferably in writing. Get a trade
confirmation slip on the day the trade is executed and ask for the contract note at the end of the
trade date. Need a broker As per SEBI (Securities and Exchange Board of India.) regulations,
only registered members can operate in the stock market. One can trade by executing a deal only
through a registered broker of a recognized Stock Exchange or through a SEBI-registered sub-
broker
Stock & Exchange Board of India
Regulation of business in the stock exchanges
Under the SEBI Act, 1992, the SEBI has been empowered to conduct inspection of stock
exchanges. The SEBI has been inspecting the stock exchanges once every year since 1995-96.
During these inspections, a review of the market operations, organizational structure and
administrative control of the exchange is made to ascertain whether:
1. The exchange provides a fair, equitable and growing market to investors
2. The exchange's organization, systems and practices are in accordance with the Securities
Contracts (Regulation) Act (SC(R) Act), 1956 and rules framed there under
3. The exchange has implemented the directions, guidelines and instructions issued by the
SEBI from time to time
4. The exchange has complied with the conditions, if any, imposed on it at the time of
renewal/ grant of its recognition under section 4 of the SC(R) Act, 1956.
During the year 1997-98, inspection of stock exchanges was carried out with a special focus on
the measures taken by the stock exchanges for investor's protection. Stock exchanges were,
through inspection reports, advised to effectively follow-up and redress the investors' complaints
against members/listed companies. The stock exchanges were also advised to expedite the
disposal of arbitration cases within four months from the date of filing. During the earlier years'
inspections, common deficiencies observed in the functioning of the exchanges were delays in
post trading settlement, frequent clubbing of settlements, delay in conducting auctions,
inadequate monitoring of payment of margins by brokers, non-adherence to Capital Adequacy
41
Norms etc. It was observed during the inspections conducted in 1997-98 that there has been
considerable improvement in most of the areas, especially in trading, settlement, collection of
margins etc
COCHIN STOCK EXCHANGE LTD.
COCHIN STOCK EXCHANGE LTD. is one of the premier Stock Exchanges in India,
established in the year 1978. The exchange had a humble beginning with just 5 companies listed in 1978
-79, and had only 14 members. Today the Exchange has more than 508 members and 240 listed
companies. In 1980 the Exchange computerized its offices. In order to keep pace with the changing
scenario in the capital market, CSE took various steps including trading in dematerialized shares. CSE
introduced the facility for computerized trading - "Cochin Online Trading (COLT)" on March 17, 1997.
CSE was one of the promoters of the "Interconnected Stock Exchange of India (ISE)". The objective was
to consolidate the small, fragmented and less liquid markets into a national level integrated liquid market.
With the enforcement of efficient margin system and surveillance, CSE has successfully prevented
defaults. Introduction of fast track system made CSE the stock exchange with the shortest settlement
cycle in the country at that time. By the dawn of the new century, the regional exchanges faced a serious
challenge from the NSE & BSE. To face this challenge CSE promoted a 100% subsidiary called the
"Cochin Stock Brokers Ltd. (CSBL)" and started trading in the National Stock Exchange (NSE) and
Bombay Stock Exchange (BSE).
CSBL is the first subsidiary of a stock exchange to get membership in both NSE & BSE.
CSBL also became a depository participant in the Central Depository Services Ltd. The CSE has
been playing a vital role in the economic development of the country in general, and Kerala in
particular and striving hard to achieve the following goals:
1. Providing investors with high level of liquidity whereby the cost and time involved in
the entry into and exit from the market are minimized.
2. Bringing in high tech solutions and make all operations absolutely transparent.
3. Building infrastructure for capital market by turning CSE into a financial super market.
4. Serve the investors of the region.
42
5. Professional stock broking and investment management.
6. Imparting Capital Market knowledge to all intermediaries on a continuous basis.
The Cochin Stock Exchange is directly under the control and supervision of Securities &
Exchange Board of India (the SEBI), and is today a demutualized entity in accordance with the
Cochin Stock Exchange (Demutualization) Scheme, 2005 approved and notified by SEBI on
29th of August 2005. Demutualization essentially means de-linking and separation of ownership
and trading rights and restructuring the Board in accordance with the provisions of the
scheme. The Exchange has been demutualised and the notification thereof published in the
Gazette.
Management of Cochin Stock Exchange Ltd
The policy decisions of the CSE are taken by the Board of Directors. The Board is
constituted with 12 members of whom less than one-fourth are elected from amongst the trading
member of CSE, another one fourth are Public Interest Directors selected by SEBI from the
panel submitted by the Exchange and the remaining are Shareholder Directors. The Board
appoints the Executive Director who functions as an ex-officio member of the Board and takes
charge of the administration of the Exchange.
Management - Board of Directors
The Exchange is professionally managed, under the overall direction of the Board of
Directors. The Board consists of eminent professionals from fields such as judiciary,
administration and management, who are known as Public Interest Directors. The Public Interest
Directors constitute one fourth of the total strength of the Board .The representation of brokers of
the Exchange is limited to one fourth of the total strength of the Board .The remaining are
representatives of shareholders without trading rights, called the Shareholder Directors
Board of Directors
Sl.No. Name & Address Designation Contact nos. Email id
43
1.
Shri T.N.T Nayar(IRS Retd)
Retd. Chief Commissioner of Income Tax and Member, Central Administrative Tribunal.
Public Interest. Director
Res.0484-2318362
Mob.9447064246
Official -9388959820
2
Shri.A.S Narayanamoorthy Chartered Accountant
Public Interest Director
Off. 2312960, 2316538 Mob.9847004207 Res. 2319367
3
Shri.C.J.Mathew Member(Rtd.), Postal Services Board, India
Public Interest Director
Res.2317240 Mob. 9447370661
4
Shri Robins Jacob
Share Holder Director
Mob.9447465885 [email protected]
5
Shri M.Vijayakumar
Share Holder Director
Res. 0487-2382331 Mob.9895700905
6
Shri Varghese Menachery
Share Holder Director
Off.2391123 Res.0484-3224471 Mob.9388688471
7
Shri. Varghese Mathew
Member Director
Res. 2424875 Off. 2390856 Cubicle 2402557 Mob. 93492 53814
8 Shri Abraham P.Korah Member Res.2331391 [email protected]
44
Director Off.3042392 Mob.9846040094
9
Shri K.Jacob George
Member Director
Res.2665634 Off. 2665454, 2665457 Mob.9388830345
10
Shri P.C. Cyriac, IAS
Shareholder Director
2310492 Mob.9447305842
11
Shri V A Vijayan Menon
Retired ROC Shareholder Director
2306864
12 Shri. V SrinivasanExecutive Director
Off. 3048525 [email protected]
Previous Presidents
Mr. P. S. Joseph :: 1984-89
Mr. K. K. Thomas :: 1989-91
Mrs. Omana Abraham :: 1991-92
Mr. K. K. Thomas:: 1992-94
Mr. Augustin Kolenchery :: 1994-96
Mr. P. Oommen Isen :: 1996-98
Mr. N. Ninan Varkey :: 1998-99
Mr. Chacko J. Kallivayalil :: 1999-00
Mr. Johny J. Kannampilly :: 2000-01
Mr. K.V.Thomas :: 2001-02
Mr. Justice K.John Mathew :: 2002-07
Mr. T.N.T.Nayar :: 2007-08
Mr. P.C.Cyriac :: 2008-
45
ORGANIZATION STRUCTURE
46
47
Legal department
Guided by the Officer-Legal, the Legal Department is primarily responsible for advising
the management of the merits and demerits of legal issues involving the Exchange. The
department consistently monitors the compliance parameters in terms of the Companies Act,
SEBI Act, Securities Contracts Regulation Act and other related statutes. Listing Guidelines and
related criteria stipulated by SEBI, and the rules, regulations, directives and circulars issued by
SEBI with regard to trading in the Capital Market are consistently scrutinized and necessary
directions are given to the concerned departments to ensure strict and continued compliance.
Relevant developments are brought to the notice of the members and the investing public.
Officer-Legal is the Compliance Officer as per the provisions of SEBI regulations and also
functions as Secretary to the Board of Directors. Other major activities undertaken by the
department relate to Investor Grievance Service, Arbitration and Resolution of issues pertaining
to declared defaulters.
Systems Department
The Systems Department is the heart of the various operations of CSE. The department
provides the necessary technical support for screen based trading and the computerized
functioning of all the other departments.
The activities of the department include: -
1. Developments of software needed for the functions of the exchange.
1. Maintenance of Multex software, which enables online trading with NSE and
BSE.
2. Maintenance of an effective network of computers for the smooth functioning of
the CSE.
3. Providing the necessary services to the Settlement and Surveillance Departments.
4. The support for maintenance of depository participants’ accounts with the CSBL
DP.
48
The major back office system software used are NESS and BOSS respectively for NSE
and BSE trades calculations. This software is developed in-house by the software professionals
at the Exchange and are used to maintain the entire records of all the trades that occur each day.
It also does all the required calculations for deductions and also generates reports require by the
brokers and their clients. The trading software used in CSBL is Multex, developed by CMC. The
advantage of using Multex is that both BSE and NSE scrip can be traded using this facility.
CSBL has provided trading facility in equities through Multex to a large number of their clients
over the Wide Area Network. Currently, the clients are connected by VPN, ISDN, Dial-Up,
Vsat etc.
49
Membership Department
The Membership Department screens applications from prospective members to ensure
that they are eligible to be members of the Exchange as per provisions of the Securities Contracts
Regulation Act. It is also verified whether they are ‘Fit and Proper’ persons eligible to be
members as per the SEBI (Criteria for Fit and Proper persons) Regulation 2004. The eligible
applications are processed and forwarded to SEBI for the purpose of obtaining registration with
50
SEBI. The department continuously follows up the status of the applications with SEBI and
provides necessary data if any required by SEBI. The members are informed of their fee liability
as and when information in this regard is obtained from SEBI. The Membership Department
also assists SEBI by ensuring proper delivery of notices and letters issued by SEBI to the
concerned members. The changes in status and constitution of the Brokers are sent for approval
to the Governing Board of the Exchange and thereafter to SEBI and Members are given
necessary directions wherever required. Change in address and contact information are updated
in the Finance and Accounting System and SEBI intimated.
Listing Department
The Listing Department guides prospective companies desirous of being listed on the
Exchange by providing the knowledge base and information on the statutory requirements that
have to be complied with. The major functions undertaken by the department include post-listing
monitoring and compliance with the listing agreement, monitoring the listing agreements and
reviewing the provisions of listing agreement from time to time with specific reference to SEBI
Regulations/Circulars that are in force. The department also ensures diligence in scrutinizing
listing applications and adhering to the Listing Norms.
Compliance Monitoring is carried out with specific emphasis on the following clauses in the
Listing Agreement.
1. Clauses 15/16 - Short/non intimation of BC/RD
2. Clause 19 – Intimation of Board Meeting including advance notice wherever required
3. Clause 20- Outcome of Board Meeting
4. Clause 24 – In-principle approvals
5. Clause 31 – Annual Reports
6. Clause 32 – Name Change, Cash Flow, Consolidated Financial Statement, Related Party
Disclosures etc.
51
7. Clause 35 – Quarterly submission of Shareholding Pattern.
8. Clause 36 – Material Price sensitive Information
9. Clause 40 - Continuous Listing requirements
10. Clause 41 – Financial Results and Limited Review Reports
11. Clause 47 – Appointment of Compliance Officer
The department also performs the processing of the documents submitted by companies
on new listings/additional listings and provides them with the listing approval/trading permission
and also ensures that listing fee/processing fee is paid at the stipulated time.
Settlement Department
Settlement Department is a key department of the Exchange, dealing with cash and
securities. It assists the brokers in settling the matters related to their pay-in and payout, recovery
of dues and settling issues related to bad deliveries. This department is headed by a Deputy
Manager assisted by two Senior Officers who take care of the operations involved in the
settlement activities in CSE. The Exchange follows the T+2 settlement system.
Marketing Department
The Marketing Department interacts with the brokers of the exchange trading both within
the state and outside and collects their opinions and suggestions. These are brought to the notice
of the Committee constituted for the purpose and decisions of the committee are placed for
approval of the Governing Board of the Exchange .The efforts are aimed at improving the quality
and efficiency of the service offered. In addition, the department conducts extensive surveys and
campaigns in remote areas and where necessary organizes awareness programmes about capital
markets. Experts with sufficient experience in the trade brief the participants and address their
queries. Talk shows and interviews are conducted on television channels, clippings are displayed
in theatres all with a view to increase public awareness and motivate their interest in the Capital
52
Markets .The marketing wing also coordinates the off campus programmes of the CSE Institute
and organizes regular classes at authorized centres after verifying the availability of suitable
infrastructure and facilities.
Surveillance Department
The Exchange has set up the Surveillance Department to keep a close watch on price
movements of scrip and to detect market abuse like price rigging, monitor abnormal prices and
volumes which are not consistent with normal trading pattern etc. The main objective of the
department is to ensure a free and fair market, to avoid manipulations and to manage risks. The
surveillance function at the exchange has assumed greater importance in the last few years. SEBI
has directed the Exchange to set up a separate surveillance department with staff exclusively
assigned for this function.
The Surveillance Department
1. Keeps a close watch on the price movement of scrip.
2. Detects market manipulations like price rigging.
3. Monitors abnormal changes in prices and volumes which are not consistent with
normal trading pattern.
4. Monitors the member brokers’ positions to ensure that defaults do not occur.
The department conducts in-depth investigation based on preliminary enquiries made into
trading of the scrip as also at the instance of SEBI. . Conducting investigations involves the
following stages: -.
1. Identification of scrip based on the alerts thrown by the online system and offline
reports.
2. Identification of Members from whom the client details have to be called for .
3. Preparation of company profile including Corporate News and Financial results.
4. Compilation of client details.
5. Preparation of reports. In case irregularities are found, necessary action is
initiated.
53
Finance Department
The Finance Department controls the financial transactions of the Exchange and is the
life line of the organization. The department is headed by a Finance Officer.
The activities of the department include
i. Fund Management
ii. Interaction with bankers
iii. Maintaining general accounts of the Exchange
iv. Preparation of various financial statements.
v. Maintaining payrolls and cash register.
vi. Coordinating accounting transactions of different branches and departments.
vii. Taxation
viii. Budgeting and Expense research.
ix. Maintenance of internal control system.
x. Liaison with external and internal auditors
xi. Annual Report Generation
54
CHAPTER -IV
LITERATURE REVIEW
Maurer Raimond and Shohreh Valiani, (Hedging the exchange rate risk in international
portfolio diversification)1
The authors examine the effectiveness of controlling the currency risk for international
diversified mixed-asset portfolios via two different hedge instruments, currency forwards and
currency options. They compare the currency forward is compared with currency options to
control the foreign currency exposure risk. Results show that European put-in-the-money options
have the potential to substitute the optimally forward-hedged portfolios .The research shows the
risk and return implications of different currency hedging strategies.
John T. Harvey, (The Determinants of Currency Market Forecasts: An Empirical Study)2
The author briefly compares the orthodox Neoclassical and post Keynesian approaches to
exchange rates. From the neoclassical perspective, expectations, per se, do not affect currency
prices. Rather, they are simply the mechanism by which the fundamentals, those variables
guaranteeing the efficient operation of the market, set exchange rates. However, Post Keynesian
economics suggests a more active role for expectations. As per Geoff Hodgson, “Actions flow
from judgements about the future (which often lack a firm, objective empirical foundation) as
well as from observation of the convention that is formed by the action of others.” a theoretical
model is constructed, which consequently forms the basis of the empirical test. The paper
concludes that the expectation variables are not random and exhibit a pattern and are explicable.
Sivakumar Anuradha and Sarkar Runa (corporate hedging for foreign exchange risk of
India)3
This paper evaluates the various alternatives available to Indian firms for hedging foreign
exchange exposure. The paper concludes that forwards and options are preferred as short term
hedging instruments while swaps are preferred as long term hedging instruments. The high usage
of forward contracts by Indian firms as compared to firms in other markets underscores the need
for rupee futures in India. The paper concludes by pointing out that the onus is on Reserve Bank
of India, the apex bank of the country, and its Working Group on Rupee Futures to realize the
need for rupee futures in India and the convertibility of the rupee. Risk management techniques
vary with the kind of exposure and the term of firm faces. Accounting exposure, also called
55
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. Economic exposure is the extent to
which a firm's market value, in any particular currency, is sensitive to unexpected changes in
foreign currency. Transaction Exposure is a form of short term economic exposure due to fixed
price contracting in an atmosphere of exchange-rate volatility.
Hlupic Vlatka, Paul Walker and Zahir Irani, (Predicting movements in foreign currency
rates using simulation modeling) 4
This paper addresses using simulation modelling to predict movements in foreign
currency rates. The technical analysis represents the focus of the research, providing the
framework for the majority of current dealing decisions which are based on theory, rather than
pure experience. The paper investigates whether and how simulation modelling can be used
effectively to assist in predicting how foreign exchange rates will move when something occurs
which either increases or decreases its value in relation to other currencies. These factors
incorporate specific functions of the economy under the broad headings of money markets,
economic, employment, base rates, intervention, political, gilts, and other. After an
understanding of the reasons why currency rates move, the paper emphasises on the structure of
changes which would move the currency exchange rates up or down, if movement was
applicable .Harrington and Niehaus (1999) classify the business risk is divided into three types,
price, credit, and pure. Price risk refers to uncertainty of cash flows owing to changes in output
and input prices. Credit risk occurs mostly in financial institutions because loans are the primary
products. Since there is a probability of default by the borrower, firms engaging in this business
face credit risk. Non-financial firms are also vulnerable to this risk due to credit selling. The
difference between financial and non-financial firms is the magnitude of the risk. The foreign
exchange rate risk is only one source of price risk. This arises from fluctuations of input prices as
a result of exchange rate movements. This type of risk occurs due to firms' activity to obtain
inputs from foreign countries. The reasons for obtaining inputs from foreign markets are often
dictated by several considerations, including price, quality, and availability. Under similar
considerations, firms expand their operation by selling products in foreign countries. Since the
sales price is affected by exchange rate changes, firms are exposed to foreign exchange rate risk.
56
Ahamed Kameel Mydin Meer, (Hedging Foreign Exchange Risk with Forwards, Futures,
Options and the Gold Dina) 5
The author compares and contrasts the use of derivatives – forwards, futures and options
– and the gold dinar for hedging foreign exchange risk. He says that the 1997 East Asian
currency crisis made apparent how vulnerable currencies can be. The speculative attacks on the
Ringgit almost devastated the economy if not for the quick and bold counter actions taken by the
Malaysian government, particularly in checking the offshore Ringgit transactions. It also became
apparent the need for firms to manage foreign exchange risk. The article argues how a gold dinar
system is likely to introduce efficiency into the market while reducing the cost of hedging
foreign exchange risk, compared with the use of the derivatives.
Ian H. Giddy and Gunter Dufay (The Management of Foreign Exchange Risk) 6
Exchange risk is the effect that unanticipated exchange rate changes have on the value of
the firm. The paper explores the impact of currency fluctuations on cash flows, on assets and
liabilities, and on the real business of the firm. There are three important issues in this regard.
1. The exchange risks the firm faces, and methods available to measure currency
exposure.
2. Based on the nature of the exposure and the firm's ability to forecast currencies, what
hedging or exchange risk management strategy should the firm employ?
3. Which of the various tools and techniques of the foreign exchange market should be
employed
Phornchanok Cumperayot (Dusting off the perception of risk and returns in forex
markets,2003)7
This paper proposes an alternative expectation formation process for macroeconomic
variables by introducing additional risk factors based on the volatility of macroeconomic
fundamentals. The paper proposes, to capture the exchange rate volatility, in addition to
traditional fundamentals (like money supply and real income) time variation of these
fundamentals are incorporated to describe the expected exchange rate returns. The paper finds an
evidence for the correction of equilibrium errors towards the long run equilibrium in the
modified sticky-price model. In the long run, an increase in the domestic money supply or a
decrease in the foreign money supply tends to depreciate the domestic currency and vice-versa.
The impacts of macroeconomic sources of risk are also significant. Uncertainty about the
57
economy lowers the demand for the currency, relative to the fundamental based value. From an
asset pricing perspective, increased risk is accompanied by increased expected future returns,
leading to a current depreciation of currency.
Yi-Chein Chiang (Foreign Exchange Exposures, Financial and Operational Hedge
Strategies of Taiwan Firms)9
This study examines financial and operational hedge strategies of foreign exchange
exposures simultaneously. Empirical findings show that the use of operational hedge strategies
does not help reduce foreign exchange exposures for Taiwan firms. Also, the use of foreign
currency derivatives (FCD) is an effective hedging strategy in a one-month horizon, but it is less
effective when the horizon lengthens. In addition, the use of foreign currency-denominated debts
(FDD) always increases foreign exchange exposures.
Hochschule & Schweiz (Foreign Exchange Risk: Pricing and Hedging Exotic
nstruments)10
This paper discusses exotic instruments used in the Foreign Exchange (FX) markets. An
overview of the most popular exotic derivatives is presented, followed by the pricing alternatives
of these securities. Dynamic hedging of exotic options becomes impractical due to big values of
delta and gamma around barrier close to maturity. For barrier options it is possible to construct a
hedge that does not require continuous rebalancing. Such static hedge consists in setting up a
portfolio of vanilla options that matches the barrier option to be hedged. Static hedging is
sometimes, as it requires an unrealistic basket of vanilla options, either in terms of using options
struck at levels at which there is little market liquidity, either in terms of the number of the
options in the basket. The study also finds that when necessary adjustments are taken into
account, static hedging performs better than dynamic hedging, both from the market risk point of
view and from the model risk point of view.
Bjorn Dohring (Hedging and invoicing strategies to reduce exchange rate exposure: a euro
area perspective)11
Domestic-currency invoicing and hedging allow internationally active firms to reduce
their exposure to exchange rate variations. This paper discusses exchange rate exposure in terms
of transaction risk (the risk of variations of the value of committed future cash flows), translation
risk (the risk of variations of the value of assets and liabilities denominated in foreign currency)
and broader economic risk (which takes into account the impact of exchange rate variations on
58
competitiveness). The paper argues that domestic-currency invoicing and hedging with exchange
rate derivatives allow a fairly straightforward management of transaction and translation risk and
discusses under which circumstances their use is optimal. Economic risk is by its very nature
harder to manage, but the paper argues that natural hedging provides possibilities for doing so.
The discussion of management techniques for exchange rate exposure is complemented with an
analysis of their actual use.
Martin Glaum (Foreign Exchange Risk Management in German Non-Financial
Corporations: An Empirical Analysis)12
The paper reports the results of an empirical study into the foreign exchange risk
management of large German non-financial corporations. Of the 154 firms that were addressed, a
total of 74 took part in the study. The managers of these firms were asked about the measurement
of exchange risk, about their management strategies, and about organizational issues. The results
can be summarized as follows. The majority of the firms are concerned about managing their
transaction exposure. Most firms adopted a selective hedging strategy based on exchange rate
forecasts. Only a small minority of firms does not hedge foreign exchange risk at all, and only
few companies hedge their transaction exposure completely. Looking in more detail at the
management of the firms' exposure to the US-dollar, we found that only 16% of the firms were
fully hedged. The majority of firms had realized hedge ratios between 50 and 99%. The study
found a number of interesting discrepancies between the positions of the academic literature and
corporate practice. For instance, numerous firms are concerned about their accounting exposure
and some firms are actively managing it. The exposure concept favoured by the academic
literature, that is, economic exposure, is of little importance in practice. Further the paper found
that almost half of the firms manage their exchange positions on the basis of the micro hedge
approach. In other words, they forego the possibility to establish the firm's net exposure by
balancing out cash outflows and inflows first. The most interesting finding from an academic
point of view, however, is the widespread use of exchange rate forecasts and of exchange risk
management strategies based on forecasts (selective hedging). By adopting such strategies, the
managers indicate that they do not believe that the foreign exchange markets are information
efficient and they are able to beat the market with their own forecasts. The academic literature,
on the other hand, emphasizes that it is very difficult indeed to make systematically successful
exchange rate forecasts.
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Gleason, Sang Kim & Mathur (The Operational and Financial Hedging Strategies of U.S.
High Technology Firms)13
This paper examines the operational hedging strategies of U.S. high technology firms and
how this hedging is related to financial hedging. It establishes that derivatives users are larger
and are more R&D intensive than non-derivative users. The operational hedging and financial
hedging are complementary. Firms that are geographically diversified have more foreign
exchange exposure. However, firms that use financial hedging are able to significantly lower
their exchange rate exposure. Also, financial hedging adds value for high technology firms,
while operational hedging does not. High technology firms in the U.S. make substantial
investments in intangible assets. These firms seek to exploit their unique assets by expanding
globally, which increases the volatility of their cash flows and the risk of financial distress. Thus,
high technology firms view hedging as a viable strategy for managing risks. These firms
undertake some combination of operational and financial hedging to manage risk. There are four
distinct measures of operational hedging: the number of foreign countries in which a firm
operates, the number of broad regions where a firm operates, and two dispersion measures based
on the Hirshman-Herfindal concentration index.
Ching Hsueh Liu (Foreign Exchange Hedging and Profit Making Strategy using Leveraged
Spot Contracts)14
This research has produced results relevant to speculating and hedging activities in the
leveraged spot market. The paper has developed a new speculating and hedging approach in the
foreign exchange market using leveraged spot markets, an application which has received scant
attention in the literature. Speculators can have a broader range of financial alternatives that
allow them to take advantage of favourable currency movement, while at the same time reducing
the riskiness of speculation by receiving risk-free income from a positive interest rate differential
between two countries. From a hedger’s perspective, hedging using the leveraged spot market
can yield a superior outcome when compared to traditional hedging tools such as unleveraged
forward contracts.
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CHAPTER -V
Corporate Hedging in India
The Indian economy saw a sea change in the year 1999 whereby it ceased to be a closed
and protected economy, and adopted the globalization route, to become a part of the world
economy. In the pre-liberalization era, marked by State-dominated, tightly regulated foreign
exchange regime, the only risk management tool available for corporate enterprises was,
‘lobbying for government intervention’. With the advent of LERMS (Liberalized Exchange Rate
Mechanism System) in India, in 1992, the market forces started to present a regime with steady
price volatility as against the earlier trend of long periods of constant prices followed by sudden,
large price movements. The unified exchange rate phase has witnessed improvement in
informational and operational efficiency of the foreign exchange market, though at a halting
pace. The important point is that measuring risk and exposures is an essential component of a
firm's risk management strategy. Without knowledge of the primitive risk exposures of a firm, it
is not possible to test whether firms are altering their exposures in a manner consistent with
theory. Recent product innovations in the financial markets and the use of these products by the
corporate sector are also examined. In addition to the traditional "physical" products, such as
spot and forward exchange rates, the new "synthetic" or derivative products, including options,
futures and swaps, and their use by the corporate sector are considered. These synthetic products
have their market value determined by the value of a specific, underlying, physical product. The
spurts in foreign investments in India have led to substantial increase in the quantum of inflows
and outflows in different currencies, with varying maturities. Corporate enterprises have had to
face the challenges of the shift from low risk to high- risk operations involving foreign exchange.
There was increasing awareness of the need for introduction of financial derivatives in order to
enable hedging against market risk in a cost effective way. Earlier, the Indian companies had
been entering into forward contracts with banks, which were the Authorized Dealers (AD) in
foreign exchange. But many firms preferred to keep their risk exposures un-hedged as they found
the forward contracts to be very costly. In the current formative phase of the development of the
foreign exchange market, it will be worthwhile to take stock of the initiatives taken by corporate
enterprises in identifying and managing foreign exchange risk. Indian economy in the post-
liberalization era has witnessed increasing awareness of the need for introduction of various risk
management products to enable hedging against market risk in a cost effective way.
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Foreign exchange market
The foreign exchange market (forex, FX, or currency market) is a worldwide
decentralized over-the-counter financial market for the trading of currencies. Financial centers
around the world function as anchors of trading between a wide range of different types of
buyers and sellers around the clock, with the exception of weekends. The foreign exchange
market determines the relative values of different currencies. The primary purpose of the foreign
exchange market is to assist international trade and investment, by allowing businesses to
convert one currency to another currency. In a typical foreign exchange transaction a party
purchases a quantity of one currency by paying a quantity of another currency. The modern
foreign exchange market started forming during the 1970s when countries gradually switched to
floating exchange rates from the previous exchange rate regime, which remained fixed as per the
Bretton Woods system.
1) huge trading volume, leading to high liquidity
2) geographical dispersion
3) continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT on
Sunday until 22:00 GMT Friday
4) the variety of factors that affect exchange rates
5) the low margins of relative profit compared with other markets of fixed income
6) the use of leverage to enhance profit margins with respect to account size
Exchange Rates
A foreign exchange rate represents the value of a specific currency compared to that of
another country. Currency rates are applicable only on currency pairs. The currency listed on the
left is called the reference (or base) currency while the one listed to the right is the quote (or
term) currency. Exchange rates are always written in the form of quotations. A quotation reflects
the number of quote currencies
that can be bought by using a single unit of reference currency. Exchange rates, or the value of
one currency in terms of another, can be highly volatile, since they are impacted by a plethora of
economic and political occurrences across the globe. Due to this, it is important for businessmen,
62
traders, investors and travellers to stay in touch with the current exchange rates. Periods of
economic slowdowns and political tension tend to exacerbate fluctuations in the current
exchange rates.
Fixed rate -This currency exchange rate is determined by a government agency or the central
bank. This official exchange rate is regularly monitored by the bank and maintained by using the
country’s own foreign exchange reserves.
1. Fixed exchange rate provides stability in the foreign exchange market and certainty about
the future course of the exchange rate and it eliminates risks caused by uncertainty due to
fluctuations in the exchange rates. The stability of exchange rate encourages international
trade. On the contrary, flexible exchange rate system causes uncertainty and might also
often lead to violent fluctuations in international trade. As a result foreign trade oriented
economies become subject to severe economic fluctuations, if import elasticity’s are less
than export elasticity’s.
2. The fixed exchange rate system creates conditions for smooth flow of international
capital simply because it ensures a certain return on the foreign investment. While in the
case of flexible exchange rate, capital flows are constrained because of uncertainty about
expected rate of return.
3. The fixed rate eliminates the possibility of speculation, whereby it removes the dangers
of speculative activities in the foreign exchange market. On the contrary flexible
exchange rates encourage speculation.
4. The fixed exchange rate system reduces the possibility of competitive depreciation of
currencies as it happened during 1930s. Also, deviations from fixed rate are easily
adjustable.
5. A case is also made in favor of fixed exchange rate on the basis of existence of currency
areas. The flexible exchange rate is said to be unsuitable between the nations which
constitute a currency area, since it leads to a chaotic situation and hence hampers trade
between them.
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Floating rate - In this flexible exchange rate regime, the private market determines a currency’s
value. However, the value fluctuates according to the demand/supply trends in the market.
1. Flexible exchange rate system provides larger degree of autonomy in respect of domestic
economic policies as it is not obligatory for the countries to tune their domestic policies
to fixed foreign exchange rate.
2. Flexible exchange rate is self-adjusting and therefore it does not devolve on the
government to maintain an adequate foreign exchange reserve.
3. The flexible exchange rate, which is determined by market forces, has a theory behind it
and has the quality of predictability.
4. Flexible exchange rates serve as a barometer of the actual purchasing power and strength
of a currency in the foreign exchange market. It serves as a useful parameter in the
formulation of the domestic economic policies.
5. Economists have also argued that the most serious charge against fluctuating exchange
rate i.e. uncertainty is not tenable because speculators themselves create conditions for
exchange rate stability. Also, the degree of uncertainty associated with flexible exchange
rate could not be much greater then what the world has experienced with adjustable fixed
exchange rate under the Bretton wood’s system
Factors Influencing Current Exchange Rates
The following factors have an impact on current exchange rates:
1. Inflation: If the rate of inflation in a country is lower than that in another country,
demand for the former’s exports will rise. This, in turn, would create rising demand for
that country’s currency, exerting upward pressure on its value.
2. Change in Competitiveness: Related to the inflation rate, this factor affects exchange
rates considerably. Goods and services produced by a country can become more
competitive in the global market as a result of an increase in labor productivity. This
increases the demand for these goods. A high volume of trade results in appreciation in
the value of the country’s currency.
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3. Higher Interest Rates: When the interest rates offered by banks or financial institutions
of a particular country rise, depositing money in that country becomes a profitable
investment option. This results in increased demand for the currency of that country.
4. Speculation: This is more of a sentimental factor than an economic one. Some people
believe that the value of a country’s currency may rise in the near future. They buy the
currency to earn profits, following appreciation in the exchange rates. This buying
activity results in increased demand for the currency.
5. Current Account Surplus: This factor is guided by the balance of trade of a country.
When the value of the country’s exports exceeds the value of its imports, the inflow of
foreign currency is higher than the outflow.
6. Value of Other Currencies: The strength or weakness of a currency can lead to a
decline or rise in the value of another currency. For example, the weakening of the Euro
led to the appreciation of the exchange rate of pound sterling between 1999 and 2001.
Current exchange rates are determined by the market forces of demand and supply. Most
governments play a limited role in influencing exchange rates. Since the forex market is
so vast, global exchange rates cannot be impacted by an individual trader.
Indian Rupee Exchange Rate
Rupees are used in a number of countries including India and Pakistan. The Indian
currency is issued by the Reserve Bank of India (RBI). The Indian rupee exchange rate is
measured against six currency trade weighted indices. These currencies belong to countries that
have a strong trade relationship with India. The exchange rate of the Indian rupee (or INR) is
determined by market conditions. However, in order to maintain effective exchange rates, the
RBI actively trades in the USD/INR currency market. The rupee currency is not pegged to any
particular foreign currency at a specific exchange rate. The RBI intervenes in the currency
markets to maintain low volatility in exchange rates and remove excess liquidity from the
economy.
History of Indian Rupee
Historically, the Indian rupee was a silver-based currency, while the major economies of
the world were following the gold standard. The value of the rupee was severely impacted when
65
large quantities of silver was discovered in the US and Europe. After independence, India started
following a pegged exchange rate system. The country was forced to go through several rounds
of devaluation from the 1960s to the early 1990s due to war and balance of payments problems.
The rupee was made convertible on the current account in 1993. The Indian currency is set to be
made fully convertible in phases over the five years ending 2010-2011. In June 2008, the rupee
appreciated to a ten-year high of US$39.29. The stability of the Indian economy attracted
substantial foreign direct investment, while high interest rates in the country led to companies’
borrowing funds from abroad.
The global financial crisis exerted pressure on crude oil prices, which gradually
plummeted to below $50 a barrel. Due to this, dollar inflow declined, with oil companies and
investors purchasing more and more dollars. Persistent outflow of foreign funds increased the
pressure on the rupee, causing it to decline. On March 5, 2009, the Indian currency depreciated
to a record low of US$52.06. The US dollar's gains against other major currencies also weighed
on the rupee.
At March end, the rupee stood at:
I USD = 50.6402 INR
1 Euro = 67.392 INR
1 Pound Sterling = 72.4022 INR
100 Japanese Yen = 51.3776 INR
The exchange rate trend between the rupee and the US dollar over the six years to 2010 (as on
January 1) one US $ equal to INR .The value of the rupee depends on PPP (or purchasing power
parity), which reflects the quality of life that can be maintained at a particular standard level of
income. Another major factor influencing the value of the rupee is the stock market. An
overvalued index results in the overvaluation of the rupee
2005 43.27 INR
2006 44.95 INR
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2007 44.11 INR
2008 39.41 INR
2009 48.58 INR
2010 45.59 INR
Meaning of Risk
Risk means condition or choices that have certain consequences of loss or danger. In
probability and statistics, financial management, and investment management, risk is used to
describe the likelihood of variability in outcomes around expected value, which is often
measured by the extent of the dispersion around the mean or average value of the underlying
variables. Thus, the term risk, which is used here, refers to the situations where outcomes are
uncertain that may lead to the losses.
Foreign Exchange Risk
Forex risk is the variability in the profit due to change in foreign exchange rate. Suppose
the company is exporting goods to foreign company then it gets the payment after month or so
then change in exchange rate may effect in the inflows of the fund. If rupee value depreciated he
may lose some money. Similarly if rupees value appreciated against foreign currency then it may
gain more rupees. Hence there is risk involved in it.
(Bartov and Bodnar, 1994). Loderer and Pichler (2000) for a detailed discussion on firms’
awareness of their foreign exchange risk exposure(1)
Nature of Foreign Exchange Risk
Foreign Exchange dealing is a business that one get involved in, primarily to obtain
protection against adverse rate movements on their core international business. Foreign
Exchange dealing is essentially a risk-reward business where profit potential is substantial but it
is extremely risky too.
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Foreign exchange business has the certain peculiarities that make it a very risky business.
These would include:
1. Forex deals are across country borders and therefore, often foreign currency prices are
subject to controls and restrictions imposed by foreign authorities. Needless to say, these
controls and restrictions are invariably dictated by their own domestic factors and
economy.
2. Forex deals involve two currencies and therefore, rates are influenced by domestic as
well as international factors.
3. The Forex market is a 24-hour global market and overseas developments can affect rates
significantly.
4. The Forex market has great depth and numerous players shifting vast sums of money.
Forex rates therefore, can move considerably, especially when speculation against a
currency rises.
5. Forex markets are characterized by advanced technology, communications and speed.
Decision-making has to be instantaneous.
Classification of Foreign Exchange Risk
1. Position Risk
2. Gap or Maturity or Mismatch Risk
3. Translation Risk
4. Operational Risk
5. Credit Risk
1. Position Risk
The exchange risk on the net open Forex position is called the position risk. The position can
be a long/overbought position or it could be a short/oversold position. The excess of foreign
currency assets over liabilities is called a net long position whereas the excess of foreign
68
currency liabilities over assets is called a net short position. Since all purchases and sales are at a
rate, the net position too is at a net/average rate. Any adverse movement in market rates would
result in a loss on the net currency position.
For example, where a net long position is in a currency whose value is depreciating, the
conversion of the currency will result in a lower amount of the corresponding currency resulting
in a loss, whereas a net long position in an appreciating currency would result in a profit. Given
the volatility in Forex markets and external factors that affect FX rates, it is prudent to have
controls and limits that can minimize losses and ensure a reasonable profit.
The most popular controls/limits on open position risks are:
1. Daylight Limit: Refers to the maximum net open position that can be built up a trader
during the course of the working day. This limit is set currency-wise and the overall
position of all currencies as well.
2. Overnight Limit: Refers to the net open position that a trader can leave overnight – to be
carried forward for the next working day. This limit too is set currency-wise and the
overall overnight limit for all currencies. Generally, overnight limits are about 15% of the
daylight limits.
2. Mismatch Risk/Gap Risk
Where a foreign currency is bought and sold for different value dates, it creates no net
position i.e. there is no FX risk. But due to the different value dates involved there is a
“mismatch” i.e. the purchase/sale dates do not match. These mismatches, or gaps as they are
often called, result in an uneven cash flow. If the forward rates move adversely, such mismatches
would result in losses. Mismatches expose one to risks of exchange losses that arise out of
adverse movement in the forward points and therefore, controls need to be initiated.
The limits on Gap risks are:
1. Individual Gap Limit: This determines the maximum mismatch for any calendar month;
currency-wise.
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2. Aggregate Gap Limit: Is the limit fixed for all gaps, for a currency, irrespective of their
being long or short. This is worked out by adding the absolute values of all overbought
and all oversold positions for the various months, i.e. the total of the individual gaps,
ignoring the signs. This limit, too, is fixed currency-wise.
3. Total Aggregate Gap Limit: Is the limit fixed for all aggregate gap limits in all
currencies.
3. Translation Risk
Translation risk refers to the risk of adverse rate movement on foreign currency assets and
liabilities funded out of domestic currency.
There cannot be a limit on translation risk but it can be managed by:
1. Funding of Foreign Currency Assets/Liabilities through money markets i.e. borrowing or
lending of foreign currencies
2. Funding through FX swaps
3. Hedging the risk by means of Currency Options
4. Funding through Multi Currency Interest Rate Swaps
4. Operational Risk
The operational risks refer to risks associated with systems, procedures, frauds and human
errors. It is necessary to recognize these risks and put adequate controls in place, in advance. It is
important to remember that in most of these cases corrective action needs to be taken post-event
too. The following areas need to be addressed and controls need to be initiated.
1. Segregation of trading and accounting functions: The execution of deals is a function
quite distinct from the dealing function. The two have to be kept separate to ensure a
proper check on trading activities, to ensure all deals are accounted for, that no positions
are hidden and no delay occurs.
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2. Follow-up and Confirmation: Quite often deals are transacted over the phone directly
or through brokers. Every oral deal has to be followed up immediately by written
confirmations; both by the dealing departments and by back-office or support staff. This
would ensure that errors are detected and rectified immediately.
3. Settlement of funds: Timely settlement of funds is necessary not only to avoid delayed
payment interest penalty but also to avoid embarrassment and loss of credibility.
4. Overdue contracts: Care should be taken to monitor outstanding contracts and to ensure
proper settlements. This will avoid unnecessary swap costs, excessive credit balances and
overdrawn Nostro accounts.
5. Float transactions: Often retail departments and other areas are authorized to create
exposures. Proper measures should be taken to make sure that such departments and areas
inform the authorized persons/departments of these exposures, in time. A proper system
of maximum amount trading authorities should be installed. Any amount in excess of
such maximum should be transacted only after proper approvals and rate.
5. Credit Risk
Credit risk refers to risks dealing with counter parties. The credit is contingent
upon the performance of its part of the contract by the counter party. The risk is not
only due to nonperformance but also at times, the inability to perform by the counter
party.
The credit risk can be
1. Contract risk: Where the counter party fails prior to the value date. In such a case, the
Forex deal would have to be replaced in the market, to liquidate the Forex exposure. If
there has been an adverse rate movement, this would result in an exchange loss. A
contract limit is set counter party-wise to manage this risk.
2. Clean risk: Where the counter party fails on the value date i.e. it fails to deliver the
currency, while you have already paid up. Here the risk is of the capital amount and the
loss can be substantial. Fixing a daily settlement limit as well as a total outstanding limit,
counter party-wise, can control such a risk.
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3. Sovereign Risk: refers to risks associated with dealing into another country. These risks
would be an account of exchange control regulations, political instability etc. Country
limits are set to counter this risk
Exchange-Rate Risk and Globalization
Exchange rate volatility is one of the most difficult and unrelenting problems in the era of
globalization. Firms with foreign transactions and obligations may face substantial losses due to
adverse movements in exchange rates. Firms are exposed to the adverse movement of exchange
rates because of three broad reasons. First, all foreign financial transactions involving cash
payments must often be denominated in the creditor’s domestic currency. As the exchange rates
fluctuate between the time of contract and the date of payment, there is the possibility of losses
because the amount of money that has to be available for conversion from the debtor’s to
creditor’s currency at the payment date is larger than it was expected on the contract. Second, the
exposure arises because of the size of the foreign transactions. Finally, the length between the
date of contract and the date of payment is also the reason for firms’ exposure to foreign
exchange rate risk.
MaurerRaimond and ShohrehValiani, (Hedging the exchange rate risk in international portfolio
diversification(2)
In this study the authors examine the effectiveness of controlling the currency risk for
international diversified mixed-asset portfolios via two different hedge instruments, currency
forwards and currency options.
The Dimensions of Foreign Exchange Exposures
Beside the financial impacts of cash losses and increased debt obligations, the adverse
effects of foreign exchange have several dimensions for firms with foreign operations. For the
purpose of financial reporting, the foreign operational units must often translate items in the
financial statement at the common exchange rate that may differ from the rate at which the
transaction items prevail. As a result, the parent company will experience exchange gains or
losses which, in turn, influences the firm’s performance from the perspectives of investors,
banks, analysts, and other external users who rely merely on consolidated financial statements.
72
The adverse effect of exchange rate movements for firms with foreign operations has yet another
dimension. A depreciation of domestic exchange rate of the overseas operational units may not
only change the value of assets and liabilities that are translated in the currency of the parent
company but also increase the competitiveness of exportable products of the operational units.
Thus, the reported decrease in the assets and liabilities at the parent company do not reflect the
true value of the revenue and expense streams of the operational units since any advantage from
a depreciation may offset the lower value of assets and liabilities from translation. Hence, an
appropriate measure of the adverse effect of exchange rate movements is the expected cash flows
of the operational units. Although the first and the second dimensions of the adverse
consequences of exchange rate movements appear contradictory, it may actually have the same
effects on the parent company and the overseas operational units. For example, the decreased
value of retained earnings when it is translated at the currency of the parent company may also
be experienced by the foreign operating firms. This is because the real economic environment of
the operating firms remains unknown Regardless of whether the domestic economic environment
where the operational units conducting business improve or deteriorate the obvious effects of
exchange rate movements on cash flows of both overseas operating firms and parent company is
inevitable. The variability of input costs and a decrease in the products’ competitive position
may contribute to an increase in variability of the firm’s expected cash flows. The persistent
variability of cash flows can cause further severe direct and indirect problems including,
liquidity, bankruptcy and financial, spoiling investment decisions and the firm’s ability to raise
capital, and the perception of stakeholders, regulators, and society in general of inadequate
corporate governance.
Foreign Exchange Rate Risk and Exposure
The word risk is often used interchangeably with exposure. Although these words have a
close relationship, the meaning is different. The risk is usually concerned with the probability of
an unexpected outcome, while exposure is concerned with the magnitude of the possibility of
loss. The definition of foreign exchange risk differs to foreign exchange exposure. Foreign
exchange risk can be defined as "related to the variability of domestic-currency values of Assets,
liabilities, or operating incomes due to unanticipated changes in exchange rates, whereas foreign
exchange exposure is “what is at risk". Foreign exchange risk arises as a result of uncertainty
73
about the future spot exchange rate. It is a result of uncertainty about the future spot exchange
rate (due to the variability of exchange rates), the domestic value of assets, liabilities, operating
incomes, profit, rates of return, and expected cash flows that are stated in foreign currency are
uncertain. Exposure can exist on assets, liabilities, and operating incomes. Exposure exists on
foreign assets when the real domestic currency value of foreign assets rises and when the foreign
currency appreciates, and vice versa. This relationship can be simplified with the following
regression equation:
(A/L) = ß S
Where, A and L are changes in the real domestic currency value of foreign assets or
liabilities, S is changes in exchange rates, and ß is the slope of the equation as well as a measure
of exposure. The larger the value of ß the more sensitive the value of the assets towards
exchange rate changes, and therefore, the larger the exposure.
Eitman and Stonehill (1986) and Shapiro (1991) define the three types of foreign
exchange exposure. Hedging preferences and foreign exchange exposure management (2)
findarticles.com/p/articles/mi_qa3674/is.../ai_n8713577/
1. Translation exposure
2. Transactions exposure
3. Economic exposure
Foreign Exchange Exposure
Foreign exchange risk is related to the variability of the domestic currency values of
assets, liabilities or operating income due to unanticipated changes in exchange rates. Foreign
currency exposures and the attendant risk arise whenever a company has an income or
expenditure or an asset or liability in a currency other than that of the balance-sheet currency.
Indeed exposures can arise even for companies with no income, expenditure, asset or liability in
a currency different from the balance-sheet currency. When there is a condition prevalent where
the exchange rates become extremely volatile the exchange rate movements destabilize the cash
flows of a business significantly. Such destabilization of cash flows that affects the profitability
of the business is the risk from foreign currency exposures.
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Classification of Exposures
Financial economists distinguish between three types of currency exposures – transaction
exposures, translation exposures, and economic exposures. All three affect the bottom- line of
the business.
1. Transaction Exposure
Transaction exposure can be defined as “the sensitivity of realized domestic currency
values of the firm’s contractual cash flows denominated in foreign currencies to unexpected
exchange rate changes. Transaction exposure is sometimes regarded as a short-term economic
exposure. Transaction exposure arises from fixed-price contracting in a world where exchange
rates are changing randomly.
A company is exporting deutsche mark and while costing the transaction had reckoned
on getting says Rs.24 per mark. By the time the exchange transaction materializes i.e. the export
is affected and the mark sold for rupees, the exchange rate moved to say Rs.20 per mark. The
profitability of the export transaction can be completely wiped out by the movement in the
exchange rate. Such transaction exposures arise whenever a business has foreign currency
denominated receipt and payment. The risk is an adverse movement of the exchange rate from
the time the transaction is budgeted till the time the exposure is extinguished by sale or purchase
of the foreign currency against the domestic currency. Furthermore, in view of the fact that firms
are now more frequently entering into commercial and financial contracts denominated in
foreign currencies, judicious management of transaction exposure has become an important
function of international financial management.
Some strategy to manage transaction exposure
1. Hedging through invoice currency: While such financial hedging instruments as
forward contract, swap, future and option contracts are well known, hedging through the
choice of invoice currency, an operational technique, has not received much attention.
The firm can shift, share or diversify exchange risk by appropriately choosing the
currency of invoice. Firm can avoid exchange rate risk by invoicing in domestic
currency, there by shifting exchange rate risk on buyer. As a practical matter, however,
75
the firm may not be able to use risk shifting or sharing as much as it wishes to for fear of
losing sales to competitors. Only an exporter with substantial market power can use this
approach. Further, if the currencies of both the exporter and importer are not suitable for
settling international trade, neither party can resort to risk shifting to deal with exchange
exposure.
2. Hedging via lead and lag: Another operational technique the firm can use to reduce
transaction exposure is leading and lagging foreign currency receipts and payments. To
“lead” means to pay or collect early, where as “lag” means to pay or collect late. The firm
would like to lead soft currency receivables and lag hard currency receivables to avoid
the loss from depreciation of the soft currency and benefit from the appreciation of the
hard currency. For the same reason, the firm will attempt to lead the hard currency
payables and lag soft currency payables. To the extent that the firm can effectively
implement the Lead/Lag strategy, the transaction exposure the firm faces can be reduced.
2. Translation Exposure (Accounting Exposures)
Translation exposure is defined as the likely increase or decrease in the parent company’s
net worth caused by a change in exchange rates since last translation. This arises when an asset
or liability is valued at the current rate. No exposure arises in respect of assets/liabilities valued
at historical rate, as they are not affected by exchange rate differences. Translation exposure is
measured as the net of the foreign currency denominated assets and liabilities valued at current
rates of exchange. If exposed assets exceed the exposed liabilities, the concern has a ‘positive’ or
‘long’ or ‘asset’ translation exposure, and exposure is equivalent to the net value. If the exposed
liabilities exceed the exposed assets and results in ‘negative’ or ‘short’ or ‘liabilities’ translation
exposure to the extent of the net difference. Translation exposure arises from the need to
“translate” foreign currency assets or liabilities into the home currency for the purpose of
finalizing the accounts for any given period.
A typical example of translation exposure is the treatment of foreign currency
borrowings. Consider that a company has borrowed dollars to finance the import of capital goods
worth $10000. When the import materialized the exchange rate was say Rs 30 per dollar. The
imported fixed asset was therefore capitalized in the books of the company for Rs 300000. In the
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ordinary course and assuming no change in the exchange rate the company would have provided
depreciation on the asset valued at Rs 300000 for finalizing its accounts for the year in which the
asset was purchased. If at the time of finalization of the accounts the exchange rate has moved to
say Rs 35 per dollar, the dollar loan has to be translated involving translation loss of Rs50000.
The book value of the asset thus becomes 350000 and consequently higher depreciation has to be
provided thus reducing the net profit.
Thus, Translation loss or gain is measured by the difference between the value of assets
and liabilities at the historical rate and current rate. A company which has a positive exposure
will have translation gains if the current rate for the foreign currency is higher than the historic
rate. In the same situation, a company with negative exposure will post translation loss. The
position will be reversed if the currency rate for foreign currency is lesser than its historic rate of
exchange. The translation gain/loss is shown as a separate component of the shareholders’ equity
in the balance-sheet. It does not affect the current earnings of the company.
3. Economic Exposure
Economic exposure can be defined as the extent to which the value of the firm would be
affected by unanticipated changes in exchange rates. An economic exposure is more a
managerial concept than an accounting concept. A company can have an economic exposure to
say Yen: Rupee rates even if it does not have any transaction or translation exposure in the
Japanese currency. This would be the case for example, when the company’s competitors are
using Japanese imports. If the Yen weekends the company loses its competitiveness (vice-versa
is also possible). The company’s competitor uses the cheap imports and can have competitive
edge over the company in terms of his cost cutting. Therefore the company’s exposed to
Japanese Yen in an indirect way.
In simple words, economic exposure to an exchange rate is the risk that a change in the rate
affects the company’s competitive position in the market and hence, indirectly the bottom-line.
Broadly speaking, economic exposure affects the profitability over a longer time span than
transaction and even translation exposure. Under the Indian exchange control, while translation
and transaction exposures can be hedged, economic exposure cannot be hedged.
Economic exposure consists of mainly two types of exposures.
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1. Asset exposure
2. Operating exposure
Exposure to currency risk can be properly measured by the sensitivities of (1) the future home
currency values of the firm’s assets (and liabilities) (2) the firm’s operating cash flows to random
changes in exchange rates.
1. Asset exposure: A U.S. firm has an asset in Britain whose local currency price is
random. Let us assume that there are three states of the world, with each state equally
likely to occur. The future local currency price of this British asset as well as the future
exchange rate will be determined, depending on the realized state of the world.
2. Operating exposure: Operating exposure can be defined as “the extent to which the
firm’s operating cash flows would be affected by random changes in exchange rates”.
Operating exposure may affect in two different ways to the firm, viz., competitive effect
and conversion effect. Adverse exchange rate change increase cost of import which
makes firm’s product costly thus firm’s position becomes less competitive, which is
competitive effect. Adverse exchange rate change may reduce value of receivable to the
exporting firm which is called conversion effect.
Some strategy to manage operating exposure
1. Selecting low cost production sites: When the domestic currency is strong or expected
to become strong, eroding the competitive position of the firm, it can choose to locate
production facilities in a foreign country where costs are low due to either the
undervalued currency or underpriced factors of production. Recently, Japanese car
makers, including Nissan and Toyota, have been increasingly shifting production to U.S.
manufacturing facilities in order to mitigate the negative effect of the strong yen on U.S.
sales. German car makers such as Daimler Benz and BMW also decided to establish
manufacturing facilities in the U.S. for the same reason. Also, the firm can choose to
establish and maintain production facilities in multiple countries to deal with the effect of
exchange rate changes. Consider Nissan, which has manufacturing facilities in the U.S.
and Mexico, as well as in Japan. Multiple manufacturing sites provide Nissan with great
deal of flexibility regarding where to produce, given the prevailing exchange rates. When
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the yen appreciated substantially against the dollar, the Mexican peso depreciated against
the dollar in recent years. Under this sort of exchange rate development, Nissan may
choose to increase production in the U.S. and especially in Mexico, in order to serve the
U.S. market. This is, in fact, how Nissan has reacted to the rising yen in recent years.
Maintaining multiple manufacturing sites, however, may prevent the firm from taking
advantage of economies of scale, raising its cost of production. The resultant higher cost
can partially offset the advantages of maintaining multiple production sites.
2. Flexible sourcing policy: Even if the firm manufacturing facilities only in the domestic
country, it can substantially lessen the effect of exchange rate changes by sourcing from
where input costs are low. Facing the strong yen in recent years, many Japanese firms are
adopting the same practice. It is well known that Japanese manufacturers, especially in
the car and consumer electronics industries, depend heavily on parts and intermediate
products from such low cost countries as Thailand, Malaysia, and China. Flexible
sourcing need not be confined just to materials and parts. Firms can also hire low cost
guest workers from foreign countries instead of high cost domestic workers in order to be
competitive.
3. Diversification of the market: Another way of dealing with exchange exposure is to
diversify the market for the firm’s products as much as possible. Suppose that GE is
selling power generators in Mexico as well as Germany. Reduced sales in Mexico due to
the dollar appreciation against the peso can be compensated by increased sales in
Germany due to dollar depreciation against the euro. As a result, GE’s overall cash flows
will be much more stable than would be the case if GE sold only in one foreign market,
either Mexico or Germany. As long as exchange rates do not always move in the same
direction, the firm can stabilize its operating cash flow by diversifying its export market.
4. R&D efforts and product differentiation: Investment in R&D activities can allow the
firm to maintain and strengthen its competitive position in the face of adverse exchange
rate movements. Successful R&D efforts allow the firm to cut costs and enhance
productivity. In addition, R&D efforts can lead to the introduction of new and unique
products for which competitors offer no close substitutes. Since the demand for unique
products tend to be highly inelastic, the firm would be less exposed to exchange risk. At
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the same time, the firm can strive to create a perception among consumers that its product
is indeed different from those offered by competitors. This helps firm to pass-through any
adverse effect of exchange rate on to the customers.
5. Financial hedging: While not a substitute for the long-term, financial hedging can be
used to stabilize the firm’s cash flow. For example, the firm can lend or borrow foreign
currencies as a long term basis. Or, the firm can use currency forward of options
contracts and roll them over if necessary
Foreign Exchange Exposure Management and the Value of Firm
From literature it evident that a sufficient condition for managing foreign exchange
exposures is that it increases the expected value of the firm. The value of the firm is the present
value of the projected cash flows; that is, cash flows that have been discounted at a certain rate
reflecting both the degree of risk in the business and the financing generated from many sources
used by the firm there are three ways of increasing firm value by implementing exposure
management:
(I) Reduction in tax
(ii) The reduction of the expected cost of financial distress
(iii) Improving investment decisions and increasing the ability to raise capital.
Martin Glaum (Foreign Exchange Risk Management in German Non-Financial Corporations: An
Empirical Analysis.(3)
The paper reports the results of an empirical study into the foreign exchange risk management of
large German non-financial corporations. Of the 154 firms that were addressed, a total of 74 took
part in the study
The Reduction in Taxes and Exposure Management
With respect to increasing the expected the net cash flows, it is important to notice that it
is implicitly concerned with the reduction of the out flows. One way to increase the net cash
flows is by reducing the amount of tax in the pre-tax income. Exposure management can reduce
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the expected pre-tax income if a firm effective tax schedule is ‘convex’, that is, the amount of tax
should be paid increase as the pre-tax income rises (progressive tax rate). The more convex the
corporate tax schedule, the more benefit from exposure management can be gained. The reason
for this is that exposure management can presumably smooth out the pre-tax income. Since the
amount of pre-tax cash flows moves in the mean, the amount of tax to be paid is less than that of
pre-tax with variability.
Exposure Management and Expected Cost of Financial Distress
Besides the reduction in taxes, the value of a firm can also be increased by reducing the
expected costs of financial distress. Financial distress is a situation where firms are close to
bankruptcy even though they may never actually go bankrupt. Firms can be categorized as in
financial distress when their income is not sufficient to cover all fixed claims. The probability of
financial distress is determined by two factors. The first is the firm’s ability to pay fixed claims.
Another factor is firm’s income volatility. The second factor should be considered as a
determinant of probability of financial distress because the more volatile firms' income the
higher the probability of default. If financial distress leads to bankruptcy, there will be many
expenses that should be paid. And there must be some dialogue between the management of the
bankrupt firm and the creditors. There are also legal expenses to be paid, such as, court costs and
advisory fees. The expected costs of financial distress arise from three sources. First, costs
arising from the legal and administrative expenses of bankruptcy including court costs and
advisory fees (direct costs). Second, costs arise from conflicts between debt holders and equity
holders (indirect costs). Finally, costs arising from non-financial stakeholders, such as customers,
employees, suppliers, and the community in which firms operate (indirect cost). Exposure
management could reduce the variability of expected future cash flows while the stability of cash
flows can reduce the probability of financial distress. Therefore, foreign exchange exposure
management increases the value of the firm by decreasing the problems associated with financial
distress.
Exposure Management and Investment Decisions
In order to address the effect of exposure management as a financial policy towards
investment decisions, it may be useful to look back to the central argument of the Modigliani-
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Miller theorem in which they argue that financing decisions, choosing between debt and equity,
have no implications for investment. In the following description, the role of currency
management on maintaining the stability of the firm’s cash flows will explain how a financing
decision will improve investment decisions and increase debt capacity. For this purpose, the
cause of investment problems is explored, particularly those arising from conflict between debt
holders and equity holders. Basically, the problem arises because of self-interest towards claims
between them. On the one hand, bond holders have fixed claims so that they have to bears most
of the firm’s risk. On the other hand, equity holders have claims based on a certain percentage of
firm’s cash flows. The real cause of the problem between them is the perception by debt holders
that equity holders tend to dominate decisions in the firms. Therefore, managers of most firms
will take action on behalf of the equity holders, thereby, maximizing the shareholders benefits. It
can also be said that there is a possibility of the managers ignoring the interest of debt holders.
The conflict between debt holders and equity holders can usually be found in highly leveraged
firms, that is, those with a larger portion of debt than equity to finance the investment. Myers has
recognized this problem widely known as ‘under investment’. The conflict between debt and
equity holders occurs when the firm has a plan to finance a new investment with more debt.
Certainly, this situation does not bring benefits within the perspective of current debt holders
because financing investment using more debt will be more risky. As a result, the debt holders
tend to limit the firm’s borrowing in the future or the existing bondholders will ask higher rate as
compensation to bearing a higher risk. Due to this limitation, the firm has difficulty in financing
the new investment with more debt. Consequently, although there is a project that has positive
NPV, the equity holders will not take the investment particularly if the value of the firm assets is
low because the bondholders will receive the benefit if the positive NPV project is taken. This
problem can be eased by the implementation of exposure management. The currency exposure
management can be implemented when the cost of external sources of funds are more expensive
that of internal. If a firm does not manage exposures, there might be some variability in their
cash flows. According to the authors, there will be two implications resulting from such
variability. First, there will be variability in the amount of money raised internally. Second, there
will be variability in the amount of investment. The investment and financing plan will be
disturbed by a variability of cash flows. Therefore, maintaining the stability of cash flows in
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currency management is a logical argument because firms that have difficulty in financing
investment using external sources of funds will rely on their internal sources.
Empirical Evidence of Exposure Management on the Financing Decision
The benefit of exposure management on the planning process of investment is a
commonly held in finance literature. However, there have been disputes among researchers.
Some researchers have argued that there is no relationship between the implementation of
exposure management and the degree of leverage in a firm’s capital structure. Others conclude
that there is a relationship which can avoid conflicts between debt and equity holders. Normally,
firms with higher risk (low rated) tend to issue short-term debt, and then swap to pay a fix rate
for floating rate incomes. The under investment problem can be reduced because all investment
gains go to shareholders. On the other hand, shareholders cannot choose risky projects because
this action will increase the risk premium of the outstanding short-term debt. There is a negative
correlation between the degree of leverage measured by debt-to-equity ratio, in the capital
structure and hedging. Hedging does not have an effect on the conflict between debt holders and
equity holders raised from the degree of leverage. The reason for this inconsistency with the
benefit of hedging to reduce underinvestment is because firms that have a bigger leverage
usually also have smaller investment options, then hedge less since there are no sufficient funds
for hedging. There are three possible causes of losing market share. Book-to-market-ratio is the
ratio between book value of equity (BV) and its market value (MV). This ratio shows share
prices relative to book value. Firms with high MV/BV have lo w share price relative to boo k
value. These firms tend to have lower profitability and are susceptible to financial distress (more
detail in Fama and French (1995). Therefore, MV/BV can be used as a proxy variable of firms
with higher growth in their investment opportunity. First, it is caused by competitor reaction
(‘competitor driven’). Firms that is financially stronger may take advantage of the condition by
aggressive advertising or pricing their products to drive out the susceptible competitors. The
second cause is called ‘manager-driven’, that is, managers may downsize the firms to achieve
efficiency by for instance, selling unproductive assets. Third, customers may be reluctant to do
business with distressed firms (‘customer-driven’). When R&D is considered, the authors also
found that customers would be more hesitant to deal with the firms that spent more on R&D.
This is due to a customer perception that a high R&D expenditure indicates that those firms are
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specialized in the products. Consequently, highly leveraged firms with high R&D expenditure
will be more susceptible to bankruptcy.
Necessity of managing foreign exchange risk
A 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. Research 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 analyzing the historical sequence of
exchange rates.(Soenen,1979). However, when the efficient markets theory is applied to the
foreign exchange market under floating exchange rates there is some evidence to suggest that the
present prices properly reflect all available information. 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. It implies that foreign exchange risk management cannot
be done away with by employing resources to predict exchange rate changes.
Hedging:
Hedging means a transaction undertaken specifically to offset some exposure arising out of the
firm’s usual operations. In other words, a transaction that reduces the price risk of an underlying
security or commodity position by making the appropriate offsetting derivative transaction. In
hedging a firm tries to reduce the uncertainty of cash flows arising out of the exchange rate
fluctuations. With the help of this a firm makes its cash flows certain by using the derivative
markets.
Tools to manage foreign exchange risk involved due to fluctuations in exchange rates
A firm may be able to reduce or eliminate currency exposure by means of internal and
external hedging strategies.
Gleason, Sang Kim & Mathur (The Operational and Financial Hedging Strategies of U.S.High
Technology Firms (4)
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This paper examines the operational hedging strategies of U.S. high technology firms and how
this hedging is related to financial hedging. It establishes that derivatives users are larger and are
more R&D intensive than non-derivative users
1. Internal Hedging Strategies
1. Invoicing
A firm may be able to shift the entire risk to another party by invoicing its exports in its
home currency and insisting that its imports too be invoiced in its home currency, but in the
presence of well-functioning forwards markets this will not yield any added benefit compared to
a forward hedge. At times, it may diminish the firm’s competitive advantage if it refuses to
invoice its cross-border sales in the buyer’s currency.
In the following cases invoicing is used as a means of hedging:
1. Trade between developed countries in manufactured products is generally invoiced in the
exporter’s currency.
2. Trade in primary products and capital assets are generally invoiced in a major vehicle
currency such as the US dollar.
3. Trade between a developed and a less developed country tends to be invoiced in the
developed country’s currency.
4. If a country has a higher and more volatile inflation rate than its trading partners, there is
a tendency not to use that country’s currency in trade invoicing.
2. Netting and Offsetting:
A firm with receivables and payables in diverse currencies can net out its exposure in
each currency by matching receivables with payables. Thus a firm with exports to and imports
from say Germany need not cover each transaction separately; it can use a receivable to settle all
or part of a payable and take a hedge only for the net DEM payable or receivable. Even if the
timings of the two flows do not match, it might be possible to lead or lag one of them to achieve
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a match. To be able to use netting effectively, the company must have continuously updated
information on inter-subsidiary payments position as well as payables and receivables to
outsiders. One way of ensuring efficient information gathering is to centralize cash management.
3. Leading and lagging:
Another internal way of managing transactions exposure is to shift the timing of
exposures by leading or lagging payables and receivables. The general rule is lead, i.e. advance
payables and lag, i.e. postpone receivables in “strong” currencies and, conversely, leads
receivables and lag payables in weak currencies. Simply shifting the exposure in time is not
enough; it has to be combined with a borrowing/lending transaction or a forward transaction to
complete the hedge.
Both these tools exist as a response to the existence of market imperfections.
2. External Hedging Strategies
1. Using hedging for forwards market:
In the normal course of business, a firm will have several contractual exposures in various
currencies maturing at various dates. The net exposure in a given currency at a given date is
simply the difference between the total inflows and the total outflows to be settled on that date.
2. Hedging with the money market:
Firms, which have access to international money markets for short-term borrowing as well as
investment, can use the money market for hedging transactions exposure. Sometimes the money
market hedge may turn out to be the more economical alternative because of some constraints
imposed by governments. For instance, domestic firms may not be allowed access to the
Euromarkets in their home currency or non-residents may not be permitted access to domestic
money markets. This will lead to significant differentials between the Euromarkets and domestic
money market interest rates for the same currency. Since forward premia/ discounts are related to
Euromarkets interest differentials between two currencies, such an imperfection will present
opportunities for cost saving. Time to time cost saving opportunities may arise either due to
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some market imperfection or natural market conditions, which an alert treasurer can exploit to
make sizeable gains. Having decided to hedge an exposure, all available alternatives for
executing the hedge should be examined.
3. Hedging with Currency Options:
Currency options provide a more flexible means to cover transactions exposure. A contracted
foreign currency outflow can be hedged by purchasing a call option (or selling a put option) on
the currency while an inflow can be hedged by buying a put option. (Or writing a call option.
This is a “covered call” strategy).
Options are particularly useful for hedging uncertain cash flows, i.e. Cash flows those are
contingent on other events. Typical situations are:
1. International tenders: Foreign exchange inflows will materialize only if the bid is
successful. If execution of the contract also involves purchase of materials, equipment’s,
etc. from third countries, there are contingent foreign currency outflows too.
2. Foreign currency receivables with substantial default risk or political risk, e.g. the host
government of a foreign subsidiary might suddenly impose restrictions on dividend
repatriation.
4. Hedging with currency futures:
Hedging contractual foreign currency flows with currency futures is in many respects
similar to hedging with forward contracts. A receivable is hedged by selling futures while a
payable is hedged by buying futures. A futures hedge differs from a forward hedge because of
the intrinsic features of future contracts. The advantages of futures are, it easier and has greater
liquidity. Banks will enter into forward contracts only with corporations (and in rare cases
individuals) with the highest credit rating. Second, a futures hedge is much easier to unwind
since there is an organized exchange with a large turnover.
Hedging as a tool to manage foreign exchange risk.
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There is a spectrum of opinions regarding foreign exchange hedging. Some firms feel
hedging techniques are speculative or do not fall in their area of expertise and hence do not
venture into hedging practices. Other 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.
The Management of Foreign Exchange Risk by Ian H. Giddy and Gunter Dufey New York
University and University of Michigan(4)
There are some explanations backed by theory about the irrelevance of managing the risk
of change in exchange rates. For example, the International Fisher effect states that exchange
rates changes are balanced out by interest rate changes, the Purchasing Power Parity theory
suggests that exchange rate changes will be offset by changes in relative price indices/inflation
since the Law of One Price should hold. Both these theories suggest that exchange rate changes
are evened out in some form or the other. Also, the Unbiased Forward Rate theory suggests that
locking in the forward exchange rate offers the same expected return and is an unbiased indicator
of the future spot rate. But these theories are perfectly played out in perfect markets under
homogeneous tax regimes. Also, exchange rate-linked changes in factors like inflation and
interest rates take time to adjust 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. It has also been argued that a
hedged firm, being less risky can secure debt more easily and this enjoy a tax advantage (interest
is excluded from tax while dividends are taxed). This would negate the Modigliani-Miller
proposition as shareholders cannot duplicate such tax advantages. The MM 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. They find a
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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
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.
1. 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.
2. 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
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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 standardized dollar
futures equal to the amount to be hedged as the risk is that of appreciation of the dollar. As
mentioned earlier, the tailor ability 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.
3. 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 favorable 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
4. 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
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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 realized by
investing the proceeds from the loan would match the interest rate payment (in the foreign
currency) for the loan.
The Corporate Hedging Process
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Step 1: Identify the Risks
Before management can begin to make any decisions about hedging, it must first identify
all of the risks to which the corporation is exposed. These risks will generally fall into two
categories: operating risk and financial risk. For most non-financial organizations, operating risk
is the risk associated with manufacturing and marketing activities. A computer manufacturer, for
example, is exposed to the operating risk that a competitor will introduce a technologically
superior product which takes market share away from its leading model. In general, operating
risks cannot be hedged because they are not traded.
The second type of risk, financial risk, is the risk a corporation faces due to its exposure
to market factors such as interest rates, foreign exchange rates and commodity and stock prices.
Financial risks, for the most part, can be hedged due to the existence of large, efficient markets
through which these risks can be transferred. In determining which risks to hedge, the risk
manager needs to distinguish between the risks the company is paid to take and the ones it is not.
Most companies will find they are rewarded for taking risks associated with their primary
business activities such as product development, manufacturing and marketing. For example, a
computer manufacturer will be rewarded (i.e., its stock price will appreciate) if it develops a
technologically superior product or for implementing a successful marketing strategy.
Most corporations, however, will find they are not rewarded for taking risks which are
not central to their basic business (i.e., interest rate, exchange rate, and commodity price risk).
The computer manufacturer in the previous example is unlikely to see its stock price appreciate
just because it made a successful bet on the dollar/yen exchange rate. Another critical factor to
consider when determining which risks to hedge is the materiality of the potential loss that might
occur if the exposure is not hedged. As noted previously, a corporation's optimal risk profile
balances the benefits of protection against the costs of hedging. Unless the potential loss is
material (i.e., large enough to severely impact the corporation's earnings) the benefits of hedging
may not outweigh the costs, and the corporation may be better off not hedging.
Step 2: Distinguish Between Hedging and Speculating
One reason corporate risk managers are sometimes reluctant to hedge is because they
associate the use of hedging tools with speculation. They believe hedging with derivatives
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introduces additional risk. In reality, the opposite is true. A properly constructed hedge always
lowers risk. It is by choosing not to hedge that managers regularly expose their companies to
additional risks.
Financial risks - regardless of whether or not they are managed - exist in every business.
The manager who opts not to hedge is betting that the markets will either remain static or move
in his favor. For example, a U.S. computer manufacturer with French franc receivables that
decides to not hedge its exposure to the French franc is speculating that the value of the French
franc relative to the U.S. dollar will either remain stable or appreciate. In the process, the
manufacturer is leaving itself exposed to the risk that the French franc will depreciate relative to
the U.S. dollar and hurt the company's revenues.
A reason some managers choose not to hedge, thereby exposing their companies to
additional risk, is that not hedging often goes unnoticed by the company's board of directors.
Conversely, hedging strategies designed to reduce risk often receive a great deal of scrutiny.
Corporate risk managers who wish to use hedging techniques to improve their company's risk
profile must educate their board of directors about the risks the company is naturally exposed to
when it does not hedge.
Step 3: Evaluate the Costs of Hedging In Light of the Costs of Not Hedging
The cost of hedging can sometimes make risk managers reluctant to hedge. Admittedly,
some hedging strategies do cost money. But consider the alternative. To accurately evaluate the
cost of hedging, the risk manager must consider it in light of the implicit cost of not hedging. In
most cases, this implicit cost is the potential loss the company stands to suffer if market factors,
such as interest rates or exchange rates, move in an adverse direction. In such cases the cost of
hedging must be evaluated in the same manner as the cost of an insurance policy, that is, relative
to the potential loss.
In other cases, derivative transactions are substitutes for implementing a financing
strategy using a traditional method. For example, a corporation may combine a floating-rate bank
borrowing with a floating-to-fixed-rate swap as an alternative to issuing fixed-rate debt.
Similarly, a manufacturer may combine the spot purchase of a commodity with a floating-to-
fixed swap instead of buying the commodity and storing it. In most cases where derivative
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strategies are used as substitutes for traditional transactions, it is because they are cheaper.
Derivatives tend to be cheaper because of the lower transaction costs that exist in highly liquid
forward and options markets.
Step 4: Use the Right Measuring Stick to Evaluate Hedge Performance
Another reason for not hedging often cited by corporate risk managers is the fear of
reporting a loss on a derivative transaction. This fear reflects widespread confusion over the
proper benchmark to use in evaluating the performance of a hedge. The key to properly
evaluating the performance of all derivative transactions, including hedges, lies in establishing
appropriate goals at the onset. As derivative transactions are substitutes for traditional
transactions. A fixed-rate swap, for example, is a substitute for the issuance of a fixed-rate bond.
Regardless of market conditions, the swap's cash flows will mirror the bonds. Thus, any money
lost on the swap would have been lost if the corporation had issued a bond instead. Only if the
swap's performance is evaluated in light of management's original objective (i.e., to duplicate the
cash flows of the bond) will it become clear whether or not the swap was successful.
Step 5: Don't Base Your Hedge Program on Your Market View
Many corporate risk managers attempt to construct hedges on the basis of their outlook
for interest rates, exchange rates or some other market factor. However, the best hedging
decisions are made when risk managers acknowledge that market movements are unpredictable.
A hedge should always seek to minimize risk. It should not represent a gamble on the direction
of market prices.
Step 6: Understand Your Hedging Tools
A final factor that deters many corporate risk managers from hedging is a lack of
familiarity with derivative products. Some managers view derivatives as instruments that are too
complex to understand. The fact is that most derivative solutions are constructed from two basic
instruments: forwards and options, which comprise the following basic building blocks:
a. Options
b. Swaps
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c. Futures
d. Puts
e. Calls
f. Forwards
Step 7: Establish a System of Controls
As is true of all other financial activities, a hedging program requires a system of internal
policies, procedures and controls to ensure that it is used properly. The system, often
documented in a hedging policy, establishes, among other things, the names of the managers
who are authorized to enter into hedges; the managers who must approve trades; and the
managers who must receive trade confirmations. The hedging policy may also define the
purposes for which hedges can and cannot be used. For example, it might state that the
corporation uses hedges to reduce risk, but it does not enter into hedges for trading purposes. It
may also set limits on the notional value of hedges that may be outstanding at any one time. A
clearly defined hedging policy helps to ensure that top management and the company's board of
directors is aware of the hedging activities used by the corporation's risk managers and that all
risks are properly accounted for and managed
A well-designed hedging program reduces both risks and costs. Hedging frees up
resources and allows management to focus on the aspects of the business in which it has a
competitive advantage by minimizing the risks that are not central to the basic business.
Ultimately, hedging increases shareholder value by reducing the cost of capital and stabilizing
earnings
The Hedging Decision
The issue of whether or not to hedge risk continues to baffle many corporations. At the
heart of the confusion are misconceptions about risk, concerns about the cost of hedging, and
fears about reporting a loss on derivative transactions. A lack of familiarity with hedging tools
and strategies compounds this confusion. Corporate risk managers also face the difficult
challenge of getting hedging tools (i.e., derivatives) approved by the company's board of
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directors. The purpose of this newsletter is to clarify both some of the basic misconceptions
surrounding the issue of risk as well as the tools and strategies used to manage it. "Derivations"
is part of our commitment to work with you to create financial solutions.
The literature on the choice of hedging instruments is very scant. Among the
available studies, Géczy et al. (1997) argues that currency swaps are more
cost-effective for hedging foreign debt risk, while forward contracts are more
cost-effective for hedging foreign operations risk.(5)
The Challenge
An effective hedging program does not attempt to eliminate all risk. Rather, it attempts to
transform unacceptable risks into an acceptable form. The key challenge for the corporate risk
manager is to determine the risks the company is willing to bear and the ones it wishes to
transform by hedging. The goal of any hedging program should be to help the corporation
achieve the optimal risk profile that balances the benefits of protection against The Costs Of
Hedging.
Firms increase 2010 hedge ratios relative to previous years
In the aggregate, G-3 corporates have hedged 58% of 2010 FX exposures, which
represents a new survey record high for March. As usual, US companies remain the most
aggressive, hedging 66% of 2010 foreign currency, while Japanese corporates, the least
aggressive at this point in the year, have hedged only 39% . European corporate clients have
hedged 55% of 2010 exposures. With the exception of the US, every region increased current
year hedge ratios relative to March 2009. For the US, this year’s hedge ratio was near the high of
the range over the past 5 years at 66%. Increasing hedge ratios were most notable in Japan and
Europe where ratios increased by 15%-point and 13%-point respectively, relative to last March.
These observations come after a sharp decline in March hedge ratios in 2009. Both Europe and
Japan lowered their hedge ratios from the Q2 survey significantly in 2009
G-3 corporates 2010 and 2011 hedge ratios
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Source:- Corporate Hedging Survey 2010[Global FX Strategy]
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
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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. First, the following section describes the factors that affect the
decision to hedge and then the factors affecting the degree of hedging are considered.
1. 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.
2. 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. A 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.
3. 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 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
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Corporate Hedging in India
The move from a fixed exchange rate system to a market determined one as well as the
development of derivatives markets in India have followed with the liberalization of the
economy since 1992. In this context, the market for hedging instruments is still in its developing
stages. In order to understand the alternative hedging strategies that Indian firms can adopt, it is
important to understand the regulatory framework for the use of derivatives here.
Hedging imperatives
Hedging is imperative for companies which have revenue flows with a single-currency bias or
that are denominated in a single currency. In that case, the flexibility and cushion provided by a
currency-diversified revenue stream is not available. Official statistics show that Indian exports
are still predominantly invoiced in the US dollar. Therefore, Indian companies, by and large, do
not enjoy the benefits of the foreign exchange market equivalent of portfolio diversification. Of
course, an alternative in such a situation is to move the cost base itself to the currency in which
companies’ exports are predominantly invoiced. This could involve a shift to imported raw
materials from locally procured raw materials and/or financing both for working capital and
capital expenditure in the currency which causes exposure on the income side. Official balance
of payments statistics show that Indian companies are trying out these strategies. Non-oil and
non-consumption imports have registered strong growth over the past few years. (The recent
permission for also hedging the price risk on the commodities planned to be imported is another
important step towards reducing the overall level of risk on companies’ operating cash flows, as
this would serve to fix the dollar or foreign currency price of the commodity being imported).
Indian companies have also taken to foreign currency borrowings for their working
capital/capital expenditure in a big way.
Critical Scenarios
Systematic hedging also becomes critical in scenarios where currencies are subject to secular
trends. The earnings stream of a company with international exposures could remain broadly
anchored to its medium-term growth rate if what is lost in one year is made up in another year on
account of volatility in exchange rates. The stock market also may not worry much about
companies with currency exposures even if the exposures are not hedged in such a scenario. But
where currency volatility becomes minimal or negligible; a company has to methodically hedge
its operating exposures. It will otherwise face considerable erosion of its local currency earnings
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base or could face pressure on the expenditure side. There is an inverse relationship between the
level of currency volatility and the stability/growth of the earnings stream. The rupee, for
instance, appears to be in the midst of a secular and structural run against the dollar. It has raised
4-5 per cent per annum, on average, against the dollar in the past five years, interrupted only by
brief reversals. In other words, volatility in the bilateral dollar-rupee currency pair has been low,
though that in the derived currency pairs such as, say, in the Euro-rupee or British Pound-rupee
has been notable because of the variability in the Euro-dollar or Pound-dollar pairs. From a
capital market perspective, the corporate policy on earnings distribution or the dividend policy,
for instance, could have an important bearing on companies’ decision to hedge and the
formulation of a hedging policy. High dividend pay-outs could be considered the managements’
way of assuring its shareholders (and prospective investors) about the inherent strengths and,
more important, the growth potential of the earnings stream and operating cash flows. It then
becomes incumbent on the finance manager to minimise volatility in the earnings stream and in
the cash-flows generated so that the dividend pay outs are serviced smoothly. The need to
preserve the stability and inherent growth potential of the earnings stream could also be strong
for those companies that have to, say, carry on R&D operations uninterrupted. Usually, the R&D
effort consumes so much resources that local sales alone may not be enough. Wider markets
(exports) and the revenues they bring are also necessary to justify the resources consumed in the
R&D phase. There is a mutually reinforcing relationship here. High expenditure during the R&D
stage demands very wide markets but the revenue flows from those markets have to be
protected/hedged so that the earnings stream/cash-flow remains strong enough to support
continued R&D. A Ranbaxy or a Dr Reddy’s, for instance, would need a comprehensive hedging
policy to be in place, given their R&D efforts and the diverse markets in which they sell.
Hedging Instruments for Indian Firms
The recent period has witnessed amplified volatility in the INR-US exchange rates in the
backdrop of the sub-prime crisis in the US and increased dollar-inflows into the Indian stock markets. In
this context, the paper has attempted to study the choice of instruments adopted by prominent firms to
stem their foreign exchange exposures. All the data for this has been compiled from the 2008-2009
Annual Reports of the respective companies.
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Evidence of corporate hedging in India
Instrument Rs(cr) Nature of Exposure
Reliance
Currency SwapOptions Contracts
Forward Contracts
1064.492939.76
5764.10
Earnings in all business are linked to USD. The key input, crude oil is purchased in USD. All export revenues are in foreign currency and local prices as well.
Maruti Udyog Forward Contracts
Currency Swap
641(INR-JYP)70($-INR)124.70(USD-INR)
Import /Royalty payable in yen and Exports Receivables in dollars.
Interest rate and forex risk .
Mahindra and Mahindra
Forward Contracts 350(INR-JYP)2(INR-EUR)5($-INR)
Trade payable s in Yen and Euro and export receivables in dollars.
Currency Swaps 5390(JYP-INR) Interest rate and forex risk
Tata Consultancy Services
Forward Contracts
Options Contracts
15(EUR-INR)21(GBP-INR)
830($-INR)47.5(EUR-INR)76.5(GBP-INR)
Revenues largely denominated in foreign currency, predominantly US$, GBP, EURO .Other currencies include Australian $, Swiss Franc etc.
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Ranbaxy
Forward contracts 398($-INR)11(EUR-$)
Exposed on accounts receivables and loans payable. Exposure in USD and Jap Yen
Hedging by Indian Firms
It can be seen that earnings of all the firms are linked to either US dollar, Euro or Pound
as firms transact primarily in these foreign currencies globally. Forward contracts are commonly
used and among these firms, Ranbaxy and RIL depend heavily on these contracts for their
hedging requirements. As discussed earlier, forwards contracts can be tailored to the exact needs
of the firm and this could be the reason for their popularity. The tailor ability is a consideration
as it enables the firms to match their exposures in an exact manner compared to exchange traded
derivatives like futures that are standardized where exact matching is difficult. RIL, Maruti
Udyog and Mahindra and Mahindra are the only firms using currency swaps. Swap usage is a
long term strategy for hedging and suggests that the planning horizons for these companies are
longer than those of other firms. These businesses, by nature involve longer gestation periods
and higher initial capital outlays and this could explain their long planning horizons. Another
observation is that TCS prefers to hedge its exposure to the US Dollar through options rather
than forwards. This strategy has been observed among many firms recently in India. This has
been adopted due to the marked high volatility of the US Dollar against the Rupee. Options are
more profitable instruments in volatile conditions as they offer unlimited upside profitability
while hedging the downside risk whereas there is a risk with forwards if the expectation of the
exchange rate (the guess) is wrong as firms lose out on some profit. The use of Range barrier
options by Infosys also suggests a strategy to tackle the high volatility of the dollar exchange
rates. Software firms have a limited domestic market and rely on exports for the major part of
their revenues and hence require additional flexibility in hedging when the volatility is high.
Another implication of this is that their planning horizons are shorter compared to capital
intensive firms. It is evident that most Indian firms use forwards and options to hedge their
foreign currency exposure. This implies that these firms chose short-term measures to hedge as
opposed to foreign debt. This preference is possibly a consequence of their costs being in
Rupees, the absence of a Rupee futures exchange in India and curbs on foreign debt. It also
follows that most of these firms behave like Net Exporters and are adversely affected by
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appreciation of the local currency. There are a few firms which have import liabilities which
would be adversely affected by Rupee depreciation. However it must be pointed out that the data
set considered for this study does not indicate how the use of foreign debt by these firms hedges
their exposures to foreign exchange risk and whether such a strategy is used as a substitute or
complement to hedging with derivatives.
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Findings
1. Due to volatility in the currency market, the frequency of change in
exchange rate is very high. The investors are prone to high risk because of this
fluctuation. The changes in the value of underlying asset are dependent on exchange rate
exposure. For an investor, derivatives and hedging instruments play an important role in
dealing with their exposure.
2. Hedger will be always being at a risk free edge because the hedging tools
provide protection against the risk and the future losses. It is evident from the study that
the hedger enjoys a better return compared to no hedger, and partial hedger.
3. The result of hedging strategy, whether it is profit or loss is directly
dependent on the market conditions. The forex market is volatile in nature. The trends
and the events in the in the forex market affect the spot price. Profit and Loss of hedging
contract is based on the spot price. So the difference in the spot price affects the
effectiveness of hedging strategies.
4. Forward and future contracts are taken for the study. There are two types
of market conditions that affect the hedging strategies. Bullish and Bearish market
conditions are affecting the profitability of the hedger.
5. Under the Bullish market conditions hedger makes profit. Corporates are
using large amount of money to enter in to the contract so the profit can be extended to
any amount.
6. In the bearish market conditions sometimes the hedger makes loss in the
case of forward contract because of the nature of the contract. Forward contracts are
exercised at the end of the maturity period
7. Hedgers can use the future contracts to avoid the loss due to the bearish
market conditions. Future contracts can be exercising in the open market at any time prior
to the maturity period. The future contract can be covered or exercised at the buyers wish.
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