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A Paper Presentation By Kushaal Subramony Sony Saju George Remya Josephine Antony Sreeja Sukumaran Teby C Baaby Gangaveer Singh
• India is among one of the prominent importers and exporters of the world. • The engagement in imports has exposed businesses to exchange rate risk, which acts in favour of the importer sometimes while other times can lead to a financial havoc. • Last year due to recession, Indian Rupee depreciated greatly, impacting Indian importers immensely as it lead to an increased cost of product acquisition. • Unstable exchange rates affect businesses tremendously and it is difficult to difficult to change the prices of products accordingly. • A number of banks and government organisations help companies that are extensively involved in importing activities. • SMEs are adversely affected by the exchange rate fluctuations.
Market Forces and its Impact on Exchange rate movements.
• Exchange rate movements are driven by Demand and Supply principle. • Some of the important factors affecting the demand and supply of any currency are as follows:-
Interest Rate parity
Law of one price Macro-Economic Environment Stock Market Political Factors
INTEREST RATE PARITY
Any disparity between the interest rates of two countries is equalized by the movement in their currency exchange rates. • Sometimes known as the International Fisher effect. • When one makes investments in two different currencies the return on both the investments are the same even though the interest rates may be different in absolute terms.
LAW OF ONE PRICE
• The same goods should be sold at the same price anywhere in the world.
• Either the price of the goods or exchange rate must be adjusted to adopt the same price.
• A positive macro-economic environment also increases the demand for a currency. • The economic data about the below indicators are also likely to cause fluctuations in exchange rates are :1. Consumer Price Index 2. Producer Price Index 3. Gross Domestic Product 4. Productivity 5. Industrial Production 6. International Trade
Role of RBI in FOREX
• Sales and purchase of foreign exchange
• Intervention has changed over the years from Bretton Woods system
•To influence the trend movement in exchange
• To maintain export competitiveness • To manage volatility to reduce risk
• To protect currency from speculative attack
• Increased importance of capital flows
•IMF principle of 1977 regarding central bank intervention only for disorderly market conditions •Sterilised intervention – Offset government debt
•Non sterilised intervention – Without offset
• Studies show that intervention can contain exchange rate volatility • To match demand and supply of foreign currency
March 1993 – July 1995(Stability)
• Dual exchange rate to Unified exchange rate • Capital inflows tended appreciating pressure on rupee • Reserve bank foreign asset raised to $20 Billion • Preserving competitiveness and building reserves
August 1997 – August 1998(Volatility)
•South East Asian currency crisis • High volatility • Adoption of stringent monetary and administrative measures in spot and futures
How does RBI manages exchange rate in the interbank market?
• Foreign Exchange Exposure Limit (FEEL) • Basically restricts the banks to keep a net asset (long) or net liability (short) position in foreign currencies. • Presently FEEL for each bank is set at 10 % of it’s paid up capital. • In the presence of FEEL, banks’ net purchases or net sales in foreign exchange on a given day have to be within their FEEL.
• Direct selling or buying of foreign exchange by State Bank in the interbank market. • Such sale/purchase can be in spot or forward value • It can have two objectives To provide support to the market for lumpy payments To manage the Rs/$ parity
• Intervention may be direct or indirect. Currently RBI only indirectly intervenes in the market.
Impact of forex fluctuation on SMEs
• Wild foreign exchange fluctuation has been taking a toll on India Inc and has not only caused losses, but also created a huge confusion over the hedging solution. • Both exporters and importers are concerned about the uncertainty caused by the volatility.
Impact of the appreciation of the rupee on various sectors
Industry % of imported content Low High Medium Medium High % of exports impact Leather Refineries Auto Engineering Airlines High Low Low Low Low Adverse Beneficial Beneficial Beneficial Beneficial
Gems and Jewellry
Impact on exporters
• Currency appreciation adversely impact exporters while currency depreciation benefits exporters.
Impact on Importers
• Currency appreciation impacts the importers favorably as it reduces the cost of imported goods
Impact on Borrowers
• Indian firms are availing of loans in foreign currencies as these loans are cheaper than Rupee loans. However, when taking a foreign currency loan, there is a risk related to exchange rate fluctuations.
What are Currency Futures?
• Futures are – standardized, – negotiable, and – exchange-traded contracts to buy or sell an underlying asset • In case of Currency Futures the underlying asset is the exchange rate. – In India only those contracts based on USD/INR are traded.
Why Currency Futures?
• Exchange Rate fluctuates • Expose investors to currency risks.
– If domestic currency depreciates (appreciates) against the foreign currency, the exposure would result in loss (gain) for importers and gain (loss) for exporters.
• Currency futures enable traders to hedge their FX risks.
– taking a position in the future market that is opposite to a position in the physical market
How Currency Futures can Help?
• Unhedged Exposure: Let’s say on March 1, 2008, an Indian refiner enters into a contract to export 1000 barrels of oil with payment to be received in US Dollar (USD) on June 1, 2008. The price of each barrel of oil has been fixed at USD 80/barrel at the prevailing exchange rate of 1 USD = INR 44.05; the price of one barrel of oil in INR works out to be is Rs. 3524 (80 x 44.05). On June 1, 2008, the INR actually appreciates against the USD and now the exchange rate stands at 1 USD = INR 40.30. Hence the same barrel of oil that initially would have garnered him Rs. 3524 (80 x 44.05) will now realize Rs. 3224, which means 1 barrel of oil ended up selling Rs. 3524 – Rs. 3224 = Rs. 300 less and hence the 1000 barrels of oil has become cheaper by INR 3,00,000.
Since he is concerned that the value of USD will fall he decides go short on currency futures, it means he sells a USD/INR future contract. This protects the importer because weakening of USD would lead to profit in the short futures position, which would effectively ensure that his loss in the physical market would be mitigated. The following figure and exhibit explain the mechanics of hedging using currency futures.
Currency Futures-An effective risk management tool
• Currency Futures is very important risk management tool, in face of wide fluctuations in FOREX Rates.
• Small exporters don't have right risk management policy. Currency Futures and its adoption by the SMEs can help in remedying these.
Risk exposure strategies
• • • • • Foreign currency receivables holdings. Price competitive markets Price variance clauses with customers Cash flow position Fluctuation and significant effect on profits • Which currencies are you exposed to?
Risk mitigation strategies
• No hedging • Selective hedging • Systematic hedging
Risk mitigation tools
• • • • Currency diversification Forward contracts Swaps Call and put options
SOLUTIONS OFFERED BY BANKING & FINANCIAL INSTITUTIONS
SPECIALISED PRODUCTS OFFERED
• Interest Rate Product – Principal Only Swap (POS) • Exchange Rate Product – Forward Booster
Interest Rate Product – Principal Only Swap (POS)
• Change a liability of interest. • Example of POS
Exchange Rate Product – Forward Booster
• It is an option contract • Example of exchange rate product
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