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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
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.
SOME FACTS ABOUT INTERNATIONAL TRADE AND ITS INSTITUTIONS WORLD TRADE STATISTICS
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 reason why 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.
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.
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, we should 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 world by 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
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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 will decide 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, we find three types of risks. Transaction exposure Translation exposure and Economic exposure. To have a better idea, we will dig in them all.
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 financial statements 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 ratios etc. 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.
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. In such 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.
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.
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 in the 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 there are 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 the reasons 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, also confer benefits from concentrating order flow and providing a transparent venue for price discovery, while over-the-counter forward contracts rely on bilateral negotiations. 2. Two characteristics of futures contract- their minimal margin requirements 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 all futures 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 delivery dates 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 price discovery 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 specified amount 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 the expiration 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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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.
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 ex- change market.
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, without incurring foreign exchange risk. It is an effective and efficient cash management tool for companies that have assets and liabilities denominated in different currencies. On the near date, 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. In most cases, 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.
The SolutionIn 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 near date and you would deliver EUR 500,000 to the bank. In return the bank will deliver USD 450,000 to you on the near date (typically but not always the spot date). 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, 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 points adjustment is easily explained and calculated. In this case, assume the prevailing interest rate in Europe is 5% and in the United States are 3%. 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%. The purpose of the forward points adjustment is to equalize this interest rate differential and compensate you for 'giving up' or 'receiving' the higher interest bearing currency.
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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. $450k divided by EUR 500k =Spot Exchange Rate of 0.9000 In the three month period the bank could earn 5% interest on the EUR 500k for three 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 506,250 At the end of the period you would have USD 453,375 Far Date $453,375 divided by EUR 506,250 = Exchange Rate of 0.8955 Bank returns 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 $2,250. In cases where your surplus funds are in a currency with a low interest rate and your funding need is in a country with a higher interest rate environment, the forward points will be against you and the gain in the example above would be reversed.
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Hence, introduction of USD-INR options would complete the spectrum of derivative products available to hedge INR currency risk.
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The market witnessed expanding volumes in the initial years with volumes up to US$ 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 these transactions 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 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.
The above regulations led to a constriction in the market because of the onesided nature of the market. However, with a liberalizing regime and a buildup in foreign exchange reserves, the spot access was initially increased to US$ 25 million 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.
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Forward contracts are most suitable for the companies. There is data to support 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
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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 to either US dollar, Euro or Pound as firms transact primarily in these foreign currencies globally. Forward contracts are commonly used and among these firms, Ranbaxy and RIL depend heavily on these contracts for their hedging requirements. As discussed earlier, forwards contracts can be tailored to the exact needs of the firm and this could be the reason for their popularity. 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. RIL, Maruti Udyog and Mahindra and Mahindra are the only firms using currency swaps. 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. These businesses, by nature involve longer gestation periods and higher initial capital outlays and this could explain their long planning horizons. Another observation is that TCS prefers to hedge its exposure to the US Dollar through options rather than forwards. This strategy has been observed among many firms recently in India. This has been adopted due to the marked high volatility of the US Dollar against the Rupee. 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 use of Range barrier options by Infosys also suggests a strategy to tackle the high volatility of the dollar exchange rates. 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. Another implication of this is that their planning horizons are shorter compared to capital intensive firms. It is evident that most Indian firms use forwards and options to hedge their foreign currency exposure. This implies that these 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 absence of a Rupee futures exchange in India and curbs on foreign debt. It also follows that 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 import liabilities which would be adversely affected by Rupee depreciation. However, 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.
INTERNATIONAL CONCERNS
Derivatives contracts are increasing to $111 trillion at end-December 2001 from $94 trillion at end-June 2000. This growth in the derivatives segment is even more substantial when viewed in the light of declining activity in the spot foreign exchange markets. The turnover in traditional foreign exchange markets declined substantially between 1998 and 2001. In April 2001, average daily turnover was $1,200 billion, compared to $1,490 billion in April 1998, 14 percent decline when volumes are measured at constant exchange rates. Whereas the global daily turnover during the same period in foreign exchange and interest rate derivative contracts, including what are considered to be traditional foreign exchange derivative instruments, increased by an estimated 10 percent to $1.4 trillion. 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.
1998 1527 0
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Amount in USD
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 down from 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.
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How is it in 2010
43 207 1490 1765 475 spot trancsation outright forward foreign exchange swaps currency swaps options other products
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 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. 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 Western Union Money Transfer.
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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 the world 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 have felt the heat of the global meltdown at their bottoms.
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BIBLIOGRAPHY
1. www.rbi.org.in 2. www.bis.com 3. www.finmin.nic.in 4. www.commerce.nic.in 5. www.imf.com
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