Management Research Project Final Report

Evolution of Forex Markets In India And its usage as a tool for Risk Management

Date: 31st January, 2011

Research Guide: Prof. Meenaxi Dhariwal

By: Akshay Doshi (09BS0000149) IBS Mumbai akshay27@gmail.com

List Of Contents
S. 1 R. Topic
Project Details 2 Evolution of Forex Markets in India st a. 1 Stage nd b. 2 Stage rd c. 3 Stage i. Devaluation and its impacts ii. RBI and its FERA 3 Transition From role to FEMA a. FERA and its purposes b. FEMA and its restrictions c. Differences and similarities 4 Foreign Currency Market in India 5 Foreign Exchange Risk 6 Management Foreign Exchange Hedging Instruments a. Currency Forwards b. Currency Futures c. Currency options d. Currency Swaps 7 Hedging Strategies a. Using Currency Forwards/Futures b. Using Currency Options c. Using Hedging Instruments 8 Choice of Currency Swaps 9 Regulations pertaining to forex 10 instruments Forex risk management in 11 Indian IT Industry Conclusion and References

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Project Details
The project analyzes the history of forex market and the significance of their operations in India. For this I have divided my project into three important stages:-

Stage I
In this stage, the evolution of foreign currency markets in India will be studied. This will give a background of how foreign currency and its reserves is so important for an exportoriented economy like India and how it gradually emerged from controlled market to a market driven structure. This will also involve a synopsis about a gradual transition of regulations through the two most important acts : o Foreign Exchange Regulations Act (FERA) TO o Foreign Exchange Management Act (FEMA)

Stage II
In this stage, the existing forex market in India will be analyzed. This will include details of the exchanges, facilitating currency trading in India and also about the various forex instruments and their characteristics and the importance of banks in this system.

Stage III
Once the forex market is analyzed at a macro-level, the final stage of the project analyzes this market at a firm-specific level, i.e. how different Indian organizations can use forex instruments and stock exchanges to reduce their currency risk exposure. Many Indian companies, especially those in export industries suffered from heavy forex losses due to recent crisis. Thus, using forex instruments as a tool to reduce the currency risk exposure is a very important function of forex management. This stage analyzes the importance of forex instruments for different hedging, speculation and arbitrage purposes.

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Objectives of the Project

To understand the evolution of forex market in India To understand the impact of forex market regulations in India To analyze the usage of different foreign currency instruments To understand the significance of banks in this system To analyze the risks, associated with trading in this market Analysis of the opportunities, available in the other forex markets, compared to that in

domestic markets Analyzing, how the forex instruments can be effectively used as the tools for risk management. To analyze the facilities, provided by the recently inaugurated currency futures trading exchange by NSE.

Methodology, Used
Secondary Data Collection Mainly, this method will be utilized for data collection and analysis. This includes referring to various articles in journals, newspapers and websites.

Limitations of the Project

Forex market is not the only market to mitigate the risk. There are also several other avenues, available for risk diversification which are not discussed in this project Forex market and its instruments should be seen as the instruments of hedging and not as tools for speculation and arbitrage.

Schedule of Submitting Report Documents

1. 2. 3. 4. Initial Information Report July 24th, 2009 Project Proposal August 20th, 2009 Interim Report December 21st, 2009 Final Report March 4th, 2009

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Evolution of Forex Markets in India

Indian forex market owes its origin to the important step that RBI took in 1978 to allow banks to undertake intra-day trading in foreign exchange. As a consequence, the stipulation of maintaining square or near square position was to be complied with only at the close of business each day. During the period 1975-1992, the exchange rate of rupee was officially determined by the RBI in terms of a weighted basket of currencies of Indias major trading partners and there were significant restrictions on the current account transactions. Lets have a look at these stages, through a graph

1st STAGE: Early Stages: 1947-1977

The evolution of Indias foreign exchange market may be viewed in line with the shifts in Indias exchange rate policies over the last few decades from a par value system to a basket-peg and further to a managed float exchange rate system. During the period from 1947 to 1977, India followed the par value system of exchange rate. Initially the

rupees

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external par value was fixed at 4.15 grains of fine gold. The Reserve Bank maintained the par value of the rupee within the permitted margin of 1 per cent using pound sterling as the intervention currency. Since the sterling-dollar exchange rate was kept stable by the US monetary authority, the exchange rates of rupee in terms of gold as well as the dollar and other currencies were indirectly kept stable. The devaluation of rupee in September 1949 and June 1966 in terms of gold resulted in the reduction of the par value of rupee in terms of gold to 2.88 and 1.83 grains of fine gold, respectively. The exchange rate of the rupee remained unchanged between 1966 and 1971. With the breakdown of the Bretton Woods System in 1971 and the floatation of major currencies, the conduct of exchange rate policy posed a serious challenge to all central banks worldwide as currency fluctuations opened up tremendous opportunities for market players to trade in currencies in a borderless market. In December 1971, the rupee was linked with pound sterling. Since sterling was fixed in terms of US dollar under the Smithsonian Agreement of 1971, the rupee also remained stable against dollar. In order to overcome the weaknesses associated with a single currency peg and to ensure stability of the exchange rate, the rupee, with effect from September 1975, was pegged to a basket of currencies. The currency selection and weights assigned were left to the discretion of the Reserve Bank. The currencies included in the basket as well as their relative weights were kept confidential in order to discourage speculation. It was around this time that banks in India became interested in trading in foreign exchange.

2nd STAGE: Formative Period: 1978-1992

The impetus to trading in the foreign exchange market in India came in 1978 when banks in India were allowed by the Reserve Bank to undertake intra-day trading in foreign exchange and were required to comply with the stipulation of maintaining square or

near square position only at the close of business hours each day. The extent of position which could be left uncovered overnight (the open position) as well as the limits up to which dealers could trade during the day were to be decided by the management of banks. The exchange rate of the rupee during this period was officially determined by the Reserve Bank in terms of a weighted basket of currencies of Indias major trading partners and the exchange rate regime was characterized by daily announcement by the Reserve Bank of its buying and selling rates to the Authorized Dealers (ADs) for undertaking merchant transactions. The spread between the buying and the selling rates was 0.5 percent and the market began to trade actively within this range. ADs were also permitted to trade in cross currencies (one convertible foreign currency versus another). However, no position in this regard could originate in overseas markets.

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As opportunities to make profits began to emerge, major banks in India started quoting two-way prices against the rupee as well as in cross currencies and, gradually, trading volumes began to increase. This led to the adoption of widely different practices (some of them being irregular) and the need was felt for a comprehensive set of guidelines for operation of banks engaged in foreign exchange business. Accordingly, the Guidelines for Internal Control over Foreign Exchange Business, were framed for adoption by the banks in 1981. The foreign exchange market in India till the early 1990s, however, remained highly regulated with restrictions on external transactions, barriers to entry, low liquidity and high transaction costs. The exchange rate during this period was managed mainly for facilitating Indias imports. The strict control on foreign exchange transactions through the Foreign Exchange Regulations Act (FERA) had resulted in one of the largest and most efficient parallel markets for foreign exchange in the world, i.e., the hawala (unofficial) market. By the late 1980s and the early 1990s, it was recognized that both macroeconomic policy and structural factors had contributed to balance of payments difficulties. Devaluations by Indias competitors had aggravated the situation. Although exports had recorded a higher growth during the second half of the 1980s (from about 4.3 per cent of GDP in 1987-88 to about 5.8 per cent of GDP in 1990-91), trade imbalances persisted at around 3 per cent of GDP. This combined with a precipitous fall in invisible receipts in the form of private remittances, travel and tourism earnings in the year 1990-91 led to further widening of current account deficit. The weaknesses in the external sector were accentuated by the Gulf crisis of 1990-91. As a result, the current account deficit widened to 3.2 per cent of GDP in 1990-91 and the capital flows also dried up necessitating the adoption of exceptional corrective steps. It was against this backdrop that India embarked on stabilization and structural reforms in the early 1990s. Our imports were more than the exports. Foreign exchange was not adequate even

for essentials like medicines, defense and capital goods. How can one permit the import of luxuries! India was dependent upon foreign aids and loans for meeting the balance of payments deficit. In the situation, Government of India (GOI) worked out the following strategy to conserve foreign exchange. 1. Import Licensing No Indian could import anything without obtaining a licence. Under the Import licensing law, GOI could permit import of some items and could ban the import of nonessential items. Gold was one such item whose import was banned. Reduction of imports would reduce the demand for Foreign exchange (Fx). Simultaneously, all exports were encouraged to increase the inflow of fx.

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2. Customs Duty Where goods were not banned for imports, very heavy customs duties were imposed. This made imports costlier, so reduced the demand for fx and simultaneously gave revenue to the Government. 3. Introduction of FERA Under FERA, GOI acquired complete monopoly over fx. It acquired the rights to take over the fx earned by all residents and to allocate the same to those who would need fx. All foreign investments by Indian residents were banned. The detailed explanation of FERA will be done in the later part of the report. Consequences of these laws It is said that wherever there are profits, there will be some people to do that business. If you permit the business openly, good businessmen will be in the business. They will pay taxes and abide by the law. If you prohibit the business ; the mafia will take over. They will not pay any taxes and terrorise the regulatory authority, destabilise Government also. Internationally, foreign exchange dealing is done by young professionals who are highly paid by the banks and other similar institutions. In India, fx dealing was done by the havala recketeer. Internationally, gold import and export was done by well respected multinationals. In India it was being done by the smuggler. Import licensing created scarcities/non-availability of several products in India. Customs duties created huge price differences between the International market price and the local market prices. Both together created a huge, profitable smuggling market. Havala business complimented smuggling and completed the financial cycle. The syndicate of smugglers, mafia and havala racketeers have used a well

intended legal system to carry on their business at the cost of Indian economy.
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India had a usurious tax system. Maximum Marginal Rates Income-tax Wealth-tax Estate Duty 97% 8% 85%

Continuously depreciating rupee was causing erosion of wealth. These had ensured that every law abiding rich person would soon become a pauper. Excessively regulated economy with excessive powers of penalty, prosecution and harassment by all sorts of bureaucrats had created an anti-businessman, anti-rich atmosphere. All these had caused an outward flight of capital.

3rd STAGE: The Process of Liberalization (1991 onwards)

The initiation of economic reforms in July 1991 saw significant two-step downward adjustment in the exchange rate of the rupee on July 1 and 3, 1991 with a view to placing it at an appropriate level in line with the inflation differential to maintain the competitiveness of exports. Subsequently, following the recommendations of the High Level Committee on Balance of Payments (Chairman:Dr C. Rangarajan) the Liberalized Exchange Rate Management System(LERMS) involving dual exchange rate mechanism was instituted in March 1992, which was followed by the ultimate convergence of the dual rates effective from March 1, 1993(christened modified LERMS). The unification of the exchange rate of the rupee marks the beginning of the era of market determined exchange rate regime of rupee, based on demand and supply in the forex market. It was also an important step in the progress towards current account convertibility, which was finally achieved in August 1994 by accepting Article VIII of the Articles of Agreement of the International Monetary Fund.

The appointment of an Expert Group on Foreign Exchange (popularly known as Sodhani Committee) in November 1994 is a landmark in the design of foreign exchange market in India. The Group studied the market in great detail and came up with far reaching recommendations to develop, deepen and widen the forex market. In the process of development of forex markets, banks have been accorded significant initiative and freedom to operate in the market. To quote a few important measures relating to market development and liberalization, banks were allowed freedom to fix their trading limits, permitted to borrow and invest funds in the overseas markets up to specified limits,

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accorded freedom to determine interest rates on FCNR deposits within ceilings and allowed to use derivative products for asset-liability management purposes. Similarly, corporate were given flexibility to book forward cover based on past turnover and allowed to use a variety of instruments like interest rates and currency swaps, caps/collars and forward rate agreements in the international forex market. Rupee-foreign currency swap market for hedging longer -term exposure has developed substantially in the last few years.

Rupee Value - World Bank (1995)

Consider World Bank's Development Report for the year 1995. The report gives details of GNP per capita of several countries converted into U.S. $ by two different methods. In all these statistics, considerable degree of assumptions is built in. Hence they can be used only as a rough guide. The rough guide says that the market exchange rate values rupee at one fourth its PPP rate. In other words, if the m arket rate 36 per Dollar, Rs. is Rs. 9 per Dollar. the PPP rate should be Rs. 60 per Pound, Or if the market rate is Rs. 15 per Pound. the PPP rate should be This sounds unbelievable. So let us see another example What may be the income of a peon or a clerk in India where he can live a lower-middleclass standard of living in that time? One might estimate - say Rs.2000 per month. With this salary, his family could live a subsistence level existence in Bombay. In U.S.A., the lowest paid peon would earn at least $ 1000 per month. This salary would translate into Indian rupee at market rate, into Rs.36,000 per month; at PPP rate, into Rs. 9,000 per month. Can anyone say that a person earning Rs. 36,000/- per month would live at subsistence level in

Bombay ? Which rate is more realistic ? Rs.9 per dollar or Rs.36 per dollar ?

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Devaluation
GOI found that devaluation of rupee was very profitable. Every devaluation meant that. Imports became costlier. Hence, Indians would import less. Hence, less demand for foreign exchange. Where import is unavoidable, and people would import; at the same rates, customs revenue increased. Exports become more competitive, and profitable. so exporters would export more and India would get more foreign exchange. Debt servicing became costlier. But India was continuously borrowing more than repaying. So, no worry in that case. IMF, world Bank, U.S.A. and the Aid India consortium were constantly pressurising India to devalue its rupee. Apparently, every devaluation of rupee was keeping everyone happy. Impact of Devaluation An economic calculation may be good in one situation, at one time. When the circumstances change, the policies must change. In the book "Rethinking the future", Mr. Rowan Gibson says- "Future will not be a continuation of the past". In the past, you have driven along a road. It does not mean that the same road will continue in future. In fact, the road stops here, today. There is no further road. You have to make new road and you have to make your own map. What succeeded in the past may not succeed today or tomorrow. Consider a few examples. 1. In June, 1991 the rate of Indian rupee Vs. U.S. $ was Rs. 18 per dollar. In 1997, the rate was Rs. 36 per dollar, and the external debt was $ 92 billion.

Because of devaluation, Government has suffered a loss of Rs. 1,656 billions, as shown in the table. Assuming @ 5% Debt Servicing cost, India is spending extra Rs. 83 billions on this count alone. Compare this with our budgetary deficit of Rs. 69 billions. (For the year 96-97, as per the budget presented on 28th Feb., 1997.)

2. Assume, a commodity X has the international price of $ 10. India is importing that commodity worth $ 1 billion a year. At market price, India is paying Rs. 36 billion a year. At PPP price, India would have paid only Rs. 9 billion a year. The undervalued rupee

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Year 1991 1992

Value of debt $ 92bn. $ 92 bn.

Rate 18 36

Value of debt Rs. 1656 bn. Rs. 3312 bn.

Loss in Rs. 1656 bn.

causes extremely high cost of imported goods like crude oil. It is a strong reason for the Indian economy being a high cost economy. 3. Many of our exports are import intensive. When we devalue the rupee, we cause costpush inflation; hence our exports become uncompetitive; hence we need a devaluation - which causes inflation. We fell into a vicious cycle. Only way out was to start revaluing the currency. 4. Foreign Investors want their return on investments NET of - Indian taxes, Cost of Risks and Red tapism, and Depreciation of rupee. Consistent depreciation of rupee means a consistent erosion of his investment, and discourages foreign investment. What is loss to a foreign investor is also a loss to the Indian investor. That is clearly one of the reasons why Indian rich people have stored their wealth outside India. If, instead of depreciating, the rupee starts appreciating, the return on investment increases tremendously making India an attractive place for investment. 5. No country can survive in the long run without exports paying for imports. When we export the goods, price of the same commodity in India goes up. Potatoes and onions had gone beyond the reach of the common man. Export is the main culprit due to the lack of export surpluses. 6. Because the exporter is assured of a continuously declining rupee and his consequent profits; he does not try to export high tech-goods with value addition. He is selling away commodity goods at throw - away prices. He does not create a brand image abroad. The only strategy is, -"sell cheap". Exporting Iron ore, cotton and yarn is one series of examples. Even in Computer Software exports we are largely doing "body shopping". If the exporters are put on notice that rupee will start appreciating, there will be a tremendous scare. 7. It is open knowledge that in case of most exporters, the foreign buyer knows Indian cost - sheet fully. The foreign buyer pays only that price which gives bare minimum profits to the Indian exporters. Now assume that we are exporting goods worth Rs. 36

millions. We will get foreign exchange of U.S. $ 1 million. If the exchange rate were nearer the PPP rate of Rs.9 = $1; we would have got probably $ 4 millions. It is also possible that the export would not have taken place. The issue is, we are exporting by under cutting. We are not exporting by value addition. In the process, the exports where we have some strength is also thrown away at cheap price. Devaluation of currency causes outward flight of capital. Revaluation of currency (supported by fundamentals) causes Inward flight of capital.

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RBI and its Role

Liberalization of economy - had increased competition. Several Indian industrialists had cried hoarse and asked for protection under one guise or the other. Government has not listened to their appeals and gone ahead with liberalization. Message was clear. "You have been provided crutches for too long a time. You must learn to face normal "free" and "competitive" world that prevails abroad. No more crutches." One of the tasks of the Central Government and Central Bank of any country was :

To maintain stability of its currency. To control inflation To stabilize exchange value of its currency.

This task was to be achieved by appropriate economic and fiscal action, and by market intervention. That is how it is done in the "free" and "competitive world". However, when a Government and its Central Bank are unable to stabilize their currency through market forces, they run for the crutches. They pass laws providing that nobody can deal in foreign exchange that those who are permitted to deal in foreign exchange must deal at the rates prescribed by the Central Bank (Section 8 of FERA); that no one can take any foreign exchange out of the country (Sections 8,9,16 of FERA) and so on. Indian Government was preparing to remove these crutches. That is reason for optimism. The industrialists have a right to say - 'that the Government which is asking the industry to walk without crutches; should itself also walk without the crutches'.

Future role of RBI

1. In future, the role of RBI has to be similar to that of Central Banks world over. It is not RBI's function to sit in judgment over several business decisions to be taken by the businessmen - Indian as well as foreign. In a fast moving economy, one cannot expect that for several business decisions, the businessman has to go to RBI and take a

"prior permission". This is the bottleneck in expanding Indian economy. 2. RBI has to act like SEBI. Businessman can go ahead and do his business. There will be prescribed guidelines and regulations for business. It will be expected that the businessman will follow these guidelines. There will be no question of taking prior permissions. If anybody violates the guidelines, RBI/enforcement directorate will strike just as SEBI or police may strike a violator of law.

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3. Fx gamblers world over can cause violent fluctuations in exchange rate and can cause grave damage. India will need a modern version of Section 8 and the relevant powers to curb speculation and gambling in Indian rupee for some time. 4. When the Indian economy is more liberalized; the financial markets are deepened and well connected globally and RBI has some comfortable reserves so that it can take effective market steps; then Section 8 can be scrapped. 5. One cannot passively wait for these to happen. Effective, positive action has to be taken to create such an environment. GOI and RBI are already taking actions in this direction.

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TRANSITION FROM FERA TO FEMA

FERA (Foreign Exchange Regulation Act)
The Foreign Exchange Regulation Act (FERA) was legislation passed by the Indian Parliament in 1973 by the government of Indira Gandhi. FERA imposed stringent regulations on certain kinds of payments, the dealings in foreign exchange and securities and the transactions which had an indirect impact on the foreign exchange and the import and export of currency. The replacement of FERA (Foreign Exchange Regulation Act) by FEMA (Foreign Exchange Management Act) reflects a paradigm shift in the attitude and the perception from that of restriction and regulation, including the mistrust and doubting every transaction as being violation of the foreign Exchange laws to that of management of foreign Exchange. FERA was enacted at the time when foreign exchange was scarce and was perceived to be a rare commodity and hence required constant monitoring and regulation. Purposes of FERA 1. To help RBI in maintaining exchange rate stability. 2. To conserve precious foreign exchange. 3. To prevent/regulate Foreign business in India. FERA therefore proceeded on the presumption that all foreign exchange earned by Indian residents rightfully belonged to the Government of India and had to be collected and surrendered to the Reserve bank of India (RBI) expeditiously. It regulated not only transactions in forex, but also all financial transactions with non-residents. FERA primarily prohibited all transactions, except to the extent permitted by general or specific permission by RBI. As a result, Forex reserves swelled, the rupee was made convertible on current account. In this liberal atmosphere, the government realized that possession of forex could no longer be regarded as a crime, but was an economic offence, for which the more appropriate punishment was a penalty. Thus, the need of FEMA was felt.

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FEMA (FOREIGN EXCHANGE MANAGEMENT ACT)

FEMA has been set up to consolidate and amend the law relating to foreign exchange, with the objective of facilitating foreign external trade and payments for promoting the orderly development and maintenance of foreign exchange. Under FEMA, all current account transactions in forex (such as expenses, which are not for capital purposes) are permitted, except to the extent that the Central Government notifies. However, so far as capital account transactions are concerned, all capital account transactions in forex are prohibited, except to the extent as may be notified by RBI. Restrictions under FEMA for remittances One cannot remit money for purchase of lottery tickets, for subscription to banned/prescribed magazines, to football pools, sweepstakes, for payment for telephone callback services, etc. Up to US $ 5,000 in every calendar year for foreign travel (increased from the limit of US $ 3,000 under FERA). Up to US $ 25,000 per trip for a business trip or for attending a conference abroad, irrespective of the length of the trip (under FERA, you had limits per day plus an entertainment allowance). For gifts up to US $ 5,000 per beneficiary per annum (under FERA, the limit was US $ 1,000 and restricted only to defined relatives). For donations up to US $ 5,000 per beneficiary. Maintenance of close relatives abroad up to US $ 5,000 per recipient. Foreign studies up to US $ 30,000, or the estimate from the foreign institution, whichever is higher. For meeting expenses for medical treatment abroad, up to the estimate from doctor in India or hospital or doctor abroad.

Differences between both the acts

The exclusion of the presumption of Mens Rea (guilty mind) and abetment (encouragement to commit a crime) in FEMA, represent a material shift in perception of the Authorities in their handling of Forex violations.

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 On account of the Globalization of the Economy, and with the impending Convertibility on the Capital Account - what constitutes a 'Capital Account Transaction' and 'Current Account Transaction' among others have been clearly defined. The concept of an "Authorized person" to deal in Foreign Exchange has been widened under FEMA to include an Authorized Dealer, Money Changer, or an offshore banking unit or any person authorized to deal in Forex and Foreign Securities. FERA also suffered from lack in uniformity and harmony, with other Laws. Under FERA the concept of a "Resident " was distinct and separate to that under the Income Tax Act, and hence this was remedied by FEMA. The most significant difference however was in the nature and perception of Offenceswhilst under FERA every offence was a Criminal Offence - punishable with imprisonment; under FEMA the offences are Civil Offences and punishable with a monetary penalties only. The right of an impleaded person to seek assistance in the form of a legal counsel or a Chartered Accountant has been recognized and granted under the FEMA. The most Draconian Provision under FERA of arrest and detention by the Enforcement Directorate of any person suspected of or even alleged to have committed an offence punishable under the act has been considerably curtailed to take effect only when one fails to pay the monetary penalty. Under the new FEMA, even the quantum of the monetary penalty has been curtailed from five times the amount involved to three times the value of the transaction. The sweeping powers of search and seizure granted to a police officer, under FERA have been curtailed and restricted. Yet there are certain similarities between the two, which are explained ahead. Similarities in both the acts

 Both the acts continue to be governed by the Reserve Bank of India and the Central Govt. as the Regulatory Bodies. The Directorate of Enforcement continues to be the agency for Enforcement of the provisions of Search and Seizure. The presumption of Extra -Territorial Jurisdiction as envisaged by FERA has been retained.

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FOREIGN CURRENCY MARKET IN INDIA

Features of Forex Markets
There are several features of Indian forex market which, are briefly stated as under.

1. Participants
The foreign exchange market in India comprises of retail customers, commercial banks, Authorized Dealers (ADs)/brokers in foreign exchange and Reserve Bank of India. Retail Customers

The customers who are engaged in foreign trade participate in foreign exchange markets by availing of the services of banks. Exporters require converting the dollars into rupee and importers require converting rupee into the dollars as they have to pay in dollars for the goods / services they have imported. Similar types of services may be required for setting any international obligation i.e., payment of technical know-how fees or repayment of foreign debt, etc. Commercial Banks They are most active players in the forex market. Commercial banks dealing with international transactions offer services for conversation of one currency into another. These banks are specialized in international trade and other transactions. They have wide network of branches. Generally, commercial banks act as intermediary between exporter and importer who are situated in different countries. Typically banks buy foreign exchange from exporters and sells foreign exchange to the importers of the goods. Similarly, the banks for executing the orders of other customers, who are engaged in international transaction, not necessarily on the account of trade alone, buy and sell foreign exchange. As every time the foreign exchange bought and sold may not be equal banks are left with the overbought or oversold position. If a bank buys more foreign exchange than what it sells, it is said to be in overbought/plus/long position. In case bank sells more foreign exchange than what it buys, it is said to be in oversold/minus/short position. The bank, with

open position in position, in the market. If the bank is having oversold position it will buy from the market and if it order to avoid has overbought position it will sell in the market. This action of bank may trigger a spate risk on of account of exchange rate buying and selling of foreign exchange in the market. Commercial banks have following movement, objectives for being active in the foreign exchange market: covers its They render better service by offering competitive rates to their customers engaged in international trade.

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They are in a better position to manage risks arising out of exchange rate fluctuations. Foreign exchange business is a profitable activity and thus such banks are in a position to generate more profits for themselves. They can manage their integrated treasury in a more efficient manner. Central Banks In most of the countries, central banks are charged with the responsibility of maintaining the external value of the domestic currency. If the country is following a fixed exchange rate system, the central bank has to take necessary steps to maintain the parity, i.e., the rate so fixed. Even under floating exchange rate system, the central bank has to ensure orderliness in the movement of exchange rates. Generally this is achieved by the intervention of the bank. Sometimes this becomes a concerted effort of central banks of more than one country. Apart from this central banks deal in the foreign exchange market for the following purposes:

Exchange rate management Though sometimes this is achieved through intervention, yet where a central bank is required to maintain external rate of domestic currency at a level or in a band so fixed, they deal in the market to achieve the desired objective Reserve management Central bank of the country is mainly concerned with the investment of the countrys foreign exchange reserve in a stable proportions in range of currencies and in a range of assets in each currency. These proportions are, inter alias, influenced by the structure of official external assets/liabilities. For this bank has involved certain amount of switching between currencies. Central banks are conservative in their approach and they do not deal in foreign exchange markets for making profits. However, there have been some aggressive central banks but market has punished them very badly for their adventurism. In the

recent past Malaysian Central bank, Bank Negara lost billions of dollars in foreign exchange transactions. Intervention by Central Bank

It is truly said that foreign exchange is as good as any other commodity. If a country is following floating rate system and there are no controls on capital transfers, then the exchange rate will be influenced by the economic law of demand and supply. If supply of foreign exchange is more than demand during a particular period then the

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foreign exchange will become cheaper. On the contrary, if the supply is less than the demand during the particular period then the foreign exchange will become costlier. The exporters of goods and services mainly supply foreign exchange to the market. If there are no control over foreign investors are also suppliers of foreign exchange.

Exchange Brokers Forex brokers play a very important role in the foreign exchange markets. However the extent to which services of forex brokers are utilized depends on the tradition and practice prevailing at a particular forex market center. In India dealing is done in interbank market through forex brokers. In India as per FEDAI guidelines the ADs are free to deal directly among themselves without going through brokers. The forex brokers are not allowed to deal on their own account all over the world and also in India.

2. Segments
The foreign exchange market can be classified into two segments. The merchant segment consists of the transactions put through by customers to meet their transaction needs of acquiring/offloading foreign exchange, and inter-bank segment encompassing transactions between banks. At present, there are over 100 ADs operating in the foreign exchange market. The banks deal among themselves directly or through foreign exchange brokers. The inter-bank segment of the forex market is dominated by few large Indian banks with State Bank of India (SBI) accounting for a large portion of turnover, and a few foreign banks with benefit of significant international experience.

3. Market Makers
In the inter-bank market, SBI along with a few other banks may be considered as the market-makers, i.e., banks which are always ready to quote two-way prices both in the spot and swap segments. The market makers are expected to make a good price with narrow spreads both in the spot and the swap segments. The efficiency and liquidity of a

market are often gauged in terms of bid-offer spreads. Wide spreads are an indication of an illiquid market or a one way market or a nervous condition in the market. In India, the normal spot market quote has a spread of 0.5 to one paisa, while the swap quotes are available at 2 to 4 paise spread. At times of volatility, the spread widens to 5 to 10 paise.

4. Data on Forex Markets

The RBI publishes daily data on exchange rates, forward premia, foreign exchange turnover etc. in the Weekly Statistical Supplement (WSS) of the RBI Bulletin with a lag of one week. The movement in foreign exchange reserves of the RBI on a weekly basis is furnished in the same publication. The RBI also publishes data on Nominal Effective Exchange Rate (NEER)

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and Real Effective Exchange Rate (REER), RBI's purchases and sales in the foreign exchange market along with outstanding forward liabilities on reserves etc. in the monthly RBI Bulletin with a time lag of one month. Since July 1998, the Reserve Bank of India started publishing the 5-country trade based NEER and REER in addition to 36-country NEER and REER in the RBI Bulletin. Way ahead of many developing and industrial country central banks, the RBI has been publishing the size of its gross intervention (purchase and sale) each month and its net forward liability position.

Unique Features of Indian Forex Market

1. Gold Policy Liberalization of gold policy had an indirect but, significant impact on the forex market. The major thrust of the liberalization process in gold policy centered around opening up of additional channels of import, a logical consequence of which was the reduction in differential between the international and domestic price of gold. The price differential of gold was as high as 67 per cent in 1992 when the structural reform process was initiated; it fell to 6 per cent by the end of 1998. The unofficial market in foreign exchange which drew its sustenance from the illegal trade in gold went out of existence as an immediate fall out. In essence, the import of gold which was largely on unofficial account in earlier years, was officialised, and correspondingly the foreign exchange used to finance such unofficial imports was also officialised, mainly through enhanced flow under invisibles account. 2. NRI Deposits Various deposit schemes have been designed from time to time to suit the requirements of non-resident Indians (NRIs). Currently, we have three NRI deposit schemes, viz., Non Resident External (NRE) account which is denominated in rupees, Non Resident Non Repatriable (NRNR) account, which is non-repatriable rupee account except for the interest component which is repatriable, and the Foreign Currency Non Resident (Bank) (FCNR-B) account which is a foreign currency account. Banks have also been allowed considerable freedom in deployment of these funds. Of interest to forex markets is the

operation of FCNR-B scheme, because banks have to bear exchange risk. Banks either hold these deposits in foreign currency investing them abroad or lend in foreign currency to corporates in India or swap into rupees and lend to Indian corporates in rupees. Tracking the use of FCNR (B) deposits is essential in appreciating forex markets. 3. Public Enterprises Operations of large public sector undertakings have a significant impact especially on spot market, and their procedures for purchase or sale of foreign currency also impact on market sentiments. To this end, and in order to enable Public Sector Enterprises (PSEs)

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to equip themselves in formulating an approach to management of foreign currency exposure related risks, the Government of India had set up a Committee in January 1998. The Report of the Committee explicitly brings out the approach that is appropriate for risk management with reference to the foreign currency exposure of PSEs. PSEs with large volume of foreign exchange exposure were also advised by the Committee to consider setting up Dealing Room for undertaking treasury functions both for rupee and foreign exchange which include management of rupee resources, foreign exchange transactions and risk management. Adoption of approaches recommended would enable the PSEs to spread their demand and supply in forex market, in a non-disruptive way to the benefit of both the PSE concerned and functioning of forex market in India. 4. Clearing House The idea of establishing a Foreign Exchange Clearing House (FXCH) in India was mooted in 1994. The Expert Group on Foreign Exchange Markets in India also recommended introduction of foreign exchange clearing and making netting legally enforceable. The Scheme was conceived as multilateral netting arrangement of interbank forex transactions in US dollar. The membership would be open to all ADs in foreign exchange participating in the inter-bank foreign exchange market. RBI will also be a participating member. The net position of each bank arrived at the end of the trading day would be settled through a Clearing Account to be maintained by RBI. It was recognised that a substantial reduction in number of Nostro account transactions of the participating banks would lead to economy in settlement cost and efficiency in settlement. Other benefits include easing the process of reconciliation of Nostro accounts balances by banks, reduction in size of credit and liquidity exposure of participating banks and hence systemic risk, etc. The long-term objective is to establish clearing house as a separate legal entity with risk and liquidity management features, infrastructure and operational efficiency akin to other leading clearing systems. 5. Role of FEDAI In a regime where exchange rates were fixed and there were restrictions on outflow of foreign exchange, the RBI encouraged the banks to constitute a self regulatory body and lay down rules for the conduct of forex business. In order to ensure that all the banks participated in the arrangement, the RBI placed a condition while issuing foreign

exchange licence that every licensee agree to be bound by the rules laid down by the bankers body the FEDAI. FEDAI also accredited brokers through whom the banks put through deals.

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Foreign Exchange Risk Management Process & Necessity

Firms dealing in multiple currencies face a risk (an unanticipated gain/loss) on account of sudden/unanticipated changes in exchange rates, quantified in terms of exposures. Exposure is defined as a contracted, projected or contingent cash flow whose magnitude is not certain at the moment and depends on the value of the foreign exchange rates. The process of identifying risks faced by the firm and implementing the process of protection from these risks by financial or operational hedging is defined as foreign exchange risk management.

Kinds of Foreign Exchange Exposure

Risk management techniques vary with the type of exposure (accounting or economic) and term of exposure. 1. Accounting exposure, also called translation exposure, results from the need to restate foreign subsidiaries financial statements into the parents reporting currency and is the sensitivity of net income to the variation in the exchange rate between a foreign subsidiary and its parent. 2. Economic exposure is the extent to which a firm's market value, in any particular currency, is sensitive to unexpected changes in foreign currency. Currency fluctuations affect the value of the firms operating cash flows, income statement, and competitive position, hence market share and stock price. Currency fluctuations also affect a firm's balance sheet by changing the value of the firm's assets and liabilities, accounts payable, accounts receivables, inventory, loans in foreign currency, investments (CDs) in foreign banks; this type of economic exposure is called balance sheet exposure. Transaction Exposure is a form of short term economic exposure due to fixed price contracting in an atmosphere of exchange-rate volatility.

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Foreign Exchange Risk Management Framework

Once a firm recognizes its exposure, it then has to deploy resources in managing it. A heuristic for firms to manage this risk effectively is presented below which can be modified to suit firm-specific needs i.e. some or all the following tools could be used. 1. Forecasts: After determining its exposure, the first step for a firm is to develop a forecast on the market trends and what the main direction/trend is going to be on the foreign exchange rates. The period for forecasts is typically 6 months. It is important to base the forecasts on valid assumptions. Along with identifying trends, a probability should be estimated for the forecast coming true as well as how much the change would be. 2. Risk Estimation: Based on the forecast, a measure of the Value at Risk (the actual profit or loss for a move in rates according to the forecast) and the probability of this risk should be ascertained. The risk that a transaction would fail due to market-specific problems should be taken into account. Finally, the Systems Risk that can arise due to inadequacies such as reporting gaps and implementation gaps in the firms exposure management system should be estimated. 3. Benchmarking: Given the exposures and the risk estimates, the firm has to set its limits for handling foreign exchange exposure. The firm also has to decide whether to manage its exposures on a cost centre or profit centre basis. A cost centre approach is a defensive one and the main aim is ensure that cash flows of a firm are not adversely affected beyond a point. A profit centre approach on the other hand is a more aggressive approach where the firm decides to generate a net profit on its exposure over time. 4. Hedging: Based on the limits a firm set for itself to manage exposure, the firms then decides an appropriate hedging strategy. There are various financial instruments available for the firm to choose from: futures, forwards, options and swaps and issue of foreign debt. Hedging strategies and instruments are explored in a section. 5. Stop Loss: The firms risk management decisions are based on forecasts which are but

estimates of reasonably unpredictable trends. It is imperative to have stop loss arrangements in order to rescue the firm if the forecasts turn out wrong. For this, there should be certain monitoring systems in place to detect critical levels in the foreign exchange rates for appropriate measure to be taken. 6. Reporting and Review: Risk management policies are typically subjected to review based on periodic reporting. The reports mainly include profit/ loss status on open contracts after marking to market, the actual exchange/ interest rate achieved on each exposure, and profitability vis--vis the benchmark and the expected changes in overall

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exposure due to forecasted exchange/ interest rate movements. The review analyses whether the benchmarks set are validand effective in controlling the exposures, what the market trends are and finally whether the overall strategy is working or needs change.

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Foreign Exchange Hedging 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. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party. 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 INRUSD 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. 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. The previous example for a forward contract for RIL applies here also just that RIL will have to go to a USD futures exchange to purchase standardised dollar futures equal to the amount to be hedged as the risk is that of appreciation of the dollar. As mentioned earlier, the tailorability of the futures contract is limited i.e. only standard denominations of money can be bought instead of the exact amounts that are bought in forward contracts.

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). 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.

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If the exchange rate movement is favourable i.e the dollar depreciates, then RIL can buy them at the spot rate as they have become cheaper. In the other case, if the dollar appreciates compared to todays 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. Example: 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. 5. Foreign Debt: Foreign debt can be used to hedge foreign exchange exposure by taking advantage of the International Fischer Effect relationship. Example: An exporter who has to receive a fixed amount of dollars in a few months from present. The exporter stands to lose if the domestic currency appreciates against that currency in the meanwhile so, to hedge this, he could take a loan in the foreign currency for the same time period and convert the same into domestic currency at the current exchange rate. The theory assures that the gain realised by investing the proceeds from the loan would match the interest rate payment (in the foreign currency) for the loan.

Detailed explanation of each Instrument

1. Currency Forwards: Forwards, like other derivative securities, can be used to

hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive.

Relationship between the forward price and the expected future spot price: The market's opinion about what the spot price of an asset will be in the future is the expected future spot price. Hence, a key question is whether or not the current forward price actually predicts the respective spot price in the future. There are a number of different hypotheses which try to explain the relationship between the current forward price, and the expected future spot price.

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Market situation, where Expected > Futures Price, is referred to as normal backwardation. Since, forward/futures prices converge with the spot price at maturity, normal backwardation implies that futures prices for a certain maturity are increasing over time. The opposite situation is referred to as Contango. Likewise, Contango implies that futures prices for a certain maturity are falling over time.

2. Currency Futures: Futures contracts can be on different underlying assets like commodity (commodity futures), equity (stock futures), index (index futures) and foreign exchange (forex futures). Internationally, currency futures can be cash settled or settled by delivering the respective obligation of the seller and buyer. All settlements, however, unlike in the case of OTC markets, go through the exchange. Currency futures are a linear product, and calculating profits or losses on Currency Futures will be similar to calculating profits or losses on Index futures. In determining profits and losses in futures trading, it is essential to know both the contract size (the number of currency units being traded) and also what the tick value is. A tick is the minimum trading increment or price differential at which traders are able to enter bids and offers. Tick values differ for different currency pairs and different underlyings. For e.g. in the case of the USD-INR currency futures contract the tick size shall be 0.25 paise or 0.0025 Rupee. To demonstrate how a move of one tick affects the price, imagine a trader buys a contract (USD 1000 being the value of each contract) at Rs. 42.2500. One tick move on this contract will translate to Rs.42.2475 or

Rs.42.2525 depending on the direction of market movement.

Purchase price: Price increases by one tick: New price: Purchase price:

Rs.42.2500 +Rs.00.0025 Rs.42.2525 Rs.42.2500

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Price decreases by one tick: Rs.00.0025 New price: Rs.42.2475

Difference between Currency Forwards & Currency Futures:

Unlike forward contracts, the futures contracts are standardized and exchange traded. While, forward contracts are exchanged OTC. Currency Forward contracts are customized contracts depending upon the requirements of the parties in the contract. However, Currency Futures contracts are standardized contract with standard underlying instrument, a standard quantity of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. In case of currency forwards its rather difficult to find a counter party with equal and opposite requirements. The main advantage of currency futures over its closest substitute product, viz. forwards which are traded over the counter lies in price transparency, elimination of counterparty credit risk and greater reach in terms of easy accessibility to all. Currency futures are expected to bring about better price discovery and also possibly lower transaction costs, due to standardization which is not the case with currency forwards. Apart from pure hedgers, currency futures also invite arbitrageurs, speculators and those traders who may take a bet on exchange rate movements without an underlying or an economic exposure as a motivation for trading. However, currency forwards are primarily used only for risk hedging purposes. 3. Currency Options: A foreign exchange option (commonly shortened to just FX option or currency option) is a derivative financial instrument where the owner has the right but not the obligation to exchange money denominated in one currency into another

currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest, largest and most liquid market for options of any kind in the world. Most of the FX option volume is traded OTC and is lightly regulated, but a fraction is traded on exchanges like the International Securities Exchange, Philadelphia Stock Exchange, or the Chicago Mercantile Exchange for options on futures contracts.

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Example: For example a GBP/USD FX option might be specified by a contract giving the owner the right but not the obligation to sell 1,000,000 and buy $2,000,000 on December 31. In this case the pre-agreed exchange rate, or strike price, is 2.0000 USD per GBP (or 0.5000 GBP per USD) and the notionals are 1,000,000 and $2,000,000. This type of contract is both a call on dollars and a put on sterling, and is often called a GBPUSD put by market participants, as it is a put on the exchange rate; it could equally be called a USDGBP call, but market convention is quote GBPUSD (USD per GBP). If the rate is lower than 2.0000 come December 31 (say at 1.9000), meaning that the dollar is stronger and the pound is weaker, then the option will be exercised, allowing the owner to sell GBP at 2.0000 and immediately buy it back in the spot market at 1.9000, making a profit of (2.0000 GBPUSD - 1.9000 GBPUSD)*1,000,000 GBP = 100,000 USD in the process. If they immediately exchange their profit into GBP this amounts to 100,000/1.9000 = 52,631.58 GBP. Advantages of currency options Hedge for currency exposures to protect the downside while retaining the upside, by paying a premium upfront. This would be a big advantage for importers, exporters (of both goods and services) as well as businesses with exposures to international prices. Currency options would enable Indian industry and businesses to compete better in the international markets by hedging currency risk. Non-linear payoff of the product enables its use as hedge for various special cases and possible exposures. e.g. If an Indian company is bidding for an international assignment where the bid quote would be in dollars but the costs would be in rupees, then the company runs a risk till the contract is awarded. Using forwards or currency swaps would create the reverse positions if the company is not allotted the contract, but the use of an option contract in this case would freeze the liability only to the option premium paid upfront.

 The nature of the instrument again makes its use possible as a hedge against uncertainty of the cash ows. Option structures can be used to hedge the volatility along with the non-linear nature of payoffs. Attract further forex investments due to the availability of another mechanism for hedging forex risk.

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4. Currency Swaps: Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps. However, unlike interest rate swaps, currency swaps can involve the exchange of the principal. There are three different ways in which currency swaps can exchange loans: The most simple currency swap structure is to exchange the principal only with the counterparty, at a rate agreed now, at some specified point in the future. Such an agreement performs a function equivalent to a forward contract or futures. The cost of finding a counterparty (either directly or through an intermediary), and drawing up an agreement with them, makes swaps more expensive than alternative derivatives (and thus rarely used) as a method to fix shorter term forward exchange rates. However for the longer term future, commonly up to 10 years, where spreads are wider for alternative derivatives, principal-only currency swaps are often used as a costeffective way to fix forward rates. This type of currency swap is also known as an FX-swap. Another currency swap structure is to combine the exchange of loan principal, as above, with an interest rate swap. In such a swap, interest cash flows are not netted before they are paid to the counterparty (as they would be in a vanilla interest rate swap) because they are denominated in different currencies. As each party effectively borrows on the other's behalf, this type of swap is also known as a back-to-back loan. Last here, but certainly not least important, is to swap only interest payment cash flows on loans of the same size and term. Again, as this is a currency swap, the exchanged cash flows are in different denominations and so are not netted. An example of such a swap is the exchange of fixed-rate US Dollar interest payments for floating-rate interest payments in Euro. This type of swap is also known as a cross-currency interest rate swap, or cross-currency swap. Advantages of Currency Swaps Flexibility Currency swaps give companies extra flexibility to exploit their comparative advantage

in their respective borrowing markets. Interest rate swaps allow companies to focus on their comparative advantage in borrowing in a single currency in the short end of the maturity spectrum vs. the longend of the maturity spectrum. Currency swaps allow companies to exploit advantages across a matrix of currencies and maturities.

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 The success of the currency swap market and the success of the Eurobond market are explicitly linked. Exposure Because of the exchange and re-exchange of notional principal amounts, the currency swap generates a larger credit exposure than the interest rate swap. Companies have to come up with the funds to deliver the notional at the end of the contract. They are obliged to exchange one currency's notional against the other currency's notional at a fixed rate. The more actual market rates have deviated from this contracted rate, the greater the potential loss or gain. This potential exposure is magnified with time. Volatility increases with time. The longer the contract, the more room for the currency to move to one side or other of the agreed upon contracted rate of principal exchange. This explains why currency swaps tie up greater credit lines than regular interest rate swaps. Pricing We price or value currency swaps in the same way that we learned how to price interest rate swaps, using a discounted cash flow analysis having obtained the zero coupon version of the swap curves. Generally, currency swaps transact at inception with a net present value of zero. Over the life of the instrument, the currency swap can go in-the-money, out-of-themoney or it can stay at-the-money.

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Hedging Strategies Using Different Hedging Instruments

1. Using Forward / Futures
Hedging means taking a position in the future / forward market that is opposite to a position in the physical market with a view to reduce or limit risk associated with unpredictable changes in exchange rate. Methodology of hedging currency risks using Currency Futures and Currency Forwards is almost the same, considering the differences between the two as discussed above. The impact of the spot price movements on both the contracts is just the same. Types of FX Hedgers using Futures / Forwards: Long hedge: Underlying position: short in the foreign currency Hedging position: long in currency futures / forwards Short hedge: Underlying position: long in the foreign currency Hedging position: short in currency futures / forwards The proper size of the Hedging position: Basic Approach: Equal hedge Modern Approach: Optimal hedge Equal hedge: In an Equal Hedge, the total value of the futures contracts involved is the same as the value of the spot market position. As an example, a US importer who has an exposure of 1 million will go long on 16 contracts assuming a face value of 62,500 per contract. Therefore in an equal hedge: Size of Underlying position = Size of Hedging position. Optimal Hedge: An optimal hedge is one where the changes in the spot prices are negatively correlated with the changes in the futures prices and perfectly offset each other. This can generally be described as an equal hedge, except when the spot-future basis relationship changes. An Optimal Hedge is a hedging strategy which yields the highest level

of utility to the hedger.

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Example 1: Long Futures Hedge Exposed to the Risk of Strengthening USD Unhedged Exposure: Lets say on January 1, 2008, an Indian importer enters into a contract to import 1,000 barrels of oil with payment to be made in US Dollar (USD) on July 1, 2008. The price of each barrel of oil has been fixed at USD 110/barrel at the prevailing exchange rate of 1 USD = INR 39.41; the cost of one barrel of oil in INR works out to be Rs. 4335.10 (110 x 39.41). The importer has a risk that the USD may strengthen over the next six months causing the oil to cost more in INR; however, he decides not to hedge his position. On July 1, 2008, the INR actually depreciates and now the exchange rate stands at 1 USD = INR 43.23. In dollar terms he has fixed his price, that is USD 110/barrel, however, to make payment in USD he has to convert the INR into USD on the given date and now the exchange rate stands at 1USD = INR43.23. Therefore, to make payment for one dollar, he has to shell out Rs. 43.23. Hence the

same barrel of oil which was costing Rs. 4335.10 on January 1, 2008 will now cost him Rs. 4755.30, which means 1 barrel of oil ended up costing Rs. 4755.30 - Rs. 4335.10 = Rs. 420.20 more and hence the 1000 barrels of oil has become dearer by INR 4,20,200. When INR weakens, he makes a loss, and when INR strengthens, he makes a profit. As the importer cannot be sure of future exchange rate developments, he has an entirely speculative position in the cash market, which can affect the value of his operating cash flows, income statement, and competitive position, hence market share and stock price. Hedged Exposure: Lets presume the same Indian Importer pre-empted that there is good probability that

INR will weaken against the USD given the current macro-economic fundamentals of increasing Current Account deficit and FII outflows and decides to hedge his exposure on an exchange platform using currency futures. Since he is concerned that the value of USD will rise he decides go long on currency futures, it means he purchases a USD/INR futures contract. This protects

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the importer because strengthening of USD would lead to profit in the long futures position, which would effectively ensure that his loss in the physical market would be mitigated.

Following summarizes the outcome of all the transactions: Profit on Futures Transactions: INR 48,09,200 Sale price of Futures (INR 43,89,000) Purchase price of Futures INR 4,20,200 Profit on Futures Contract INR 47,55,300 Cash Purchase Price (INR 4,20,200) Profit on Futures Contracts INR 43,35,100 Return to Hedge Observation: Following a 9.7% rise in the spot price for USD, the US dollars are purchased at the new, higher spot price, but profits on the hedge foster an effective exchange rate equal to the original hedge price.

Return to Hedge:

Example 2: Short Futures Hedge Exposed to the Risk of Weakening USD Unhedged Exposure: Lets 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). The refiner has a risk that the INR may strengthen over the next three months causing the oil to cost less in

INR; however he decides not to hedge his position.

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Date 01-Jan-2008

01-July-2008

Spot Market Current Cost of 1000 barrels at current exchange rate of The Spot Price is INR 43.23 per USD. Therefore the Import cost is INR 47,55,300

Futures Market July USD Contracts is at INR 39.90. Cost of 1000 barrels Sell USD contracts at the prevailing rate of 43.72. Total realization is INR 48,09,200

On June 1, 2008, the INR actually appreciates against the USD and now the exchange rate stands at 1 USD = INR 40.30. In dollar terms he has fixed his price, that is USD 80/barrel; however, the dollar that he receives has to be converted in INR on the given date and the exchange rate stands at 1USD = INR40.30. Therefore, every dollar that he receives is worth Rs. 40.30 as against Rs. 44.05. 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. When INR strengthens, he makes a loss and when INR weakens, he makes a profit. As the refiner cannot be sure of future exchange rate developments, he has an entirely speculative position in the cash market, which can affect the value of his operating cash flows, income statement, and competitive position, hence market share and stock price. Hedged: Lets presume the same Indian refiner pre-empted that there is good probability that INR will strengthen against the USD given the current macroeconomic fundamentals of reducing fiscal deficit, stable current account deficit and strong FII inflows and decides to hedge his exposure on an exchange platform using currency futures. 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.

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Date 01-Mar-2007

01-June-2007

Spot Market Current Cost of 1000 barrels at current exchange rate of INR 44.05PriceUSD is The Spot per is INR

Futures Market June USD Contracts is at INR 44.20. Consideration from the sale of 80 contracts Buy USD contracts at

per USD. Therefore the prevailing rate of 40.45. export revenue is INR Total realization is INR 32,24,000 Follow ing sum m arizes the outcom e of all the transactions: Profit on Futures Transactions: INR 35,36,000 Sale price of Futures (INR 32,36,000) Purchase price of Futures INR 3,00,200 Profit on Futures Contract INR 32,24,000 Cash Purchase Price INR 3,00,000 Profit on Futures Contracts INR 35,24,000 Return to Hedge 32,36,000

Return to Hedge:

Observation: Following an 8.51% fall in the spot price for USD, the US dollars are sold at the new, lower spot price; but profits on the hedge foster an effective exchange rate equal to the original hedge price. Example 3: Retail Hedging Remove Forex Risk while Investing Abroad Lets say when USD/INR at 44.20, an active stock market investor decides to invest USD 200,000 for a period of six months in the S&P 500 Index with a perspective that the market will grow and his investment will fetch him a decent return. In Indian terms, the investment is about Rs. 8,840,000. Lets say that after six months, as per his anticipation, the market wherein he has invested has appreciated by 10% and now his investment of USD 200,000 stands at USD 220,000. Having earned a decent return the investor decides to square off all his positions and bring back his proceeds to India. The current USD/INR exchange rate stands at 40.75 and his investment of USD 220,000 in Indian term stands at Rs. 8,965,000. Thus fetching him a meager return of 1.41% as compared to return of 10% in USD, this is because during the same period USD has depreciated by 7.81% against the INR and therefore the poor return. Consequently, even after gauging the overseas stock market movement correctly he is not able to earn the desired overseas return because he was not able to capture and manage his currency exposure. Lets presume

the same Indian investor pre-empted that there is good probability that the USD will weaken given the then market fundamentals and has decided to hedge his exposure on an exchange platform using currency futures.

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Since he was concerned that the value of USD will fall he decides go short on currency futures, it means he sells a USD/INR futures contract. This protects the investor because weakening of USD would lead to profit in the short futures position, which would effectively ensure that his loss in the investment abroad would be mitigated.

Following summarizes the outcome of all the transactions: Profit on Futures Transactions: INR 88,55,500 Sale price of Futures (INR 81,68,950) Purchase price of Futures INR 6,86,550 Profit on Futures Contract INR 89,65,000 Stock Proceedings INR 6,86,550 Profit on Futures Contracts INR 96,51,550 Return to Hedge

Return to Hedge:

Observation: Had the exchange rate been stagnant at 44.20 during the six-month investment period the investment in Rupee terms would have grown from INR 884,00,000 to INR 9,724,000 fetching him a return of INR 8,84,000 in absolute terms. However, during the investment period, the USD has depreciated by 7.81% and hence his investment has earned him a return of only INR 125,000. Had he hedged his exposure using currency futures, he could have mitigated a major portion of his risk as explained in the above example; he is not able to mitigate his risk completely even with the basis remaining the same because during the holding period his investment has grown from USD 2,00,000 to USD 2,20,000. The exhibit below gives the tabular representation of the portfolio with and without currency hedging:

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Date Leg I

Leg II

Spot Market Current investment value of USD 2,00,000 at current exchange rate of INR 44.20 The Spot Price is INR 40.75 per USD. Therefore the investment revenue is INR

Futures Market USD Contracts is at INR 44.50. Consideration from the sale of 199 contractscontracts at Buy USD the prevailing rate of 41.05. Total realization is INR 81,68,950

Hence a hedging using currency future has provided him better return as compared to the one without hedging. Also, it is not possible for every investor to gauge both the markets correctly, as in this case the investor may be an intelligent and well informed stock investor, but he may not be equally good when it comes to currency market; also it is not necessary that both markets move in the direction of the investors advantage. So its advisable that if an investor is taking a bet in one market, he will be better off if he can mitigate the risk related to other markets.

2. Using Currency Options

Currency Options are effective tools for investors to hedge their currency risks. Options primarily involve buying and selling of call and put options. Similar to the equity options, various strategies can be applied in currency options as well in order to effectively hedge currency risk. Investors can use currency options when it has an exposure in a non-domestic currency. For example, any Canadian resident owning a noncanadian dollar asset, such as a US equity portfolio, stands to lose money in Canadian dollar terms if the US dollar depreciates against the Canadian dollar. Currency risk can be hedged by buying a Put option on the US dollars, as the value of the option stands to increase if the dollar falls. Conversely, the holder of the noncanadian dollar liability faces the risk of the US dollar rising against the Canadian dollar, which would increase the liability in the Canadian dollar terms. An investor can hedge this risk with a call option on the US dollar, which should increase in value if the US dollar rises. Example 1: Hedging a US Equity Portfolio Consider, for example, a Canadian investor who holds a US dollar equity portfolio worth $1,00,000 on March 28th 2006. With an exchange rate of CAD/USD 1.17, the portfolio is worth C$1,17,000. However if the US dollar depreciates, the investor will incur a loss in the value of the portfolio in the Canadian dollar terms. The investor can hedge this risk by buying US dollar put option as follows:

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Without Hedging

Portfolio Return Hedging with Currency Futures

Invests and sells 199 Futures contracts @ Rs. 44.50 After six months, square off futures position @ Rs. 41.05 Return in Rs. Terms: On investment = Rs. 1,25,000 On futures = Rs. 686550 Net return = 9.18%

Invest $ 2,00,000 (USD = Rs.44.20) Investment grows to $2,20,000 after six months Offloads investment when the exchange rate is Return in $ terms = 10% Return in Rs. Terms = 1.41% i.e. (210,000 x 44) (200,000 x 45)

Number of put options to be purchased = 20 contracts of $10,000 each. Considering the price of the options as 1.4 cents Canadian, we get the total cost of options as = C$2,800 The hedge represents an investment of C$2,800 in the put options, which can be thought of as an in investor paying 2.4% as an insurance premium on the equivalent C$1,17,000 portfolio. Consider following scenarios on the expiration: A 4% drop in the US dollar. At expiration, the USD/CAD rate is 112.33. In this case the US$ 1,00,000 portfolio is worth C$1,12,330 a loss of C$4,670. After exercise the investors, the investors account will be credited am amount of: Put option settlement = (117-112.33) x 10000 x 20 / 100 = C$9,340 Therefore investors 20 options are now worth C$9,340, which largely offsets the loss in the value of the portfolio of US stocks because of the change in the exchange rates and the investors cost of C$2,800 for the purchase of put options. A 4% rise in the US dollar. At expiration, the USD/CAD rate is 121.68. In this case the USD$ 1,00,000 portfolio is worth C$1,21,680. However the put option is worthless and the investor will lose the C$2,800 premium paid on the purchase of the options, which will be again compensated by the gain made on the value of the portfolio. Hence, four basic currency options trades buy calls, sell calls, buy puts and sell puts combined with a variety of strike prices and expiration months give the investor almost unlimited strategy alternatives. Most of the options strategies like straddle, strangle, condor, butterfly are also applicable to the currency options. The advantages of limited risk and high leverage make currency options an attractive vehicle for the option buyer desiring to trade based on his views of future exchange rates.

3. Using Currency Swaps

A company needs to borrow Euros to fund an investment project. The cash flows will

also be in Euros. It transpires that by issuing a loan in USD the company can obtain the required funds more cheaply than by issuing a loan in EUR. However, in that case, the company would be faced with the situation where the interest payments would be in USD whereas the income would be in EUR. The company therefore decides to enter into a Currency Swap whereby it receives the USD interest rate and pays the EUR interest rate.

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The following three examples show how, through a Currency Swap, the standard interest rate for the term and currency of the debenture loan are swapped: 1. Swap of the principal amounts at the beginning of the Currency Swap

2. Swap of the interest flows during the currency swap

3. Swap of the principal amounts at maturity of the currency swap

Hence, a currency swap enables the company to obtain funding in a specific currency and swap it to another currency in order to reduce costs. A Currency Swap is a bespoke product and can, in terms of the calculation principal, starting date and underlying term, be very closely tailored to the user's requirements. Installment and drawdown schedules are possible. With a Currency Swap, it is easy to swap the currency of the cash flow and the nature of the corresponding interest flows temporarily. A Currency Swap can be easily wound up. This occurs by means of settlement of the spot value of the swap. This may be negative (penalty interest) or positive (income).

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Choice of hedging instruments

The literature on the choice of hedging instruments is very scant. Among the available studies, Gczy 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. This is because foreign currency debt payments are long-term and predictable, which fits the long-term nature of currency swap contracts. Foreign currency revenues, on the other hand, are short-term and unpredictable, in line with the short-term nature of forward contracts. A survey done by Marshall (2000) also points out that currency swaps are better for hedging against translation risk, while forwards are better for hedging against transaction risk. This study also provides anecdotal evidence that pricing policy is the most popular means of hedging economic exposures. These results however can differ for different currencies depending in the sensitivity of that currency to various market factors. Regulation in the foreign exchange markets of various countries may also skew such results.

Determinants of Hedging Decisions

The management of foreign exchange risk, as has been established so far, is a fairly complicated process. A firm, exposed to foreign exchange risk, needs to formulate a strategy to manage it, choosing from multiple alternatives. This section explores what factors firms take into consideration when formulating these strategies. 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. 3. 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.

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4. 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. The above 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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REGULATIONS PERTAINING TO FOREX INSTRUMENTS

Indian Forex Policy
The Reserve Bank of India (the nations central bank) has the authority to issue guidelines to all residents, non residents and foreigners for forex transactions. The infringement of any such law is punishable by the Foreign Exchange Management Act (FEMA) provision. According to this law (which was remodelled in 1999), no person shall:

Deal in forex or foreign security with any unauthorized person Make any kind of payment to a person who is not an Indian resident Conduct any financial transaction in the country involving a right to acquire any asset outside Indian territory by anybody Cannot freely exchange the rupee for other currencies Have to prove the need for doing so in case of visits to foreign countries On proving the need, can exchange foreign currencies up to a certain annual limit

In India, forex trading is allowed only among those who are licensed dealers in foreign exchange. Transactions in foreign exchange are not permissible for Indians, even under the liberalised scheme of $100,000. One can be imprisoned under the FEMA provision for committing this non bailable offence. Only corporate organizations are allowed to trade in foreign exchange in India, subject to the condition that they use the existing reserves of dollars which they have earned through their normal business. These companies can not buy dollars by converting rupees into USD. Also, they can not use leverage of more than 10. However, with the economy of the country opening up to the world markets, the Reserve Bank of India is realizing the need to soften Indian forex regulations to match the globalization trend in other spheres. One of the significant developments in this regard was RBI allowing trade in currency futures in 2008. Speculative trading also became permissible, since asking for proof of a hedging need is difficult. Broad principles for undertaking derivative transactions

The major requirements for undertaking any derivative transaction from the regulatory perspective would include:

Market-makers may undertake any derivative structured product (a combination of permitted cash and generic derivative instruments) as long as it is a combination of

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two or more of the generic instruments permitted by RBI and the marketmakers should be in a position to mark to market or demonstrate valuation of these constituent products based on observable market prices. Hence, it may be ensured that structured products do not contain any derivative, which is not allowed on a stand alone basis. Moreover, second order derivatives, like swaption, option on future, compound option etc. are not permitted.

A user should not have a net short options position, either on a stand alone basis or in a structured product, except to the extent of permitted covered calls and puts. All permitted derivative transactions, including roll over, restructuring and novation shall be contracted only at prevailing market rates. Markto-market gain/loss on roll over, restructuring, novation etc. should be cash-settled. All risks arising from derivatives exposures should be analysed and documented. The management of derivatives activities should be an integral part of the overall risk management policy and mechanism. It is desirable that the board of directors and senior management understand the risks inherent in the derivatives activities being undertaken. Market-makers should have a Suitability and Appropriateness Policy vis--vis users in respect of the products offered, on the lines indicated in these guidelines. Market-makers and users regulated by RBI should not undertake any derivative transaction involving the rupee that partially or fully offset a similar but opposite risk position undertaken by their subsidiaries/branches/group entities at offshore location(s). Market-makers may maintain cash margin/liquid collateral in respect of

derivative transactions undertaken by users on mark-to-market basis, irrespective of the latters credit risk assessment.

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1. Currency Forwards/Futures
I. Participants Users Persons resident in India with crystallized foreign currency / foreign interest rate exposure, as permitted by RBI Persons resident outside India with genuine currency exposure to the rupee, as permitted by RBI Market-makers Authorised Dealers Category I Banks

II. Purpose Residents in India To hedge crystallized foreign currency / foreign interest rate exposure To transform exposure in one currency to another permitted currency.

Residents outside India To hedge or transform permitted foreign currency exposure to the rupee, as permitted by RBI.

2. Foreign Currency Rupee Swap

I. Participants Users A person resident in India who has a long-term foreign currency or rupee liability

Market-makers Authorised Dealers Category I Banks

II. Purpose

Users To hedge or transform exposure in foreign currency / foreign interest rate to rupee / rupee interest rate Market-makers Can only take up residual positions, as permitted by RBI and not allowed to run a book.

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3. Cross Currency options

I. Participants Users A person resident in India with crystallized foreign currency exposure, as permitted by RBI. Market-makers Authorised Dealers Category I Banks, approved as marketmaker by RBI.

II. Purpose Users To hedge or transform foreign currency exposure arising out of current account transactions Market-makers To cover risks arising out of market-making in foreign currency rupee options as well as cross currency options, as permitted by RBI

4. Foreign Currency Rupee Options

I. Participants Users Customers of market-makers who have genuine foreign currency exposures, as permitted by RBI. Authorised Dealers Category - I Banks for the purpose of hedging trading books and balance sheet exposures. Market-makers

Authorized I Banks, approved by RBI. Dealers Category- Authorized Dealers Category-I Banks who are not market-makers can write foreign currency rupee options on a back-to-back basis, provided they have a CRAR of 9% or above. II. Purpose To hedge currency exposure

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Forex Risk Management by the Indian Information Technology Industry

Since Indian IT companies are predominantly software exporters, they need to parse out the risks associated with multi-currency dealings by going in for various forex instruments. In hedging, companies generally cover a proportion of foreign currency receivables or rupee expenses at a pre-determined rate. As per industry estimates, one per cent movement in the Indian rupee impacts operating margins by approximately 0.25 per cent. A hedging programme restricts the impact on operating margins to approximately 0.13-0.15 per cent. Any depreciation of the rupee pegs up realizations and bodes well for margins. Since IT companies get both long-term and short-term turnkey engagements, hedging has to be active both in the long-term as well as the short-term. In 2008, The Indian rupee had touched its all-time high of Rs 38 against the US dollar, riding on the back of huge forex inflows and growing exports. Hence, most economists and IT companies discretely started preparing for a regime with the Indian rupee at 35 to a dollar. Several Topline IT companies went in for long-term forex contracts, protecting a huge chunk of their expected receivables at a rate between 39 and 41.

However in 2009, rupee changed course in a few quarters to reach levels of 47-48, thereby exposing software companies to both the translational and the transactional impact of currency volatility. Not just dollar, the Australian dollar moved by around 15 per cent, the euro changed track by nearly 5 per cent and the UK pound moved by around 8 per cent. Varying Forex Risk Management Policies:

(Wipro): more active for the short-term, overall hedge book has Tata come down over the last four quarter due to extreme near term volatility. Consultancy Hexaware Technologies (Hexaware): the tenure of hedges from three years to Services (TCS): had a strategy of up to hedging its dollar two years. exposure for a Tech Mahindra: cover upto five years due to the profile of the business; however, period of two a years or more, larger proportion of the covers is for the first few years. now duration of Infosys Technologies (Infosys): strategy of hedging for the next two quarters at its forex any contracts will not point of time, because the volatility in the currency is huge and if long-term view is be more than a taken, it could hurt the company. year. Wipro Technologies
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Tata Consultancy Services

TCS, like most IT companies, had a strategy of hedging its dollar exposure for a period of two years or more. Hence, it booked $349 million of hedges through a combination of put and call options that gave it the right to sell $1 for Rs 39 and an obligation to sell $1 for Rs 41 if exercised by the counterparty in the FY 2008-2009. Effectively, it had then decided to confine its forex exposure to the range of Rs 39-41 (to the dollar). As a result, the company reported a forex loss of Rs 85 crore in the June quarter and Rs 192 crore in the March quarter of the Year 2008-2009. Of the $349 million, hedges worth $226 million are expected to expire over the next three quarters. In view of the continuing volatility, TCS has decided that the duration of its forex contracts will not be more than a year. Revenue Distribution by Geography:
% of Revenue Geography 2008-2009 2007-2008 2006-2007 Americas 51.38 UK 18.99 Europe 10.53 India 7.85 Asia Pacific 4.75 Iberoamerica 4.71 ME/Africa 1.79 Total 100.00 50.77 19.78 9.21 8.95 5.20 4.40 1.69 100.00 51.43 20.29 8.19 9.00 5.78 3.85 1.46 100.00

Summary of the Foreign Exchange Derivative Transaction for the Years 2006-2007 to 20082009:

Outstanding Foreign Exchange Forward Contracts

Outstanding Foreign Exchange Options Contracts

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Infosys Technologies
One company that has benefited from a short-term hedging strategy is Infosys Technologies, which had a hedging position of $598 million at the end of the Junequarter 2009-10. We continue with our strategy of hedging for the next two quarters at any point of time. We do not want to go beyond that because the volatility in the currency is huge and if we take a long-term view it could hurt us, the Infosys Chief Financial Officer, V. Balakrishnan, said in a recent conference call with analysts.

Distribution of Revenue by Currencies:

Summary of the Foreign Exchange Derivative Transaction for the Years 2006-2007 to 2008-2009: Outstanding Foreign Exchange Forward Contracts

Outstanding Foreign Exchange Options Contracts

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Conclusion
Derivative use for hedging is only to increase due to the increased global linkages and volatile exchange rates. Firms need to look at instituting a sound risk management system and also need to formulate their hedging strategy that suits their specific firm characteristics and exposures. In India, regulation has been steadily eased and turnover and liquidity in the foreign currency derivative markets has increased, although the use is mainly in shorter maturity contracts of one year or less. Forward and option contracts are the more popular instruments. Regulators had initially only allowed certain banks to deal in this market however now corporates can also write option contracts. There are many variants of these derivatives which investment banks across the world specialize in, and as the awareness and demand for these variants increases, RBI would have to revise regulations. For now, Indian companies are actively hedging their foreign exchanges risks with forwards, currency and interest rate swaps and different types of options such as call, put, cross currency and range-barrier options. The high use of forward contracts by Indian firms also highlights the absence of a rupee futures exchange in India. However, the Dubai Gold and Commodities Exchange in June, 2007 introduced Rupee- Dollar futures that could be traded on its exchanges and had provided another route for firms to hedge on a transparent basis. There are fears that RBIs ability to control the partially convertible currency will be subdued by this introduction but this issue is beyond the scope of this study. The partial convertibility of the Rupee will be difficult to control if many exchanges offer such instruments and that will be factor to consider for the RBI. The Committee on Fuller Capital Account Convertibility had recommended that currency futures may be introduced subject to risks being contained through proper trading mechanism, structure of contracts and regulatory environment. Accordingly, Reserve Bank of India in the Annual Policy Statement for the Year 2007-08 proposed to set up a Working Group on Currency Futures to study the international experience and suggest a suitable framework to implement

the proposal, in line with the current legal and regulatory framework. The limitation of this study is that only one type of risk is assumed i.e the foreign exchange risk. Also applicability of conclusion is limited as only very few firms were reviewed over just one time period. However the results from this exploratory study are encouraging and interesting, leading us to conclude that there is scope for more rigorous study along these lines.

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References
Modules / Text: National Institute of Securities Markets Currency Derivatives Certification Introduction to Cross-Currency Swaps Bank of America (Monograph Series No. 243) Currency Options Reference Manual Montreal Exchange RBI Foreign Exchange Policy Review Manual RBI Circular on Introduction of Foreign Currency-Rupee Options

Websites: www.forex.com www.rbi.org www.Risk-management.guide.com www.forexcentre.com www.Fxstreet.com www.easy-forex.com www.blonnet.com

Research Papers:

Foreign Exchange Markets Rajesh Chakrabarthi College of Management, Georgia Tech Marketing, Finance & International Strategy - Anuradha Sivakumar and Runa Sarkar
Industrial and Management Engineering Department, Indian Institute of Technology, Kanpur

Foreign Exchange Derivatives Market in India : Status and Prospects - Neeraj Gambhir and
Manoj Goel

Annual Reports:

Tata Consultancy Services

http://www.tcs.com/investors/financial_info/Pages/default.aspx

Infosys Technologies
http://www.infosys.com/investors/reports-filings/annual-report/Pages/index.aspx

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