NMIMS

FOREX EXPOSURE MANAGEMENT

P R O J E C T

R E P O R T

FOREX EXPOSURE MANAGEMENT
Pr oj ec t Gu id e : Pr of . A. L. ia Bh at

By S. SH RE EK AN T MF M-II IB , RO LL N- 14 2 O NA RS EE M ON JE E IN ST IT UT E OF M AN AG EM EN T ST UD IE S, VI LE P AR LE , MU MB AI AC AD EM IC Y EA R 20 01 2 -2 00

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TABLE OF CONTENTS
RUDIMENTS OF FOREIGN EXCHANGE...............................................................................................4 1.1 FOREIGN EXCHANGE-INTRODUCTION.......................................................................................................4 1.2 THE NEED FOR FOREIGN EXCHANGE.......................................................................................................5 1.3 CAN THE TRANSACTION BETWEEN TWO COUNTRIES BE SETTLED IN A 3RD COUNTRY?........................................5 1.4 FOREIGN EXCHANGE MARKET...............................................................................................................5 1.5 PARTICIPANT OF FOREIGN EXCHANGE MARKETS.......................................................................................6 1.6 TYPES OF DEALING IN THE LOCAL FOREIGN EXCHANGE MARKETS.................................................................7 1.7 FACTORS THAT CONTRIBUTE TO THE GROWTH OF INDIAN FOREX MARKETS.....................................................8 OVERVIEW OF FOREIGN TRADE........................................................................................................12 ORGANISATIONAL SET UP OF M/S CIBA SPECIALTY CHEMICALS INDIA LTD..................14 1.8 INTRODUCTION..................................................................................................................................14 1.9 BACKGROUND..................................................................................................................................16 FOREX MANAGEMENT POLICY..........................................................................................................17 1.10 PRE-REQUISITES..............................................................................................................................17 1.11 ANALYSIS......................................................................................................................................17 1.12 CONCEPT OF GROSS EXPOSURE AND NET EXPOSURE.............................................................................18 1.13 FRAMING A POLICY ........................................................................................................................18 1.14 PERFORMANCE EVALUATION CRITERIA................................................................................................20 1.15 FOREIGN EXCHANGE RISK MANAGEMENT POLICY OF M/S CSCIL..........................................................20 1.16 RISK MEASUREMENT APPROACH........................................................................................................21 1.17 TYPES OF FOREIGN EXCHANGE RISKS.................................................................................................22 1.18 RECOGNITION OF EXCHANGE RISKS.....................................................................................................23 1.19 FOUR STEPS IN RISK MANAGEMENT...................................................................................................24 1.20 POSSIBLE PERFORMANCE EVALUATION CRITERIA AT M/S CSCIL:.............................................................28 1.21 CONCEPT TRANSFER PRICING............................................................................................................30 1.22 PERIOD OF MEASUREMENT................................................................................................................31 1.23 NET POSITION................................................................................................................................31 1.24 EXHIBIT-1: FOREX RATES & EXPOSURES..........................................................................31 1.25 MATURITY MISMATCH OR GAPS.........................................................................................32 STRUCTURE OF LIMITS.........................................................................................................................35 1.26 OVERALL LIMITS...........................................................................................................................35 1.27 INDIVIDUAL DEALER LIMITS.............................................................................................................35 GUIDELINES FOR RISK MANAGEMENT...........................................................................................37 1.28 HEDGING..................................................................................................................................37 1.29 PASSIVE RISK MANAGEMENT..............................................................................................37 1.30 ACTIVE RISK MANAGEMENT..............................................................................................38 VALUATIONS OF FOREIGN EXCHANGE EXPOSURES.................................................................39 INTERNAL CONTROLS...........................................................................................................................40 1.31 BALANCE OF PAYMENT........................................................................................................41 1.31.1 SOME BASIC CONCEPTS.........................................................................................................41 1.32 COMPONENTS OF BALANCE OF PAYMENTS :..........................................................................................42 1.32.1 Current account..........................................................................................................................42 1.32.2 Trade flows.................................................................................................................................42 1.32.3 Invisibles.....................................................................................................................................42 1.32.4 Deficit & Surplus........................................................................................................................42 1.32.5 Capital Account..........................................................................................................................44 THE MANAGEMENT OF FOREIGN EXCHANGE RISK .................................................................46 1.33 OVERVIEW...............................................................................................................................46 1.34 SHOULD FIRMS MANAGE FOREIGN EXCHANGE RISK-HOW? ........................................47 1.35 ECONOMIC EXPOSURE, PURCHASING POWER PARITY & THE INTERNATIONAL FISHER EFFECT......................49

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1.36 FOREIGN EXCHANGE FORECASTING.....................................................................................................49 1.37 HISTORICAL PERSPECTIVE ON EXCHANGE RATE, GOLD STANDARD..............................................................50 1.37.1 Gold standard ............................................................................................................................50 1.37.2 Definition of Arbitrage ..............................................................................................................51 1.37.3 Bretton Wood’s System ..............................................................................................................51 1.38 FEATURES OF EXCHANGE RATE SYSTEM .............................................................................................51 1.38.1 Collapse of Bretton Woods System (1944 to 1971)...................................................................52 1.39 FLOATING EXCHANGE RATE SYSTEM................................................................................................52 1.40 OBJECTIVES OF LIMITED FLEXIBILITY SYSTEM......................................................................................53 1.41 CRAWLING PEG (GLIDING PARITIES ) ....................................................................................................53 1.42 MIXED SYSTEM.............................................................................................................................53 1.43 EXCHANGE RATE ARRANGEMENTS ....................................................................................................53 1.44 MARKET SIZE ...............................................................................................................................54 1.45 MECHANICS OF EXCHANGE RATE......................................................................................................54 1.46 IDENTIFYING EXPOSURE ...................................................................................................................56 1.47 METHOD FOLLOWED BY US COMPANIES............................................................................................58 1.48 EXPOSURE - TYPES AND DESCRIPTION .............................................................................63 1.49 MANAGING ECONOMIC EXPOSURE ...................................................................................64 1.50 STEPS IN MANAGING ECONOMIC EXPOSURE .................................................................64 1.51 GUIDELINES FOR CORPORATE FORECASTING OF EXCHANGE RATES ..........................................................66 1.52 TOOLS AND TECHNIQUES FOR THE MANAGEMENT OF FOREIGN EXCHANGE RISK ......................................70 FOREIGN EXCHANGE MARKET.........................................................................................................70 1.53 STRUCTURE OF THE FOREX MARKET:..................................................................................................70 1.54 MARKET PLAYERS :.........................................................................................................................71 1.55 MECHANICS OF CURRENCY TRADING: ................................................................................................71 1.56 TYPES OF TRANSACTIONS AND SETTLEMENT DATES :..............................................................................71 1.57 ARBITRAGE BETWEEN BANKS:...........................................................................................................72 1.58 INVERSE QUOTES AND 2-POINT ARBITRAGE............................................................................................72 1.59 OUTRIGHT FORWARD QUOTATIONS.....................................................................................................73 1.60 DISCOUNTS AND PREMIA IN THE FORWARD MARKET..............................................................................73 1.61 ANNUALIZED PREMIUM / DISCOUNT:...................................................................................................74 1.62 MARGIN REQUIREMENT:...................................................................................................................74 1.63 FORWARD CONTRACTS, FUTURES & CURRENCY OPTIONS...........................................74 1.63.1 Forward Contract.......................................................................................................................74 1.63.2 Currency Futures .......................................................................................................................75 1.63.3 Debt instead of forwards or futures ..........................................................................................76 1.63.4 Currency Options ......................................................................................................................77 1.63.5 Swap............................................................................................................................................78 1.63.6 Cross Rates.................................................................................................................................78 1.63.7 Controlling Corporate Treasury Trading Risks ........................................................................79 1.64 MARKET FORECASTS ......................................................................................................................80 1.65 MARKET PARTICIPANTS....................................................................................................................80 1.66 MARKET PARTICIPANTS - 4 CATEGORIES.............................................................................................81 1.67 HEDGE FUNDS................................................................................................................................81 1.68 DEALING ROOMS............................................................................................................................81 1.69 INFORMATION SYSTEMS ...................................................................................................................81 1.70 PAYMENT AND COMMUNICATION SYSTEM............................................................................................82 1.71 RISK APPRAISAL ............................................................................................................................82 1.72 BENCHMARKING .............................................................................................................................83 1.73 HEDGING ......................................................................................................................................84 1.74 STOP LOSS ...................................................................................................................................85 1.75 REPORTING AND REVIEW .................................................................................................................86 1.76 CONCLUSION .................................................................................................................................87 LATEST IN FOREIGN EXCHANGE - TECHNOLOGY ADVANTAGE...........................................88 RESREVE BANK OF INDIA REGULATIONS & DEFINITIONS......................................................92 1.77 SHORT TITLE & COMMENCEMENT......................................................................................................92 1.78 DEFINITIONS .................................................................................................................................92 1.79 SUMMARY OF EXCHANGE RATE REGIME IN INDIA.................................................................................93 1.80 EXCHANGE RATE CALCULATIONS.......................................................................................................93

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.....NMIMS FOREX EXPOSURE MANAGEMENT 1........................95 INFORMATION ON EURO .............................96 1.........81 MULTI CURRENCY OPTION............ foreign exchange has been given a statutory definition: Def: Sec 2(b) of Foreign Exchange Regulation Act............................................98 RUDIMENTS OF FOREIGN EXCHANGE 1.................................1 Foreign Exchange-Introduction Foreign Exchange......................... In other words. fall in the category of foreign exchange................. means foreign money................. all claims to foreign currency payable abroad............... foreign exchange and near money instruments denominated in foreign currency.............................................LESSONS TO BE LEARNT.................83 WHAT ARE EURO MARKETS ?.................................. all deposits......................... traveler’s cheques.96 1........96 FOREX MARKET IN INDIA.......................... expressed or drawn in Indian currency but payable in any foreign currency Page 4 of 100 ........................................................... credits and balances payable in any foreign currency and any drafts......................................94 FROM THE ILLUSTRATION ........... 1973 states: “Foreign Exchange” means foreign currency and includes: 1...... whether consisting of funds held abroad in foreign currency or bill or cheques in foreign currency etc. Thus........... In India.............................. are called foreign exchange..................... simply stated........................................................ letter of credit and bills of exchange...........82 EVOLUTION OF EURO MARKET................

And therefore. it can be inferred that in case goods are bought or sold outside the country. the Japanese exporter requires Yen i. as the same is his home currency. A Japanese company exports electronic goods to USA and invoices the goods in US Dollars. then importer in USA will get his dollars converted in Yen and pay the exporter. Thus.2 The need for Foreign Exchange An example in this aspect would be apt to understand the need of Foreign Exchange. any instruments payable. his home currency for procuring raw material locally and making payments for the labour charges incurred for the purpose etc. Ex: An Indian exporter. it is also possible that the transactions between two countries might be settled in the currency of third country.3 Can the transaction between two countries be settled in a 3rd Country? Yes. However. If the Japanese exporter invoices his goods in Yen. at the option of drawee or holder thereof or any other party thereto. 1.e. either in Indian currency or in foreign currency or partly in one and partly in the other. as in this case. Such transaction may give rise to conversion of currencies at two stages. he would need exchanging US dollars for Yen. The American importer will pay the amount in US dollars. the transaction may give rise to exchange of currencies in the exporter’s country as well as the importer’s country.4 Foreign Exchange Market Page 5 of 100 . exporting goods to Singapore may raise an invoice for the goods sold in US dollars and as the importer in Singapore has to make payment in US dollars and as the importer in Singapore has to make payments in US dollars. exchange of currencies becomes necessary. 1. Thus.NMIMS FOREX EXPOSURE MANAGEMENT 2. 1. he will have to exchange his Singapore dollars into US dollars. The Indian exporter on receipt of US dollars will exchange them into Indian Rupees.

Commercial Banks Commercial banks dealing with international transactions offer services for conversion of one currency into another. in most of the countries. Also services may be required for settling any International obligations i. However. It does not have any geographic location. They deal with each other through telephones.. it is possible to access any trader in any corner of the world within a few seconds. it is a facilitating mechanism through which one country’s currency can be exchanged i. like an exporter or importer. e bought or sold for the currency of another country. and electronic systems. Central Banks The central banks. This is achieved by central bank’s intervention in the forex market. They are the most active players in forex market. the rate so fixed. Even under the floating exchange system the central bank has to ensure orderliness in the movement of exchange rates. Customers The customers who are engaged in foreign trade participate in foreign exchange markets by availing of the services of banks. payment of technical know-how fees or repayment of foreign debt etc.5 Participant of Foreign Exchange Markets Any one who exchanges the currency of one country for currency of another country or needs such services is said to participate in foreign exchange markets. If the country is following a fixed exchange rage system then the central bank has to take necessary steps to maintain the parity i. Apart from intervention the Central bank deal in the foreign exchange markets for the purpose of: • Exchange rate Management Page 6 of 100 .e.e. In fact now deal can be done through electronic dealing systems that allow bid and offer rates to be matched automatically through central computers and thus transaction take place in jiffy. telexes. The main players in the foreign exchange markets are: a. The foreign exchange market comprises of all the foreign exchange traders who are connected to each other throughout the world through telecommunication network... have been charged with the responsibility of maintaining the external value of the currency of the country. With advent of advanced technology like Reuters Money 2000-2. b. 1. c.NMIMS FOREX EXPOSURE MANAGEMENT Foreign Exchange market is in fact misnomer or misleading in as much as there is no market place as such which can be called foreign exchange market.

they deal in the market to achieve the desired objective. As the exchange controls have been loosened. influenced by the structure of official external assets/liabilities. Reserve Management Central Bank is predominantly concerned with investment of countries foreign exchange reserves in fairly stable proportions in range of currencies.NMIMS FOREX EXPOSURE MANAGEMENT Sometimes it is achieved thru the intervention yet where a Central Bank is required to maintain external rate of the domestic currency at a level or in a band so fixed. i. take positions. in London. Exchange Brokers In India dealing is done in inter bank market through forex brokers.e. and in a range of assets in each currency. if they feel that rate of a particular currency is likely to go up in short term then they buy currency and sell it as soon as they are able to make quick profits. The process of reserve management inevitably involves a certain amount of switching between currencies. However. in India also some of the big corporates are booking and canceling forward contracts and at times the same borders on speculative activity. Speculators Major chunk of the foreign exchange dealings in the forex market is on account of speculators and speculative activities.6 Types of dealing in the local Foreign Exchange Markets Page 7 of 100 . Similarly. inter-alia. These proportions are. The forex brokers are not allowed to deal in their own account all over the world and also in India. 1. in India the A Ds are free to deal directly among themselves without going through brokers. Corporations-MNCs & TNCs having business operations beyond their national frontiers and on account of their cash flows being large and in multi currencies get into foreign exchange exposures. Sometimes they take positions so as to take advantage of the exchange rate movement in their favor and for undertaking this activity they have state of art dealing rooms. With a view to take advantage of the exchange rate movements in their favor they either delay covering exposures or do not cover until cash flows materialize. Banks do the same in view to make profit on account of favorable movement in exchange rates. New York and Paris inter bank transactions are put through forex brokers. e. d. 1.

there is not much liquidity and depth in the foreign exchange market in India and the market notices even the small demand or supply. w. The banks in India are allowed to deal freely amongst themselves. This facility was available to residents only. Page 8 of 100 .7 Factors that contribute to the growth of Indian Forex Markets Global Forex market has taken quantum jump and the Indian market has followed suit. 1. Most of the banks are not market makers and rather they are market users. However. 1934. • Inter-Bank Transaction When one bank deals with another bank i. so called. Thus. freely. This transaction can be undertaken only on account of genuine exposure of the customers and speculation is prohibited. RBI has discontinued. the RBI has been invested with the right to intervene in the market as and when necessary and it intervenes in its wisdom it deems fit. • Overseas Transaction When a bank in India buys/sells foreign exchange in the overseas foreign markets then it is called an overseas transaction. buys/sells foreign exchange. RBI has also been intervening in the market through Spot. In fact RBI has been buying foreign exchange when there was excess supply in the market. RBI has also permitted banks on a selective basis to initiate positions overseas. RBI has loosened the grip further and allowed NRIs/FIIs also to book forward contract for certain accounts/investments by them in India.e.e. RBI is not obliged to sell foreign exchange but buys foreign exchange offered to it buy A Ds at market related rates. After Rupee has joined the freely floating currencies there are days when exchange rates in inter bank markets have been very volatile and RBI has been forced to intervene in the market almost on regular basis. Therefore. • Transaction between Banks and RBI After introduction of Modified Liberalized Exchange Rate Management System (Modified LERMS) and on account of amendment to Section 40 of RBI Act. the practice of announcing its two way exchange rates. These merchant can book. it is known as inter bank dealing. f Oct 4th 1995. The banks in India can cover its positions arising out of merchant transactions or inter bank dealings freely in overseas exchange market. Forward & Swaps quite often after the Rupee started floating. re-book. However. cancel forward contracts with Authorised Dealers with respect to their genuine foreign exchange exposure. particularly during such periods.NMIMS FOREX EXPOSURE MANAGEMENT • Merchant Transaction When authorized dealers buy/sell foreign exchange from/to exporter/importers and other customers then it’s called a merchant transaction.

banks have access to the inter bank markets for conversion of forex funds into Indian rupees and re-conversion of the same on a continuous basis has given the fillip in the market. It will gradually replace national currencies such as German Mark or the French Frank etc. Thus. to some extent. Rigid and tight exchange controls have been relaxed and the banks are completely free to deal in the inter bank market as also. The market also trades in exotic currencies like Middle East currencies. The average daily turnover in the spot market was around US$ 1. The average daily gross turnover in the dollarrupee segment of the Indian forex market (merchant plus inter-bank) was in the vicinity of US$ 3 billion during 1998-99.4-trillion in transactions daily. Reuters/Telerate system etc.3 billion.7 billion. SWIFT. The daily turnover in the merchant segment of the dollar-rupee segment of foreign exchange market was US$ 0. With limited integration of Indian and overseas forex markets. while turnover in the inter-bank segment was US$ 2. Pound Sterling(GBP). Italian Lira(ITL) etc. many more foreign banks have set up shops in India and those. Swiss Franc(CHF). have also contributed to the increased inter-bank dealings and consequently increase in the trading volume in the foreign exchange markets.. The EURO is a new single currency used by most of the nations of the Western Europe. Deutsche Mark(DEM). they are able to generate larger turnover. Euro will also play a major role as far trading in India in concerned. The Liberalised Exchange Rate Management System and freedom given to the corporates to book. have established more branches. albeit to a small extent. This has contributed to higher foreign exchange turnover. an access to the foreign currency assets and liabilities. The turnover in the Indian forex market has also been increasing over the years.8 billion during 1998-99.NMIMS FOREX EXPOSURE MANAGEMENT Better communication network like telephones. in the overseas market. which were already operating.2 billion and in the forward and swap market. Thus. French Franc(FRF). telexes. Banks have been allowed to have. With opening up of the banking sector to private sector more players have been added to the market. Also. Page 9 of 100 . Japanese Yen(YEN). • Growth of forex market over the years The forex market is the world's largest financial market. with $1. have been made available to the forex dealers and these have contributed to the speed and efficiency of the market. • Types of currencies traded in Indian Market The major currencies being traded in the Indian Forex market are US dollar. re-book and cancel forward contracts so long they have the genuine exposure. the daily turnover was US$ 1.

Authorisations have been given to certain financial institutions to undertake specific types of foreign exchange transactions incidental to their main business. are granted to banks. This. even Euro started as a stronger currency than USD and Australian Dollar is the commonwealth currency so it has to follow the path of GBP. we follow a direct exchange rate quote which gives the home currency price of a certain amount of the foreign currency quoted. or in any other manner as it deems fit. faces the risk that Page 10 of 100 . which is called the `indirect exchange rate quote'. the amount of foreign currency is fixed and the amount of home currency keeps varying with the change in exchange rate. who buys goods priced in foreign currency. banks in Great Britain quote the value of the pound Sterling in terms of the foreign currency. A traveler going to visit another country has the risk that if that country's currency appreciates against their own. • Authorised dealers in foreign exchange RBI may. as an authorised dealer. • Rupee quoted against Dollar In India. however. and also involves itself in matters of mutual interest of the Authorised Dealers. his revenue in terms of the Indian rupee. FEDAI also accredits brokers through whom the banks put through deals.e. which are also called `restricted authorised dealers'. Generally. • Activities that can possibly carry foreign exchange exposure Foreign exchange exposures arise from many different activities. authorise any person to deal in foreign exchange or in foreign securities. an exporter who sells his/her product in a foreign currency faces the risk that if the value of the Indian rupee appreciates vis-à-vis dollar. An importer.NMIMS FOREX EXPOSURE MANAGEMENT • FEDAI's role in the forex market Foreign Exchange Dealers Association of India (FEDAI) sets the ground rules for fixation of commissions and other charges. which are well equipped to undertake foreign exchange transactions in India. Euro and Australian Dollar is called indirect quote because GBP has always been stronger than USD. in the form of licenses. to deal in foreign exchange. on an application made to it in this behalf. their trip will be more expensive. nose-dives. Similarly. is not the only method of quoting the exchange rate. money-changer or off-shore banking unit. authorisations. i. The form of quoting Pound sterling.

• Authorised money-changers and the powers they are they vested with The Reserve Bank of India has empowered certain people. etc. thereby making the localcurrency cost of the imports greater than expected..e. subject to the condition that all such collections are surrendered by them in turn to an authorised dealer in foreign exchange/ full-fledged money-changer. i. they should not purchase or sell foreign exchange from/to the public. i. rather they are supposed to play the role of facilitators for undertaking the function of money changing. especially foreign tourists. the Reserve Bank of India has stated that there is no objection to employment of brokers. They are required to provide facilities for encashment of foreign currency to visitors from abroad. have the liberty to enter into a trade contract in whichever currency he or she desires? The Reserve Bank of India has not placed any restrictions on any foreign currency being chosen for trade purposes. shops. Exchange brokers are. hence. their principal as well as the brokers must comply with the requirement of the exchange control. full-fledged moneychangers who can undertake both purchase and sale transactions with the public. emporia. to deal in foreign currency. i. coins and travelers cheques. • Has the Reserve Bank permitted exchange brokers to operate in the foreign exchange market? Yes. exporter or any other person. i. and restricted money-changers who are authorised only to purchase foreign currency notes.e.e. freely convertible foreign currency. travel agents. They can be classified into two categories. an importer. They are not allowed to deal in foreign exchange. but the EXIM policy stipulates that all export contracts and invoices shall be denominated in permitted currencies only. • Does a customer.. subject to certain restrictions. but in all cases. Page 11 of 100 .e. not authorised to deal in foreign exchange on their own account. however.NMIMS FOREX EXPOSURE MANAGEMENT the rupee might depreciate against the dollar.

NMIMS

FOREX EXPOSURE MANAGEMENT

OVERVIEW OF FOREIGN TRADE
Any business is open to risks from movements in competitors' prices, raw material prices, competitors' cost of capital, foreign exchange rates and interest rates, all of which need to be (ideally) managed. These Risk Management Guidelines are primarily an enunciation of some good and prudent practices in exposure management. They have to be understood, and slowly internalised and customised so that they yield positive benefits to the company over time. It is imperative and advisable for the Apex Management to both be aware of these practices and approve them as a policy. Once that is done, it becomes easier for the Exposure Managers to get along efficiently with their task. The efforts of globalization of Indian economy have set a new pace to foreign trade. Further, the advent of economic reforms, liberalisation, deregulation & the process of opening up the economy to global players had a far-reaching impact on foreign trade. Capital flows across nations have registered a quantum leap with the removal of rigid exchange controls by many nations and the consequent increase in cross-border trade. The impact of these developments is visibly obvious in the developing nations. It can be observed that foreign trade constituting exports and imports were USD 46391 Mio in the year 1990-91 which increased to USD 73872 Mio in 1995-96 and subsequently to 107456 Mio in 1999-00. It is also encouraging that the exports now finance over 78 percent of imports compared to only about 60 percent in the latter half of the eighties. India’s export performance grew by 11.5 PA; almost double that of world exports which grew by 5.6 percent. Similarly, the quantified export growth was 20 percent in 1996-97, 18 percent in 1997-98 & 21 percent in 1998-99. Measured by all standards India’s foreign trade definitely entered as fast track in the new global trajectory. Therefore, the demands on Public Sector Banks (PSBs) too increased in the area of handling international trade and related services. While the expansion in economic activities in various other sectors could be handled by emerging new financial institutions and non-banking financial institutions, the requirements of foreign trade, international settlement of transactions, global funds transfer and other exotic services related to Foreign Exchange (FX) transactions need to be routed through the authorised dealers. Therefore, the pressure for service centers more on the selected authorised branches of PSBs and EXIM bank. But, on the other hand, the infrastructure to handle foreign trade in Public Sector Banks is growing at a lesser pace than the pace of growth of foreign trade, which often creates a vacuum impinging the quality of services. The attempt of PSBs to cope with growing demand is transparent.

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The opening of specialised FX desk in branches, the proliferation of dedicated overseas business branches, mechanisation of operations, introduction of new range of products/services etc. are certainly the manifestation of PSBs to meet the needs of increasing foreign trade entrepreneurs. These large increases in foreign trade by India are having its effects directly or indirectly on every organisations. The reduction of import duty tariffs is exposing domestic organisations to the global environment. Domestic organisations are now restructuring their business to take advantage of lower imports in order to produce more competitive finished goods. Similarly, reduced costs and incentives provided by the Government to promote exports attracts the domestic organisations to export trade. This new environment has forced the organisations to participate in foreign trade, which in turn has led them to face new foreign currency exposure. In the succeeding sections, we shall see more of M/s CSCIL, its policies for handling its Foreign Trade Exposures and other related matters of Foreign Trade, and managing of foreign exchange exposures.

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ORGANISATIONAL SET UP OF M/S CIBA SPECIALTY CHEMICALS INDIA LTD
1.8 Introduction M/s CSCIL was incorporated in the year 1975 on the 1st of July with an authorised Share Capital of 10000000 Equity Shares of Rs.100/- each amounting to Rs.10 Crore. Issued, Subscribed and Paid-up share capital amounted to Rest. 5 Cores made up of 500000 equity shares of Rs.100/each with 51% foreign stake. The Parent Company of Ciba Specialty Chemicals Inc. is based in Basle, Switzerland. It is a multi-segment; multi product range is now diversified into the following areas:
1. 2. 3. 4. 5.

Plastic Additives Coating Effects Water & Paper Treatment Textile Effects Home & Personal Care

With respect to the exposures in Foreign Currency, the Company has exposures in respect of:
1. 2. 3. 4. 5. 6. 7.

Imported Raw Materials & Capital Goods Exports Royalty Payments Technical Know-how Fees Commission in respect of Exports Dividend Remittance Income from Research & Development Services rendered

The figures for last 5 years in relation to imports & exports have been tabulated below and also presented graphically. It is observed that M/s CSCIL is a net importer and, therefore, its policy is based on imports. Exports are, therefore, considered as an internal hedge, subject to mismatches of maturity dates. It is important to note here that any adverse impact of rupee depreciation or devaluation will have a favourable impact on exports and vice versa. Now, moving onto a sound risk management policy vis-à-vis the policy of M/s CSCIL the following graph will make an attempt to understand how each of the above mentioned exposures are managed.

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48 97-98 36.Crores 95-96 22.52 97-98 89.49 89. CRORES Year 95-96 96-97 97-98 98-99 99-00 YEAR EXPORTS OF CSCIL IN THE LAST 5 YEARS Year Rs.13 Page 15 of 100 .NMIMS FOREX EXPOSURE MANAGEMENT IMPORTS OF CSCIL IN THE LAST 5 YEARS Year Rs.95 CSCIL EXPORTS.13 98-99 64.76 98-99 62.LAST 5 YEARS 22.23 96-97 20.LAST 5 YEARS 60 40 0 96-97 97-98 98-99 20 1 2 Year 95-96 99-00 RS.49 99-00 164.40 99-00 83.95 63.96 CSCIL IMPORT.52 95-96 96-97 97-98 98-99 99-00 64.97 96-97 63.Crores 95-96 15.97 164.

the USD vis-à-vis Rupee rate was rock steady at about Rs. However. USD suffered a setback of more than 20% between May 1994 to August 1994 against European currencies and Yen. it also depreciated by 20% against European currencies and Yen. but also due to Foreign Direct Investments (FDI) and Portfolio investments by Foreign Institutional investors. This was followed by huge inflow of foreign currency in the country. Indian Rupee first depreciated against USD by more than 20% and then recovered by about 7%. All this brings about the importance of active Forex management by Corporates. Also Corporates having exposure to other foreign currencies had to face the same. for a long time. This paper attempts to explain all the important parameters of active Forex management. during this period also. during a period of unprecedented steady Rupee against USD faced substantial volatility.45 for more than 30 months.15% against European currencies and Yen. It is broadly divided into five major sections viz: • • • • • Forex Management Policy Treasury Performance Evaluation Criteria Policy and Performance evaluation of derivative products Managing External Commercial borrowings Concept of Transfer Pricing Page 16 of 100 . USD has appreciated by a range of 10 . In the recent past alone. Therefore.31. Indian Rupee was continuously but steadily depreciating against major foreign currencies.NMIMS FOREX EXPOSURE MANAGEMENT 1. As a result. Up to 1992. The huge inflows were not only due to increase in exports. as steady decline of Indian Rupee was more or less matched by the forward cover premiums.9 Background Liberalisation of Indian Economy coupled with lowering of import tariffs on one hand and thrust on exports on other hand has resulted into significantly higher transactions denominated in foreign currency for many Corporates.40 . Thus. The year 1992 saw Indian Rupee being officially devalued by more than 10% in 8 days time. Indian Rupee is linked to other currencies through USD. Forex Management was relatively easier.

NMIMS FOREX EXPOSURE MANAGEMENT FOREX MANAGEMENT POLICY 1.in value will be brought to the notice of the Exposure Manager. It is the responsibility of the Exposure Manager to ensure that he receives the requisite information on exposures from various sections of the company in time. A detailed and well laid down policy should determine authority and responsibility of various people involved in the process. The process is followed sequentially as shown below: DEPT/ACTIVITY Purchase Dept/ Import Order Sales Dept/ Exporter Order DEPT/ACTIVITY Finance Dept/Forex Policy (Norms) Finance Dept/Forex Policy (Norms) EXPOSURE Forward Contract cover Full/Part Keep part or full exposure open RESULT Execution  of Order  Sales Realisation 1 2 It is absolutely essential that the import and export order should clearly state the currency. as finance people are more aware of forex risk and closer to bankers who offer forex hedging products as well as settle all forex transactions. It’s recommended that the exposure should be recognised with only on receipt of a complete import or export order. 1. shipment schedule. The first step in this direction is having a clear forex management policy. Variable / Cash Flows Contracted Foreign Currency Cash Flows Foreign Interest Rates.000/. Ideally. as soon as they are projected. The following cash flows/ transactions are considered for the purpose of exposure management. Corporate Finance should be responsible for Forex Management.10 Pre-requisites It is said that whatever gets measured gets managed better.11 Analysis These exposures will be analysed and the following aspects will be studied: Page 17 of 100 . payment terms etc. whether Floating or Fixed Cash Flows from Hedge Transactions Projected/ Contingent Cash Flows Transaction Type Both Capital and Revenue in nature All Interest Payments/ Receipts All Open hedge transactions Both Capital and Revenue in nature • • Cash Flows above $100.

treat the exposures separately. There are certain limitations of looking at Net Exposures: • The period of inflow and outflow may not match. net forex inflow against forex outflow. It should clearly state the risk the management is willing to take and the delegation of authority. therefore. all of them recommend a range between 25% to 75% for forward covers. 1.12 Concept of Gross Exposure and Net Exposure Some managements look at imports and exports separately and. It means that the values covered should never be below 25% of the exposure & not beyond 75% of the exposures.13 Framing a Policy Forex policy will reflect the management philosophy to the risk. • The currency of inflow and outflow may be different.how certain are the amounts and/ or value dates Inflow-Outflow Mismatches / Gaps Time Mismatches / Gaps Currency Portfolio Mix Floating / Fixed Interest Rate ratio 1.NMIMS FOREX EXPOSURE MANAGEMENT       Foreign Currency Cash Flows/ Schedules Variability of Cash flows . • Cancellation or postponement of an import or export order may result into substantial change in risk profile. A slightly different but more practical approach to this is shown below: a) Operational or Treasury Department Level: Page 18 of 100 . Practically. Some are more particular where some imports are made towards export order & therefore. The policies have been discussed followed by many Corporates and recommendations of leading forex consultants. This is the reason why exposure of imports and exports should be managed separately. to various people.

We will see this in our next section. Here there is a question.35% and/or somewhat aggressive Organisation For organisation who do not 25%-45% have a proper set up or those who are risk averse COVER (MAXIMUM) 65%-75% 55%-75% 1 2 Top Mangement’s decision should always be based upon input and recommendations of either the operations level management or Banks or Consultants. We will observe that the arithmetic mean of minimum cover and maximum cover is 50%.NMIMS FOREX EXPOSURE MANAGEMENT 1 COVER (MINIMUM) For professionally managed 35% and/or some what aggressive Organisation For Organisations who do not 45% have proper set up or those who are risk averse COVER (MAXIMUM) 65% 2 55% b) Top management level (Owner/Managing Director/ Head of Finance) COVER (MINIMUM) For professionally managed 25% . This is same as the probability of getting head or tail when we toss a coin. Page 19 of 100 . It should always be recorded in writing. Is there any logic in keeping the mean at 50%? The answer is Yes.

Most of the corporate exposures will be for this period. 3. Even among those. 2. Forex market has rarely responded to basic fundamental factors in short to medium terms. as this may result into total failure of the system or taking up of undue risk by the Treasury Manager. management expertise and corporate philosophy on risk taking in this area. This policy seeks to establish a sound and appropriate risk management process. In view of the above. 1. The second problem could be the efforts required to evaluate the performance. Rewards normally depend upon the risk one is taking.14 Performance Evaluation Criteria Very few organisations have an elaborate forex policy. which is even slightly above average. When USD started depreciating against Yen and European currencies in 1994-95. even intervention by 12 central banks of most powerful nations in the world could not arrest the dollar fall. Like any other market. capitalization and loss bearing capacity. These policies will help the institution in managing the impact of exchange rate/ interest rate fluctuations on its profit and loss account and its balance sheet. The foreign exchange policy is also based on and in consistency with the organization’s broader business strategies. Why? • • One major problem is that of a having reasonable and rational performance evaluation criteria. should be acceptable. forex is a zero sum game.NMIMS FOREX EXPOSURE MANAGEMENT 1. There are many large players trying to outperform each other. Forex business exceeds USD 1000 billion every day. Consider following factors: 1. Short to medium term refers to a period of 1 week to 6 months. A major factor could also be the fear of a bad performance. This issue is attacked first as it helps prepare ground for our recommendations towards the end of this section. it’s recommended that any performance. Its advised not to set very ambitious performance criteria. 4.15 Foreign Exchange Risk Management Policy of M/s CSCIL Importance: Any institution exposed to risk on account of foreign exchange exposure should maintain written policies and procedures that clearly outline its risk management strategy. very few have performance evaluation criteria. Page 20 of 100 .

1. the reporting and measurement in terms of exposure for risk management is adhered to. Responsibility for daily currency risk management activities is concentrated in a central Treasury Function. in detail the primary components of risk management process at CSCIL. the Corporate Treasurer defines the net position and gaps/maturity of the company. Responsibility for reporting risk exposures to senior management is with a unit independent of the treasury function to ensure that control and policy compliance objectives are met. In the light of the above. The senior management is responsible for ensuring that procedures exist is followed strictly for conducting transactions on a day-to-day basis.16 Risk Measurement Approach A sound risk measurement should identify ⇒ the various types of foreign exchange risks that the institution is exposed to (which has been listed in the earlier pages) ⇒ the point of recognition of these risks ⇒ the period of measurement. we shall study. Page 21 of 100 . Using these. monitoring and reporting risk. The Board of Directors has approved the Foreign exchange risk management guidelines.NMIMS FOREX EXPOSURE MANAGEMENT The primary components of the risk management process are: • A comprehensive risk management approach • A details structure of limits • Guidelines and other parameters used to govern risk management • A strong management information system for controlling. The Corporate Treasurer is responsible for defining and managing the net currency exposure and gaps or maturity mismatches of the company from the exposures and gaps of the various individual units of the company. Also.

3 24 0 Page 22 of 100 .17 Types of Foreign Exchange Risks A foreign exchange risk can be defined as the net effect of rate fluctuations on the Profit & Loss Account (P&L) and on the Balance Sheet position. In this context a foreign exchange risk impacting the P&L Account would arise on account of: 1 2 3 4 5 6 7 Imports of raw materials/exports of goods Availment of buyers/suppliers credits Sundry remittances of royalty/traveling expenses etc Principal amount of foreign exchange loan repayment Interest payments on outstanding foreign exchange loans Translation of financial statements of offshore branches/subsidiaries incorporated overseas Depreciation on fixed assets financed through foreign exchange loans A foreign exchange risk impacting the Balance Sheet (B/S) would be: ∗ ∗ Imports of fixed assets financed though foreign exchange loans Approvals for foreign exchange loans (loans pending draw-down) Also important to note is the risk on account of interest rate fluctuations in the case of loans/borrowings/lendings etc. These also need to be addressed by an institution as they can be optimally managed with the use of derivatives such as Interest Rate Swaps.NMIMS FOREX EXPOSURE MANAGEMENT 1. Income from Research and Development Amount PA (Rest in Mio) 1719 1631 3 0 2. Forward Rate Agreements etc.a. Volumes of foreign exchange exposures at CSCIL as at 31/03/01 are listed below: Nature of Exposures Imports Exports Royalty Technical Know How Fees Indent Commission Dividend @ 50% p.

a. therefore.NMIMS FOREX EXPOSURE MANAGEMENT Nature of Exposure Imports Exports Royalty Technical Know How Fees Indent Commission Dividend @50% p. M/s CSCIL recognises its exports and covers the same only on raising of import order in the case of imports and on receipt of a confirmed export order in the case of exports or on approval for foreign exchange loans. At the time of shipment of goods/draw down of loans IV. in Switzerland based on certain factors like dividend is paid at the rate declared on equity of the company and equivalent USD or CHF (Swiss Francs) is remitted. royalty and technical know-how fees to its parent company. the variations in the estimation of budgets may have a serious impact on the profitability of a company and. the same are recognised as and when they arise/on due dates.. M/s CSC Inc. At the time of Budgeting II. I. Similar is the case of technical know how fees and royalty remittances as the same are paid as a percentage on sales. Page 23 of 100 . 1. M/s CSCIL remits dividends. On due date of payment In order to be proactive in managing foreign exchange exposures. Basle. It is important to note here that certain foreign exchange remittances may not really involve risk to to the remitter. the company should also factor in that all budgeted items will not necessarily fructify. recognise a foreign exchange risk from the time of budgeting as this would be the earliest point in time where an exposure can be recognised.18 Recognition of Exchange risks There are recognise Income from Research theoretically a number of alternatives when a company should and Development the existence of a foreign exchange exposure. For example. Secondly. As regards its other exposures. However. At the time of raising import orders/receiving export orders/approvals of foreign exchange loans III.

3. Build internal control mechanism to control and monitor all the risks. 2. 4. these payments needs to be managed as it would yield better results or higher remittances to the Parent Company with a limited liability on M/s CSCIL. 1.NMIMS FOREX EXPOSURE MANAGEMENT However. Define a risk management policy for the organization and quantifying maximum risk that organization is willing to take if quantifiable. Measure the risks if quantifiable and enumerate otherwise. Page 24 of 100 . Understand the nature of various risks.19 Four Steps in Risk Management 1.

which is the risk of the Counter party not honouring its commitment because of the restrictions imposed by the government though counter party itself is capable to do so. The loss would be the difference between the original contract rate and the current rates. Settlement Risk 5. Dealing Risk 4. which arises when large positions in individual instruments or exposures reach more than a certain percentage of the market. If the Counterparty is situated in another country. Counter party Risk or Credit Risk This is the risk of loss due to a default of the Counterpart in honouring its commitment in a transaction (Credit Risk). this also involves Country Risk. 3. 5. instrument or issue. Price risk can increase further due to Market Liquidity Risk. Price or Market Risk 2. If the Counter party goes bankrupt on any day. Price Risks or Market Risk This is the risk of loss due to change in market prices. Settlement Risk Settlement risk is the risk of Counterparty defaulting on the day of the settlement. Operating Risks 1. Dealing risk is therefore limited to only the movement in the prices and is measured as a percentage of the total exposure. 4. Operating Risks Page 25 of 100 . all unsettled transactions would have to be redone in the market at the current rates. Dealing Risk Dealing Risk is the sum total of all unsettled transactions due for all dates in future. In addition the transaction would have to be redone at the current market rates. Such a large position could be potentially illiquid and not be capable of being replaced or hedged out at the current market value and as a result may be assumed to carry extra risk. Counter party or Credit Risk 3. The risk in this case would be 100% of the exposure if the corporate gives value before receiving value from the Counterparty.NMIMS FOREX EXPOSURE MANAGEMENT Step 1 – Understanding Risks Risks can be classified into five categories: 1. 2.

value date. termites etc. Further operating risks could be classified as under: • • • • • • Legal Regulatory Errors & Omissions Frauds Custodial Systems Legal Legal risk is the risk that the organisation will suffer financial loss either because contracts or individual provisions thereof are unenforceable or inadequately documented. currency. negligence and malfeasance. amount. Page 26 of 100 . and buy/sell side or settlement instructions. water. Frauds Some examples of frauds are: • • • • • Front running Circular trading Undisclosed Personal trading Insider trading Routing deals to select brokers Custodial Custodial risk is the loss of prime documents due to theft. This risk is enhanced when the documents are in transit. misunderstanding and confusion as to responsibility and authority. Regulatory Regulatory risk is the risk of doing a transaction. fire.NMIMS FOREX EXPOSURE MANAGEMENT Operational risk is the risk that the organization may be exposed to financial loss either through human error. which is not as per the prevailing rules and laws of the country. or through uncertainty. misjudgment. These may relate to price. or because the precise relationship with the counter party is unclear. Errors & Omissions Errors and omissions are not uncommon in financial operations.

Control of Operating Risk Establishment of an effective and efficient internal control structure over the trading and settlement activities. Modeling. Step 2 . Simulation. Diversification is used to reduce systematic risk in a given portfolio. Stress Testing.Risk Measurement There are a number of different measures of price or market risk which are mainly based on historical and current market values Examples are Value at Risk (VAR). incompatible system configurations. Cost Center Vs. or establishment of a great many diverse.Define Risk Policy Decide the basic risk policy that the organisation wants to have. Step 4. Revaluation. Profit Center A cost center approach looks at exposure management as insurance against adverse movements. Page 27 of 100 . as well as implementing a timely and accurate Management Information System (MIS). In a profit center approach.Risk Control Control of Price Risk Position limits are established to control the level of price or market risk taken by the organization. One is not looking for optimisation of cost or realisation but meeting certain budgeted or targeted rates. Most organisations would fall somewhere in between the two extremes. Back Testing. Step 3. Risk and reward go hand in hand. the business is taking deliberate risks to make money out of price movements. etc. which cannot be effectively linked by the automated transmission of data and which require considerable manual intervention. Control of Credit Risk Credit limits are established for each counter party for both Dealing Risk and Settlement Risk separately depending upon the risk perception of the counter party. or inability of systems to develop quickly enough to meet rapidly evolving user requirements. This may vary from taking no risk (cover all) to taking high risks (open all).NMIMS FOREX EXPOSURE MANAGEMENT Systems Systems risk is due to significant deficiencies in the design or operation of supporting systems.

NMIMS

FOREX EXPOSURE MANAGEMENT

Tools to control operating risks
• • • • • • • • • • • •

Comprehensive Systems and Operations Manuals Proper Organizations structure and adequate personnel Separation of trading function from settlement, accounting and risk control functions. Strict enforcement of authority and limits Written confirmation of all verbal dealings Voice recording Legally binding agreements with counter parties ensuring proposed transactions are not ultra vires. Contingency Planning Internal Audits Daily reconciliations Ethical standards and codes of conduct Dealing discipline

1.20 Possible performance evaluation criteria at M/s CSCIL: 1. Spot rate on settlement date Actual rate of remittance is compared against spot rate on settlement date. As a result, performance of uncovered transactions is “Average” or “0” in mathematical terms. Thus, only performance of covered transactions gets reflected in this type of evaluation. Moreover, throughout the exposure period, there is no target for the Treasury Manager. 2. Forward rate on date of exposure In this method, “Forward Rate” quoted for the expected date of settlement is taken as standard for evaluation of performance. Since this rate is known from day one, there is certainly a target for the Treasury Manager. However, in this case, performance of covered transactions will be “0” or average. Thus, only performance of uncovered transactions gets judged. Therefore, this method is also not desirable. Both the above methods suffer from one major limitation. They have no reference to the forex policy of the organisation. To elaborate, in case of 1st method, if the rupee is not expected to depreciate to the extent of premium, the Treasury Manager would like to keep all the import transactions uncovered and cover all the export transactions.

Page 28 of 100

NMIMS

FOREX EXPOSURE MANAGEMENT

Similarly, when he expects rupee to depreciate beyond the premium levels, he would like to cover all the import transactions and keep open all the export transactions. What one must find out is whether the policy permits taking such steps? Can a policy afford to be so flexible? If not, then a Treasury Manager has no authority to take such extreme positions. And when he cannot take position as per his views, can he be made responsible for that position? To take a concrete example, if we are following: Method 1: Treasury Manager will incur loss on covered transaction for imports (and uncovered export transactions), if rupee is steady vs. premium. Since the policy requires certain minimum cover, Treasury Manager will attribute the losses to the policy. Method 2: Similarly, if we are following this method and say Rupee depreciates beyond premium, the Treasury Manager will incur loss on uncovered import and covered exports. Again he will attribute it to policy. In short, f the Treasury Manager cannot take a decision to keep uncovered 100% transactions or cover 100% transactions; he cannot be expected to perform as per either Method 1 or Method 2. Therefore, a more practical method is recommended. Method 3: 50% at forward rate on date of exposure and 50% at settlement date rate, for each transaction. This method has following advantages: I) For 50% of the amount of each transaction, there is a clear target, while for remaining 50%, the Treasury Manager will have to be really alert, watchful and use his knowledge and experience of market. In method 1, performance of uncovered items does not get evaluated, while in method 2, performance of covered item does not get evaluated. However, in method 3, performance of both covered and uncovered transactions gets evaluated (though only to the extent of 50%). Normally any policy will allow taking cover up to 50% and keeping 50% open. Therefore, Treasury Manager will have full authority to reach a position, which is in line with performance measurement criteria. Therefore, he cannot attribute anything to rigid forex policy.

II)

III)

In view of the above, I am of the opinion that method III is most balanced and acceptable way of performance evaluation.

Page 29 of 100

NMIMS

FOREX EXPOSURE MANAGEMENT

An imaginary but realistic situations have been taken and the performance is calculated under various methods. The results of the same are given in the annexure. I am sure that the example clearly brings out limitation of the first two methods and advantages of method III. 1.21 Concept Transfer Pricing Some company’s follow the concept of transfers pricing for forex transactions viz. imports and exports. In this concept, the operating divisions and Finance agree on a budget rate of exchange at the beginning of a period, generally a financial year. During the whole year, the transactions are passed on to the divisions at the agreed transfer price rate. The difference between actual rate and transfer price is borne by Finance Department. According to advocates of this concept, it helps operating divisions to meet the budgeted targets, as they are assured of a certain rate for forex. However, there is a major practical difficulty in this concept. Suppose for 1997-98, we have agreed on a transfer price @ 1 USD = Rs.37/-. Let us assume that some divisions are importing finished goods costing USD 10 per kg. The product is sold in the market at Rs.400/- per kg. Now, suppose the USD/Rupee rate goes to Rs.41/- by June 1997. If the division still continues to import the material (as it can get USD at Rs.37/- being agreed rate with Finance), the division will make a profit of Rs.30/- per kg. Finance losses will be Rs.40/- per kg. The Company as a whole will lose Rs.10/- per kg. Is this situation acceptable? The reality is that operating or business divisions must accept that there could be changes in cost of inputs or sales realisation due to changes in exchange rate. As a matter of fact, can some one guarantee purchase or sale price even for local materials? Just because there is an added element of exchange rate fluctuation, business divisions cannot pass it on entirely to finance. The best way to handle this kind of situation is to have a continuous communication between Finance and business divisions. Depending on level of forex business, Finance Division should send weekly or fortnightly information about spot and forward rates for major currencies to business divisions. Based on this, business divisions should take their decisions and inform the exposure to Finance as early as possible. In exceptional cases, if there is any large import or export order with a very small margin, business division may insist on 100% cover specifically. Such requests should be accepted by Finance. However, in such cases, there should be no performance evaluation of such transactions, as the forward cover was business decision and not a finance decision.

In summary, it’s recommended that:

Page 30 of 100

23 Net Position Using these above criteria the Corporate Treasurer defines the new position if the Company. exposure up to 1 year or till the financial year-end. 1. as recommended that an exposure should be recognised at the time of budgeting. The period of measurement should coincide with the budgeting period. Statistically. There has to be performance measurement criteria. Transfer pricing concept should be avoided as far as possible. The policy should be reviewed every year. the company distinguishes between the USD/INR and the cross currency exposure for every item independently as the local market in India determines the USD/NSR rate only and the cover on any other currency is possible through its cross with USD/INR. However.22 Period of Measurement An institution would also need to define the time period over which exposure must be managed.24 EXHIBIT-1: FOREX RATES & EXPOSURES 23-Oct-2001 0915 hrs 25-Oct-01 Currency Inter Spot 1 month 1 month 2 month 3 month 3 month 6 month Page 31 of 100 . it’s shown in the exhibit below: 1. For example. III) 1. giving weightage to both forward rate on date of exposure and spot rate on settlement date. the FOREX risks are measured to a period of 1 year. specific covers for large transactions may be taken as a business decision.NMIMS FOREX EXPOSURE MANAGEMENT I) II) there should be well laid down forex policy. For this purpose. In case of CSCIL. The General Manager Finance to the Managing Director reports the net position on a weekly basis. This differentiation is important as it enables the company to match or offset exposures effectively and the hedging strategy for the crosses would be different as compared to that of the USD/INR. However. separately for imports and exports.

S. 21 1.04 49. 96 1.66 29 .45 29 . Dollar Euro Deutsche Mark Jap.50 3 . 50 1. 39 43. 22 42. 57 24. 89 0. 81 26. 08 6. an import payment for USD 100. 06 6. 99 42.4 4 2. 62 43. 48 4. 20 48.05 0.26 19 . 37 3. 01 68.000 for the value 15th through the money market or through Foreign Exchange forward markets. 07 6. 66 30. 24 19. 60 2. 91 3. 19 2. 16 5.1 3 3. 07 28.86 39 .06 0. 87 67. 47 2.04 0. 65 3.7 9 42.09 0. 19 43. 61 2.05 0. 58 21. 49 2.171.05 0. 24 19.7 8 28.05 0.04 0. 78 4. 34 1.09 6 .25 MATURITY MISMATCH OR GAPS By using the above criteria.05 0. 16 39. 49 24. This gap can be closed out by doing a “Swap” where the Institution buys USD 100. 72 26. 33 22. 85 26.06 0.0 5 6.04 0. 66 22. 97 48 . 54 24. 47 24.05 0.02 0. 83 26.69 69 . 54 69.05 0.05 0.NMIMS FOREX EXPOSURE MANAGEMENT Bank TT buy % TT Sell TT buy TT Sell premia TT buy TT Sell TT buy TT Sell % premia TT Buy U. 24 3. 63 4.0 6 4. 25 1.07 0. 74 26. 19 122.42 40 . 47 1.89 31 . For e.1 3 48. 32 30. 51 2.87 26 . 39 69. 17 5.02 3 . 07 6.7 3 67. 05 6. 15 5.44 42 .04 0. 81 47.51 4 . Yen (100) Swiss Franc Pound Sterling Belgian Franc French Franc Italian Lira (100) Dutch Guilder Canadian Dollar Austrian Schilling Danish Kroner Singapore Dollar Swedish Kroner Australian dollar 99 89 47.04 48.05 0. 0.2 6 21.59 25 . 90 3. 67 0.75 1 . 23 7. 08 5. 25 19.7 0 26. 32 40. 22 1.93 4 .05 0.09 0. 64 1. 36 29. 77 39.04 0. 63 69. 08 6. 83 10. 36 2. 20 4.4 6 24. 15 40.05 0. the Corporate Treasurer defines the gaps of the Company in USD/INR and the crosses.04 0. 66 2.1 8 19.. 85 29. 49 22. though the company does not have any net foreign exchange position.000 for value 1st and sells USD 100.45 1 .84 22 .84 43 . 43 45.0 7 5.05 0.19 5 . A gap reflects a mismatch between the maturity dates and inflows and outflows thereby creating an interest rate differential risk.1 8 30.g.04 0. 45 69. 55 29.37 48 . 15 43. 20 19.21 19 . it has a maturity mismatch. Page 32 of 100 . 47. 52 1. 83 26. 55 24. 66 30. 57 24. 98 4. 74 30. 66 1. 58 15.04 0.68 2 .04 0.04 0.04 0. 19 19.06 6 . 63 2. 43 8.52 2 .7 4 1. 29 48.05 0.04 0. 25 30. 24 39.6 1 38.11 5 . 15 29.76 21 . 03 1. 32 22.51 24 . In this case. 77 3.40 30 . 36 4. 41 21.76 26 . 09 5. 69 39.000 may be due on the 1st of the month and an export payment for the same amount would be receivable of the 15th of the same month.16 68 . 58 29. 15 5. 81 30. 25 19.

02.98 121524. Exhibit 2 & 3 are sorted on due dates to find out Maturity Mismatches or Gaps and the same are covered separately.71 329610 Page 33 of 100 .03.03.98 22.12.02.99 22.12.03.22 36. Like wise when an import order is issued in favour of some supplier.24 36.99 36.2 and the relevant data is completed from information available from the export order.02.12.99 4318321.99 24.99 165000021.2: EXPORT OPEN ORDER-(AS ON DD\MM\YY) PYMN T TYPEPO NO PO DATE SHIPMENT BANK STATUS FC TERM 21B 21B 21B 21B 21B 121120.98 121221.02. the same is entered in Exhibit No.32 43428000 26.99 304021.03.99 6375021.99 23.98 21.99 BNP BNP ANZ ANZ ANZ DR/UR DR/UR DR/UR DR/UR DR/UR CHF CHF CHF CHF CHF C/X FC AMT BUG SET BUDGTD BUDGTD DATE RATE AMT X X H H X 2478021.02.03.98 24.33 553337 26.2 represents the reporting system of exports.98 121322.99 4200021. FOREX EXPOSURE EXHIBIT.99 25.NMIMS FOREX EXPOSURE MANAGEMENT We shall see now how the exposures are reported to the General Manager Finance in case of exports and imports.12.12.02.46 36.03.12.98 21.99 22.98 121423.99 15450321.92 37.65 84056 27.02. When a confirmed export order is received the same is entered in Exhibit No.12.99 23.98 21.99 8400021.03.14 1599633 2324325 1564088 1550640 3119760 EXHIBIT-3 : IMPORT OPEN ORDER(AS ON DD\MM\YY) PYMT TYPEPO NO PO DATE SHIPMENT BANK STATUS FC TERM 21B 60B 90B 90B 90B I-1211 I-1212 I-1213 I-1214 I-1215 20.99 1189521.12.03.99 24.03. Exhibit No.02.12.3.49 4092784 27.99 BNP BNP BNP BNP BNP EX/1111 USD EX/1112 USD EX/1113 USD EX/1114 USD EX/1115 USD C/X FC AMT BUG SET BUDGTD BUDGTD DATE RATE AMT C X X C C 4414021.03.99 22. The specimen of these formats is listed below.98 23.99 25.12.02.02.

H-Hedged FC: Invoice in Foreign Currency Amt BUD SETT DT: Forecasted Settlement Sate BUD RATE: The forward rate for that duration as quoted in the PO recd date BUD AMT: (FC Amt X Budgeted Rate) ACUTAL RATE: Actual Rate ACUTAL AMT: (FC Amt X Actual Rate) PERFORMANCE : Difference between Budgeted & Actual Page 34 of 100 . O-Others. E-Exposed. UR-under retirement FC: Foreign Currency C/X: C-covered. G-group Companies PO No: Purchase Order No PO Date: Purchase Order Number PO Recd: Date of which the order reaches the Treasury Shipment: Shipment Date Bank: Thru which Order was settled Status: DR-document received.NMIMS FOREX EXPOSURE MANAGEMENT NOTE: Pymnt terms: Payment term of the order Type: B-Basle.

27 Individual Dealer Limits • Type of foreign exchange products that can be dealt. Each dealer should have a limit on the size of any individual deal. • Deal size limit. The foreign exchange policy as approved by the Board of Directors should define the following limits: 1. Different dealers may have different deal size limits. 2. Page 35 of 100 .NMIMS FOREX EXPOSURE MANAGEMENT STRUCTURE OF LIMITS The Foreign Exchange Policy should clearly outline the limits of all foreign exchange positions and gaps of the country. 1. Total open gap position limit for the Company. The overall limits in the case of M/s Ciba Specialty Chemicals India Limited are fixed at 80% to 120% of total exposure. The policy should not only define the personnel authorised to engage in foreign exchange business but also outline who will be authorised to deal in what type of foreign exchange products . For example the dealers may only be allowed to engage in outright purchases or sales of foreign exchange but all foreign exchange option transactions are done by the Corporate Treasurer and Interest Rate or Currency Swaps may be done subject to senior management approval. Each dealer can have a different limit based on his experience and expertise. These limits on risk taking must be decided bearing in mind the risk profile of the company and the quantum of capital the company is willing to put a risk on account of movements of exchange rates. • Position and gap limit of each authorised dealer.26 Overall Limits Total open position limit for the company either as a percentage of net position or as a fixed limit based on capital adequacy. The Direct Hedge PLUS Internal Hedge should at no point of time of time exceed 120% of total exposure. Hence a cascading structure of limits for all type of foreign exchange products is to be outlined for: • • • Senior Management (Managing Director/Vice President) Corporate Treasurer Dealers 1.

Page 36 of 100 . The Board of Directors approves an Increase in the total open position or open gap position of the company. the policy also outlines the reporting and approval hierarchy for all types of limit excesses by the dealers or Corporate Treasurer based on the quantum of excess.NMIMS FOREX EXPOSURE MANAGEMENT The policy also defines the hierarchy for approval of temporary increases/changes in limits. Similarly.

However in the long run it proposes to fix such limits on the budgeted rate on the day the exposure arises. CSCIL has its import exposures in CHF and export exposures in USD. However. whereas net USD/FCY could continue to be covered 100%. Conversely.. In order that this negative effect is contained the company should define “Stop-Loss” limits for all open positions. when import orders are placed or export orders are received or foreign currency loans are availed of. “Take-Profit” limits should also be defined to enable the company to crystallise gains on profitable open positions. the company could stand to lose should the market not move in the anticipated direction. USD 5 million. it covers only USD / Rest and covers CHF/USD either subsequently or on spot depending on circumstances/market rates. Page 37 of 100 . This strategy could. CSCIL has not yet defined its “stop-loss” or “take-profit” limits and its policy is purely based on the overall limits. the company may cover only 50% of net import exposures in USD/INR. For example. Hence.e. The company should as far as possible match offsetting exposures prior to taking cover. the company may leave some portions of their foreign exchange exposure or gaps open with the aim of capitalising on certain anticipated market movements. i. this may result in a gap or a maturity mismatch. 1. save the company the cost of USD/INR discounts. the company should decide the extent of total foreign exchange exposures and gaps that the Central Treasury may keep open either as a percentage of its total exposure.28 HEDGING The company may cover all exposures for forward maturities as they arise. Hence the company would need to close out these gaps by doing Swaps. This would result in increased cost of imports or lower realisation of exports. However.29 PASSIVE RISK MANAGEMENT The company can choose to cover selectively and progressively based on its view of individual currency movements.g. in some circumstances. The stop-loss limit should be defined based on the quantum of money the company is willing to risk on its open position. The company may also follow a policy of keeping a certain pre-defined percentage of their exposures covered. Secondly. or as a fixed limit. However.NMIMS FOREX EXPOSURE MANAGEMENT GUIDELINES FOR RISK MANAGEMENT One of the following strategies may be adopted for the management of currency exposures: 1. in imports. when the company matches offsetting exposures. for e.

• Stop-Loss Limits for all open positions. this activity should be carried out after adequate internal approval (Board –approved). due to Exchange Control restrictions “Active Risk Management” is curtailed to the extent possible within documentation constraints and against underlying open exposure. The objective of the Corporate Treasurer is managing forex exposure and minimising losses due to fluctuations at CSCIL. Therefore.30 ACTIVE RISK MANAGEMENT In addition to the above mentioned risk management strategies. Risk Management Policy is obtained and with an appropriate degree of internal control. but to cover risks. CSCIL is in no way in favor of Active Risk Management. This activity should then be viewed as an additional product line or profit center. or as a quantum of money at risk per trader per day/month. However. Even though realised Gains/Losses are accounted as a separate profit center the objective is not profit making. This includes: • Persons authorised to create risk positions and the spot position limit and gap limit of each trader so authorised.NMIMS FOREX EXPOSURE MANAGEMENT 1. Page 38 of 100 . either as a percentage variance of the exchange rate. the company may also decide to trade in the currencies in which it has underlying exposures and hence an existing need to manage exchange risk. • Total open position limits and gap limits for the company at any given point in time. or total money at risk limit across these activities. It should also be noted that.

Exchange Gains or Losses at M/s CSCIL are classified under the following account heads: 1. loans. Realised Gains/Losses . 2. In the case of passive & active risk management. the company also assigns a budget rate or target rate to its exposures as and when they arise.Third Party Realised Gains/Losses . exports. The performance or the portfolio is then to be measured against these budgeted rates by comparing the market rates prevailing at which the exposure can be covered against the budgeted rate. This rate can be the forward value of the exposure on the day the exposure is recognised.Cancellations Page 39 of 100 . In order to achieve this. 3. there may be trading positions where the budgeted rate would be the rate at which the position was initiated as this would also be valued at prevailing market rates (also known as Market-to-Market).NMIMS FOREX EXPOSURE MANAGEMENT VALUATIONS OF FOREIGN EXCHANGE EXPOSURES The company makes an analysis of the performance of its foreign exchange portfolio in order to value at current market rates the cost of its imports.Inter Company Realised Gains/Losses . etc.Forward Covers Realised Gains/Losses .. which is calculated by adding the premium amount to the spot value of that currency. Accounting for the effects of changes in foreign exchange rates may be done in accordance with the Accounting Standards 11(revised) issued by the Institute of Chartered Accountants of India. and thus measure the impact of exchange/interest movements on its Balance Sheet and Profit & Loss Account on a monthly basis. 4.

Internal Audits addresses the functioning of the Central Treasury. D E C T N O R O . S U R Y ) ( T G . M E A . ORGANOGRAM of M/s Ciba Specialty Chemicals India Limited EFFECTIVE COMMUNICATION INCREASES PRODUCTIVITY Case Study : Ciba Specialty Chemicals (I) Ltd. The Settlements Department monitors positions of the dealers and any excesses of any limits are to be reported directly to the senior management.NMIMS FOREX EXPOSURE MANAGEMENT INTERNAL CONTROLS The Institution needs to monitor open positions and stop loss limits on a continuous basis and evaluate periodically the performance of the foreign exchange portfolio. M A N ( M I S ) A N A A T ) M A N A G E R M A N A G E R E X E C U T IV E S E X E C U T IV E S S T A F F S T A F F Page 40 of 100 . O D I R R & E C T G D O I R R S A M .F I N A G N C E R A M G ( T R . T I O N ) S R . M ( S T M A N A ( S T A T ) G E R . on a weekly basis. M T R O G E R S L R & A / C 'S A ) G E R F R D O N T O F F I C E C K B A E A L E R S S U P P O S F F I C E E R V I C E S R . adherence to policy & operational risks. This is counter checked by an Independent Settlements Departments. The Board of Directors also reviews the portfolio performance periodically. The Central Treasury reports. the open positions and open gaps to Senior Management as represented in Exhibit 1 . The foreign exchange portfolio is marked to market at least once a week and a valuation report (cross checked by Settlements) is sent by the Corporate Treasurer to Management . ( C O N G . M A X A .

1 SOME BASIC CONCEPTS The fundamental reason why foreign trade benefits an economy is the so-called principle of comparative advantage. receipt and payments on account of all the three components make the “Balance of Payments” of the country. Since BOP is always balanced the balancing is done thru Foreign Exchange Reserve of the country. The principle of comparative advantage is easy to understand. efficiency of producing goods and services’ in other words. costs or technology. If the receipt under the 3 components i. aids. It obviously makes economic sense for the lawyer to hire a stenographer and devote all his time to working as a lawyer as his comparative advantage. Let us assume that as a lawyer he can earn Rest. banking.31 BALANCE OF PAYMENT 1.The 3rd component of balance of payment is grants. It is customary to classify a country’s external receipts and Page 41 of 100 . 1. 50/. and not absolute. as the relative efficiencies would surely differ in practice. 5000/. then international trade can be beneficial to all the countries. say one year. foreign investment etc falls under Capital Account. These receipts and payments could be of account on account of import and export of goods and the difference on this account is known as ‘balance of trade. Incidentally the BOP of a country is always balanced. Balance of Payments of a country is systematic records of all receipts and payments between residents of the country with non-residents of the country over a period of time. we are referring to relative.NMIMS FOREX EXPOSURE MANAGEMENT 1. even if a country is the most efficient producer of all the goods and services it needs it will still benefit by engaging in international trade. obviously lies in working as a lawyer. If different countries concentrate on providing products and services in which they have comparative advantages arising out of differences in resources. e goods. the question of external receipts and payments has to be considered. given the earnings and expenses. insurance etc are also added to that of goods then the difference on this account is known as ‘balance on current account.’ 3. services and capital account are less than the payments then the BOP of the country is said to be negative or adverse. The classic textbook example is that of a person who happens to be both the best lawyer as well as the best stenographer in the city. It is a known factor that international trade benefits an economy.Per Hour while he can hire a stenographer[who may not be as good as himself] at say Rest. Remember. If receipt and payments on account of import and export of services like tourism.Per Hour.’ 2. Thus..31.

81 percent. transportation and insurance. export commissions. 1. Conventionally. research income. 1.2 Trade flows Strong economic growth of economy in 1995-96 resulted in widening of the trade deficit to USD 8. 1.32. lubricants] imports decline by 4 percent during April November 1996 as against an increase of 36 percent last year’s. This was reflected in non-pol [petroleum. 1. trade in physical goods is distinguished from trade-in services. It is expected that this trend would continue as a moderate rate at the rate of [20] percent in 1996-97.Current Account and Capital Account. resulting in narrowing of the trade deficit.3 Invisibles Invisibles have maintained a rising trend in recent years. on account of steady increase in private transfer receipts. It is expected that the trade for 1996-97 would be between 7. Invisibles comprise current international payments for items other than merchandise exports or imports. The third category falling under BOP is the Reserve Account.1 Current account The Current Account in turn.32.5 to 8 bn. Trade flows & 2.66 percent.4 Deficit & Surplus Meaning of Deficit and Surplus in BOP Page 42 of 100 . interest. It is customary to report imports on CIF basis and exports on FOB basis for calculating the trade balance. Some of the more important items under the head [invisibles] comprising travel. Invisibles Of the two trade flows comprising exports and imports of goods is easier to understand.9 bn. oil. high interest rates and an overall liquidity squeeze in the corporate sector through second half of 1996 saw growth taper off rapidly. Trade flows and invisibles together comprise the current account of a country and the difference give the current account surplus deficit.32 Components of Balance Of Payments: 1.NMIMS FOREX EXPOSURE MANAGEMENT payments under two broad headings. dividend payments and other miscellaneous income and expenditure. indenting commission. However.32. is split under two heads 1.32. The difference between the two is commonly referred to as the surplus or deficit trade balance. exports showed slightly higher growth at 7. whereas imports till November were up by 4.

Below the line (this net balance should be equal in magnitude but opposite in sign of the balance above the line). 3. Need to optimally group various accounts within BOP statement so as to give proper signals to the authorities to correct disequilibrium. there is a BOP deficit). 12. They 6. An accommodating transaction (below the line) is undertaken with a view to settle the imbalance arising out of other transactions. 2. BOP is a double entry accounting record and hence must balance except for errors and omissions. in response to given configuration of price.g. exchange rate. This means a transaction undertaken for its own sake. it is a mixture. then there is BOP surplus and if negative. etc. The items below the line are "compensatory" in nature. Some degree of ambiguity is inevitable. 11. "finance or settle" the imbalance above the line. For e. Division of entire BOP into set of accounts a. Exports and imports of goods / services. it is an accommodating transaction in the second case an autonomous while in the third. interest rate. Government borrowing from World Bank may be used to finance the deficit on other transactions or to finance a public sector project or a combination. 8. As such deficit or surplus refer to subsets of accounts included in BOP. b.NMIMS FOREX EXPOSURE MANAGEMENT 1. and usually to realize profit / reduce cost. The transactions above the line are "autonomous transactions". Above the line (if the net balance is positive. several concepts of "balance " have evolved: • Trade Balance: This is the balance on the merchandise trade account. In the first case. 7. financing the deficits arising out of autonomous transactions. 9. migrant workers remittances. 10. 5. Page 43 of 100 . private sector capital flows. These are imbalances or economic disequilibria. Difficulties in deciding what is autonomous and what is accommodating. It does not take into account situation elsewhere in the BOP. unilateral gift are all clear cases of autonomous transactions. Sale or purchase of foreign exchange to engineer certain movements in exchange rate is clearly an accommodating transaction. BOP deficit or surplus is understood to mean deficit or surplus on all autonomous transactions taken together. 4. As such.

17. 19.32. b. discrepancy in valuation and timing. Relevance of BOP Statistics and Decision Making 14. Currency risk hedging possible with forward markets 1. Signal of policy shift by the monetary authorities either unilaterally or with the trading partners. • Current Account Balance: This is the net balance on the entire current account. These are group together under this heading. The idea is short term capital flows are volatile but long term capital flows are of a more permanent nature and are indicative of the under laying strengths and weaknesses of the economy. excludes private transfers and investment income). The balance Page 44 of 100 . the importer bears the risk and vice versa.their accentuation or reversal. some other items are subject to errors arising out of data inadequacy.NMIMS FOREX EXPOSURE MANAGEMENT • Balance on goods and services: This is the balance between exports and imports of goods and services (in the current account. Continuing current account deficit may lead to tax incentives. excess demand over supply or otherwise for the currency. c. Data for successive months can give an indication of trends . More often. 16. 13. • Balance on current account and long-term capital (also known as basic balance): Indicates long-term trends in the BOP. A country facing current account deficit may resort to raise interest rates to attract short-term capital inflows to arrest depreciation of the currency. Who bears exchange risk? a. external investments or disinvestments. both bear the risk. Errors and omissions While changes in reserve assets are accurately measured and recorded. If invoice is in exporter's currency.5 Capital Account Transfers on capital account include external borrowings or payments of external borrowings. Impact on the exchange rates in the short term. 18. US Dollar. errors in reporting. BOP reflects 15.

Page 45 of 100 .NMIMS FOREX EXPOSURE MANAGEMENT of current account and capital account together will result in the country’s reserves of foreign exchange going up or down correspondingly. A current account deficit may be combined with a higher capital account surplus and therefore reflect as an addition to the country’s reserves of foreign exchange. In macro economic and national accounting term the current account is a mirror image of the difference between domestic savings and domestic investments. The current account deficit or surplus of a country can also be looked at in another way. On the other hand if the domestic savings are insufficient to finance the domestic investments a deficit on current account would result and would need to be financed either through a draw down of reserves or by external borrowings. If domestic savings exceed the domestic investments then a surplus on current account will result.

In most currencies there are futures or forward exchange contracts whose prices give firms an indication of where the market expects currencies to go. that exchange risk is diversifiable.NMIMS FOREX EXPOSURE MANAGEMENT The Management of Foreign Exchange Risk 1. based on the nature of the exposure and the firm's ability to forecast currencies. the Japanese company.33 OVERVIEW (a) Goals Exchange risk is the effect that unanticipated exchange rate changes have on the value of the firm. and what methods are available to measure currency exposure? Second. on assets and liabilities. Yet from this simple question several more arise. forwards and futures. for they may be offset by positions taken elsewhere in the firm. And not just gains or losses on current transactions. than perhaps it's a non-risk. what exchange risk does the firm face. if an individual owns a share in Hitachi. Finally. whose gain or loss? Clearly not just those of a subsidiary. What counts. This chapter explores the impact of currency fluctuations on cash flows. If it is. in other words. and options. for the firm's value consists of anticipated future cash flows as well as currently contracted ones. which of the various tools and techniques of the foreign exchange market should be employed: debt and assets. what hedging or exchange risk management strategy should the firm employ? And finally. First. risk is not risk if it is anticipated. so proxies have to be used. The chapter concludes by suggesting a framework that can be used to match the instrument to the problem. The academic evidence linking exchange rate changes to stock prices is weak. (b) What is exchange risk? Exchange risk is simple in concept: a potential gain or loss that occurs as a result of an exchange rate change. For example. and on the real business of the firm. he or she will lose if the value of the yen drops. First. is shareholder value. Three questions must be asked. yet the impact of any given currency change on shareholder value is difficult to assess. And these contracts offer the Page 46 of 100 . modern finance tells us. Moreover the shareholder who has a diversified portfolio may find that the negative effect of exchange rate changes on one firm is offset by gains in other firms.

futures and options. Finally.34 SHOULD FIRMS MANAGE FOREIGN EXCHANGE RISK-HOW? Many firms refrain from active management of their foreign exchange exposure. investors themselves can hedge corporate exchange exposure Page 47 of 100 .NMIMS FOREX EXPOSURE MANAGEMENT ability to lock in the anticipated change. they say that the firm does not have any exchange risk because it does all its business in dollars (or yen. It has been argued. These and other issues justify a closer look at this area of international financial management. They make this decision for a number of reasons. that the firm cannot improve shareholder value by financial manipulations: specifically. in the tradition of the Modigliani-Miller Theorem. as speculative. imprecision should not be taken as an excuse for indecision. But as in many business situations. and we should not be gambling on currencies. Saying like "we are in the business of manufacturing slot machines. All transactions such as imports or exports are covered. First. they say that the firm is hedged. They consider any use of risk management tools. they assert that the balance sheet is hedged on an accounting basis-especially when the "functional currency" is held to be the dollar. But a moment's thought will make it evident that even if you invoice Japanese customers in dollars. So revenues are influenced by currency changes. Fourth. so that transactions hedging is a very incomplete strategy. but refusing to use forwards and other instruments may expose the firm to substantial speculative risks. This ignores the fact that the bulk of the firm's value comes from transactions not yet completed. Third. So perhaps a better concept of exchange risk is unanticipated exchange rate changes. even though they understand that exchange rate fluctuations can affect their earnings and value. Or they argue that such financial manipulations lie outside the firm's field of expertise. and foreign subsidiaries finance in local currencies. management does not understand it. 1. they claim that exposure cannot be measured. Second." Perhaps they are right to fear abuses of hedging techniques. when the Yen drops your prices will have to adjust or you'll be undercut by local competitors. They are rightcurrency exposure is complex and can seldom be gauged with precision. such as forwards. or whatever the home currency is). But is there any economic justification for a "do nothing" strategy? Modern principles of the theory of finance suggest prima facie that the management of corporate foreign exchange exposure may neither be an important nor a legitimate concern.

usually referred to as the International Fisher Effect. markets. taking maximum advantage of interest subsidies and minimizing the effect of taxes and political risk. It follows that anything that reduces the probability of Page 48 of 100 . cannot borrow as much. Yet there are deeper reasons why foreign exchange risk should be managed at the firm level. better known as Purchasing Power Parity (PPP).NMIMS FOREX EXPOSURE MANAGEMENT by taking out forward contracts in accordance with their ownership in a firm. The assessment of exposure to exchange rate fluctuations requires detailed estimates of the susceptibility of net cash flows to unexpected exchange rate changes. and the relevant technologies. Managers do not serve them by second-guessing what risks shareholders want to hedge. and create a variety of operating and investment problems. be diversified away provided again. This reasoning is buttressed by the likely effect that exchange risk has on taxes paid by the firm. Modern research in finance supports the reasoning that earnings fluctuations that threaten the firm's continued viability absorb management and creditors' time. However. because interest is tax deductible whereas dividends are not. it can. The resulting variability of net cash flow is of significance as it can subject the firm to the costs of financial distress. It is generally agreed that leverage shields the firm from taxes. deviations from PPP and IFE can persist for considerable periods of time. especially at the level of the individual firm. To the extent that foreign exchange risk represents unsystematic risk. entail out-of-pocket costs such as legal fees. of course. These conditions include the relationship between prices of goods in different markets. perhaps one that does not hedge exchange risk. in all but the most perfect financial markets. that investors have the same quality of information about the firm as management-a condition not likely to prevail in practice. But the extent to which a firm can increase leverage is limited by the risk and costs of bankruptcy. the firm has considerable advantages over investors in obtaining relatively inexpensive debt at home and abroad. A riskier firm. The same argument supports the importance of corporate exchange risk management against the claim that in equity markets it is only systematic risk that matters. and between interest rates and exchange rates. Another line of reasoning suggests that foreign exchange risk management does not matter because of certain equilibrium conditions in international markets for both financial and real assets. or even default. including under investment in R&D. Furthermore. One counter-argument is that transaction costs are typically greater for individual investors than firms. Operating managers can make such estimates with much more precision than shareholders who typically lack the detailed knowledge of competition.

with financing decisions and with income earned in foreign currencies. Purchasing Power Parity & The International Fisher Effect Exchange rates. which have import for the nature of corporate foreign exchange. which relates the forward exchange_rate-to-exchange_rate expectations. & (3) the unbiased forward rate theory. 1. Though it is difficult to forecast the exact time of change or change on a particular day. The exchange rate forecasts help to: 1. shareholders benefit from hedging. exchange rate forecast are very useful in planning long-term investments. interest rates and inflation rates are linked to one another through a classical set of relationships. It is also important for a forex manager to understand the intricacies and the limitations of forecasting foreign exchange rates as it helps them to utilize the alternate avenues to manage exchange rate risk. These relationships.NMIMS FOREX EXPOSURE MANAGEMENT bankruptcy allows the firm to take on greater leverage. 4. the available forecasts are accurate enough to forecast direction and magnitude of change in longer term. 3. Hence. 2. and so pay less taxes for a given operating cash flow. which ties interest rate differences to exchange rate expectations.35 Economic Exposure. they must themselves devise appropriate hedging strategies. Corporate management of foreign exchange risk in the traditional sense is only able to protect expected nominal returns in the reference currency. These relationships are: (1) the Purchasing Power Parity Theory. Analyze attractiveness of foreign borrowings Plan investments in foreign countries Plan long term export-import strategy Manage exchange rate risks and plan hedging strategies Page 49 of 100 . risk. which describes the linkage between relative inflation rates and exchange rates. there is one task that the firm cannot perform for shareholders: to the extent that individuals face unique exchange risk as a result of their different expenditure patterns. (2) the International Fisher effect.36 Foreign Exchange Forecasting Forecasting foreign exchange rate is important for forex management as it reduces the uncertainties associated with commitments to accept or to make payments in foreign currencies with short-term and long-term investment decisions. along with two other key "parity" linkages. 1. However. If foreign exchange hedging reduces taxes.

37 Historical perspective on exchange rate. Currency is paper and authorities standing ready to convert unlimited amount of paper currency into gold and vice versa at fixed conversion ratio. 3. 1. Perfectly flexible or floating. Stable and predictable exchange rates 2. Money supply in country must be tied to the amount of gold held by monetary authorities in reserve. They must fix rate of conversion of paper money issued by them into gold. 2. a number of hybrids with varying degrees of flexibility. Built in anti-inflationary bias – no reckless expansion of money supply 3.37. They must ensure free flow of gold between countries on gold standard. • Exchange Rate Regime : Refers to mechanism. procedure and institutional framework for determining exchange rates at a point of time and changes in the same over a period of time including the factors. which induce the changes. at a fixed rate. 3. Between the two extremes. Perfectly rigid or fixed exchange rates. • Monetary authorities must obey three golden rules 1. 2.NMIMS FOREX EXPOSURE MANAGEMENT 1. • Two extremes of exchange rate regimes 1. the paper currency issued by them into another paper currency of different country operating on gold specie or gold bullion standard. Politically difficult to administer 5. • Pros and cons of gold standard regimes 1. Limping gold standard Page 50 of 100 .1 Gold standard • Oldest system till world war 1 • Gold specie standard : Actual currency in circulation consisted of gold coins with fixed gold content. • Gold exchange standard : Authorities standing ready to convert. Imposes very rigid discipline 4. Gold standard • Exchange Rate : Is the value of one currency in terms of another. • Gold bullions standard : The basis of money remains a fixed rate of gold.

25 other countries follow suit. • Fall in domestic money supply and hence deflation. 7. Britain restored gold standard at end of world war-I but finally abandoned in 1931.38 Features of Exchange Rate System • US Government commitment to convert dollars freely into gold at US dollars 35 per Oz.2 Definition of Arbitrage A transaction in which one buys something for a given sum of money and after going through one or more buy / sell transactions. 1. when faced with prospect of massive gold outflow Interwar instability and Bretton Woods.37. ends up with a larger sum of money than what was spent at the beginning. which had to be financed by export of gold.NMIMS FOREX EXPOSURE MANAGEMENT 6. Change over from fixed exchange rates to fluctuating exchange rates. • Fall in imports by USA and consequent trade deficits by European countries. allied powers.3 Bretton Wood’s System • 1944: Near end of Word War II. If authorities suspend the free convertibility of paper currency into gold. 1. Page 51 of 100 . • Fall in currency values and finally UK decides to quit gold standard. • Birth of International Monetary Fund (IMF) and World Bank 1.37. • Exchange rate regime put in place can be characterized as gold exchange standard (in 1968 it became limping gold exchange standard). • Stock market crash in late 20’s pushing USA into recession. it is called limping gold standard. • Other members countries of IMF agreed to fix the parities of their currencies vis-à-vis the dollar with variation within 1% on either side of central permissible parity. Interwar period : • Break down of gold standard. thus realizing an arbitrage profit without exposure to any risk. UK and USA took up the task of thorough overall of international monetary system.

War ravaged Europe and Japan economies were being rebuilt. • Thus. Result : Loss of faith in ability of the US to convert dollars into gold.1 Collapse of Bretton Woods System (1944 to 1971) • Triffin Paradox : Bretton Woods System depended on dollar performing its role as key currency. Page 52 of 100 .10 % could be made without the consent of IMF while larger changes with IMF’s approval. Countries other than US had to accumulate dollars to make payments. US had to run BOP deficits. US Government undertook obligation not to change value of 1. 1. • US gold stock inadequate to honor convertibility commitments.39 Floating Exchange Rate System • Original proponent was Milton Friedman (1953). • Parity of currency against the dollar could be changed in case of “fundamental disequilibrium”. • US finally abdicated its role as anchor of world monetary system and era of floating exchange rates starts. • 1944 to 1960 US deficits were moderate.NMIMS FOREX EXPOSURE MANAGEMENT • Should the exchange rate hit either of the limits. monetary authorities of the country obliged to “defend” its own currency through buy / sell of dollars to any extent required to keep the exchange rate within the limits. Bretton Woods introduced “adjustable” rate system in place of “fixed rate (equal to gold standard)” system. This is theoretical. • In freely floating exchange rate situation.38. • Member countries of IMF allowed to borrow from IMF to carry out interventions. • Changes up to +/. • dollar. no effort is made by the authorities to influence current value and future evolution of exchange rate. the country repeatedly faces BOP disequilibrium and has to constantly intervene and either buy or sell dollars. • Abortive attempt to salvage the system by means of series of parity realignments dollar devaluation in terms of gold and widening bands around central parities. Hence. • 1960s saw rising BOP deficits of USA. • Fundamental disequilibrium : when at a given exchange rate. • Relative price of currency determined by demand and supply and authorities make no attempt to hold exchange rate.

• Financial market meant for capital transactions open to all participants.42 Mixed System • Some transactions are subject to fixed rate while others are subject to market determined floating rates.NMIMS FOREX EXPOSURE MANAGEMENT In practice interventions (managed or dirty floats) so as to smoothen out short terms fluctuations or force the rate towards a particular target value. Pegged to a single currency (dollar or Euro) or currency basket like SDR. • Change in parity in a year is subject to sub ceiling say not more than 8. • To effect changes in gradual and plant banner rather than abrupt or unpredictable manner (seen in floating rate system). 1. • 1. Combinations between the two exchanges • IMF classifies exchange arrangements under 3 heads 1. Market forces 3. 1. 1. • Brazil and Portugal have adopted in past. • Commercial market meant for current account transactions allowed to be operated by “authorized dealers”.33% of variation per month. Page 53 of 100 . relative inflation rates and moving average of past spot rates.43 Exchange Rate Arrangements • Exchange rate of any currency settled in many ways: 1. • Motive is to control capital flows. • Belgium (1955 to 1990) operated current account transactions at fixed rate and capital flows at floating rate.41 Crawling peg (gliding parities) • Replaces the abrupt parity changes with gradual modification with permissible variations around parity in a narrow band (usually) +/-1 %. • Parity changes carried out based on set of indicators like current account deficit.40 Objectives of Limited Flexibility System • To introduce flexibility into fixed rate system. Administered by Central Bank 2.

because arbitragers will take advantage of such situations until price differences are eliminated.3 trillion. The International Fisher Effect (IFE) states that the interest rate differential will exist only if the exchange rate is expected to change in such a way that the advantage of the higher interest rate is offset by the loss on the foreign exchange transactions. 6. East Asia melt down is expected to be temporary phase and on the whole this trade will compensate for loss of intra-European trade. but the most common representation links the changes in exchange rates to those in relative price indices in two countries.45 Mechanics Of Exchange Rate The Purchasing Power Parity (PPP) theory can be stated in different ways. in the absence of trade restrictions changes in the exchange rate mirror changes in the relative price levels in the two countries. Conclusion : Over 90% transactions are financial or speculative. World Trade of Services (1997) = US $ 1. 3. This "Law of One Price" leads logically to the idea that what is true of one commodity should be true of the economy as a whole--the price level in two countries should be linked through the exchange rate--and hence to the notion that exchange rate changes are tied to inflation rate differences. 4. US dollars remains most traded currency in market and involved in 87% of world transactions. Managed or independently floating. 2. 1. 7. World Merchandised Exports in 1997 = US $ 5. At the same time. Trade with emerging markets will boom. With introduction of Euro.44 Market Size 1. 8. 3. Flexibility limited against single currency (Danish Krone against Euro). 5.3 trillion. Rate of change of exchange rate = Difference in inflation rates The relationship is derived from the basic idea that. under conditions of free trade.NMIMS FOREX EXPOSURE MANAGEMENT 2. prices of similar commodities cannot differ between two countries. 1. Geographical spread from Tokyo to West Coast of USA. intra-European trading will die. This International Fisher Effect can be written as follows: The expected rate of change of the exchange rate = The interest rate differential In practical terms the IFE implies that while an investor in a low-interest country can convert his funds into the currency of the high-interest country Page 54 of 100 . Daily Foreign Exchange Transaction Volume > US $2 trillion.

is made relevant by these "temporary deviations. The Unbiased Forward Rate Theory asserts that the forward exchange rate is the best. strategic commitments. or. And returns on equity will also reflect required rates of return. Therefore. due to the relationship between rates of devaluation and inflation differentials. we can summarize the impact of unexpected exchange rate changes on the internationally involved firm by drawing on these parity conditions." Page 55 of 100 . because of contractual. the unbiased forward rate theory suggests that locking in the forward exchange rate offers the same expected return as remaining exposed to the ups and downs of the currency -.NMIMS FOREX EXPOSURE MANAGEMENT and get paid a higher rate. On the liability side. it can be expected to err as much above as below the forward rate. Given sufficient time. significantly. it would seem that a firm operating in this setting will not experience net exchange losses or gains. his gain (the interest rate differential) will be offset by his expected loss because of foreign exchange rate changes. The "expected" rate is only an average but the theory of efficient markets tells us that it is an unbiased expectation--that there is an equal probability of the actual rate being above or below the expected value. and. This is simply the principle of Purchasing Power Parity and the Law of One Price operating at the level of the firm. these factors will also neutralize the impact of the changes on the value of the firm . these equilibrium conditions rarely hold in the short and medium term. competitive forces and arbitrage will neutralize the impact of exchange rate changes on the returns to assets. the cost of debt tends to adjust as debt is repriced at the end of the contractual period. However. its management. reflecting (revised) expected exchange rate changes. more importantly. The theory is grounded in the efficient markets theory.on average. and an unbiased. and is widely assumed and widely disputed as a precise explanation. estimate of the expected future spot exchange rate. The unbiased forward rate theory can be stated simply: The expected exchange rate = The forward exchange rate Now. Finally. in a competitive market these will be influenced by expected exchange rate changes. the essence of foreign exchange exposure. In the long run.

Unfortunately. this approach yields data that frequently differ from those relevant for business decision-making. at risk.both by decision makers as well as students of exchange risk -. equipment. This issue has been clouded by the fact that financial results for an enterprise tend to be compiled by methods based on the principles of accrual accounting. that is. Their core assets consist of inventories... real assets (as compared to paper assets) are not labeled with currency signs that make foreign exchange exposure analysis easy. have. only a relatively small proportion of their total assets in the form of receivables and other financial claims. and the ongoing cash flow effects which are referred to as economic exposure. Clearly. namely future cash flows and their associated risk profiles. Non-financial business firms. not equities. as a rule. the location of an asset in a country is an all too fallible indicator of their foreign exchange exposure. (a) Exposure in a simple transaction Page 56 of 100 . however. and in what way. This reminder is necessary because most commonly accepted notions of foreign exchange risk hedging deal with assets. such time your assets in the currency in which they are denominated" applies in general to banks and similar firms. Some basic concepts are mentioned here to make the present chapter self-contained. In other words. fixed income claims.e. or rather the value of their assets. often closely related to technological capabilities that give them earnings power and thus value. is much more difficult: the identification of the nature and magnitude of foreign exchange exposure.NMIMS FOREX EXPOSURE MANAGEMENT 1. The task of gauging the impact of exchange rate changes on an enterprise begins with measuring its exposure.46 Identifying Exposure The first step in management of corporate foreign exchange risk is to acknowledge that such risk does exist and that managing it is in the interest of the firm and its shareholders. Most importantly. considerable efforts are expended -. As a result. i. special purpose buildings and other tangible assets. referred to as accounting or translation exposure. or value. on the other hand. the amount. Unfortunately. The focus here is on the exposure of non financial corporations. Both concepts have their grounding in the fundamental concept of transactions exposure. The relationship between the three concepts is illustrated in the Exhibit 2.e.to reconcile the differences between the point-in-time effects of exchange rate changes on an enterprise in terms of accounting data. they are pertinent to (simple) financial institutions where the bulk of the assets consists of (paper) assets that have with contractually fixed returns. i. identifying what is at risk. The next step.

However. However. While this traditional analysis of transactions exposure is correct in a narrow. i. the essential assets of non financial firms have non contractual returns. they can be shielded from losses with relative ease through cash payments in advance (with appropriate discounts). when the exchange rate changes. Most commonly the problem arises when an enterprise has foreign affiliates keeping books in the respective local currency. what are involved here are simply foreign currency assets and liabilities. Thus. it could have arisen in and of itself through independent foreign borrowing and lending. unless unexpected exchange rate changes have a systematic effect on credit risk. revenue and cost streams from the production and sale of their goods and services which can respond to exchange rate changes in very different ways. (b) Accounting Exposure The concept of accounting exposure arises from the need to translate accounts that are denominated in foreign currencies into the home currency of the reporting entity. it becomes apparent that the exchange risk results from a financial investment (the foreign currency receivable) or a foreign currency liability (the loan from a supplier) that is purely incidental to the underlying exports or import transaction.e.NMIMS FOREX EXPOSURE MANAGEMENT The typical illustration of transaction exposure involves an export or import contract giving rise to a foreign currency receivable or payable. With returns from financial assets and liabilities being fixed in nominal terms. it is really relevant for financial institutions. In doing this. only. While income statements of foreign affiliates are typically translated at a periodic average rate. or via the use of forward exchange contracts. through the factoring of receivables. On the surface. when analyzed carefully. whose value is contractually fixed in nominal terms. the value of this export or import transaction will be affected in terms of the domestic currency. For purposes of consolidation these accounts must somehow be translated into the reporting currency of the parent company. a decision must be made as to the exchange rate that is to be used for the translation of the various accounts. balance sheets pose a more serious challenge. To a certain extent this difficulty is revealed by the struggle of the accounting profession to agree on appropriate translation rules and the Page 57 of 100 . formal sense.

Method 1. Alternatively. and which are. are translated at the historical exchange rate.47 Method Followed By US Companies Over time. Non-monetary items in the balance sheet. with instantaneous adjustment. A comparative historical analysis of translation rules may best illustrate the issues at hand. Accordingly. translated at the historical rate. 1. each method can be identified by the way in which it separates assets and liabilities into those that are "exposed" and are. The current/non current method of translation divides assets and liabilities into current and non-current categories. and those whose value is deemed to remain unchanged. therefore. the exchange rate used to translate balance sheet items depends on the valuation method used for a particular item in the balance sheet. this translation method has become outmoded. items carried at historical cost are to be translated at the historical exchange rate. This is equivalent of what is known in economics as the Law of One Price. A similar but more sophisticated translation approach supports the so-called Temporal Method. such as tangible assets. Here.NMIMS FOREX EXPOSURE MANAGEMENT treatment of the resulting gains and losses. it is to be translated using the current exchange rate. These four methods differ with respect to the presumed impact of exchange rate changes on the value of individual categories of assets and liabilities. if an item is carried on the balance sheet of the affiliate at its current value. Supporting this method is the economic rationale that foreign exchange rates are essentially fixed but subject to occasional adjustments that tend to correct themselves in time. As a result. Under the monetary/non-monetary method all items explicitly defined in terms of monetary units are translated at the current exchange rate. Thus.. this method synchronizes the time Page 58 of 100 . U. Method 3. translated at the current rate. Method 4. with subsequent changes in the international financial environment.S. only in a few countries is it still being used. i. using maturity as the distinguishing criterion. regardless of their maturity.e. The underlying assumption here is that the local currency value of such assets increases (decreases) immediately after a devaluation (revaluation) to a degree that compensates fully for the exchange rate change. Method 2. This assumption reflected reality to some extent. However. therefore. only the former are presumed to change in value when the local currency appreciates or depreciates vis-à-vis the home currency. companies have followed essentially four types of translation methods. the rate prevailing on the date of the balance sheet.

when "current value accounting" is used. Thus. translation rules do not take account of the fact that exchange rate changes have two components: Page 59 of 100 . translation--however sophisticated--will not redress this original shortcoming. accounting data reveals very little about the ability of the firm to change costs. More importantly. that is. As long as foreign affiliates compile balance sheets under traditional historical cost principles. the temporal method gives essentially the same results as the monetary/non-monetary method. prices and markets quickly. the lack of current value accounting frustrates the best translation efforts. At best. a purchase or a sales contract. Regarding the 1st method. such obligations are shown as contingent liabilities. Translation rules do not distinguish between expected and unexpected exchange rate changes. Alternatively. many of the perceived problems had their roots not so much in translation. it must be recognized that normally. accounting values of assets and liabilities do not reflect the respective contribution to total expected net cash flow of the firm.NMIMS FOREX EXPOSURE MANAGEMENT dimension of valuation with the method of translation. Because of the historical cost principle. will not be booked until the merchandise has been shipped. for example. The 2nd method surfaced in our discussion of the temporal method: whenever asset values differ from market values. commitments entered into by the firm in terms of foreign exchange. Critique of the Accounting Model of Exposure Even with the increased flexibility users of accounting information must be aware that there are three system sources of error that can mislead those responsible for exchange risk management: 1. then the temporal method calls for the use of the current exchange rate throughout the balance sheet. the firm may be committed by strategic decisions such as investment in plant and facilities. 3. Accounting data do not capture all commitments of the firm that give rise to exchange risk. Such "commitments" are important criteria in determining the existence and magnitude of exchange risk. when accounts are adjusted for inflation. but in the fact that in an environment of inflation and exchange rate changes. Finally. 2. However.

What is much more difficult. is to gauge the impact of an exchange rate change on assets with non-contractual returns. The most Page 60 of 100 . i. Contractual versus Non-contractual Returns An assessment of the nature of the firm's assets and liabilities and their respective cash flows shows that some are contractual. some of which seem to be at variance with frequently used ideas in the popular literature and apparent practices in business firms.NMIMS FOREX EXPOSURE MANAGEMENT 1." 3. factors. for trading and manufacturing firms at least. & a revaluation of traditional perspectives such as "transactions risk. to the extent that maturities (actually. Such returns. fixed in nominal. While conventional discussions of exchange risk focus almost exclusively on financial assets. This thumbnail sketch of the economic foreign exchange exposure concept has a number of significant implications. the basic rationale for corporate foreign exchange exposure management is to shield net cash flows. the firm is concerned only about net assets or liabilities denominated in foreign currency. monetary terms. earnings from fixed interest securities and receivables. & 1. with respect to financial items. and the negative returns on various liabilities are relatively easy to analyze with respect to exchange rate changes: when they are denominated in terms of foreign currency. the real goods and services. and thus the value of the enterprise. there are implications regarding: 1. the role of forecasting exchange rates in the context of corporate foreign exchange risk management. buildings and inventories make the decisive contribution to the total cash flow of those firms. real estate. or "captive" finance companies in order to leave banking to bankers and instead focus on the management of core assets!) And returns on such assets are affected in quite complex ways by changes in exchange rates. such assets are relatively less important than others. however. "durations" of asset classes) are matched. Thus. the question of whether exchange risk originates from monetary or non-monetary transactions. for example. Indeed. 2.e. (Indeed companies frequently sell financial assets to banks. from unanticipated exchange rate changes. their terminal value changes directly in proportion to the exchange rate change. expected changes that are already reflected in the prices of assets and the costs of liabilities (relative interest rates). Specifically. equipment.

NMIMS FOREX EXPOSURE MANAGEMENT essential consideration is how the prices and costs of the firm will react in response to an unexpected exchange rate change. Page 61 of 100 . For example. if prices and costs react immediately and fully to offset exchange rate changes. the firm's cash flows are not exposed to exchange risk since they will not be affected in terms of the base currency.

invoice in German marks. prices and costs move inversely to spot rate changes. in turn. and have DM-denominated receivables. the currency in which the accounting records are kept. but Page 62 of 100 . they occur in greater amounts. and is. are determined by competitive conditions. The currency of determination refers to revenue and operating expense flows. tend to be determined in U. In the example in the previous section. even while denominated in local currency. dollars. the firm may contract.NMIMS FOREX EXPOSURE MANAGEMENT Currency of denomination versus currency of determination One of the central concepts of modern international corporate finance is the distinction between the currency in which cash flows are denominated and the currency that determines the size of the cash flows. In the very short run.but not exactly. The functional currency concept introduced in FAS 52 is similar to the "currency of determination" -. dollars! This occurs because DM-prices for each consecutive shipment are adjusted to reflect world market prices. it does not matter whether. respectively. through the choice of invoicing currency. These patterns depend not only on the products involved. However. As a result. even though payments are made in local currency. If foreign exporters do not provide price concessions. is yet another matter. the functional currency concept pertains to an entity as a whole. as a matter of business practice. However. however. and physically collect DM cash flow. which are beyond the immediate control of the firm. that a firm selling in export markets may record assets and liabilities in its local currency and invoice periodic shipments in a foreign currency and yet. the currency of recording. To complicate things further. therefore. The significance of this distinction is that the currency of denomination is (relatively) readily subject to management discretion. less precise. Prices and cash flows. be invoiced in. and pay for each individual shipment in its own local currency. the cash flow. any debt contracted by the firm in foreign currency will always be recorded in the currency of the country where the corporate entity is located.S. In reality. the cash outflow of the importer behaves just like a foreign currency cash flow. It is possible. therefore. over a longer period of time. that is. For example. if prices in the market are dominated by transactions in a third country. Yet an additional dimension of exchange risk involves the element of time. the cash flows received may behave as if they were in that third currency. To illustrate: a Brazilian firm selling coffee to West Germany may keep its records in cruzeiros. this price adjustment process takes place over a great variety of time patterns. virtually all local currency prices for real goods and services (although not necessarily for financial assets) remain unchanged after an unexpected exchange rate change. the value of its legal obligation is established in the currency in which the contract is denominated. only to find that its revenue stream behaves as if it were in U. is determined by the relative value of the foreign currency. the tendency is for Purchasing Power Parity and the Law of One Price to hold.S. which.

1. The treasurer is not sure whether the short-term debt should be hedged. though. or what currency to issue long term debt in. Thus. or foreign direct investment. the nature of competition. and a number of other factors.48 EXPOSURE . the official currency unit of the European Community. A further implication of the time-frame element is that exchange risk stems from the firm's position when its cash flows are. at least one of these reactions is possible within a relatively short time.NMIMS FOREX EXPOSURE MANAGEMENT also on market structure. Exhibit 6 summarizes the firm-specific effects of exchange rate changes on operating cash flows. at other times the firm is "locked-in" through contractual or strategic commitments extending considerably into the future. those firms that are free to react instantaneously and fully to adverse (unexpected) rate changes are not subject to exchange risk. government policies such as price controls. generalizations remain difficult to make. Conceptually. rather than the risk resulting from any specific international involvement. for shipment to Germany and other continental European countries.TYPES AND DESCRIPTION WHAT IS ECONOMIC EXPOSURE? Economic exposure is tied to the currency of determination of revenues and costs. Indeed. Considerable work has been done on the phenomenon of "pass-through" of price changes caused by (unexpected) exchange rate changes. but working capital required to pay local salaries and expenses has been financed in Dutch guilders. The Netherlands. because all the factors that determine the extent and speed of pass-through are very firm-specific and can be analyzed only on a case-by-case basis at the level of the operating entity of the firm (or strategic business unit). the Venezuelan state-owned oil company. for a significant period. How the treasurer will source long term financing ? In the past all long-term finance has been provided by the parent company. The firm planned to invoice its clients in ECU. general business conditions. exposed to (unexpected) exchange rate changes. recently set up an oil refinery near Rotterdam. Sometimes. companies engaged purely in domestic transactions but who have dominant foreign competitors may feel the effect of exchange rate changes in their cash flows as much or even more than some firms that is actively engaged in exports. it is important to determine the time frame within which the firm cannot react to (unexpected) rate changes by: (1) raising prices (2) changing markets for inputs and outputs and/or (3) adjusting production and sales volumes. M/s PDVSA. imports. This is Page 63 of 100 . And yet.

Page 64 of 100 . WHAT IS TRANSACTION EXPOSURE? Transactions exposure has to do with the currency of denomination of assets like accounts receivable or payable.NMIMS FOREX EXPOSURE MANAGEMENT an example of a situation where the definition of exposure has a direct impact on the firm's hedging decisions. the firm must project its cost and revenue streams over a planning horizon that represents the period of time during which the firm is "locked-in. This is because the currency of determination is the U. If the ECU rises against the dollar. So financing should definitely not be done in Dutch guilders. PDVSA-Netherlands has contractual. It must then assess the impact of a deviation of the actual exchange rate from the rate used in the projection of costs and revenues. ECU-denominated assets that should be financed or hedged with ECU. PDVSA must adjust its ECU price down to match those of competitors like Aramco. Since the world market price of oil is dollars.49 MANAGING ECONOMIC EXPOSURE (a) Economic Effects of Unanticipated Exchange Rate Changes on Cash Flows From this analytical framework. Estimation of planning horizon as determined by reaction period. First of all. some practical implications emerge for the assessment of economic exposure. WHAT IS TRANSALATION EXPOSURE? Translation exposure has to do with the location of the assets. PDVSA-Netherlands does not have exposure to the ECU. In this case it would be a totally misleading measure of the effect of exchange rate changes on the value of the unit. For future sales. Economic exposure is tied to the currency of determination of revenues and costs. PDVSA can and should raise prices to keep the dollar price the same. dollar. After all. this is the effective currency in which PDVSA's future sales to Germany are made.50 STEPS IN MANAGING ECONOMIC EXPOSURE 1. has no import. Ex : Once sales to Germany have been made and invoicing in ECU has taken place. but neither determine the currency of revenues. 1. be it a refinery in Rotterdam or a tanker en route to Germany. the oil comes from Venezuela and is shipped to Germany: its temporary resting place. Clearly the currency of determination is influenced by the currency in which competitors denominate prices.S. since competitors would do likewise. If the dollar rises against the ECU. however. 1." or constrained from reacting to (unexpected) exchange rate changes. Both provide value added.

Finance managers who focus exclusively on credit and foreign exchange markets may easily miss the essence of corporate foreign exchange risk. regardless of whether they invoice in their own or in the foreign currency. How quickly can the firm change sources for inputs and markets for outputs? Or. three questions capture the extent of a company's foreign exchange exposure. Estimation of expected revenue and cost streams. Decision on trade-off between arbitrage gains vs.NMIMS FOREX EXPOSURE MANAGEMENT 2. 5. Choice of appropriate currency for debt denomination. To what extent do volume changes.multi-national corporation the net exposure may not be very large at all because of the many offsetting effects. the effects on the various cash flows of the firm must be netted over product lines and markets to account for diversification effects where gains and losses could cancel out. 10. wholly or in part. and production. 6. For a multiunit. associated with unexpected exchange rate changes. the executives within business firms who can supply the best estimates on these issues tend to be those directly involved with purchasing. given the expected spot rate. exchange risk stemming from exposure in markets where rates are distorted by controls. 3. enterprises that have invested in the development of one or two major foreign markets are typically subject to considerable fluctuations of their net cash flows. The remaining net loss or gain is the subject of economic exposure management. And by contrast. Determination of average interest period of debt. 4. Estimation of effect on revenue and expense streams for unexpected exchange rate changes. marketing. How quickly can the firm adjust prices to offset the impact of an unexpected exchange rate change on profit margins? 2. Subsequently. Page 65 of 100 . 1. 7. Determination of expected future spot rate. 9. multi-product. alternatively. Selection between direct or indirect debt denominations. Estimation of necessary amount of foreign currency debt. 8. Decision about "residual" risk: consider adjusting business strategy. how diversified are a company's factor and product markets? 3. have an impact on the value of assets? Normally. For practical purposes.

will only be undertaken as a last resort. In the present currency markets. but primarily on the liability side of the firm's balance sheet. This can be achieved by maneuvering assets. therefore. Among the operating policies is the shifting of markets for output. it follows that operating policies are not the tools of choice for exchange risk management. It is not surprising.[this] would certainly not be a suitable means of transport for taking advantage of exchange rate movements.NMIMS FOREX EXPOSURE MANAGEMENT Financial versus operating strategies for Hedging When operating (cash) inflows and (contractual) outflows from liabilities are affected by exchange rate changes. the general principle of prudent exchange risk management is: Any effect on cash inflows and outflows should cancel out as much as possible. When should operations -. liabilities or both.. Does it not therefore make sense to adjust operations to hedge against these effects? Many companies. on the extent to which the firm wishes to rely on currency forecasting to make hedging decisions. and production facilities as a defensive reaction to adverse exchange rate changes. An aeroplane would be more in line with the requirements of the present era. deviations from purchasing power parity provide profit opportunities for the operations-flexible firm. Whether and how these steps should be implemented depends first. that exposure management focuses not on the asset side. such as Japanese auto producers. are now seeking flexibility in production location. especially if undertaken over a short span of time. 1. Hence operating policies. and second. The problem is that Philips' production could not fit into either craft. It is obvious that such measures will be very costly. Put differently. which have been designed to reduce or eliminate exposure.. when less expensive options have been exhausted. product-lines. This philosophy is epitomized in the following quotation. in part to be able to respond to large and persistent exchange rate changes that make production much cheaper in one location than another.51 Guidelines for Corporate Forecasting of Exchange Rates Page 66 of 100 . which could put down anchor wherever exchange rates enable the company to function most efficiently. on the range of hedging tools available and their suitability to the task.the asset side -.be used? We have seen that exchange rate changes can have tremendous effects on operating cash flows. It has often been joked at Philips that in order to take advantage of currency movements. sources of supply. it would be a good idea to put our factories aboard a supertanker.

so if there are enough such participants the forward rate will always be bid up or down until it equals the expected future spot. capital flows. it offers opportunities for speculative profits for those who correctly assess the future spot price relative to the current forward rate. The actual exchange rate may deviate from the expected by some random error. The models they use are typically one or more of the following kinds: 1. In a broad sense they are "efficient. the story is a lot more complex. Because expectations of future spot rates are formed on the basis of presently available information (historical data) and an interpretation of its implication for the future. No model has yet proved to be the definitive one. and so the stronger is its exchange rate. they tend to be subject to frequent and rapid revision. fundamental 3. risk neutral players will seek to make a profit their forecast differs from the forward rate. In practice. Many models have been developed to explain and to forecast exchange rates. and hence are difficult to forecast. technical Exchange rates react quickly to news. Specifically. rational expectations and portfolio balance are all now understood to factor into the determination of currencies in a floating exchange rate system. in order to decide when and when not to hedge. The actual future spot rate may therefore deviate markedly from the expectation embodied in the present forward rate for that maturity." but tests of efficiency face inherent obstacles in testing the precise nature of this efficiency directly. Because the forward rate is a contractual price. perhaps because the structure of the world’s economies and financial markets are undergoing such rapid evolution. Monetary variables. Rates are far more volatile than changes in underlying economic variables. political event analysis 2. the more demand there is for its currency. Corporations nevertheless avidly seek ways to predict currencies. Many students have learned about the balance of trade and how the more a country exports.NMIMS FOREX EXPOSURE MANAGEMENT Academics and practitioners have sought the determinants of exchange rate changes ever since there were currencies. Research in the foreign exchange markets have come a long way since the days when international trade was thought to be the dominant factor determining the level of the exchange rate. The central "efficient market" model is the unbiased forward rate theory introduced earlier. they are moved by changing expectations. Page 67 of 100 . It says that the forward rate equals the expected future level of the spot rate.

one would expect that the forecast error is sometimes positive. provide good indicators of expected exchange rates. market-based forecasts rarely will come true. prices of future contracts. Example: Hedging with a Forward Contract Page 68 of 100 . or why consistent winners are not imitated by others or do not increase their volume of activity. an input for corporate planning and decision-making is readily available in all currencies where there are no effective exchange controls. incompetent market participants lose money and are eliminated. Otherwise one would have to explain why consistent losers do not quit the market.NMIMS FOREX EXPOSURE MANAGEMENT Another way of looking at these errors to consider them as speculative profits or losses: what you would gain or lose of you consistently bet against the forward rate. Can they be consistently positive or negative? A priori reasoning suggests that this should not be the case. However. whenever profit-seeking. all decisions are made on the basis of interpretation of past data. is important for planning purposes. however. Organized futures or forward markets provide inexpensive information regarding future exchange rates. and interest differentials for instruments of similar riskiness (but denominated in different currencies). If the market knew which would be more likely. To the extent that all significant managerial tasks are concerned with the future. alternating in a random fashion. however. In speculative markets. Thus. forward rates. Expected exchange rate changes are revealed by market prices when rates are free to reach their competitive levels. thus causing adjustment of the forward rate in the direction of their expectation. The actual price of a currency will either be below or above the rate expected by the market. In this fashion. the task of forecasting foreign exchange rates for planning and decision-making purposes. any predictive bias quickly would be corrected. using the best available data and judgment. Forecasting exchange rate changes. is quite different from attempting to beat the market in order to derive speculative profits. driven by unexpected events in the economic and political environment. Those who tend to have the best information and track record determine market rates. Any predictable. Barring such explanation. The advantage of such market-based rates over "in-house" forecasts is that they are both less expensive and more likely to be accurate. The nature of this market-based expected exchange rate should not lead to confusing notions about the accuracy of prediction. new information surfaces constantly. Therefore. anticipated exchange rate changes are a major input into virtually all decisions of enterprises involved in and affected by international transactions. sometimes negative. with the purpose of determining the most likely exchange rate. well-informed traders can take positions. economically meaningful bias would be corrected by the transactions of profit-seeking transactors.

750 from RBM and paid RBM C$11. to be paid upon delivery in two months' time.000.500.8785 per Canadian dollar. she arranged to sell 11. Fredericks received US$10. the amount received from Murray's customer.000. The two-month forward contract price was US$0.102. Page 69 of 100 . Foreign Exchange Manager at M/s Murray Chemical. was informed that Murray was selling 25. To protect her company.000 tones of Naphtha to Canada for a total price of C$11. The importance of market-based forecasts for a determination of the foreign exchange exposure of the firm is that of a benchmark against which the economic consequences of deviations must be measured. Two months and two days later.NMIMS FOREX EXPOSURE MANAGEMENT Janet Fredericks. This can be put in the form of a concrete question: How will the expected net cash flow of the firm behave if the future spot exchange rate is not equal to the rate predicted by the market when commitments are made? The nature of this kind of forecast is completely different from trying to outguess the foreign exchange markets.5 million Canadian dollars forward to the Royal Bank of Montreal.500.

according to the fundamental relationships of the international money market as illustrated in Exhibit 1. They differ in details like default risk or transactions costs. debt. or debt in DM. Thus one can hedge a DM payment using a forward exchange contract. there are different tools that serve effectively the same purpose. tools differ in that they hedge different risks. and the forward market. Wholesale market or inter-bank market where in the participants is commercial banks. This follows from the unbiased forward rate theory.53 Structure of the Forex Market: • • Retail market in which travelers and tourists exchange one currency for another in the form of currency notes or travelers cheques. or if there is some fundamental market imperfection. Indeed in an efficient market one would expect the anticipated cost of hedging to be zero. symmetric hedging tools like futures cannot easily hedge contingent cash flows: options may be better suited to the latter. where payment (delivery) is made right away (in practice this means usually the second business day). the exchange of one currency for another. Page 70 of 100 . the spot market. First. We will use the following criteria for contrasting the tools. FOREIGN EXCHANGE MARKET 1. In equilibrium the cost of all will be the same. In particular. Trading or "dealing" in each pair of currencies consists of two parts. corporates and central banks.52 Tools And Techniques For The Management Of Foreign Exchange Risk In this section we consider the relative merits of several different tools for hedging exchange risk.NMIMS FOREX EXPOSURE MANAGEMENT 1. Second. Most currency management instruments enable the firm to take a long or a short position to hedge an opposite short or long position. The spread between buying and selling is large. or futures or perhaps a currency swap. Tools and techniques: Foreign Exchange Forwards Foreign exchange is. of course. including forwards. futures. swaps and options.

comprise of commercial banks. The last tier may comprise of small local institutions and deal in very small number of major currencies against the home currency.4548 per Dollar". Bank B: Forty. Your price on Mark . Central banks intervene in the market from time to time and attempt to move the exchange rates in the targeted direction.4540 for every USD it buys. JPY. Bank A wants to buy Dollars against the DM and he conveys this in the third line.45 is the "big figure" and hence only last two figures are quoted namely 40 and 48. Page 71 of 100 .56 Types of Transactions and Settlement Dates: • Settlement of a transaction takes place by transfers of deposits between the two parties. investment dealers and large corporates.Dollar please. The spread is 8 points. Brokers also play the role of "showing" the market anonymously the prices from the price makers. If Bank A wanted to sell USD 5 million. Over 90% of the transaction is accounted for by inter-bank transactions. influencing the market.) Inter-bank dealing for a typical SPOT transaction could be something like Bank A: Bank A calling. etc. INR. CHF. The difference between bid and offered rates. Forty-Eight. Bank A: Ten Dollars Mine at Forty-Eight. It will charge DM 1. he would have said "Five Dollars yours at Forty". Bank B is offering rate of 1. The next tier may comprise of large banks that deal in restricted number of currencies and use brokers.4548 Bank B is willing to pay DM 1. FRF.54 Market Players: • • The primary price makers (professional dealers) who make a two-way market to each other and to the clients. Bank B is then said to have been "hit" on its offer side. Among the primary price makers there is a kind of tie ring a few giant multinational banks deal in large currencies in large amounts and often deal directly with each other without brokers thus. Foreign currency brokers act as middleman and provide information to market making banks about prices at which there are firm buyers and sellers in a pair of currencies.NMIMS FOREX EXPOSURE MANAGEMENT 1. • • • • 1. DEM. GBP.4540 / 1. • • • • • • • • 1. The day on which these transfers are effected is called "Settlement Date or Value Date".55 Mechanics of Currency Trading: • • ISO has developed three letter codes for all the currencies (USD. which means that "I buy 10 million Dollars at your offer price of DM 1. DM 1.4548 for every USD it sells.

4545 / 55. A swap transaction is a combination of SPOT and Forward in the opposite direction.57 Arbitrage between Banks: • Not all banks have identical quotation for a given pair of currencies at a given point of time. if this is not done. bank A will find that it is "being hit" on its bid side much more often whereas bank B will find that it is confronted largely with buyers of Pound and very few sellers.58 Inverse quotes and 2-point arbitrage • Suppose a Zurich bank offers a SPOT quotation: Page 72 of 100 . 1. Bank B would be in the opposite position. In a SPOT transaction the settlement or value date is usually two business days ahead for European currencies or Yen traded against the Dollar. Suppose banks A and B are quoting for Dollar against Pound 1.4548 from B. From time to time banks deliberately move its quotations to discourage one type of transaction and encourage the opposite. it can give rise to arbitrage opportunity as follows:  Buy Pounds at $1. Say that bank B increases its' rates to $1. the foreign exchange transaction can be categorized in to SPOT or Forward. Forward maturities are normally for whole month however.0002 per Pound till bank B raises its offer rates and/or bank A lowers its bid rates. Earn Net Profit of $0. Depending upon the time elapsed between transaction date and the settlement date. Sell Pounds at $1. banks often quote "broken date" or "odd date" contract (73 days). Should this be a holiday. The two-day gap is necessary for confirming and clearing the deal through the communication network such as SWIFT.4550 / 60 and 1.4538 / 48. However.4550 to A. It is a temporary exchange of one currency for another with an obligation to reverse it at a specific future date. the next working day is considered. the arbitrage opportunity vanishes. Yet another category is called swap. Value Dates for Forward Transaction: This is arrived at by adding one calendar month to the Value Date for a SPOT transaction between the two currencies. bank A would have built a large net short position in Pound and may now want to encourage sellers of Pound and discourage buyers. keeping the amount of one of the currencies fixed. Thus a bank will buy DM SPOT against USD and simultaneously enter into a Forward transaction with the same counter party to sell DM against USD.NMIMS FOREX EXPOSURE MANAGEMENT • • • • • • • The dealing locations need not necessarily be the settlement locations.   • Thus the two quotes must overlap by at least 1 point to prevent arbitrage. which is a combination of SPOT and Forward transaction. • 1.

Sell One Million Swiss Franks in New York and earn US$ 669500 in New York.59 Outright Forward Quotations • Quotations for such transactions are given in the same manner as SPOT quotations. the following must hold: Implied (USD / CHF) bid = 1/(CHF / USD) ask Implied (USD / CHF) ask = 1/(CHF / USD) bid 1. Page 73 of 100 .NMIMS FOREX EXPOSURE MANAGEMENT • • • • • • CHF / Dollar = 1.4570 / 95 means Bank will give FRF 4.5575 / 85 • Dollar is cheaper for delivery after 1-month compare to SPOT.5677 / 85 DM / USD 1 month Forward: 1.4955 / 62 At the same time.4955 = US$ 668700 to acquire Swiss Franks.60 Discounts and Premia in the Forward Market • Consider the following pair of quotations: DM / USD SPOT: 1. delivery 3 months from the corresponding SPOT value date. 1. a New York bank offers the following quote: USD / CHF = 0. (USD / CHF) ask is the rate that applies when bank sells Swiss Franks in exchange for Dollars. Thus a quote like: FRF / USD 3 month Forward: 4. The Dollar is said to be at a Forward discount against DM or DM at a Forward premium in relation to Dollar.4570 to buy a USD. To avoid arbitrage.6695 / 99 Buying One Million Swiss Franks from Zurich bank means $ 1000000 / 1. Couple of phone calls and risk less profit of $ 800. clearly indicating that the two bank quotations are out of line. This arbitrage transaction is called "two point arbitrage" and foreign exchange markets very quickly eliminate such opportunities if and when they arise.

XYZ Ltd may enter into a forward contract with a banker for US $ 3.5681) * 12 * 100 / 1. say US $ 1 = Rest. 43. 1. is that they require future performance. it appears to the company that the US $ may be dearer as compared to the exchange rate prevailing on that date. taking place at a specified time in the future. Example Suppose XYZ Ltd needs US $ 3. the payments procedure.00.000. • Done through either allocate credit limit or cash deposit.1. This default risk also means that many companies do not have access to the forward market in sufficient quantity to fully hedge their exchange exposure. Forward contracts are the most common means of hedging transactions in foreign currencies.61 Annualized Premium / Discount: • Annualized percentage discount / premium is calculated as: [Forward(DEM/USD)mid . no exchange of money takes place until the actual settlement date. however. FUTURES & CURRENCY OPTIONS 1.000 on 1st May 2000 for repayment of loan installment and interest.5681 = . The forward rate may be higher or lower than the spot rate prevailing on the Page 74 of 100 . it has to protect against default in commitment. the hedge disappears.73% 1.7. This commitment to exchange currencies at a previously agreed exchange rate is usually referred to as a Forward Contract.NMIMS FOREX EXPOSURE MANAGEMENT 1. and sometimes one party is unable to perform on the contract. the value date. • When bank enters into Forward deal with corporate.1 Forward Contract The rate in the forward market is a price for foreign currency set at the time the transaction is agreed to but with the actual exchange.SPOT(DEM/USD)mid ] * 12 * 100 SPOT(DEM/USD)mid • In the above example.00. For such situations.63 FORWARD CONTRACTS.63. and the exchange rate are all determined in advance. Accordingly. The trouble with forward contracts. or delivery.50. sometimes at great cost to the hedger. While the amount of the transaction.62 Margin Requirement: • Forward contract between 2 banks involves telephonic agreement on price. the discount will work out to = (1.5580 . futures may be more suitable. amount and period. When that happens. As on 1st December 1999.

NMIMS FOREX EXPOSURE MANAGEMENT date of the forward contract.00.80) Rs.132.40. Both of these features allow the futures contract to be tradable. In principle. as long as it's big enough to be worth the dealer's time. One difference between forwards and futures is standardization. June. 43. 44 irrespective of the spot rate as on that date.80 In the given example XYZ Ltd gained Rest. 2. Payment to be made as per forward contract (US $ 3. i.44.50. each contract being far smaller that the average forward transaction. 1st May 2000.240. currency futures are similar to foreign exchange forwards in that they are contracts for delivery of a certain amount of a foreign currency at some future date and at a known price. SIMEX in Singapore and the IMM in Chicago. 1. Futures are also standardized in terms of delivery date. on the other hand. The normal currency futures delivery dates are March.2 Currency Futures Outside of the interbank forward market.000 Gain arising out of the forward exchange Rs.00) Amount payable had the forward contract not been in place (US $ 3. As on the future date. the banker will pay XYZ Ltd $ 3. Let us assume forward rate as on 1st December 1999 was US$ 1 = Rest.000 Rs.. In practice. while forwards are private agreements that can specify any delivery date that the parties choose. But the most important feature of the futures contract is not its standardization or trading organization but in the time pattern of the Page 75 of 100 .00. 44. are traded in organized exchanges such the LIFFE in London. 44 as against the spot rate of Rest. 000 contract 1.134. Forwards are for any amount.000 at Rest.44.000 * Rs. September and December. while futures are for standard amounts. 2.00.000 by entering into the forward contract. 00.000 * Rs.63. 3. they differ from forward contracts in important ways. Futures. Another difference is that forwards are traded by phone and telex and are completely independent of location or time. the best-developed market for hedging exchange rate risk is the currency futures market. 4. 40.e. Let us assume that the Spot rate as on that date be US $ 1 = Rest.

She would borrow Canadian dollars. According to the interest rate parity theorem. Most big companies use forwards. This daily cash compensation feature largely eliminates default risk. forwards and futures serve similar purposes. thus losing on the spread. The cost of this money market hedge is the difference between the Canadian dollar interest rate paid and the US dollar interest rate earned. But if a money market hedge is to be done for its own sake. so the forward hedge would probably be more advantageous except where the firm had to borrow for ongoing purposes anyway.is a widely used hedging tool that serves much the same purpose as forward contracts. When payment in Canadian dollars was received from the customer. she would use the proceeds to pay down the Canadian dollar debt. but differ in their applicability. and hold them in a US dollar deposit for two months. Alternatively she could have used the Eurocurrency market to achieve the same objective. The money market hedge suits many companies because they have to borrow anyway. An example : Elizabeth sold Canadian dollars forwards. the transfer of funds takes place once: at maturity. which she would then change into francs in the spot market. In a forward contract. and tend to have identical rates. cash changes hands every day during the life of the contract. Thus. whether it involves full delivery of the two currencies or just compensation of the net value. so it simply is a matter of denominating the company's debt in the currency to which it is exposed that is logical.3 Debt instead of forwards or futures Debt -. futures tend to be used whenever credit risk may be a problem. This is costly. Page 76 of 100 . Such a transaction is termed a money market hedge. unless the firm has some advantage in one market or the other. or at least every day that has seen a change in the price of the contract.borrowing in the currency to which the firm is exposed or investing in interest-bearing assets to offset a foreign currency payment -. So the cost of the money market hedge should be the same as the forward or futures market hedge. With futures. the interest differential equals the forward exchange premium. the firm ends up borrowing from one bank and lending to another.63. the percentage by which the forward rate differs from the spot exchange rate.NMIMS FOREX EXPOSURE MANAGEMENT cash flows between parties to the transaction. as in the example. 1.

but not the obligation. Ireland. He viewed the dollar as being extremely instable in the current environment of economic tensions. For example a computer manufacturer in California may have sales priced in U. Defn. European options.19 for 245 days forward delivery.S. American options permit the holder to exercise at any time before the expiration date. only on the expiration date. options make more sense Page 77 of 100 . In some options. For such a right he pays a price called the option premium. Depending on the relative strength of the two currencies. dollars as well as in German marks in Europe. There are a number of circumstances.85% of the principal. I'm paying for downside protection while not limiting the possible savings I could reap if the dollar does recover to a more realistic level. banks and governments have extensive experience in the use of forward exchange contracts. Example Steve of Jackson Agro just agreed to purchase 15 million worth of potatoes from his supplier in County Cork.21. revenues may be realized in either German marks or dollars.63. In a highly volatile market where crazy currency values can be reached. In such a situation the use of forward or futures would be inappropriate: there's no point in hedging something you might not have. where it may be desirable to have more flexibility than a forward provides. but is not required to do so. The dollar had recently plummeted against all the EMS currencies and Steve wanted to avoid any further rise in the cost of imports. in others. With a forward contract one can lock in an exchange rate for the future. the right to sell. to exchange currency at a predetermined rate.NMIMS FOREX EXPOSURE MANAGEMENT 1. so he was strongly considering purchasing a call option instead of buying the punt forward. : A foreign exchange option is a contract for future delivery of a currency in exchange for another. the best quote he had been able to obtain was from the Ballad Bank of Dublin. a put. who would charge a premium of 0. Having decided to hedge the payment. In effect. His view.25 spot. The right to buy is a call. a futures contract on the currency. he reasoned. the instrument being delivered is the currency itself. The option seller receives the premium and is obliged to make (or take) delivery at the agreedupon price if the buyer exercises his option. Steve decided to buy the call option. however. the strike or exercise price. he had obtained dollar/punt quotes of $2. Payment of the five million punt was to be made in 245 days' time. At a strike price of $2. What is called for is a foreign exchange option: the right. $2. however. was that the dollar was bound to rise in the next few months.4 Currency Options Many companies. where the holder of the option has the right to buy (or sell) the currency at an agreed price.

5 Swap • A SWAP transaction between currencies A & B consists of a SPOT purchase (sale) of A coupled with a Forward sale (purchase) of A. The Forward deals are done in inter-bank market in the form of SWAP • Assume that a bank buys Pounds one month Forward against Dollars from a customer. This is in conformity with first principle but violets second. • How to determine whether to add or subtract? The answer guided by two principles o The bank must always profit.6 Cross Rates Page 78 of 100 . thus creating an offsetting short Pound position one month Forward. Rate at which it sells a currency must be > buys same currency.63. This simple example illustrates the lopsided character of Options. and you're not locked into a rockbottom forward rate. it will do as follows: A Swap in which it buys Pounds Spot and sells one month Forward. If it wants to square it up. both against B. 1.63. o Bid and ask spread widens as we go farther and farther into future. It has thus created long position in Pounds and short in Dollars. 15 points to be added to or subtracted from SPOT bid rate and 8 points to be added / subtracted from SPOT ask. The reason for this is that it is very difficult to find counter parties with matching opposite news to cover the original position by an opposite outright Forward. How to derive Outright Forward from swap quotation? Suppose DEM / USD SPOT is 1.NMIMS FOREX EXPOSURE MANAGEMENT than taking your chances in the market. 1. Coupled with a Spot sell of Pounds to offset the long Pound position in Spot created in the above Swap. • In the above example if we add swap points.6280 / 83. we will have 1-month Forward rate as 1. The amount of one of the two currencies is identical in SPOT and Forward • The banks quote and do outright Forward deals with non-bank customers.6265 / 75 and 1-month swap is 15/8 (15/8 is in "points") point = 10-4 • To arrive at implied Forward.

and management must necessarily give some discretion.63. the British foods group. 1.5900/5910 1 DM = Rs. In 1992 a Wall Street Journal reporter found that Dell Computer Corporation. Clearly. In 1993 the oil giant Royal Dutch-Shell revealed that currency trading losses of as much as a billion dollars had been uncovered in its Japanese subsidiary. to the corporate treasury department or whichever unit is charged with managing foreign exchange risks. the currency of determination. Page 79 of 100 . other groom engineers or accountants.22. for international trade and production is a complex and uncertain business. As we have seen. Some companies.8675/8725 In case the DM is quoted in New York as 1 USD = DM 1. even identifying the correct currency of exposure.7 Controlling Corporate Treasury Trading Risks In a corporation. for losses can get out of hand even in the best of companies. feeling professionals best handle that foreign exchange. it has become evident that some limits must be imposed on the trading activities of the corporate treasury. Not every transaction can be matched.35. and that currency losses may have been covered up. hire ex-bank dealers. Flexibility is called for.8675 then the answer for 1DM would be = Rs. if the cross rate currency for any currency is known then it is possible to arrive at the rate of the desired currency. Yet however talented and honorable are these individuals. and the publicity precipitated a management shakeout. had been trading currency options with a face value that exceeded Dell's annual international sales. is tricky. The $150 million lost almost brought the company to its knees. If 1.22. accountability and limits of some form must be part of a treasury foreign currency-hedging program. perhaps even a lot of discretion. Complex options trading were in part responsible for losses at the treasury of Allied-Lyons. performance measurement standards.5910DM= 1 USD and 1 USD = Rs. a star of the retail PC industry.5540 Similarly. Ex: Say in the Indian market the US dollar is quoted is at USD 1 = 35.NMIMS FOREX EXPOSURE MANAGEMENT In case the price of one currency is not quoted angst the other currency the parity between them is obtained by using an intermediary currency. there is no such thing as being perfectly hedged.5582. The rate thus obtained is called a cross rate and the principle applied for obtaining the cross rate is called the chain rule. Space does not permit a detailed examination of trading control methods. but some broad principles can be stated.

" Second. marking to market should be based on external.65 Market Participants • • OTC Nature . fax or electronically. counter party credit risks. This marking to market need not be included in external reports. but is necessary to avert hiding of losses. Finally. marking-to-market. the company has to form an idea of where the market is headed. as forecasts for periods beyond 6 months can be unreliable. 1. management must elucidate the goals of exchange risk management. Wherever possible. and operations risks. if the positions offset other exposures that are not marked to market. suppliers or customers. preferably in operational terms rather than in platitudes such as "we hedge all foreign exchange risks. objective prices traded in the market. Major banks act as "market makers". for all net positions taken. position limits should be made explicit rather than treated as "a problem we would rather not discuss." Instead of hamstringing treasury with a complex set of rules. As in all these things. limits can take the form of prohibiting positions that could incur a loss (or gain) beyond a certain amount. the firm must have an independent method of valuing. Third. say.NMIMS FOREX EXPOSURE MANAGEMENT First.Trades effected on phone.64 Market Forecasts After determining its Exposures. These include losses on open positions from exchange rate changes. The focus of the Apex Management is to be aware of the Direction or the Big Trend in rates • • • the underlying assumptions behind the forecasts the Probability that can be assigned to the forecast coming true the possible extent of the move The Risk Appraisal exercise and Benchmarking decisions will be based on such forecasts 1. Fourth. the risks of in-house trading (for that's often what it is) must be recognized. The company will focus on forecasts for the next 6 months. counter party risks resulting from over-the-counter forward or swap contracts should be evaluated in precisely the same manner as is done when the firm extends credit to. Page 80 of 100 . based on sensitivity analysis. any attempt to cover up losses should reap severe penalties. the instruments traded.

rate at which willing to buy and sell one currency for another (bid and offered rates). futures and options. 1. The objective is to make profit when prices revert to historical relationship.NMIMS FOREX EXPOSURE MANAGEMENT • Two way quotes .66 Market Participants . • Hedge funds typically operate on 10% margin and leverage fund corpus 10 times. • MNCs too are in the market not only for covering their own exposures but actively speculating on currency movements and making treasury management as profit center. • Fund manager fees are typically 15 to 20% of profits. • Arbitragers . Page 81 of 100 .68 Dealing Rooms • Banks in major money markets investing heavily in computer and communication infrastructure for efficient functioning of trading room. which handle not only foreign exchange but also derivatives like swaps. • Banks. Total capital is US $ 300 billion. Popular in US and privately placed.69 Information Systems • Reuter monetary service introduced in 1973 . 1. 1. 1. 9 digit dollars. Hence. far greater degree of risk and reward. The term overpriced and under priced refer to relative ruling prices in comparison to past. • Integrated dealing rooms.limited role due to communication systems. no supervision or regulation and lack of disclosure. • Speculators buying or selling currencies.4 Categories • Non-bank entities that wish to exchange currencies to meet or hedge contractual commitments (for import or export contracts). • Other real time financial data providers are Bloomberges. • Unlike MFs. • "Short" sell say (overpriced) silver and simultaneously (under priced) gold. • Deals are allowed to be struck and settlement instructions given through system. These speculators comprise of large commercial banks.67 Hedge Funds • Investment vehicles for wealthy individuals. MNCs and hedge funds. which exchange currencies to meet requirements of their clients. • Cross currency rates done by utilizing the dollar.bid and offered quotations now far greater coverage and sophistications.

It is imperative to know this before deciding on a Benchmark and devising a hedging strategy. The following Risks will be considered.xxxx and what is the likelihood of a forecast going wrong. 3.NMIMS FOREX EXPOSURE MANAGEMENT • Reuters 3000 provides dealing system + electronic broker by matching the quoted rates of subscribing banks. 4. 1. Forecast Risk What is the likelihood of the rate actually moving to xx. • No paper-based system can meet the needs. For instance. Market and Transaction Risk This will take into consideration the risks attached with each particular market and the likelihood of a transaction not going through smoothly. • Internet further revolutionizing the system. how much Profit/ Loss does the company make?” 2. Systems Risk Page 82 of 100 . • 24 hours open dealing rooms to take care of all time zones.xxxx. The monetary and time costs of hedging with a nationalised bank are generally higher than with a private/ foreign bank. • Electronic or automated interbank fund transfer system like CHIPS(clearing house interbank payment system) in New York. Risk to the Exposure or Value at Risk (VAR) Given a particular view or forecast. The VAR is the answer to the question.70 Payment and Communication System • Once deal is "done". • Rapid growth of cheap and electronic broking facilitates instant deal confirmations and has replaced traditional voice brokers. VAR tries to determine by how much the company’s underlying cash flows are affected. “If the Rate actually moves to xx. 1. the dealers simultaneously specify where they want currencies to be delivered.71 Risk Appraisal This exercise is aimed at determining where the company's exposures stand vis-à-vis market forecasts. The Rupee is given to sudden swings in sentiment. whereas the Deutschemark is generally more predictable. 1.

The company will endeavor to reduce the non-market risk or Systems Risk over time. 1. or in other words. The Benchmark will be realistic and achievable. since the exposures impact the P&L Account directly. The Forecast risk. Market and Transaction risk. 1. the Benchmark should be the Probabilistic Expectation of the rate in question. The Benchmark will reflect and incorporate the following: The Objective of Exposure Management. and Systems risk as determined earlier. 3. 2. The Benchmarks will be set for 6 months periods.NMIMS FOREX EXPOSURE MANAGEMENT The risks that arise through gaps or weaknesses in the Exposure Management system. Room for error in keeping with the Stop Loss Policy to be decided 4. Suggestions: Companies whose exposures are of long-term Capital nature can look to manage them on a Profit Center basis. Companies whose exposures are of short-term Revenue nature should manage them on a Cost Center basis. "Should Exposure Management be conducted on a Profit Center or Cost Center basis?" The Forecasts discussed and agreed upon earlier. The company will set a Benchmark for its Exposure Management practices. For example: Reporting Gap where there are delays/ errors in reporting exposures to the Exposure Management cell Implementation where there is a gap between the decision to hedge Gap and the implementation of such hedge decision. since the exposures are not open to day-to-day business risks. A small note on the Profit/ Cost center concept: Page 83 of 100 . Mathematically.72 Benchmarking This exercise aims to state where the company would like its exposures to reach.

73 Hedging This is the most visible and glamourised part of the Exposure Management function.”. as represented by the Benchmarks b. However. the Exposure Manager is required to generate a NET profit on the exposure over time. implying a lower risk appetite. it will pass a Board Resolution authorising the use of the following:       Rupee-Foreign Currency Forward Contracts Cross Currency Forward Contracts Forward-to-Forward Contracts FRAs Currency Swaps Interest Rate Swaps Page 84 of 100 .x % p. A company with a strong position in its daily bread and butter business can afford to take some financial risks and can opt for this concept. the Trader is like the Driver in a car rally. Hedges will be undertaken only after appropriate Stop-Loss and Take-Profit levels have been predetermined d.a. from the forecasted rate of x. the Exposure Manager would be required to ensure that the cash flows of the company are not adversely affected beyond a certain point. The Exposure Management Cell will be accorded full operational freedom to carry out the hedging function on a day to day basis c. a. Hedging strategies will be designed to meet the Exposure Management objectives. or whose underlying business is not on a very sound footing would be advised to adopt this concept. A company whose cash flows are volatile. In this regard. Cost Center Under this concept.NMIMS FOREX EXPOSURE MANAGEMENT Profit Center Under this concept. This is an aggressive stance implying a high degree of risk appetite on the part of Apex Management. The Benchmarks under a Cost-Center concept would take the form of “Foreign Exchange fluctuations should add no more than x% to the cost of Imported Raw Material over and above the budgeted cost. as per need and requirement. This is a defensive strategy. The Benchmarks under a Profit-Center concept would take the form of “The total cost of a foreign currency loan should be reduced by at least 25 bp over a one year period. who needs to follow the general directions of the Navigator.” 1. The company will use all hedging techniques available to it.

Chairman of the US Federal Reserve.NMIMS FOREX EXPOSURE MANAGEMENT    Currency Options Interest Rate Options Others. whether implicit or explicit. It is easier and safer to generate profits from a Cross-Currency Forward Contract and a Rest 1 Lac profit thereon is equivalent to saving a 10 paise depreciation in the Rupee (on USD 1 million) 1. For instance. The choice of currency would. on the Asian financial crisis. Suggestions: Stop Losses should be activated when Page 85 of 100 . As such. of course. There is often denial and delay in instituting proper adjustments……Reality eventually replaces hope and the cost of the delay is a more abrupt and disruptive adjustment than would have been required if action had been more preemptive. To err is human 2.74 Stop Loss Exposure Management should not be undertaken without having a StopLoss policy in place. “There is a significant bias in political systems of all varieties to substitute hope (read.” Whether an Exposure is hedged or not. instead of selling the Rupee. a Dollar payable can be hedged by selling a currency (say Sterling Pound) in order to buy Dollars. to an extent. They can. wishful thinking) for possibly difficult pre-emptive policy moves. A stitch in time saves nine It is appropriate to recount here some words from a speech of Dr Alan Greenspan. insulate themselves from such shocks by undertaking hedges in currencies other than Rupee-Dollar. Stop Loss is nothing but a commitment to reverse a decision when the view is proven to be wrong. A Stop-Loss policy is based on the following two fundamental principles: 1. delivered in December 1997. He says. depend on the trend and forecast for the currency(s) at that point of time. as may be required Suggestion: Indian companies with sizeable US Dollar denominated exposures are extremely vulnerable to sudden drastic moves in the USD-INR rate. it is assumed that the decision to hedge/ not to hedge is backed by a View or Forecast.

make sure he has set a stop-loss for positions he enters into. closing Fortnightly Monthly Page 86 of 100 . The Exposure Manager should be accorded flexibility to set appropriate Stop-Losses for each trade.75 Reporting and Review There needs to be continuous monitoring whether the Exposures are headed where they are intended to reach. the Exposure Management activities need to be reported and reviewed. 1. and profitability vis-à-vis the Benchmark VAR Report Expected changes in overall Exposure due to forecasted exchange/ interest rate movements Review A monthly Review meeting will consider the following: Issue Exposure Performance On the basis of Exposure NAV Report Points to be reviewed Is the Benchmark Periodicity Daily.NMIMS FOREX EXPOSURE MANAGEMENT • • • • Critical levels in the rate being monitored are reached. The factors/ assumptions behind a view either change or are proven wrong. While Benchmarks will be based upon the Big Trend and will incorporate a certain amount of room for error. however. As such. Reporting The Exposure Manager will prepare the following Reports on a regular basis: Report Name What it shows MTM Report The Mark-to-Market Profit/ Loss status on Open Forward Contracts Exposure NAV The All-in-all exchange/ interest rate Report achieved on each Exposure. The Exposure Manager should. on an a priori basis. the Exposure Manager should be careful to not violate the Benchmark on the wrong side. which clearly tell that the view held has been proven wrong.

76 Conclusion Exposure Management is an essential part of business and should be viewed with Objectivity. it should be remembered that o All that has been stated above cannot start happening straightaway Page 87 of 100 . say. Having said that. Production or Marketing is viewed. and should be viewed with the same clarity of vision as. It is neither a license to print money nor is it a cause for getting trapped in a Fear Psychosis.NMIMS FOREX EXPOSURE MANAGEMENT being met/ bettered? What are the chances of the Benchmark being violated on the wrong side? Reasons for the Benchmark being violated on the wrong side Market Situation Reviews of market developments Forecasts of market movements Is the Big Trend still in place? Or has it changed? Does the Benchmark Benchmarking The above two need to be changed? Is the strategy working well? Hedging Or does it MTM and Exposure NAV Reports Strategy need to be fine-tuned/ overhauled? Operational Operational Exposure Manager's experiences problems to issues be solved 1.

.TECHNOLOGY ADVANTAGE K mailer on : Finance Published : 31-10-2001 ISSN 0972-3900 International Finance Online Foreign Exchange . which no company can afford to ignore. LATEST IN FOREIGN EXCHANGE .. because it is today an activity. Reporting and Review systems that work takes time and effort There will be a Learning Curve to be overcome when setting Benchmarks There will be initial losses.. despite the growing number of sites. which should be viewed as what they are .Promises Galore (Update)-. o o There has to be a long-term commitment to Exposure Management.initial losses. Dealing Online (Advance) -.NMIMS FOREX EXPOSURE MANAGEMENT o Installing Hedging. Page 88 of 100 . experts are still skeptical about the liquidity they can provide in comparison to physical markets.Atriax has been the latest addition to sites that facilitate foreign exchange (fx) dealings online. However...Asian markets have been slow to adapt to online foreign exchange (fx) trading despite the creation of many private networks. The promises envisaged prior to the launch still elude the online segment.

efforts are on to make online fx trade a success. Such issues have to be solved as and when they arise as they are not always predictable. Experts opined that 25 to 30% of fx transactions would be done online. This is far from what was predicted. then their competitors would. Dreams . On the other hand. HSBC. They prefer to trade through dealers who can help them in making decisions.Citibank and Deustche Bank as partners. The results of CFO Asia poll. conducted for top 10 corporate treasuries at major companies in Asia. of private portals is that they lack Straight Through Processing (STP). However. and Currenex are some of them.. Vendors on their part are not disappointed.However these services are more expensive than traditional channels. Matchbook FX. Players in fx market felt that online trading would remove the chaos prevalent in the markets. Also the present systems coroprates use are time tested and suffice their needs. banks restrict their liability in case systems crash mid way through a transaction. corporate treasurers in Asia were upbeat about the introduction of online fx trading. Private portals Despite the growing number of facilitators for online trade. convenor of the Association of Corporate Treasurers. Online trade was expected to provide liquidity to players trading in global currencies and also fetch them the best price. corporates are slow in taking advantage of them. The basic drawback. they consider it is an unnecessary investment at this juncture. Another cause of concern has been legal issues. It. The major reason for this. security controls provided by these networks are unmatchable. Goldman Sachs. For instance. received a dismal response. an Internet fx technology provider. one of the first Internet forex services set up in 1999. Hence. goes beyond saying that banks should take a first step so others follow.com. Integrating corporates' systems with those of banks would take more time and involve higher costs. the challenge is to integrate these with corporates' banks end systems. it is alleged is because of banks' resistance to trade on the Internet. JP Morgan Stanley Dean Witter and UBS Warburg as its partners. They feel that it is too early to expect huge numbers. Page 89 of 100 . Clients do not like this. is that many of them are still not comfortable with online trade. which take a long time to be solved. For instance. according to Peter Wong. According to rough estimates only 2% of the trade in Asia is being done online. If banks do not adapt to online trade. None of them adopted online trade and only three of them propose to adopt it over the next few years. To conclude. The low response. The promises envisaged prior to the launch still elude the online segment A year ago.unrealised CFOWeb. Though Atriax and FXall provide STP. Speed is slow Online trade requires better connectivity that would enable faster processing of transactions. feels that treasurers in Japan have just started and those in Singapore and Honk Kong are yet to start. connectivity in Asia is inconsistent and the processing pace is phenomenally slow. however.NMIMS FOREX EXPOSURE MANAGEMENT Asian markets have been slow to adapt to online foreign exchange (fx) trading despite the creation of many private networks. Private networks have leased lines and hence enhance the speed. These expectations came about when people had a fascination for anything related to the Internet.. Fxall and Atriax have emerged to take a share of $3 trillion per day fx market. STP means complete automation from transaction to settlement. Credit Suisse First Boston. shows disappointing results. Despite these hurdles. This would enhance the speed of processing at a lesser cost and lesser number of errors. In fact many big banks have expressed their desire to start online fx trade. their trading profits. when banks give a draft contract to their clients. Also. The former has Bank of America. Apart from these mega portals many small ones are emerging. managing director of Cognotec Asia Pacific. Banks resist transparency with a fear that it might reduce their spreads and hence. The later has Chase Manhatan. from corporates' perspective. Gain Capital. the initial reaction of clients is that it is biased towards ISPs.

NMIMS FOREX EXPOSURE MANAGEMENT Page 90 of 100 .

Banks oppose opening of markets It is logical for b-to-c platforms to focus on interbank trade till buy side customers adapt to it. in a b-to-c environment where anybody can trade with anybody • As long as markets are separate banks would be protected from the threat of disinter mediation and the possibility of developing buy-side to buy-side credit relationships • In request for quote markets big banks have an undue advantage of winning clients of small banks The cumulative affect of all this will hinder the efficiency of markets. they claim to introduce new pricing mechanisms in the future. b-to-c platforms are basically private networks. credit checks would become less labour intensive. offer a new kind of mechanism known as request for quote. This should not be a handicap as they have the ability to cater to interbank (b-to-b) trading models. however. on the other hand. The same would continue if buy side segment and inter bank markets remain separated. parties to trade decide on the price. However. they are more expensive. before executing the transaction. These sites need to adopt existing models in the interbank market and focus on attracting customers from physical markets. Also these private networks enable customers to have automatic download of deals. Since counter parties trade together. Despite the convenience they offer. Reuters and EBS . offers and bids are taken from the clients and a counter party expecting the same rates is found. FXall and FX connect are sites that have been launched to facilitate clients' buying foreign exchange (fx). B-to-C platforms claim to provide transparency about the pricing they offer. Under this mechanism. However. b-to-c platforms are now gearing up to the challenges of straight through processing (STP) that is essential for interbank markets. experts opine that these two markets will remain separated.NMIMS FOREX EXPOSURE MANAGEMENT Atriax has been the latest addition to sites that facilitate foreign exchange (fx) dealings online. Atriax and FX all launched by consortium of banks would benefit the most as they can corner a bigger share of b-to-b market. Page 91 of 100 . This might be misleading as customers can make a comparison between prices banks are offering but still they cannot know the interbank pricing. Hence. These people. they are quicker and offer better security than other channels. Also these sites are yet to provide their ability to provide liquidity. Buy side customers had a bitter experience in the past while working on interbank fx platforms. customers have been slow to adapt this route. Such comparison will help customers to select the right site. experts are still skeptical about the liquidity they can provide in comparison to physical markets Atriax. Banks resisted opening up the markets. despite the growing number of sites. banks need not declare their tightest prices. which are considered to be a one -stop shop for a diverse range of products. are not interested in trading complex fx instruments. Under the system. This would mean that big banks would still command prices in the market. A majority of them are still not comfortable with electronic trading. In addition. b-to-c platforms designed to remove intermediation will not be able to achieve this and banks will continue to get their margins by acting as intermediaries. Also they offer flexibility to customers in terms of choosing between quote to order and matching mechanisms. These b-to-c platforms offer an ideal situation for banks for the following reasons: • When b-to-c and b-to-b markets remain separated. Currenex. the products they offer and pricing mechanisms. Availability of options will enable clients to compare functionality offered by them. Atriax facilitates any customer who wants to trade inclusive of b-to-b. through Reuters and Electronic Broking Services (EBS). This system uses the matching concept. This reduces the parties' vulnerability to risk and hence makes it a preferable channel in comparison to other Internet sites.old war horses Interbank market started electronic broking in early 1990s. However. Interbank markets will benefit from b-to-c channels. Bank to client (b-to-c) platforms. Slow progress b-to-c platforms are targeting buy side users (people who buy fx products).

section (1) of section 10 of the Act. (v) `Foreign exchange derivative contract' means a financial transaction or an arrangement in whatever form and by whatever name called.NMIMS FOREX EXPOSURE MANAGEMENT RESREVE BANK OF INDIA REGULATIONS & DEFINITIONS 1. 2. or (b) (c) a forward contract.77 Short title & commencement 1. (vi) `Registered Foreign Institutional Investor (FII) ' means a foreign institutional investor registered with Securities and Exchange board of India. They shall come in force on the 1st day of June 2000.78 Definitions In these Regulations. and includes. of foreign exchange. but does not include foreign exchange transaction for Cash or Tom or Spot deliveries. (iii) `Cash delivery ' means delivery of foreign exchange on the day of transaction . or a transaction which involves at least one interest rate applicable to a foreign currency not being a currency of Nepal or Bhutan . (vii) `Schedule' means a schedule annexed to these RegulationS. unless the context requires otherwise. whose value is derived from price movement in one or more underlying assets. (ii) `authorised dealer' means a person authorised as authorised dealer under sub. (viii) `Spot delivery' means delivery of foreign exchange on the second working day after the day of transaction. (i) `Act' means the Foreign Exchange Management Act. 2000.1999 (42 of 1999). other than Cash or Tom or Spot delivery. Page 92 of 100 . These Regulations may be called the Foreign Exchange Management (Foreign exchange derivative contracts) Regulations. (a) a transaction which involves at least one foreign currency other than currency of Nepal or Bhutan. 1. (iv) `Forward contract' means a transaction involving delivery.

The margins are subject to ceiling specified by FEDAI. Corporates can maintain foreign currency accounts abroad subject to approval by RBI.79 Summary of Exchange Rate Regime in India • • • Foreign exchange for all permitted imports. 1. Page 93 of 100 . All receipts from exports / remittances / income must be sold to AD at prevailing rate.80 Exchange Rate Calculations • • • • • • • • Cash or ready delivery means delivery on the same date. These include borrowing abroad. TT Rate denotes rate applicable for clean inward or outward remittance i.NMIMS FOREX EXPOSURE MANAGEMENT (ix) `Tom delivery' means delivery of foreign exchange on a working day next to the day of transaction.e. study abroad. When there is delay between bank paying the customer and bank itself getting paid (bank discounting export bill). hiring foreign personnel. etc. the bank may charge margin from the TT buying rate. payment of dividend. the delivery date is either fixed in which case the tenor is computed from the SPOT value date or it may be option Forward in which case the delivery may be during a specified week or fortnight. Value next day means delivery on the next business day. the bank undertake from the currency transfer and does not perform any other function such as handling documents. For other current account purposes like travel. SPOT means two business days ahead. interest on approved ECBs is freely available. • • 1. JV contribution. apart from effecting payment. specific exchange control guidelines. acquisition of assets abroad. A part of the earnings can be kept in the form of foreign currency for specified time period and this balance can be used for specified purpose. Similarly on the selling side when bank has to handle documents. Capital account transactions are subject to exchange controls. Rates quoted by banks to non-banking customers are called Merchant Rates. (x) The words and expressions used but not defined in these Regulations shall have the same meanings respectively assigned to them in the Act. For Forward contracts. margins are added to TT selling rate.

• Switch from primary to alternate currency is allowed on any roll over day. • If interest linked to LIBOR. • The loan document may provide for this option. borrower has option to continue in alternate currency. It would prescribe the primary currency (usually Dollar) and alternate currencies.NMIMS FOREX EXPOSURE MANAGEMENT 1. Conversion done at SPOT rate ruling on the roll over day. Page 94 of 100 . the new interest is based on LIBOR applicable to the alternate currency. switch back to primary currency or switch to another alternate currency. • Liability of the borrower is calculated in primary currency.81 Multi Currency Option • This enables the borrower to change the borrowed currency on any interest refixation day based on short-term view on likely movements in the exchange rates. • On the next roll over day.

Page 95 of 100 .  Lending bank has no difficulty in allowing multi currency option since it funds the loan through short-term borrowing. he can incur substantial repayment liability.  Borrower has to constantly monitor the exchange market and cover the exchange risk at appropriate point during the roll over by purchasing Swiss Franks in the forward market.NMIMS FOREX EXPOSURE MANAGEMENT FROM THE ILLUSTRATION .  Multi currency option does not require him to take a long term view on the currency borrowed but can limit the risk by taking a series of short term views.Lessons to be Learnt  If borrower's view on the likely movement in exchange rate goes wrong.

Short-Term Instrument Euro Commercial Paper (ECP) . Three and Six months LIBORs are normally available. Dollar being vehicle currency. CRR. A Euro currency deposit is a deposit in the relevant currency with a bank outside the home country of that currency. Parking of funds in Euro instead of US. Restrictions imposed by US authorities on domestic banks and capital markets . like Singapore and Hong Kong. It is mainly an inter-bank market trading in time deposits and debt instruments. b. For e. Interest Rates a. many European corporations have cash flows in Dollars and hence surpluses / deficits. LIBOR is index of rate charged by one first class bank in London to another first class bank for a short-term loan. c. • This results in reduced cost of funds. Page 96 of 100 . It is not necessarily rate charged by a particular bank but it is an indicator of demand supply condition in the inter-bank deposit market in London.g. Russians (Ironical) originated . • Lesser restrictions on "rating" and disclosure requirements applicable for domestic issues and registrations with security exchange authorities.82 Evolution of Euro market a.Short-Term Instrument Medium to Long-Term Floating Rate Loans Floating Rate Notes Why such instruments are so attractive? • Euro banks are free from regulatory provisions like CRR. Similarly a Euro Dollar Loan is a Dollar Loan made by bank outside the US to a customer / another bank. b. Inter-bank borrowing and lending rates are benchmarked by LIBOR. Deposit Insurance. US Dollar Deposit in London Bank is a Euro Dollar Deposit or a DM Deposit in Parris is Euro Mark Deposit. Instruments • • • • Certificates of Deposit (CD) . The prefix Euro is now outdated since such deposits / loans are often traded outside Europe.sale of gold and other commodities and buying grain.ceiling on deposit interest. A Euro currency deposits range in maturity from overnight to one year. In the Euro currency market. c. 1. b. c. etc. Deposit Insurance.NMIMS FOREX EXPOSURE MANAGEMENT INFORMATION ON EURO 1.83 What are Euro markets? a.

NMIMS FOREX EXPOSURE MANAGEMENT d. Page 97 of 100 . LIBOR varies according to the currency and the term.

It is no more a "Euro" market but a part of "offshore market". Tightening money supply or change of interest rates.00.  March 1993: Single market determined rate. Actual sale or purchase of dollars. Non-bank customers who buy / sell currency from authorized dealers. This market performed useful function of recycling "Petro-Dollars" beyond 1973 oil shock.founder member of IMF  Fixed Exchange Rate System . denominated in the currency of country C. 2.  Spot and forward rates determined by demand and supply.3529 = INR 100. Rupee linked to a secret basket. RBI continued to maintain parity with Pound and crossed currency rates determined through parity with Pound. Euro currencies market: Borrower / investor from country A could raise / place funds from / with financial institutions located in country B.  Forward Rate = Rate quoted for transaction over a period of time in case of transactions that takes place at a future date. 3.05.  Post 1971.  RBI can influence the market rates through: 1.  March 1992: LERMS .  Spot Rate = Rate used for immediate transaction for a particular time.  Buying Rate and selling rate are also referred as bid and offered rates. Verbal (media statements).00 = INR 47.g. Page 98 of 100 .Trade substantially diversified in terms of currencies.Intervention currency was Pound.  September 1975 . 2. Pound continued to intervention currency.  July 1991 major devaluation of Rupee.NMIMS FOREX EXPOSURE MANAGEMENT FOREX MARKET IN INDIA  India . US $ 1. Local Exchange Market is two tier 1.  Tomorrow value (TOM) for next working day. Tightening exchange control to curb speculation. 4.Duel Exchange Rate System 60:40. Massive cross border capital flows. Hence. Interbank market. Liberalization and removal of restrictions in developed and developing countries has accelerated geographical integration of financial markets. intervention currency changed to dollar and cash compensatory support for exports discontinued.  Indirect Rates US $ 2. Global Financial Market • • • • Emergence of global markets since mid 70's.  Direct Rate: Exchange rate for a foreign currency expressed in terms of units of local currency equal to one unit of foreign currency for e.

NMIMS FOREX EXPOSURE MANAGEMENT • • • • Early 80's: Process of disinter mediation where in highly rated issuers began approaching investors directly rather than going through bank loan route. Need for external financial assistance from developing countries due to disequilibrium in BOP. Intense competition amongst commercial banks. Extent of linkage (cost of funding) between domestic and offshore markets depends on extent of regulation in the domestic and offshore markets. lower spreads in domestic operations and hence need for additional products and markets. Page 99 of 100 .

Suresh Bagul. A. Secondary Sources of Data The Internet Economic Times Website The Business Standard Website Reserve Bank of India Website ICAI Website Giddy's Web Portal (ian.Alder. Ltd. Ltd. Mahesh Kalmane. Futures & other Derivatives .edu) The Managementor.Com website B. Ltd.giddy@nyu. M/s Ciba Specialty Chemicals India Limited II. M/s Ciba Specialty Chemicals India Limited Mr. Shapiro Options. International Financial Management-P.Alan C.P." .NMIMS FOREX EXPOSURE MANAGEMENT Bibliography & List of References I. Giddy & Gunter Dufey.APTE The Economic Times Business Standard RBI Circulars The Management of Foreign Exchange Risk .Ian H.G. Primary Sources of Data (Interview conducted with the following personnel from the Company): Mr. Michael Page 100 of 100 . Hull "Translation Methods and Operational Foreign Exchange Risk Management.John C. Ltd. Print Media Annual Annual Annual Annual Annual Report Report Report Report Report 2000-2001: 1999-2000: 1998-1999: 1997-1998: 1996-1997: M/s M/s M/s M/s M/s Ciba Ciba Ciba Ciba Ciba Specialty Specialty Specialty Specialty Specialty Chemicals Chemicals Chemicals Chemicals Chemicals India India India India India Ltd. Bharadwaj Multinational Financial Management . New York University and University of Michigan) Foreign Exchange Handbook -H.