university of mumbai--eco foreign excahge risk

7/29/2019 UNIVERSITY of MUMBAI--Eco Foreign Excahge Risk

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RESEARCH METHODOLOGY

Primary Research:

1) Western Union Money TransferMumbai.

2) Advance Travel Ltd.Vashi Navi Mumbai.

Secondary Data :

1) International Finance- Choel S. Eun and Bruce G. Resnic

2) Derivatives and Risk Management-Jhon C. Hull

3) International Finance Management-Madhu Vij

4) Web sites of-RBI,

-BIS,

-Ministry of Commerce,


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-Ministry of Finance


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We have seen the effect of the America and Europe on each other and on

rest if the world. They are trying to take a hedging against the problems they

are facing. However, we are reading all the news in newspapers about where

they are heading. Thats not our topic of the project though. We have taken a

tumbler of the tremendously shaking sea by this report. How the exchange

market started, we will not answer that, but we shall dig into how it is working

now. We will start with trade in the world.

TRENDS IN WORLD TRADE

As the business started becoming global, the international trade also got

the boost. The following chart shows that, though with some fluctuations, world

trade is increasing.

SOME FACTS ABOUT INTERNATIONAL TRADE AND ITS INSTITUTIONS

WORLD TRADE STATISTICS


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In above chart, it is shown that the percentages of the foreign trade of the

total GDP of the world. Though it is sometimes declining and looks like roller

coaster ride, it has shown tendency to increase. This has been the major reasonwhy companies all around the world have started hedging seriously.

India is also going in tandem with the world as the data shows the imports

as well as exports are increasing like anything.

Exports (including re-exports)

There is huge jump of Exports during October, 2011. They were valued at

US$ 19869.97 million (Rs.97875.32 crore) which was 10.82 per cent higher in

Dollar terms (22.92 per cent higher in Rupee terms) than the level of US$

17929.64 million (Rs. 79626.77) during October, 2010. It is just for one month.

If we see the data of seven months, cumulative value of exports for the period

April-October 2011 -12 was US$ 179777.23 million (Rs 820679.43 crore) as

against US$ 123170.46 million (Rs.564313.87 crore) registering a growth of

45.96 per cent in Dollar terms and 45.43 per cent in Rupee terms over the same

period last year. The graph also depicts the data and its upward slope.

Imports

Increment in exports is favorable for the country, but as we have to

import crude oil to run our economy, we have to enhance our import.

which during October, 2011 were valued at US$ 39513.73 million

(Rs.194636.35 crore) representing a growth of 21.72 per cent in Dollar

terms (35.01 per cent in Rupee terms) over the level of imports valued at

US$ 32461.70 million ( Rs. 144164.69 crore) in October, 2010.

Cumulative value of imports for the period April-October, 2011-12 was

US$ 273467.77 million (Rs.1251948.19 crore) as against US$ 208821.75

million (Rs. 955937.28 crore) registering a growth of 30.96 per cent in

Dollar terms and 30.97 per cent in Rupee terms over the same period last

year.


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The global trade, Indian trade vis--vis the exchange market is so

dynamic that if President Obama sneezes, the market shows its concern.

However, we cannot take sneezes of Obama as threats to the

exchange market. 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. To know how those factors affect the exchange market, weshould know what the types of risks are. And to understand risk properly,

we should know what the foreign exchange is. It is popularly known as

forex.

WHAT IS FOREIGN EXCHANGE?

Foreign Exchange rate is the rate on which two countries agree to

exchange their goods and services. It is the largest financial market in the worldby virtually any standard, and has been growing very fast during the recent

years. It has some risk entailed. It is called foreign exchange risk.

To be clearer, Foreign Exchange risk is linked to unexpected fluctuation

in the value of currency. The stronger the currency, the riskier it is. That means,

currency which is having more value has more to lose. This is because

exchange rates are generally unanticipated. For example, Indian company has

the business with one US firm and it is supposed to pay some amount for

imports. Now, if the USD appreciates (read becomes costlier), Indian company

123170.46

179777.23

208821.75

273467.77

0

50000

100000

150000

200000

250000

300000

April-October 2010 -11 April-October 2011 -12

AmountinUSD

Timeline

Export & Import

export

import


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will need more rupees to pay for the same amount of USD. Its situation will

deteriorate. Risk is involved in its practices.

Foreign exchange risk poses the greatest challenge to a multinational

company, because MNCs operate in multiple countries and currencies.

The unforgivable sins are to fail to consider the risks or fail to act on any

decisions.

First step is to consider the risk, second is to take decision for that and

third is to how to minimize that risk. One such risk arises when a company,

usually an MNC, indulge in foreign trade. The company has to hedge against

that risk in a number of ways. One way is to do interbank transaction. In this

company does nothing but the spot and forward transaction. Company willdecide what would be the exchange rate in near future, in relation to present

exchange rate. (Present exchange rate is also called current rate or spot rate).

If company wants to do standardized contracts, it can go to the Exchange

Markets. Exchange Markets provide future contracts and option contracts.

Generally MNCs have wide network of subsidiaries. Such subsidiaries

can be in strong economies or in weak economies or in both. The subsidiaries

that are in weak economies should pay their international debts or other

payments as soon as possible, because there is a greater chance of their currency

being depreciated. For example, if today we have to pay 1 USD, it will cost us

INR 51.76. But if INR is depreciating, we might have to pay INR 52 per 1 USD.

This will stand contrary, for the strong economies.

FOREX RISK

Above mentioned risk is basic type of risk. Going further in this regime, wefind three types of risks.

Transaction exposure Translation exposure and Economic exposure.

To have a better idea, we will dig in them all.


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Transaction exposure

To understand this exposure, we will start with an example.

HCL, an Indian company, exports its computers to USA. To manufacture

these computers, it imports raw materials from USA on regular basis. Lets

assume they are exporting computers worth 1 million USD. Assume further that

todays exchange rate is INR 51 per 1 USD. It will earn INR 51 millions. Now

it, again, will import raw materials in next month. Lets say, in this next month

the exchange rate is INR 52 per 1 USD. Then for same 1 million imports HCL

will have to pay INR 52 millions.

HCL has to pay INR 1 million extra because of exchange rate fluctuation.

It has a risk of INR further depreciating. This risk is, in technical language,

called Transaction risk.

Translation exposure

MNC head office and its subsidiaries may be writing their book of

accounts in different currencies. Generally this is the case. All financialstatements of foreign subsidiaries have to be translated into the home currency

for the purpose of finalizing the account. Investors are interested in their

currency values. Thats why foreign accounts are restated in their currency.

For example, say, Indian MNCs foreign affiliates are in France and

Germany. They will restate their accounts from FFR and DEM to INR. This

accounting process is called translation. At this time exchange rate will affect

the valuation of assets, capital structure ratios, profitability ratio, solvency ratiosetc. This risk is the propensity to which the financial statements are affected by

exchange rate changes. When the head office is consolidating the statements of

assets and liabilities, it should consider the exchange rate which is prevailing at

that time. But rate of the transaction date should be considered in case of

translation of revenue and expenses. Sometimes weighted average is also taken

when items are transacted more often than not. This is also called Accounting

risk, for it is related to accounting practices.


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Economic exposure

A company can have an economic exposure. But what is economic

exposure after all?

As its name suggests, it is related with the changes in economy. We

directly will refer to an example. Lets say there are two car manufacturers,

Maruti and TATA. Tatas are importing from Britain and Maruti are

manufacturing it in India. Now, when Pound sterling depreciates, Tatas are in

better position. Because they will pay less than they had to pay previously. Insuch way, Tatas are more competitive than Maruti. Maruti has lost its

competitiveness.

Economic exposure will have its affect in the long run. However, we

cannot take protection against economic exposure.

Financial engineers have devised many instruments to take care of

aforesaid risks. Lets have a look at them.

WHAT TO DO TO HAVE A SHIELD AGAINST ALL AFORESAID

EXPOSURES?

Financial engineers have devised many techniques to hedge against risks.

Most used of them are Forward exchange Contracts, Money Market Hedge and

options & swaps. Explanation of them is given as under.

Forward exchange contract

As its name suggests, it is a contract and it will take place on future date.

This future date is usually later than two business days. This contract pertains to

the exchange rates of the two concerning currencies. As the main motto is to fix

the exchange rate, the parties will decide it today. It is in the best interest of

them as they know what the existing rate is. They will decide that whatever

happens in future, they will transact at the decided rate. No change! As it is of

todays rate, it is called Spot Rate. It is decided by market mechanism of Supply

and Demand, so the parties dont need to bother about it.


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Imagine you will need raw materials in future. This future will come in

12 months time. You will buy it from foreign exporter of Germany. The amount

of purchase will be EURO 1, 00,000. Current exchange rate is, suppose, INR 70

for 1 EURO. So the supply of raw material is worth INR 70 lacs. However, if

the exchange rate changes to INR 71 for 1 EURO, then the raw material will

cost you 71 lacs. Now, lets again imagine that you expects that the euro will

increase in future. So, you will agree to buy euro on todays exchange rate of

70.

There is one risk though. You will lose if the exchange rate becomes INR

69 for 1 EURO.

This strategy works very well in extremely volatile market. And when

the parties require large amount in foreign trade.

Whats in there for India?

An important segment of the forex derivatives market in India is the

Rupee forward contracts market. This has been growing rapidly with increasing

participation from corporate, exporters, importers, banks and FIIs. Till

Derivatives Markets in India: 2003 209 February 1992, forward contracts were

permitted only against trade related exposures and these contracts could not be

cancelled except where the underlying transactions failed to materialize. In

March 1992, in order to provide operational freedom to corporate entities,

unrestricted booking and cancellation of forward contracts for all genuine

exposures, whether trade related or not, were permitted. Although due to the

Asian crisis, freedom to re-book cancelled contracts was suspended, which has

been since relaxed for the exporters but the restriction still remains for the

importers.

Advantages---

1. You are protected against any adverse movement in the exchange rate.2. You can set budgets because you know what will be the transaction costs

as you know the exchange rate.


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Disadvantages---

1. If you enter into such a contract, you have to perform your promise;otherwise, you will be prosecuted. If any adverse circumstances occur,

you are grilled.

2. Because the rate is fixed, you cannot benefit by the favorable change inthe exchange rate.

One of the major issues that need to be addressed in the forward market

relates to depth and liquidity. The forward market in our country was active

only up to six months, where two-way quotes are available. As a result of the

initiatives of the RBI, the maturity profile has elongated and now there are

quotes available up to one year. Understandably, in most of markets where thereare restrictions on capital movements, liquidity across the spectrum as seen in

the developed markets, proves to be difficult at least in the early stages of

development of the market. 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. One of thereasons for the market makers reluctance to offer these contracts could be the

absence of well-developed term money market. It could be argued that given the

future like nature of Indian forwards market, currency futures could be allowed.

Some of the benefits provided by the futures are as follows:

1. Currency futures, since they are traded on organized exchanges, alsoconfer benefits from concentrating order flow and providing a transparent

venue for price discovery, while over-the-counter forward contracts relyon bilateral negotiations.

2. Two characteristics of futures contract- their minimal marginrequirements and the low transactions costs relative to over-the-counter

markets due to existence of a clearinghouse, also strengthen the case of

their introduction.


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3. Credit risks are further mitigated by daily marking to market of allfutures positions with gains and losses paid by each participant to the

clearinghouse by the end of trading session.

4. Moreover, futures contracts are standardized utilizing the same deliverydates and the same nominal amount of currency units to be traded. Hence,traders need only establish the number of contracts and their price.

5. Contract standardization and clearing house facilities mean that pricediscovery can proceed rapidly and transaction costs for participants are

relatively low.

However, given the status of convertibility of Rupee whereby residents

cannot freely transact in currency markets, the introduction of futures may have

to wait for further liberalization on the convertibility.

Currency Options and Swaps

A currency option is a contract that gives the owner the right, but not the

obligation, to buy or sell a given quantity of a foreign currency for a specifiedamount of the domestic currency on or before a specified date in the future. 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. Being rational, the option

buyer would only exercise the option when it is to his advantage to do so; if not,

he would let it expire. Since the option provides the buyer with a type of

insurance, we would expect him to pay a price for it. This price is called the

option premium. 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 theexpiration date of the contract.

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. Currency

swaps can be fixed-for-fixed, fixed-for-floating, or floating-for-floating rate

debt service.


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Mechanics and Purposes of Currency Options and Swaps

Both currency options and swaps are frequently used to hedge foreign

exchange exposure, i.e., to protect the option buyer and the swap parties against

adverse movements in foreign exchange rates. The difference between them is

that currency options seldom have terms longer than a few years, while currency

swaps can be used to hedge long-term foreign exchange risk.

Let us look at some examples to illustrate the hedging purpose of currency

options and swaps.

Suppose that Can, a Canadian company is due to pay Brit, a British

company, $100,000 in three months to pay for raw materials. The current spot

exchange rate is $2/$1. Can can hedge this transaction by buying call options

for the delivery of $100,000 in three months at a specified rate, say, $2.1/$1.

This approach guarantees that the cost of the $100,000 will not exceed $210,000

in any event, while simultaneously allows Can to benefit should the pound

depreciates.

The cost of this flexibility is the premium that Can pays for the calls. An

example of a currency swap is a bit more involving.2 Suppose that Can has a

British subsidiary, BritSub, which needs $100,000 for its 3-year expansion

project in the U.K. One option for Can is to buy $100,000 in the spot market at

a price of $200,000, which can be raised in the Canadian capital market by

issuing 3-year bonds at 5%. Then, during the next 3 years, it will use BritSub's

revenues to pay interests of $10,000 at each year-end and repay the $200,000

principal at the end of year 3.

Revenues in pounds are translated using the spot rates at the times these

payments are due. Therefore, if the pound depreciates dramatically against the

dollar, BritSub may have to generate a substantial amount of revenues in

pounds to be able to service the dollar-denominated debt. Alternatively, Can can

raise the $100,000 directly in the international capital market or British capital

market by issuing pound-denominated bonds. Suppose that Can is not well-

known and thus can only borrow the money at a rate of 8%, whereas the current

normal borrowing rate for a well-known firm of equivalent creditworthiness is

7%.

Suppose further that Brit and its Canadian subsidiary, CanSub, have

mirror-image financing needs. CanSub needs $200,000 to finance its expansion

project in Canada with a 3-year economic life. Brit can raise $100,000 in the

British capital market at 7%, or alternatively, it can raise $200,000 in the


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international or Canadian capital market at a rate of 6%, higher than the 5% at

which Can can borrow in these markets.

A currency swap, normally arranged by a swap bank, will solve the

double problem of Can and Brit. The swap bank would instruct Can to raise the

$200,000 at 5% in the Canadian capital market and Brit to raise the $100,000 at

7% in the British capital market. The two firms would then exchange these

principals through the swap bank. At the end of each year, Can would use

$7,000 generated by BritSub and Brit would use $10,000 generated by CanSub

to make interest payments through the swap bank. At the end of year 3, the

$100,000 and $200,000 are paid back through the swap bank. As can be seen,

the swap helps Can and Sub avoids the foreign exchange risk by effectively

locking them into a series of future exchange rates. 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.

Besides serving as effective hedging mechanism, currency options and

swaps are sometimes used for speculative purposes. It should be noted that

using foreign exchange derivatives for speculative purposes is extremely risky.

Currency Options and Swaps Market Statistics

Currency options are traded on both derivatives exchanges and OTC

markets. In the U.S., foreign currency options have traded on the Philadelphia

Stock Exchange since December 1982. Exchange-traded currency options are

normally written for American dollars, with the euro and five other major

currencies3 serving as the underlying currencies.

OTC options are also written on the major seven and sometimes less

actively traded currencies. OTC options can be tailor-made, but generally are

written for large amounts4 and typically European style. The volume of OTC

currency options trading is much larger than that of organized-exchange option

trading. According to the 2004 Bank of International Settlements (BIS) Survey,

the OTC currency option daily volume alone was approximately $117 billion, a

95% growth rate since 2001, while the total daily volume of exchange-traded

currency contracts was only $10 billion.

Unlike currency options, currency swaps are only traded on OTC

markets. According to the International Swaps and Derivatives Association,

Inc., from 1991 to 2002, total outstanding currency swaps increased 400%, from

$807 billion to over $4.5 trillion.5 Furthermore, the aforementioned 2004 BIS


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Survey reported that the increase in turnover from 2001 to 2004 was particularly

large for currency swaps, up by 200%, although the size of this market remains

relatively small compared to other currency derivative products.

The five most common currencies used to denominate currency swaps

are the U.S. dollar, euro, Japanese yen, British pound, and Swiss franc. The

types of counterparties entering currency options and swaps are quite diverse,

including local and cross-border reporting dealers, other financial institutions,

and non-financial dealers. The 2004 BIS Survey reported expanded business for

all types of counterparties during the 2001-04 periods.

Galati and Melvin (2004) proposed several factors that may explain this

surge in the currency derivatives market during the 2001-04 periods. Firstly,

there existed clear, British pound, Australian dollar, Canadian dollar, Japanese

yen and Swiss franc At least U.S. $1,000,000 of the currency serving as the

underlying asset. Size of swap markets is measured by notional principal for

interest rate swaps and principal for currency swaps. Secondly, higher volatility

foreign exchange markets induced an increase in currency hedging activity.

Thirdly, 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. All of these factors encouraged both speculative strategies

and hedging activity in the foreign exchange market.

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. The

formulae are quite complex and discussing them in detail is out of the scope ofthis paper. However, 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, the exercise price, the domestic and foreign interest rates, and the term to

maturity of the option. 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, with the cash flows in the foreign currency converted to

the domestic currency at the spot rate.

Alternatively, a currency swap can be thought of as a portfolio of forwardcontracts maturing at different dates and can be priced as such.


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Example of swap

A Foreign Exchange Swap transaction allows you to utilize the funds youhave in one currency to fund obligations denominated in a different currency,without incurring foreign exchange risk. It is an effective and efficient cashmanagement tool for companies that have assets and liabilities denominated indifferent currencies. On the near date, you swap one currency for another at anagreed foreign exchange rate and agree to swap the currencies back again on afuture (far) date at a price agreed upon at the inception of the swap. In mostcases, 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 oftime the swap transaction runs for.

The Solution-

In the situation outlined above, you would agree to sell the EUR to the

bank, at the spot rate of 0.90. A full exchange of funds takes place on the neardate and you would deliver EUR 500,000 to the bank. In return the bank willdeliver USD 450,000 to you on the near date (typically but not always the spotdate). At the same time you would agree to buy back the EUR and send backthe USD in three months time at a spot price of 0.90, adjusted for forward

points of -. 0045, for a forward price of 0.8955.In this case, on the future (far) date the bank would return the EUR

500,000 and you would send the bank USD 447,750. The forward pointsadjustment is easily explained and calculated. In this case, assume the

prevailing interest rate in Europe is 5% and in the United States are 3%. Byentering into the foreign exchange swap with the bank you are giving them theuse of a currency which they could invest at 5% and in return they are givingyou the use of USD which you could only invest at 3%. The purpose of theforward points adjustment is to equalize this interest rate differential and

compensate you for 'giving up' or 'receiving' the higher interest bearingcurrency.


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The forward points are easy to calculate and a simple method is outlinedbelow:Near Date

On the near date the Bank receives EUR 500k and pays you $450k.$450k divided by EUR 500k =Spot Exchange Rate of 0.9000In the three month period the bank could earn 5% interest on the EUR 500k forthree months = EUR 6,250

In the three month period you could earn 3% interest on the $450k

for three months =$3,375

At the end of the period the bank would have EUR 506,250At the end of the period you would have USD 453,375Far Date

$453,375 divided by EUR 506,250 = Exchange Rate of 0.8955 Bankreturns the EUR 500k to you at the agreed upon rate of 0.8955 and you send the

bank USD 447,750**** The $2,250 gain you made on the transaction described above is

simply the monetized difference between the interest rates in the two

countries/currencies. 2% earnings on EUR500k for three months

translated back to USD is $2,250.

In cases where your surplus funds are in a currency with a low interestrate and your funding need is in acountry with a higher interest rateenvironment, the forward points will be against you and the gain in theexample above would be reversed.


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INDIAN MARKET CONCERNS

RUPEE CURRENCY OPTIONS

Corporate in India can use instruments such as forwards, swaps and

options for hedging cross-currency exposures. However, for hedging the USD-

INR risk, corporate is restricted to the use of forwards and USDINR swaps.

Introduction of USD-INR options would enable Indian forex market

participants manage their exposures better by hedging the dollar-rupee risk.

The advantages of currency options in dollar rupee would be as follows:

1. Hedge for currency exposures to protect the downside while retaining theupside, by paying a premium upfront. This would be a big advantage for

importers, exporters (of both goods and services) as well as businesses

with exposures to international prices. Currency options would enable

Indian industry and businesses to compete better in the international

markets by hedging currency risk.

2.

Non-linear payoff of the product enables its use as hedge for variousspecial cases and possible exposures. e.g. If an Indian company is bidding

for an international assignment where the bid quote would be in dollars

but the costs would be in rupees, then the company runs a risk till the

contract is awarded. Using forwards or currency swaps would create the

reverse positions if the company is not allotted the contract, but the use of

an option contract in this case would freeze the liability only to the option

premium paid up front.

3. The nature of the instrument again makes its use possible as a hedgeagainst uncertainty of the cash flows. Option structures can be used to

hedge the volatility along with the non-linear nature of payoffs.

4. Attract further forex investments due to the availability of anothermechanism for hedging forex risk.

Hence, introduction of USD-INR options would complete the spectrum ofderivative products available to hedge INR currency risk.


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FOREIGN CURRENCYRUPEE SWAPS

Another spin-off of the liberalization and financial reform was the

development of a fledgling market in FC-RE swaps. A fledgling market in FC-

RE swaps started with foreign banks and some financial institutions offeringthese products to corporate. Initially, the market was very small and two way

quotes were quite wide, 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. Corporate started using FC-RE swaps

mainly for the following purposes:

Hedging their currency exposures (ECBs, forex trade, etc.) To reduce borrowing costs using the comparative advantage of

borrowing in local markets (Alternative to ECBsBorrow 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. Corporate were actively

exploring the swap market in its various variants (such as principal only and

coupon only swaps), and using the route not only to create but also to extinguish

forex exposures. However, the regulator was worried about the impact of thesetransactions on the local forex markets, since the spot and forward markets were

being used to hedge these swap transactions.

So the RBI tried to regulate the spot impact by passing the below regulations:

The authorized dealers offering swaps to corporate should try and matchdemand between the corporate

The open position on the swap book and the access to the interbank spotmarket because of swap transaction was restricted to US$ 10 million

The contract if cancelled is not allowed to be re-booked or re-entered forthe same underlying.

The above regulations led to a constriction in the market because of the one-

sided nature of the market. However, with a liberalizing regime and a buildup in

foreign exchange reserves, the spot access was initially increased to US$ 25million and then to US$ 50 million. The authorized dealers were also allowed


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the use of currency swaps to hedge their asset liability portfolio. 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. 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.

USE OF VARIOUS INSTRUMENTS

The pie chart shows breakup of the whole market hedging done by major

Indian companies. These companies include Reliance, Maruti-Suzuki,

Mahindra & Mahindra, Arvind Mills, Infosys, Tata Consultancy Services, Dr.Reddys Lab and Ranbaxy.

Forward contracts are most suitable for the companies. There is data tosupport this argument. As in the above showed pie chart, forward contracts have

got the lions share, which is not less than 55% of the total market. Reasonit

provides surety about the future price and, as seen recently, it has been

increasing like hell. The pie consists of 38.53% part of Options.

Swaps are less popular as they obtain only 6.02% of the whole market. In

recent times the rupee has experienced the highest level of value erosion. In

fact, it hit the lowest point of its life, around INR 55 needed to buy just 1 USD.

There were two reason mostly affected to rupee. First is the level of inflation in

8743.253

1625.64

12478.405

Hedging by leading Companies

(in Rs.)

Options

Currency swaps

Forward


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the country. It remained nearly double digit whole year. The higher the

inflation, the lower the purchasing power of the currency and the lower the

value of currency. Second, the plight of the Eurozone economy. As the

Eurozone is performing below the expectations, people are losing faith in it.

Due to that, USD is looking very attractive currency to invest. Because of this

reason, the value of dollar is increasing. So does its price in other currency

terms.

From pie chart, it can be seen that earnings of all the firms are linked toeither US dollar, Euro or Pound as firms transact primarily in these foreigncurrencies globally. Forward contracts are commonly used and among thesefirms, Ranbaxy and RIL depend heavily on these contracts for their hedgingrequirements. As discussed earlier, forwards contracts can be tailored to the

exact needs of the firm and this could be the reason for their popularity. Thetailorability is a consideration as it enables the firms to match their exposures inan exact manner compared to exchange traded derivatives like futures that arestandardized where exact matching is difficult.

RIL, Maruti Udyog and Mahindra and Mahindra are the only firms usingcurrency swaps. Swap usage is a long term strategy for hedging and suggeststhat the planning horizons for these companies are longer than those of otherfirms. These businesses, by nature involve longer gestation periods and higherinitial capital outlays and this could explain their long planning horizons.

Another observation is that TCS prefers to hedge its exposure to the USDollar through options rather than forwards. This strategy has been observedamong many firms recently in India. This has been adopted due to the markedhigh volatility of the US Dollar against the Rupee.

Options are more profitable instruments in volatile conditions as theyoffer unlimited upside profitability while hedging the downside risk whereasthere is a risk with forwards if the expectation of the exchange rate (the guess) iswrong as firms lose out on some profit. The use of Range barrier options byInfosys also suggests a strategy to tackle the high volatility of the dollar

exchange rates. Software firms have a limited domestic market and rely onexports for the major part of their revenues and hence require additionalflexibility in hedging when the volatility is high.

Another implication of this is that their planning horizons are shortercompared to capital intensive firms. It is evident that most Indian firms useforwards and options to hedge their foreign currency exposure. This implies thatthese firms chose short-term measures to hedge as opposed to foreign debt. This

preference is possibly a consequence of their costs being in Rupees, the absenceof a Rupee futures exchange in India and curbs on foreign debt. It also followsthat most of these firms behave like Net Exporters and are adversely affected by


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appreciation of the local currency. There are a few firms which have importliabilities which would be adversely affected by Rupee depreciation.

However, it must be pointed out that the data set considered for this studydoes 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 asubstitute or complement to hedging with derivatives.

INTERNATIONAL CONCERNS

Derivatives contracts are increasing to $111 trillion at end-December2001 from $94 trillion at end-June 2000. This growth in the derivatives segmentis even more substantial when viewed in the light of declining activity in thespot foreign exchange markets.

The turnover in traditional foreign exchange markets declinedsubstantially between 1998 and 2001. In April 2001, average daily turnover was$1,200 billion, compared to $1,490 billion in April 1998, 14 percent declinewhen volumes are measured at constant exchange rates. Whereas the globaldaily turnover during the same period in foreign exchange and interest ratederivative contracts, including what are considered to be traditional foreign

exchange derivative instruments, increased by an estimated 10 percent to $1.4trillion.

One bank did the survey, as it does every year. The findings of the survey

are presented in the table and the chart on the next page. Total forex instrument

market is climbing though, not steadily. With it percentage changes are also

shown.

YEAR 1998 2001 2004 2007 2010

FOREX

INSTRUMENTS

USUANCE

1527 1239 1934 3324 3981

% CHANGE 0 -18.86 56.09 71.87 19.76


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Only once it has declined!

In span of just a decade, it has been become more than doubled.

However, its rocketing is not steady. It has declined once during the year of

2001. Since then, just see at the graph! Even the growth rate is increasing. That

means it is increasing with increasing propensity. Tough it is growing, the

Recession did not spare it from its spat. Its growth rate has been slowed downfrom 72% in 2007 to 20% in 2010. Some analysts even believe this market itself

is the culprit for the recent downturn. How ironic! The saver itself is the hunter.

Situation of different instruments in 2010 (amount in USD)

INSTRUMENT/YEAR 2010SPOT TRANSACTION 1490

OUTRIGHT FORWARD 475

FOREIGN EXCHANGE

SWAPS

1765

CURRENCY SWAPS 43

OPTIONS OTHER

PRODUCTS

207

0%

-19%

56%

72%

20%

-40%

-20%

0%

20%

40%

60%

80%

0

500

1000

1500

2000

2500

3000

3500

4000

4500

1998 2001 2004 2007 2010

AmountinUSD

Year

Global Forex Market T/O

USD

forex instruments % change


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In 2010, the picture seems to be a little rejoiced. However, if see overall,

the market is contracted by 20%. And by the size of the market, 20% is like a

fortune. Currency swaps remained to be least used instrument. On the contrary,

Foreign Exchange Contracts are as popular as before. The reasons remain the

same as above stated. The inflation and the predicament of the Eurozone.

To know what the situation of these instruments in previous year was, we

will have to consult the past data and it is in the table. (Amount in USD)

INSTRUMENT/YEAR 1998 2001 2004 2007 2010

SPOT TRANSACTION 568 386 631 1005 1490

OUTRIGHT FORWARD 128 130 209 362 475

FOREIGN EXCHANGE

SWAPS

734 656 954 1714 1765

CURRENCY SWAPS 10 7 21 31 43

OPTIONS & OTHERPRODUCTS

87 60 119 212 207

Each type of instrument has shown tendency to increase. But the last one

named OPTIONS & OTHER PRODUCTS has managed to come as underdog.

Due to traders trust towards other instruments like Spot Transaction, Outright

Forward etc. the market is growing. This shows that the dynamism is working

and companies are very well aware and armed to confront the situation. Spot

Transaction is popular because of various money changers such as WesternUnion Money Transfer.

1490

475

1765

43 207

How is it in 2010

spot trancsation

outright forward

foreign exchange swaps

currency swaps

options other products


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CONCLUSION

This is how the forex market in the world works. Such instrument

provides an ozone layer against the exposure of forex markets ultra violet

rays. There are many national and international regulatory and agencies in theworld which keeps hawk eye on such transactions. In India, SEBI and RBI work

in tandem to curb malpractices of the market. On bigger and higher level, there

is BIS (as well as WTO, to the some extent) to take care of the bullies of the

market. They have devised a very good mechanism to tackle with the

operations. The inspector is placed in every market. But, we dont have any

reason to believe that they are working properly, because, the brokers of the

market has christened them as Helen, after the dumb and deaf Helen Keller.

That is the reason why though taking every type of protection companies havefelt the heat of the global meltdown at their bottoms .


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BIBLIOGRAPHY

1.www.rbi.org.in2.www.bis.com3.www.finmin.nic.in4.www.commerce.nic.in5.www.imf.com
http://www.rbi.org.in/http://www.rbi.org.in/http://www.rbi.org.in/http://www.bis.com/http://www.bis.com/http://www.bis.com/http://www.finmin.nic.in/http://www.finmin.nic.in/http://www.finmin.nic.in/http://www.commerce.nic.in/http://www.commerce.nic.in/http://www.commerce.nic.in/http://www.imf.com/http://www.imf.com/http://www.imf.com/http://www.imf.com/http://www.commerce.nic.in/http://www.finmin.nic.in/http://www.bis.com/http://www.rbi.org.in/

university of mumbai--eco foreign excahge risk

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