FOREIGN EXCHANGE & RISK MANAGEMENT

Prepared by: Sagathiya Sanjay - 11072 Pathan Minhaz Khan -11029
Foreign Exchange Risk Management 1

TABLE OF CONTENT SR. NO. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. PARTICULARS TITLE TABLE OF CONTENT PREFACE ACKNOWLEDGEMET EXECUTIVE SUMMARY RESEARCH METHODOLOGY TRENDS IN WORLD TRADE WHAT IS FOREIGN TRADE? FOREX RISK WHAT TO DO HAVE A SHIELD AGIANST AFORESAID EXPOSURE INDIAN MARKET CONCERNS USE OF VARIUOS INSTRUMENTS INTERNATINAL CONCERNS CONCLUSION BIBLIOGRAPHY PAGE NO. 1 2 3 4 5 6 7 9 10 12 18 20 22 25 26

Foreign Exchange Risk Management

2

it has effect of the other disciplines on it. however. is Forex. Unintelligible! The industry.PREFACE Whichever the industry is. In 3rd semester. we want to assure you that we have done elementary as well as the high level study of the subject (of course. Result remains the same. We have tried our best to first understand the market. This study has been done as a part of academic intention. We have tried to take real world experience for the purpose of our study. have to do it. then to explain it in this report. The industry response was good enough. we have taken or rather we are interested in. This study is focusing on the world market. Moreover. We did not try to gauge its propensity. it’s as difficult as trying to measure the amount of water in the Indian Ocean. Foreign Exchange Risk Management 3 . strong and most of the world trade is carried out through them. It is obvious that forex appears if there is a foreign trade. However. It has been as good as any industry would have provided. It’s one of the most developing and dynamic market. who have opted for Core. this does not purport to say that other currencies business is not as developed as that of stronger one. in limit of our ability). the students. everyone tries. No one can gauge it. Because. We have used the currencies which are most popular.

The other persons. this project would not have been completed. are the Western Union Money Transfer and Advances Travel Private Limited.ACKNOWLEDGEMENT We are thankful to every person who came to help us in preparing this report. to whom we are thankful. Director of our beloved B. who helped us to understand how the forex industry works. who gave us opportunity to study in highly respected institute and inspired us to complete this report. directly or indirectly. Foreign Exchange Risk Management 4 . One such person is respected Dr. School of Business Management. Sarla Achyuthan. who helped us to choose our subject and taught us the basics as well as deeper elements of the subject.K. Without his guidance. We are also very grateful to Professor Dharmesh.

EXECUTIVE SUMMARY The knowledge of any field is very important. Those tools are sometimes savior and sometimes destroyer. This may be identified as a raw study of the whole market. primary and secondary data are taken. Internet came to rescue and for primary data. To manage highly likely risks. Foreign Exchange Risk Management 5 . To fulfill the need of data. intellectuals invented some tools. though. many officers and attendance of the Forex firms helped us. This is not highly researched and highly intelligent report. This is an attempt to understand as well as elaborate the dynamics of risk of Forex Market of the world. specially. For secondary data. As world became global village. the businesses started going global. so did the risk. if someone wants to do business in that field.

Navrangpura. Nr Swastik Char Rasta Bh My My Show Room. Resnic 2) Derivatives and Risk Management -Jhon C. -BIS.RESEARCH METHODOLOGY Primary Research: 1) Western Union Money Transfer Sur Apartment.380009 2) Advance Travel Ltd. -Ministry of Finance Foreign Exchange Risk Management 6 .380009 Secondary Data : 1) International Finance . Ahmedabad . C G Road. -Ministry of Commerce. Eun and Bruce G. 105 Sahajanand Complex.Choel S. Hull 3) International Finance Management -Madhu Vij 4) Web sites of -RBI. Navrang Pura H O Ahedabad .

the international trade also got the boost. but we shall dig into how it is working now. world trade is increasing. TRENDS IN WORLD TRADE As the business started becoming global. we will not answer that. though with some fluctuations. They are trying to take a ‘hedging’ against the problems they are facing. That’s not our topic of the project though. The following chart shows that. We will start with trade in the world.We have seen the effect of the America and Europe on each other and on rest if the world. How the exchange market started. However. SOME FACTS ABOUT INTERNATIONAL TRADE AND ITS INSTITUTIONS WORLD TRADE STATISTICS Foreign Exchange Risk Management 7 . we are reading all the news in newspapers about where they are heading. We have taken a tumbler of the tremendously shaking sea by this report.

The graph also depicts the data and its upward slope. 2011-12 was US$ 273467.87 crore) registering a growth of 45.46 million (Rs.77 million (Rs.43 per cent in Rupee terms over the same period last year. It is just for one month.35 crore) representing a growth of 21.23 million (Rs 820679. If we see the data of seven months.69 crore) in October.82 per cent higher in Dollar terms (22. it is shown that the percentages of the foreign trade of the total GDP of the world.1251948. cumulative value of exports for the period April-October 2011 -12 was US$ 179777. we have to enhance our import.97 million (Rs.73 million (Rs.28 crore) registering a growth of 30. which during October. it has shown tendency to increase. They were valued at US$ 19869.194636.19 crore) as against US$ 208821.43 crore) as against US$ 123170. Foreign Exchange Risk Management 8 .01 per cent in Rupee terms) over the level of imports valued at US$ 32461. 2011.64 million (Rs.In above chart.97 per cent in Rupee terms over the same period last year. India is also going in tandem with the world as the data shows the imports as well as exports are increasing like anything. Cumulative value of imports for the period April-October. This has been the major reason why companies all around the world have started hedging seriously. 955937.97875. 2011 were valued at US$ 39513.77) during October. but as we have to import crude oil to run our economy.72 per cent in Dollar terms (35. 79626.92 per cent higher in Rupee terms) than the level of US$ 17929. 2010.75 million (Rs.96 per cent in Dollar terms and 45. Though it is sometimes declining and looks like roller coaster ride.70 million ( Rs.96 per cent in Dollar terms and 30. Exports (including re-exports) There is huge jump of Exports during October.32 crore) which was 10.564313. 2010. 144164. Imports Increment in exports is favorable for the country.

77 The global trade. we should know what the types of risks are. and has been growing very fast during the recent years.23 export import 273467. Its situation will deteriorate. To know how those factors affect the exchange market. That means. the riskier it is. It is called foreign exchange risk.Export & Import 300000 250000 Amount in USD 200000 150000 100000 50000 0 April-October 2010 -11 April-October 2011 -12 Timeline 123170. Foreign Exchange risk is linked to unexpected fluctuation in the value of currency. we should know what the foreign exchange is. if the USD appreciates (read becomes costlier). Risk is involved in its practices. However. For example. It has some risk entailed. Indian company will need more rupees to pay for the same amount of USD. It is the largest financial market in the world by virtually any standard. currency which is having more value has more to lose. Indian trade vis-à-vis the exchange market is so dynamic that if President Obama sneezes. Indian company has the business with one US firm and it is supposed to pay some amount for imports. the market shows its concern. There are plenty of other threats which can shake the market from head to toe. There are many other factors which make forex market risky. Now.75 179777. To be clearer.46 208821. It is popularly known as forex. Foreign Exchange Risk Management 9 . WHAT IS FOREIGN EXCHANGE? Foreign Exchange rate is the rate on which two countries agree to exchange their goods and services. And to understand risk properly. This is because exchange rates are generally unanticipated. we cannot take sneezes of Obama as threats to the exchange market. The stronger the currency.

In this company does nothing but the spot and forward transaction. we might have to pay INR 52 per 1 USD. we will start with an example. Transaction exposure To understand this exposure. Generally MNCs have wide network of subsidiaries. (Present exchange rate is also called ‘current rate’ or ‘spot rate’). we will dig in them all. Going further in this regime. if today we have to pay 1 USD. we find three types of risks. If company wants to do standardized contracts. it imports raw materials from USA on regular basis. But if INR is depreciating. usually an MNC. This will stand contrary. One way is to do interbank transaction. The subsidiaries that are in weak economies should pay their international debts or other payments as soon as possible.76.    Transaction exposure Translation exposure and Economic exposure. an Indian company. it can go to the Exchange Markets. To manufacture these computers. FOREX RISK Above mentioned risk is basic type of risk. The company has to hedge against that risk in a number of ways. will import raw materials in Foreign Exchange Risk Management 10 . One such risk arises when a company. for the strong economies. Company will decide what would be the exchange rate in near future. For example. again. Assume further that today’s exchange rate is INR 51 per 1 USD. indulge in foreign trade. Now it. because there is a greater chance of their currency being depreciated. HCL. The unforgivable sins are to fail to consider the risks or fail to act on any decisions. exports its computers to USA. because MNCs operate in multiple countries and currencies. First step is to consider the risk. Exchange Markets provide future contracts and option contracts. second is to take decision for that and third is to how to minimize that risk. Such subsidiaries can be in strong economies or in weak economies or in both. To have a better idea. in relation to present exchange rate.Foreign exchange risk poses the greatest challenge to a multinational company. It will earn INR 51 millions. Let’s assume they are exporting computers worth 1 million USD. it will cost us INR 51.

We directly will refer to an example. But rate of the transaction date should be considered in case of translation of revenue and expenses. capital structure ratios. Maruti and TATA. Sometimes weighted average is also taken when items are transacted more often than not. it is related with the changes in economy. At this time exchange rate will affect the valuation of assets. However. This accounting process is called ‘translation’.next month. it should consider the exchange rate which is prevailing at that time. profitability ratio. solvency ratios etc. It has a risk of INR further depreciating. we cannot take protection against economic exposure. Financial engineers have devised many instruments to take care of aforesaid risks. Let’s say. Investors are interested in ‘their’ currency values. Let’s say there are two car manufacturers. This risk is. Because they will pay less than they had to pay previously. That’s why foreign accounts are restated in ‘their’ currency. Translation exposure MNC head office and its subsidiaries may be writing their book of accounts in different currencies. All financial statements of foreign subsidiaries have to be translated into the home currency for the purpose of finalizing the account. Now. Then for same 1 million imports HCL will have to pay INR 52 millions. Let’s have a look at them. They will restate their accounts from FFR and DEM to INR. Tatas are more competitive than Maruti. Economic exposure will have its affect in the long run. When the head office is consolidating the statements of assets and liabilities. Tatas are in better position. Tatas are importing from Britain and Maruti are manufacturing it in India. Economic exposure A company can have an economic exposure. say. called Transaction risk. HCL has to pay INR 1 million extra because of exchange rate fluctuation. This risk is the propensity to which the financial statements are affected by exchange rate changes. Maruti has lost its competitiveness. for it is related to accounting practices. in technical language. For example. in this next month the exchange rate is INR 52 per 1 USD. Generally this is the case. This is also called Accounting risk. when Pound sterling depreciates. Indian MNC’s foreign affiliates are in France and Germany. But what is economic exposure after all? As its name suggests. Foreign Exchange Risk Management 11 . In such way.

In March 1992. Money Market Hedge and options & swaps. the parties will decide it today. And when the parties require large amount in foreign trade. exporters. it is called Spot Rate. As the main motto is to fix the exchange rate. Imagine you will need raw materials in future. let’s again imagine that you expects that the euro will increase in future. So the supply of raw material is worth INR 70 lacs. it is a contract and it will take place on future date. This has been growing rapidly with increasing participation from corporate. This future date is usually later than two business days.000. There is one risk though. This future will come in 12 months time. The amount of purchase will be EURO 1. so the parties don’t need to bother about it. So. if the exchange rate changes to INR 71 for 1 EURO. you will agree to buy euro on today’s exchange rate of 70. This strategy works very well in extremely volatile market. However. unrestricted booking and cancellation of forward contracts for all genuine exposures. forward contracts were permitted only against trade related exposures and these contracts could not be cancelled except where the underlying transactions failed to materialize. banks and FIIs. Foreign Exchange Risk Management 12 . Explanation of them is given as under. Although due to the Asian crisis. they will transact at the decided rate. freedom to re-book cancelled contracts was suspended. It is decided by market mechanism of Supply and Demand. then the raw material will cost you 71 lacs. suppose. Till Derivatives Markets in India: 2003 209 February 1992.WHAT TO DO TO HAVE A SHIELD AGAINST ALL AFORESAID EXPOSURES? Financial engineers have devised many techniques to hedge against risks. You will buy it from foreign exporter of Germany. which has been since relaxed for the exporters but the restriction still remains for the importers. You will lose if the exchange rate becomes INR 69 for 1 EURO. What’s in there for India? An important segment of the forex derivatives market in India is the Rupee forward contracts market. 00. whether trade related or not. INR 70 for 1 EURO. importers. This contract pertains to the exchange rates of the two concerning currencies. Current exchange rate is. Forward exchange contract As its name suggests. Most used of them are Forward exchange Contracts. It is in the best interest of them as they know what the existing rate is. in order to provide operational freedom to corporate entities. Now. They will decide that whatever happens in future. were permitted. No change! As it is of today’s rate.

The question that we would need to address is within these constraints. how can the liquidity improve? Currency futures Indian forwards market is relatively illiquid for the standard maturity contracts as most of the contracts traded are for the month ends only. since they are traded on organized exchanges. also strengthen the case of their introduction. If you enter into such a contract. Understandably.Advantages--1. Currency futures. otherwise. You can set budgets because you know what will be the transaction costs as you know the exchange rate. The forward market in our country was active only up to six months. you are grilled.their minimal margin requirements and the low transactions costs relative to over-the-counter markets due to existence of a clearinghouse. Disadvantages--1. you cannot benefit by the favorable change in the exchange rate. If any adverse circumstances occur. It could be argued that given the future like nature of Indian forwards market. the maturity profile has elongated and now there are quotes available up to one year. also confer benefits from concentrating order flow and providing a transparent venue for price discovery. 2. Foreign Exchange Risk Management 13 . proves to be difficult at least in the early stages of development of the market. where two-way quotes are available. currency futures could be allowed. 2. As a result of the initiatives of the RBI. you have to perform your promise. You are protected against any adverse movement in the exchange rate. while over-the-counter forward contracts rely on bilateral negotiations. Because the rate is fixed. Some of the benefits provided by the futures are as follows: 1. 2. you will be prosecuted. One of the major issues that need to be addressed in the forward market relates to depth and liquidity. in most of markets where there are restrictions on capital movements. One of the reasons for the market makers’ reluctance to offer these contracts could be the absence of well-developed term money market. liquidity across the spectrum as seen in the developed markets. Two characteristics of futures contract.

e. to buy or sell a given quantity of a foreign currency for a specified amount of the domestic currency on or before a specified date in the future. Being rational. while currency swaps can be used to hedge long-term foreign exchange risk. This price is called the option premium. Currency swaps can be fixed-for-fixed. Since the option provides the buyer with a type of insurance. Currency Options and Swaps A currency option is a contract that gives the owner the right. However. but not the obligation. American options can be exercised at any time at or prior to the end of the contract. while European options can only be exercised at the expiration date of the contract. the option buyer would only exercise the option when it is to his advantage to do so. we would expect him to pay a price for it. Mechanics and Purposes of Currency Options and Swaps Both currency options and swaps are frequently used to hedge foreign exchange exposure. traders need only establish the number of contracts and their price. futures contracts are standardized utilizing the same delivery dates and the same nominal amount of currency units to be traded. 4.3. given the status of convertibility of Rupee whereby residents cannot freely transact in currency markets. A call currency option is an option to buy and a put currency option is an option to sell the foreign currency at the stated (exercise) price. Moreover.. Let us look at some examples to illustrate the hedging purpose of currency options and swaps. to protect the option buyer and the swap parties against adverse movements in foreign exchange rates. i. the introduction of futures may have to wait for further liberalization on the convertibility. if not. A currency swap involves the exchange of the principal and interest payments of a liability denominated in one currency for the principal and interest payments of a liability denominated in another currency. The difference between them is that currency options seldom have terms longer than a few years. or floating-for-floating rate debt service. 5. Contract standardization and clearing house facilities mean that price discovery can proceed rapidly and transaction costs for participants are relatively low. Foreign Exchange Risk Management 14 . he would let it expire. Hence. fixed-for-floating. Credit risks are further mitigated by daily marking to market of all futures positions with gains and losses paid by each participant to the clearinghouse by the end of trading session.

BritSub. At the end of year 3. One option for Can is to buy $100. Therefore. the swap helps Can and Sub avoids the foreign exchange risk by effectively locking them into a series of future exchange rates.000 principal at the end of year 3. which can be raised in the Canadian capital market by issuing 3-year bonds at 5%.000 generated by BritSub and Brit would use $10. An example of a currency swap is a bit more involving.000 directly in the international capital market or British capital market by issuing pound-denominated bonds. The two firms would then exchange these principals through the swap bank. during the next 3 years.000 for its 3-year expansion project in the U. Then. it will use BritSub's revenues to pay interests of $10.000 and $200.000 in the international or Canadian capital market at a rate of 6%.1/$1. it can raise $200. whereas the current normal borrowing rate for a well-known firm of equivalent creditworthiness is 7%. A currency swap.000 in three months to pay for raw materials. Can can hedge this transaction by buying call options for the delivery of $100.000 in three months at a specified rate. say. BritSub may have to generate a substantial amount of revenues in pounds to be able to service the dollar-denominated debt. Brit can raise $100. Can would use $7.000 at 5% in the Canadian capital market and Brit to raise the $100. Besides serving as effective hedging mechanism. Can can raise the $100.000.000 at 7% in the British capital market.Suppose that Can. The two firms also benefit from the cost savings as a result of the comparative advantage of Can and Sub in their respective national capital markets.000 in any event. a Canadian company is due to pay Brit.000 are paid back through the swap bank.000 at each year-end and repay the $200. while simultaneously allows Can to benefit should the pound depreciates.known and thus can only borrow the money at a rate of 8%.000 in the spot market at a price of $200. if the pound depreciates dramatically against the dollar. will solve the double problem of Can and Brit. have mirror-image financing needs. The swap bank would instruct Can to raise the $200.000 generated by CanSub to make interest payments through the swap bank. CanSub.000 to finance its expansion project in Canada with a 3-year economic life. Foreign Exchange Risk Management 15 . a British company. normally arranged by a swap bank. higher than the 5% at which Can can borrow in these markets.2 Suppose that Can has a British subsidiary. CanSub needs $200. $100.K. or alternatively. currency options and swaps are sometimes used for speculative purposes. the $100. The cost of this flexibility is the premium that Can pays for the calls. It should be noted that using foreign exchange derivatives for speculative purposes is extremely risky. $2.000 in the British capital market at 7%. This approach guarantees that the cost of the $100. Alternatively. As can be seen. The current spot exchange rate is $2/$1. At the end of each year.000 will not exceed $210. Suppose that Can is not well. Suppose further that Brit and its Canadian subsidiary. Revenues in pounds are translated using the spot rates at the times these payments are due. which needs $100.

000. Foreign Exchange Risk Management 16 . and non-financial dealers. According to the 2004 Bank of International Settlements (BIS) Survey. while the total daily volume of exchange-traded currency contracts was only $10 billion. Thirdly. Japanese yen. Exchange-traded currency options are normally written for American dollars. Japanese yen and Swiss franc At least U. other financial institutions. from $807 billion to over $4. up by 200%. although the size of this market remains relatively small compared to other currency derivative products.000 of the currency serving as the underlying asset. OTC options are also written on the major seven and sometimes less actively traded currencies. euro.. the aforementioned 2004 BIS Survey reported that the increase in turnover from 2001 to 2004 was particularly large for currency swaps. there existed clear. Secondly. the OTC currency option daily volume alone was approximately $117 billion. All of these factors encouraged both speculative strategies and hedging activity in the foreign ex. but generally are written for large amounts4 and typically European style. Canadian dollar. Inc. dollar. The types of counterparties entering currency options and swaps are quite diverse. Unlike currency options. British pound. The volume of OTC currency options trading is much larger than that of organized-exchange option trading.. including local and cross-border reporting dealers. British pound.change market. and Swiss franc. The five most common currencies used to denominate currency swaps are the U. Size of swap markets is measured by notional principal for interest rate swaps and principal for currency swaps. Firstly. foreign currency options have traded on the Philadelphia Stock Exchange since December 1982. $1.Currency Options and Swaps Market Statistics Currency options are traded on both derivatives exchanges and OTC markets. currency swaps are only traded on OTC markets. According to the International Swaps and Derivatives Association. OTC options can be tailor-made. this period was also marked with interest differentials. which encouraged investors to borrow in low interest rate currencies to invest in high interest rate currencies if the target currencies tended to appreciate against the funding currencies.S. with the euro and five other major currencies3 serving as the underlying currencies. from 1991 to 2002. higher volatility foreign exchange markets induced an increase in currency hedging activity. Galati and Melvin (2004) proposed several factors that may explain this surge in the currency derivatives market during the 2001-04 periods.5 trillion.S. Australian dollar.S. In the U. a 95% growth rate since 2001. The 2004 BIS Survey reported expanded business for all types of counterparties during the 2001-04 periods.5 Furthermore. total outstanding currency swaps increased 400%.

you would agree to sell the EUR to the bank. However. By entering into the foreign exchange swap with the bank you are giving them the use of a currency which they could invest at 5% and in return they are giving you the use of USD which you could only invest at 3%. A full exchange of funds takes place on the near date and you would deliver EUR 500. the domestic and foreign interest rates. The forward points adjustment is easily explained and calculated. Alternatively.000 to the bank. The value of a currency swap is the present value of the cash flows that a party is to pay and receive in the swap agreement discounted at proper discount rates. adjusted for forward points of -. In this case. It is an effective and efficient cash management tool for companies that have assets and liabilities denominated in different currencies. the exercise price. 0045.8955.Valuation of Currency Options and Swaps A currency option can be valued using either the binomial (for American options) or the Black-Scholes (for European options) option pricing model. with the cash flows in the foreign currency converted to the domestic currency at the spot rate. on the future (far) date the bank would return the EUR 500. assume the prevailing interest rate in Europe is 5% and in the United States are 3%. The purpose of the forward point’s adjustment is to equalize this interest rate differential and compensate you for 'giving up' or 'receiving' the higher interest bearing currency. currencies are initially swapped at the spot rate and the future (far) rate is calculated by adjusting the spot price by the forward points for the length of time the swap transaction runs for. Foreign Exchange Risk Management 17 . The SolutionIn the situation outlined above.000 to you on the near date (typically but not always the spot date). without incurring foreign exchange risk. In most cases.750. at the spot rate of 0. In return the bank will deliver USD 450. you swap one currency for another at an agreed foreign exchange rate and agree to swap the currencies back again on a future (far) date at a price agreed upon at the inception of the swap. On the near date.90. and the term to maturity of the option. At the same time you would agree to buy back the EUR and send back the USD in three months time at a spot price of 0.90. it should be noted that the value of a currency option at time t is a function of the following five variables: The spot exchange rate at time t. a currency swap can be thought of as a portfolio of forward contracts maturing at different dates and can be priced as such. In this case.000 and you would send the bank USD 447. Example of swap A Foreign Exchange Swap transaction allows you to utilize the funds you have in one currency to fund obligations denominated in a different currency. for a forward price of 0. The formulae are quite complex and discussing them in detail is out of the scope of this paper.

by paying a premium upfront.375 At the end of the period the bank would have EUR 506. Currency options would enable Indian industry and businesses to compete better in the international markets by hedging currency risk.250 At the end of the period you would have USD 453. This would be a big advantage for importers.750** ** The $2. swaps and options for hedging cross-currency exposures. Introduction of USD-INR options would enable Indian forex market participants manage their exposures better by hedging the dollar-rupee risk.375 Far Date $453.250 In the three month period you could earn 3% interest on the $450k for three months =$3.The forward points are easy to calculate and a simple method is outlined below: Near Date On the near date the Bank receives EUR 500k and pays you $450k.8955 Bank returns the EUR 500k to you at the agreed upon rate of 0.250 = Exchange Rate of 0. In cases where your surplus funds are in a currency with a low interest rate and your funding need is in a country with a higher interest rate environment.8955 and you send the bank USD 447. However. The advantages of currency options in dollar rupee would be as follows: 1.250. INDIAN MARKET CONCERNS RUPEE CURRENCY OPTIONS Corporate in India can use instruments such as forwards. 2% earnings on EUR500k for three months translated back to USD is $2. corporate is restricted to the use of forwards and USDINR swaps. the forward points will be “against you” and the “gain” in the example above would be reversed.9000 In the three month period the bank could earn 5% interest on the EUR 500k for three months = EUR 6. for hedging the USD-INR risk. exporters (of both goods and services) as well as businesses with exposures to international prices. Hedge for currency exposures to protect the downside while retaining the upside.250 “gain” you made on the transaction described above is simply the monetized difference between the interest rates in the two countries/currencies. Foreign Exchange Risk Management 18 .375 divided by EUR 506. $450k divided by EUR 500k =Spot Exchange Rate of 0.

Hence. but the market started developing as more market players as well as business houses started understanding these products and using them to manage their exposures.2.g. The nature of the instrument again makes its use possible as a hedge against uncertainty of the cash flows. Corporate were actively exploring the swap market in its various variants (such as principal only and coupon only swaps). e. Corporate started using FC-RE swaps mainly for the following purposes:   Hedging their currency exposures (ECBs. forex trade. since the spot and forward markets were being used to hedge these swap transactions. Non-linear payoff of the product enables its use as hedge for various special cases and possible exposures. and using the route not only to create but also to extinguish forex exposures. 4.) To reduce borrowing costs using the comparative advantage of borrowing in local markets (Alternative to ECBs – Borrow in INR and take the swap route to take exposure to the FC currency) The market witnessed expanding volumes in the initial years with volumes up to US$ 800 million being experienced at the peak. Using forwards or currency swaps would create the reverse positions if the company is not allotted the contract. Initially. Foreign Exchange Risk Management 19 . but the use of an option contract in this case would freeze the liability only to the option premium paid up front. Option structures can be used to hedge the volatility along with the non-linear nature of payoffs. introduction of USD-INR options would complete the spectrum of derivative products available to hedge INR currency risk. Attract further forex investments due to the availability of another mechanism for hedging forex risk. the regulator was worried about the impact of these transactions on the local forex markets. then the company runs a risk till the contract is awarded. If an Indian company is bidding for an international assignment where the bid quote would be in dollars but the costs would be in rupees. FOREIGN CURRENCY – RUPEE SWAPS Another spin-off of the liberalization and financial reform was the development of a fledgling market in FC-RE swaps. However. etc. A fledgling market in FC-RE swaps started with foreign banks and some financial institutions offering these products to corporate. 3. the market was very small and two way quotes were quite wide.

405 Options Currency swaps Forward 1625. Infosys. Reddy’s Lab and Ranbaxy. Maruti-Suzuki. Mahindra & Mahindra. Tata Consultancy Services. However. Arvind Mills. The authorized dealers were also allowed the use of currency swaps to hedge their asset liability portfolio. USE OF VARIOUS INSTRUMENTS The pie chart shows breakup of the whole market hedging done by major Indian companies. The above regulations led to a constriction in the market because of the one-sided nature of the market. Hedging by leading Companies (in Rs. A necessary pre-condition to increased liquidity would be the further development and increase in participants in the rupee swap market (linked to MIFOR) thereby creating an efficient hedge market to hedge rupee interest rate risk.253 12478. These companies include Reliance. the spot access was initially increased to US$ 25 million and then to US$ 50 million.) 8743. with a liberalizing regime and a buildup in foreign exchange reserves. Dr.64 Foreign Exchange Risk Management 20 . The above developments are expected to result in increased market activity with corporate being able to use the swap route in a more flexible manner to hedge their exposures.So the RBI tried to regulate the spot impact by passing the below regulations:    The authorized dealers offering swaps to corporate should try and match demand between the corporate The open position on the swap book and the access to the interbank spot market because of swap transaction was restricted to US$ 10 million The contract if cancelled is not allowed to be re-booked or re-entered for the same underlying.

people are losing faith in it. First is the level of inflation in the country. Maruti Udyog and Mahindra and Mahindra are the only firms using currency swaps. the plight of the Eurozone economy. RIL. Swaps are less popular as they obtain only 6. So does its price in other currency terms. The tailorability is a consideration as it enables the firms to match their exposures in an exact manner compared to exchange traded derivatives like futures that are standardized where exact matching is difficult. The use of Range barrier options by Infosys also suggests a strategy to tackle the high volatility of the dollar exchange rates. This has been adopted due to the marked high volatility of the US Dollar against the Rupee. Ranbaxy and RIL depend heavily on these contracts for their hedging requirements. As in the above showed pie chart. Because of this reason. Software firms have a limited domestic market and rely on exports for the major part of their revenues and hence require additional flexibility in hedging when the volatility is high. USD is looking very attractive currency to invest. as seen recently. forwards contracts can be tailored to the exact needs of the firm and this could be the reason for their popularity. These businesses. it has been increasing like hell. by nature involve longer gestation periods and higher initial capital outlays and this could explain their long planning horizons. Reason—it provides surety about the future price and. As discussed earlier. In fact. around INR 55 needed to buy just 1 USD. Another implication of this is that their planning horizons are shorter compared to capital intensive firms. The pie consists of 38. There were two reason mostly affected to rupee. it can be seen that earnings of all the firms are linked to either US dollar. It is evident that most Indian firms use forwards and options to Foreign Exchange Risk Management 21 . As the Eurozone is performing below the expectations. From pie chart. it hit the lowest point of its life. Options are more profitable instruments in volatile conditions as they offer unlimited upside profitability while hedging the downside risk whereas there is a risk with forwards if the expectation of the exchange rate (the guess) is wrong as firms lose out on some profit. the lower the purchasing power of the currency and the lower the value of currency. Forward contracts are commonly used and among these firms.Forward contracts are most suitable for the companies. forward contracts have got the lion’s share. Euro or Pound as firms transact primarily in these foreign currencies globally. Swap usage is a long term strategy for hedging and suggests that the planning horizons for these companies are longer than those of other firms. In recent times the rupee has experienced the highest level of value erosion. This strategy has been observed among many firms recently in India. There is data to support this argument. Due to that. The higher the inflation. Another observation is that TCS prefers to hedge its exposure to the US Dollar through options rather than forwards. which is not less than 55% of the total market. Second.02% of the whole market. It remained nearly double digit whole year.53% part of Options. the value of dollar is increasing.

200 billion. This implies that these firms chose short-term measures to hedge as opposed to foreign debt. Total forex instrument market is climbing though. compared to $1. The turnover in traditional foreign exchange markets declined substantially between 1998 and 2001. the absence of a Rupee futures exchange in India and curbs on foreign debt.87 2010 3981 19. This growth in the derivatives segment is even more substantial when viewed in the light of declining activity in the spot foreign exchange markets.09 2007 3324 71. including what are considered to be “traditional” foreign exchange derivative instruments. It also follows that most of these firms behave like Net Exporters and are adversely affected by appreciation of the local currency. In April 2001.hedge their foreign currency exposure.76 Foreign Exchange Risk Management 22 .4 trillion. With it percentage changes are also shown.86 2004 1934 56. 14 percent decline when volumes are measured at constant exchange rates.490 billion in April 1998. The findings of the survey are presented in the table and the chart on the next page. increased by an estimated 10 percent to $1. This preference is possibly a consequence of their costs being in Rupees. Whereas the global daily turnover during the same period in foreign exchange and interest rate derivative contracts. INTERNATIONAL CONCERNS Derivatives contracts are increasing to $111 trillion at end-December 2001 from $94 trillion at end-June 2000. not steadily. YEAR FOREX INSTRUMENTS USUANCE % CHANGE 1998 1527 0 2001 1239 -18. average daily turnover was $1. One bank did the survey. it must be pointed out that the data set considered for this study does not indicate how the use of foreign debt by these firms hedges their exposures to foreign exchange risk and whether such a strategy is used as a substitute or complement to hedging with derivatives. However. as it does every year. There are a few firms which have import liabilities which would be adversely affected by Rupee depreciation.

However. it has been become more than doubled. Since then. the Recession did not spare it from its spat. Situation of different instruments in 2010 (amount in USD) INSTRUMENT/YEAR SPOT TRANSACTION OUTRIGHT FORWARD FOREIGN EXCHANGE SWAPS CURRENCY SWAPS OPTIONS OTHER PRODUCTS 2010 1490 475 1765 43 207 Foreign Exchange Risk Management 23 . That means it is increasing with increasing propensity. Some analysts even believe this market itself is the culprit for the recent downturn. Its growth rate has been slowed down from 72% in 2007 to 20% in 2010. How ironic! The saver itself is the hunter. just see at the graph! Even the growth rate is increasing. It has declined once during the year of 2001. its rocketing is not steady.Global Forex Market T/O USD forex instruments 4500 4000 3500 3000 2500 2000 1500 1000 500 0 % change 72% 56% 80% 60% 40% 20% 20% 0% -19% 1998 2001 2004 Year 2007 2010 0% -20% -40% Amount in USD Only once it has declined! In span of just a decade. Tough it is growing.

The inflation and the predicament of the Eurozone. And by the size of the market. Currency swaps remained to be least used instrument. (Amount in USD) INSTRUMENT/YEAR SPOT TRANSACTION OUTRIGHT FORWARD FOREIGN EXCHANGE SWAPS CURRENCY SWAPS OPTIONS & OTHER PRODUCTS 1998 568 128 734 10 87 2001 386 130 656 7 60 2004 631 209 954 21 119 2007 1005 362 1714 31 212 2010 1490 475 1765 43 207 Each type of instrument has shown tendency to increase. To know what the situation of these instruments in previous year was.How is it in 2010 43 207 1490 1765 475 spot trancsation outright forward foreign exchange swaps currency swaps options other products In 2010. Foreign Exchange Contracts are as popular as before. if see overall. Outright Forward etc. the market is growing. This shows that the dynamism is working and companies are very well aware and Foreign Exchange Risk Management 24 . 20% is like a fortune. the market is contracted by 20%. However. the picture seems to be a little rejoiced. The reasons remain the same as above stated. Due to traders’ trust towards other instruments like Spot Transaction. But the last one named OPTIONS & OTHER PRODUCTS has managed to come as underdog. we will have to consult the past data and it is in the table. On the contrary.

Such instrument provides an ozone layer against the exposure of forex market’s ‘ultra violet rays’. They have devised a very good mechanism to tackle with the operations. to the some extent) to take care of the ‘bullies’ of the market. after the dumb and deaf Helen Keller. CONCLUSION This is how the forex market in the world works. the brokers of the market has ‘christened’ them as Helen. because. we don’t have any reason to believe that they are working properly. There are many national and international regulatory and agencies in the world which keeps hawk eye on such transactions. Foreign Exchange Risk Management 25 . Spot Transaction is popular because of various money changers such as Western Union Money Transfer. The inspector is placed in every market. That is the reason why though taking every type of protection companies have felt the heat of the global meltdown at their bottoms. In India. SEBI and RBI work in tandem to curb malpractices of the market. there is BIS (as well as WTO. But. On bigger and higher level.armed to confront the situation.

com 6.in 4. www.rbi.in 2. www.org. www.finmin.imf.commerce.com 3. www.in 5.BIBLIOGRAPHY 1.nic. www.bis. Foreign Exchange Risk Management 26 .nic.

Sign up to vote on this title
UsefulNot useful