OBJECTIVE:

➢ To understand and analysis of Current India Forex Market.

➢ To study the major participants of Forex Market.
➢ To understand the product offering of the other banks.
➢ To find the Risks associated with the Forex Market.
➢ To understand the Forex Risk Management.
➢ Currency Fluctuation
➢ Currency Hedge
➢ Design a Hedging strategy
➢ Basics Hedging Techniques
➢ To Hedge or not to hedg

INTRODUCTION
FOREIGN EXCHANGE is the process of conversion of one currency into
another currency. For a country its currency becomes money and legal
tender. For a foreign country it
becomes the value as a commodity. This commodity character can be
understood when we study about ‘Exchange Rate’ mechanism. Since the
commodity has a value its relation with the other currency determines the
exchange value of one currency with the other. For example, the US dollar in
USA is the currency in USA but for India it is just like a commodity, which has
a value which varies according to demand and supply.

Foreign exchange is that section of economic activity, which deals with

the means, and methods by which rights to wealth expressed in terms of the
currency of one country are converted into rights to wealth in terms of the
current of another country.

It involves the investigation of the method, which exchanges the

currency of one country for that of another. Foreign exchange can also be
defined as the means of payment in which currencies are converted into each
othyer and b which international transfers are made; also the activity of
transacting business in further means.

MARKET PARTICIPANTS
BANKS:
Inter banks market is at the top in forex trading. Inter-bank market accounts
53% of total transaction of the forex. Some of this trading is done on the
behalf of the customers, but proprietary desks, trading for bank’s own
account, conduct most. Today more of the trading business has moved on to
more efficient electronics system.
COMMERCIAL COMPANIES:
Commercial companies play an important role in the forex market. They do
participate in forex trading to pay activities and goods they are using in
international market. Trading is done on current exchange rate. The amount
of trading by commercial companies is very less than the bank’s or
speculator’s account in forex. Hence commercial companies have less impact
on the exchange rate.
CENTRAL BANK:
The central bank RBI (India) plays an important role in the forex market. The
central bank controls the liquidity of the foreign exchange market. They try to
control money supply, inflation and exchange rates.

HEDGERS:Some of the biggest clients of these banks are businesses that

deal with international transactions. Whether a business is selling to an
international client or buying from an international supplier, it will need to
deal with the volatility of fluctuating currencies. If there is one thing that
management (and shareholders) detest, it is uncertainty. Having to deal with
foreign-exchange risk is a big problem for many multinationals. For example,
suppose that a German company orders some equipment from a Japanese
manufacturer to be paid in yen one year from now. Since the exchange rate
can fluctuate wildly over an entire year, the German company has no way of
knowing whether it will end up paying more Euros at the time of delivery.
One choice that a business can make to reduce the uncertainty of foreign-
exchange risk is to go into the spot market and make an immediate
transaction for the foreign currency that they need. Unfortunately, businesses
may not have enough cash on hand to make spot transactions or may not
want to hold massive amounts of foreign currency for long periods of time.
Therefore, businesses quite frequently employ hedging strategies in order to
lock in a specific exchange rate for the future or to remove all sources of
exchange-rate risk for that transaction.
For example, if a European company wants to import steel from the U.S., it
would have to pay in U.S. dollars. If the price of the euro falls against the
dollar before payment is made, the European company will realize a financial
loss. As such, it could enter into a contract that locked in the current
exchange rate to eliminate the risk of dealing in U.S. dollars. These contracts
could be either forwards or futures contracts.

SPECULATORS:
Another class of market participants involved with foreign exchange-related
transactions is speculators. Rather than hedging against movement in
exchange rates or exchanging currency to fund international transactions,
speculators attempt to make money by taking advantage of fluctuating
exchange-rate levels.
RETAIL FOREIGN EXCHANGE BROKER:
IMPORTERS:
Who may need to purchase their supplier’s domestic currency to pay for the
goods he has supplied.
EXPORTERS:
Who may be paid a foreign currency by an overseas purchaser, and who
need to convert it into his or her own currency.
TOURISTS:
Who often purchase foreign currency, traveler’s cheques and bank notes,
prior to visiting an overseas country.

ATTRACTIVE FEATURES OF THE MARKET

Liquidity: The market operates the enormous money supply and gives
absolute freedom in opening or closing a position in the current market
quotation. High liquidity is a powerful magnet for any investor, because it
gives him or her the freedom to open or to close a position of any size
whatever.
Promptness: With a 24-hour work schedule, participants in the FOREX
market need not wait to respond to any given event, as is the case in many
markets.
Availability: A possibility to trade round-the-clock; a market participant need
not wait to respond to any given event.
Flexible regulation of the trade arrangement system: A position may be
opened for a pre-determined period of time in the FOREX market, at the
investor’s discretion, which enables to plan the timing of one’s future activity
in advance.
Value: The Forex market has traditionally incurred no service charges,
except for the natural bid/ask market spread between the supply and the
demand price.
One-valued quotations: With high market liquidity, most sales may be
carried out at the uniform market price, thus enabling to avoid the instability
problem existing with futures and other forex investments where limited
quantities of currency only can be sold concurrently and at a specified price

Market trend: Currency moves in a quite specific direction that can be

tracked for rather a long period of time. Each particular currency
demonstrates its own typical temporary changes, which presents investment
managers with the opportunities to manipulate in the FOREX market.
Margin: The credit “leverage” (margin) in the FOREX market is only
determined by an agreement between a customer and the bank or the
brokerage house that pushes it to the market and is normally equal to 1:100.
That means that, upon making a $1,000 pledge, a customer can enter into
transactions for an amount equivalent to $100,000. It is such extensive credit
“leverages”, in conjunction with highly variable currency quotations, which
makes this market highly profitable but also highly risky.

ANALYZING FOREX MARKET

There are two basic approaches to analyzing the Forex market. It is important
to understand how they can be used successfully.
TECHNICAL ANALYSIS:
Technical Analysis focuses on the study of price movements, using historical
currency data to try to predict the direction of future prices. The premise is
that all available market information is already reflected in the price of any
currency, and that all you need to do is study price movements to make
informed trading decisions.
The primary tools of Technical Analysis are charts. Charts are used to identify
trends and patterns in an attempt to find profit opportunities. Those who
follow this approach look for trending tendencies in the Forex markets, and
say that the key to success is identifying such trends in their earliest stage of
development.
FUNDAMENTAL ANALYSIS:
Fundamental Analysis focuses on the economic, social, and political forces
that drive supply and demand. The premise is that macroeconomic indicators
such as economic growth rates, interest rates, inflation, and unemployment
can be used to make informed trading decisions.
Traders using Technical Analysis follow charts and trends, typically following
a number currency pairs simultaneously. Traders using Fundamental Analysis
must sort through a great deal of market data, and so typically focus on only
a few currency pairs. For this reason, many traders prefer Technical Analysis.
In addition, many traders choose Technical Analysis because they see strong
trending tendencies in the Forex market. They look to master the
fundamentals of Technical Analysis and apply them to numerous time frames
and currency pairs.

EXCHANGE RATES
There are 2 ways of quoting Exchange Rates:
Direct Exchange Rates:
The exchange rate for a foreign currency is expressed in terms of units of
local currency equal to one unit of foreign currency.
USD 1.00 = INR 44.50 [Direct Quote for US dollar in India]
In a direct quotation, the home currency is the price (numerator) and the
foreign currency is the commodity (denominator)
Indirect Exchange Rates:
The exchange rate is quoted in terms of the number of units of foreign
currency equal to a unit of local currency.
USD2.3529 = INR 100 [Indirect quotation in India for the US dollar]
In an indirect quotation, the home currency is the commodity (denominator)
and the foreign currency is the price (numerator)
In India, all quotations are now in terms of Direct Rates
European terms convention – Almost all exchange rates are expressed as
direct quotations from a non-American perspective (indirect quotations from
an American perspective); that is, the dollar is the commodity in the
denominator
The most important exceptions are the British pound (GBP) and the Euro
(EUR), which are quoted in American terms; that is, the dollar is the price in
the numerator. Other currencies quoted in American terms are the
Australian dollar, the New Zealand dollar, the Botswana pula, the Cyprus
pound, and the Maltese lira.
This convention means that exchange rates are usually quoted in a form in
which they are greater than 1.

There are two main types of foreign exchange rates that may be used in
foreign exchange transactions.
Spot rate - The spot rate is the exchange rate used for foreign exchange
transactions that will be settled in 2 working days time.
Example:
The yen exchange rate is 154.20/30
The dealer buys a dollar for 154.20 yen
The dealer sells a dollar for 154.30 yen
A point is .01 yen; the spread is .10 yen (10 points)

Forward rate - The forward rate is the exchange rate used for transactions
that will be settled beyond 2 working days.

Cross-rates - Rates between any two currencies can be obtained by

multiplying or dividing their rates with respect to the dollar
A cross rate is as if you are selling (buying) one currency and buying (selling)
the dollar and then selling (buying) the dollar and buying (selling) the other
currency
When you write the transactions out, the dollars cancel out leaving the other
two currencies.
Example:
Case 1: A bank that is a market maker, at what rate would buy INR and Sell
HKD if the spot rates are:
USD/INR: 45.85-90
USD/HKD: 7.8010-20
What Rate Would You Purchase At?
USD/INR: 45.85-90
USD/HKD: 7.8010-20
As a market maker the bank buys INR and Sells HKD
Transaction 1: Bank sells USD and buys INR at 45.90 [Hint: Higher Price] =>
1 USD =45.90INR
Transaction 2: Bank buys USD and sells HKD at 7.8010[Hint: Lower Price]
=>1 USD = 7.8010HKD
45.90INR=7.8010 HKD
1 INR =0.169 HKD
So Bank will buy 1 INR and sell HKD @ 0.169.

MERCHANT RATE
Buying Rate
Merchant rates are rates quoted to the customers by banks. Buying and
selling rates are further subdivided depending upon different business
transactions.
TT buying- Rate at which a Foreign Inward Remittance received by
telegraphic transfer is converted into rupees.
TT Buying rate = Interbank Buying Rate - Exchange margin
Selling Rate
TT Selling –Rate applicable when a customer sends an outward remittance
through telegraphic transfer
TT Selling rate = Interbank Selling rate + Exchange margin
Bids and Asks
The dealer buys the commodity currency at the bid price and sells it at the
ask price; therefore, the customer sells the commodity currency at the bid
price and buys it at the ask price
The bid price is always less (a smaller number) than the ask price.
Every exchange rate can be expressed as a reciprocal; however, the
reciprocal of the bid is the ask (the commodity currency changes, and the
currency the dealer is buying becomes the price currency, and the currency
the dealer is selling becomes the commodity)

Foreign Exchange Risk

When companies conduct business across borders, they must deal in foreign
currencies . Companies must exchange foreign currencies for home
currencies when dealing with receivables, and vice versa for payables. This is
done at the current exchange rate between the two countries. Foreign
exchange risk is the risk that the exchange rate will change unfavorably
before the currency is exchanged. Foreign exchange risk is linked to
unexpected fluctuations in the value of currencies. A strong currency can
very well be risky, while a weak currency may not be risky. The risk level
depends on whether the fluctuations can be predicted. Short and long-term
fluctuations have a direct impact on the profitability and competitiveness of
business.

IMPORTANCE:
 Exchange risks have been considered as a most important factors facing multinational
company management. The situation has become more critical for USA multinational company
since change in the US dollar in the early 1970s when it was no longer the central currency but
become just one of the stronger currencies which can move both up and down each other. The
importance of developing optimal MNCs policies to handle exchange risks has been pointed out.
According to American Accounting Association (AAA) the specific objectives of the
international financial function are to; -
1. Minimize exchange risks and exchange losses.
2. Minimize inflation-caused losses on a global basis.
3. Minimize the deleterious impact on global operations of individual country and
remittances controls and tariffs.
The purpose of gaining managerial control of foreign operations, joint ventures , foreign
portfolio investments, licensing arrangements , and other modes of foreign involvement that
cannot be fully included by the MNC management . The MNC’s considered in the study of FDI
with the intention of making foreign units a more- less permanent part of their structure and
operations.

Kinds of Exposures
Firms dealing in multiple currencies face a risk (an unanticipated gain/loss)
on account of sudden/unanticipated changes in exchange rates, quantified in
terms of exposures. Exposure is defined as a contracted, projected or
contingent cash flow whose magnitude is not certain at the moment and
depends on the value of the foreign exchange rates. The process of
identifying risks faced by the firm and implementing the process of protection
from these risks by financial or operational hedging is defined as foreign
exchange risk management. This paper limits its scope to hedging only the
foreign exchange risks faced by firms.
There are mainly three types of foreign exchange exposures:
○ Translation exposure
○ Transaction exposure
○ Economic Exposure

Translation Exposure
It is the degree to which a firm’s foreign currency denominated financial
statements is affected by exchange rate changes. All financial statements of
a foreign subsidiary have to be translated into the home currency for the
purpose of finalizing the accounts for any given period. If a firm has
subsidiaries in many countries, the fluctuations in exchange rate will make
the assets valuation different in different periods. The changes in asset
valuation due to fluctuations in exchange rate will affect the group’s asset,
capital structure ratios, profitability ratios, solvency ratios, etc. FASB 52
specifies that US firms with foreign operations should provide information
disclosing effects of foreign exchange rate changes on the enterprise
consolidated financial statements and equity. The following procedure has
been followed:
Assets and liabilities are to be translated at the current ratethat is the rate
prevailing at the time of preparation of consolidated statements.
All revenues and expenses are to be translated at the actual exchange rates
prevailing on the date of transactions. For items occurring numerous times
weighted averages exchange rates can be used.
Translation adjustments (gains or losses) are not to be charged to the net
income of the reporting company. Instead these adjustments are
accumulated and reported in a separate account shown in the shareholders
equity section of the balance sheet, where they remain until the equity is
disposed off.

Measurement of Translation exposure

Translation exposure = (Exposed assets - Exposed liabilities)*(change in the
exchange rate)

Transaction Exposure
This exposure refers to the extent to which the future value of firm’s
domestic cash fl0w is affected by exchange rate fluctuations. It arises from
the possibility of incurring foreign exchange gains or losses on transaction
already entered into and denominated in a foreign currency. The degree of
transaction exposure depends on the extent to which a firm’s transactions
are in foreign currency. For example, the transaction in exposure will be more
if the firm has more transactions in foreign currency. According to FASB 52,
all transaction gains and losses should be accounted for and included in the
equity’s net income for the reporting period. Unlike translation gains and
loses which require only a bookkeeping adjustment, transaction gains and
losses are realized as soon as exchange rate changes. The exposure could be
interpreted either from the standpoint of the affiliate or the parent company.
An entity cannot have an exposure in the currency in which its transactions
are measured.

Economic Exposure
Economic exposure refers to the degree to which a firm’s present value of
future cash flows can be influenced by exchange rate fluctuations. Economic
exposure is a more managerial concept than an accounting concept. A
company can have an economic exposure to say Pound/Rupee rates even if it
does not have any transaction or translation exposure in the British currency.
This situation would arise when the company’s competitors are using British
imports. If the Pound weakens, the company loses its competitiveness (or
vice versa if the Pound becomes strong). Thus, economic exposure to an
exchange rate is the risk that a variation in the rate will affect the company’s
competitive position in the market and hence its profits. Further, economic
exposure affects the profitability of the company over a longer
time span than transaction or translation exposure. Under the Indian
exchange control, economic exposure cannot be hedged while both
transaction and translation exposure can-be hedged.

There are some other risks also in International Market:

1 Country Risk:
Exposure to potential loss or adverse effects on company operations and
profitability caused by developments in a country‘s political or legal
environments. It could be due to:
○ Govt. Intervention, red tape, corruption
○ Lack of legal safeguards for intellectual property rights
○ Legislation unfavorable to foreign firms
○ Economic failures and mismanagement
○ Social and political unrest and instability
2 Cross Cultural Risk:
A situation or event where cultural miscommunication puts some human
value at stake.

3 Commercial Risks:
Exposure to market preferences and sentiments. This relates to establishing
credibility and taking much more trouble to settle down than the home-
grown company.
4 Currency Risk:
Change in foreign exchange rates may result in huge amount of losses for an
MNC. Thus this is again a risk, which needs to be tackled.
Necessity of managing forex risk :
A key assumption in the concept of foreign exchange risk is that exchange
rate changes are not predictable and that this is determined by how efficient
the markets for foreign exchange are. Research in the area of efficiency of
foreign exchange markets has thus far been able to establish only a weak
form of the efficient market hypothesis conclusively which implies that
successive changes in exchange rates cannot be predicted by analyzing the
historical sequence of exchange rates.(Soenen, 1979). However, when the
efficient markets theory is applied to the foreign exchange market under
floating exchange rates there is some evidence to suggest that the present
prices properly reflect all available information.(Giddy and Dufey, 1992). This
implies that exchange rates react to new information in an immediate and
unbiased fashion, so that no one party can make a profit by this information
and in any case, information on direction of the rates arrives randomly so
exchange rates also fluctuate randomly. It implies that employing resources
to predict exchange rate changes cannot do with foreign exchange risk
management away.
What is Forex Hedging?

A hedge is to buy a contract or tangible good that will rise in value and then offset a drop in value
of another tangible good or contract, thus protecting the trader from the second loss.
The term “hedge” comes from gambling to defend yourself from loss by making a cross-bet. In
everyday English the word hedge means a kind of defensive guarded behavior. In the last couple
of decades, the term hedge fund originated for a fund which takes quite high risks by betting on
derivative financial instruments. This is a bit confusing as hedge means being averse to risks
whereas one has to take a high risk to do Forex hedging.
FX hedging can be used by companies to eliminate foreign exchange risk when dealing in the
foreign exchange market. This can be done via either the fair value or cash flow method. The
accounting rules for foreign exchange hedging are addressed by both the US Generally Accepted
Accounting Principles (US GAAP) and by the International Financial Reporting Standards
(IFRS).
When firms conduct business across country borders, they must exchange Forex for home
currencies, when dealing with payables and receivables. This is done at the exchange rate
between the 2 countries at that time. Foreign exchange always has the risk involved that the
exchange rate will unfavorably change before you exchange the currency. Forex hedging can
protect companies from this.
Hedging is therefore a way for a firm to get rid of or minimize foreign exchange risk. 2 common
hedges are options and forwards. An options forex trade sets a rate at which the firm may choose
to exchange currencies. A forward will set an exchange rate at which the business transaction will
happen in the future.

The International Financial Reporting Standards (IFRS)

foreign exchange hedging rules
Guidelines for financial derivatives accounting and FX hedging can be found under the heading
of IFRS 7. IFRS 7 states: “an entity shall group financial instruments into classes that are
appropriate to the nature of the information disclosed and that take into account the
characteristics of those financial instruments. An entity shall provide sufficient information to
permit reconciliation to the line items presented in the balance sheet.” See their website for more
details.

The USGAAP: US Generally Accepted Accounting Principles

foreign exchange hedging rules
The UGAAP rules are almost the same as those given under IFRS. The UGAAP standards that
include Forex hedging guidelines are SFAS 133 and 138. SFAS 133, states the following: “(a)
recognized asset or liability that may give rise to a foreign currency transaction gain or loss under
Statement 52 not be the hedged item in a foreign currency fair value or cash flow hedge.” See
their website for more details.

Hedging Strategies/ Instruments

A derivative is a financial contract whose value is derived from the value of
some other financial asset, such as a stock price, a commodity price, an
exchange rate, an interest rate, or even an index of prices. The main role of
derivatives is that they reallocate risk among financial market participants,
help to make financial markets more complete. This section outlines the
hedging strategies using derivatives with foreign exchange being the only
risk assumed.
Forwards
A forward is a made-to-measure agreement between two parties to buy/sell a
specified amount of a currency at a specified rate on a particular date in the
future. The depreciation of the receivable currency is hedged against by
selling a currency forward. If the risk is that of a currency appreciation (if the
firm has to buy that currency in future say for import), it can hedge by buying
the currency forward. E.g if RIL wants to buy crude oil in US dollars six
months hence, it can enter into a forward contract to pay INR and buy USD
and lock in a fixed exchange rate for INR-USD to be paid after 6 months
regardless of the actual INR-Dollar rate at the time. In this example the
downside is an appreciation of Dollar which is protected by a fixed forward
contract. The main advantage of a forward is that it can be tailored to the
specific needs of the firm and an exact hedge can be obtained. On the
downside, these contracts are not marketable, they can’t be sold to another
party when they are no longer required and are binding.
Futures
A futures contract is similar to the forward contract but is more liquid
because it is traded in an organized exchange i.e. the futures market.
Depreciation of a currency can be hedged by selling futures and appreciation
can be hedged by buying futures. Advantages of futures are that there is a
central market for futures which eliminates the problem of double
coincidence. Futures require a small initial outlay (a proportion of the value of
the future) with which significant amounts of money can be gained or lost
with the actual forwards price fluctuations. This provides a sort of leverage.
The previous example for a forward contract for RIL applies here also just
that RIL will have to go to a USD futures exchange to purchase standardized
dollar futures equal to the amount to be hedged as the risk is that of
appreciation of the dollar. As mentioned earlier, the tailor-ability of the
futures contract is limited i.e. only standard denominations of money can be
bought instead of the exact amounts that are bought in forward contracts.

Options
A currency Option is a contract giving the right, not the obligation, to buy or
sell a specific quantity of one foreign currency in exchange for another at a
fixed price; called the Exercise Price or Strike Price. The fixed nature of the
exercise price reduces the uncertainty of exchange rate changes and limits
the losses of open currency positions. Options are particularly suited as a
hedging tool for contingent cash flows, as is the case in bidding processes.
Call Options are used if the risk is an upward trend in price (of the currency),
while Put Options are used if the risk is a downward trend. Again taking the
example of RIL which needs to purchase crude oil in USD in 6 months, if RIL
buys a Call option (as the risk is an upward trend in dollar rate), i.e. the right
to buy a specified amount of dollars at a fixed rate on a specified date, there
are two scenarios. If the exchange rate movement is favorable i.e the dollar
depreciates, then RIL can buy them at the spot rate as they have become
cheaper. In the other case, if the dollar appreciates compared to today’s spot
rate, RIL can exercise the option to purchase it at the agreed strike price. In
either case RIL benefits by paying the lower price to purchase the dollar
Swaps
A swap is a foreign currency contract whereby the buyer and seller exchange
equal initial principal amounts of two different currencies at the spot rate.
The buyer and seller exchange fixed or floating rate interest payments in
their respective swapped currencies over the term of the contract. At
maturity, the principal amount is effectively re-swapped at a predetermined
exchange rate so that the parties end up with their original currencies. The
advantages of swaps are that firms with limited appetite for exchange rate
risk may move to a partially or completely hedged position through the
mechanism of foreign currency swaps, while leaving the underlying
borrowing intact. Apart from covering the exchange rate risk, swaps also
allow firms to hedge the floating interest rate risk. Consider an export
oriented company that has entered into a swap for a notional principal of USD
1 mn at an exchange rate of 42/dollar. The company pays US 6months LIBOR
to the bank and receives 11.00% p.a. every 6 months on 1 st January & 1st July,
till 5 years. Such a company would have earnings in Dollars and can use the
same to pay interest for this kind of borrowing (in dollars rather than in
Rupee) thus hedging its exposures.
Foreign Debt
Foreign debt can be used to hedge foreign exchange exposure by taking
advantage of the International Fischer Effect relationship. This is
demonstrated with the example of an exporter who has to receive a fixed
amount of dollars in a few months from present. The exporter stands to lose
if the domestic currency appreciates against that currency in the meanwhile
so, to hedge this; he could take a loan in the foreign currency for the same
time period and convert the same into domestic currency at the current
exchange rate. The theory assures that the gain realized by investing the
proceeds from the loan would match the interest rate payment (in the foreign
currency) for the loan.

Choice of hedging instruments

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

Foreign Exchange Risk Management Framework

Once a firm recognizes its exposure, it then has to deploy resources in
managing it. A heuristic for firms to manage this risk effectively is presented
below which can be modified to suit firm-specific needs i.e. some or all the
following tools could be used.
Forecasts: After determining its exposure, the first step for a firm is to
develop a forecast on the market trends and what the main direction/trend is
going to be on the foreign exchange rates. The period for forecasts is
typically 6 months. It is important to base the forecasts on valid assumptions.
Along with identifying trends, a probability should be estimated for the
forecast coming true as well as how much the change would be.
Risk Estimation: Based on the forecast, a measure of the Value at Risk (the
actual profit or loss for a move in rates according to the forecast) and the
probability of this risk should be ascertained. The risk that a transaction
would fail due to market-specific problems4 should be taken into account.
Finally, the Systems Risk that can arise due to inadequacies such as reporting
gaps and implementation gaps in the firms’ exposure management system
should be estimated.
Benchmarking: Given the exposures and the risk estimates, the firm has to
set its limits for handling foreign exchange exposure. The firm also has to
decide whether to manage its exposures on a cost centre or profit centre
basis. A cost centre approach is a defensive one and the main aim is ensure
that cash flows of a firm are not adversely affected beyond a point. A profit
centre approach on the other hand is a more aggressive approach where the
firm decides to generate a net profit on its exposure over time.
Hedging: Based on the limits a firm set for itself to manage exposure, the
firms then decides an appropriate hedging strategy. There are various
financial instruments available for the firm to choose from: futures, forwards,
options and swaps and issue of foreign debt. Hedging strategies and
instruments are explored in a section.
Stop Loss: The firms risk management decisions are based on forecasts
which are but estimates of reasonably unpredictable trends. It is imperative
to have stop loss arrangements in order to rescue the firm if the forecasts
turn out wrong. For this, there should be certain monitoring systems in place
to detect critical levels in the foreign exchange rates for appropriate measure
to be taken.
Reporting and Review: Risk management policies are typically subjected to
review based on periodic reporting. The reports mainly include profit/ loss
status on open contracts after marking to market, the actual exchange/
interest rate achieved on each exposure, and profitability vis-à-vis the
benchmark and the expected changes in overall exposure due to forecasted
exchange/ interest rate movements. The review analyses whether the
benchmarks set are valid and effective in controlling the exposures, what the
market trends are and finally whether the overall strategy is working or
needs change.

FACTORS THAT INFLUENCES THE EXCHANGE RATES

Exchange Rate plays a vital role in a country’s level of trade, which is critical
to most every free market economy in the world. This is the reason foreign
exchange rate are among the most watched, analyzed and manipulated by
government for economic measurement. On a smaller scale the exchange
rate influences the investor’s portfolio as well.
Numerous factors determine exchange rates, and all are related to the
trading relationship between two countries. The following are some of the
principal determinants of the exchange rate between two countries.
Inflation Rate:
Inflation rate indicates the purchasing power of the investors. If the inflation
rate is very high it means liquidity in the market is more and the purchasing
power of the people is high, hence the will invest more in the foreign market.
By investing more in the forex maret the demand of the foreign currency will
increase and the foreign currency will appreciate and local currency will
depreciate. If the inflation rate is low then the results will be opposite, in that
case the local currency will appreciate due to high demand from the outside
investors and foreign currency will depreciate due to less demand.
Interest Rate:
Interest rate is one of the major factors affecting the foreign exchange rates.
If the interest is high of the country then investors will invest in the country
with high interest rate to get more returns it means the demand of the local
currency has increased and it will lead to appreciation of the currency. If the
interest decreases then the people will start borrowing the money from the
banks and their purchasing power will increase that will lead to high demand
of foreign currency and the local currency will decrease.
Current Account Deficit:
The current account is the balance of trade between a country and its trading
partners, reflecting all payments between countries for goods, services,
interest and dividends. A deficit in the current account shows the country is
spending more on foreign trade than it is earning, and that it is borrowing
capital from foreign sources to make up the deficit. In other words, the
country requires more foreign currency than it receives through sales of
exports, and it supplies more of its own currency than foreigners demand for
its products. The excess demand for foreign currency lowers the country's
exchange rate until domestic goods and services are cheap enough for
foreigners, and foreign assets are too expensive to generate sales for
domestic interests.
Public Debt:
Countries will engage in large-scale deficit financing to pay for public sector
projects and governmental funding. While such activity stimulates the
domestic economy, nations with large public deficits and debts are less
attractive to foreign investors. The reason? A large debt encourages inflation,
and if inflation is high, the debt will be serviced and ultimately paid off with
cheaper real dollars. In the worst-case scenario, a government may print
money to pay part of a large debt, but increasing the money supply
inevitably causes inflation. Moreover, if a government is not able to service
its deficit through domestic means (selling domestic bonds, increasing the
money supply), then it must increase the supply of securities for sale to
foreigners, thereby lowering their prices. Finally, a large debt may prove
worrisome to foreigners if they believe the country risks defaulting on its
obligations. Foreigners will be less willing to own securities denominated in
that currency if the risk of default is great. For this reason, the country's debt
rating (as determined by Moody's or Standard & Poor's, for example) is a
crucial determinant of its exchange rate.
Political Stability and Economic Performance:
Foreign investors inevitably seek out stable countries with strong economic
performance in which to invest their capital. A country with such positive
attributes will draw investment funds away from other countries perceived to
have more political and economic risk. Political turmoil, for example, can
cause a loss of confidence in a currency and a movement of capital to the
currencies of more stable countries.
Movement of Reserves

Review of Growth of Reserves since 1991

India’s foreign exchange reserves have grown significantly since 1991. The
reserves, which stood at US$ 5.8 billion at end-March 1991 increased gradually to
US$ 54.1 billion by end-March 2002, after which it rose steadily reaching a level of
US$ 309.7 billion in March 2008. The reserves declined to US$ 252.0 billion in
March 2009. The reserves stood at US$ 292.9 billion as on September 30, 2010
compared to US $ 279.1billion as on March 31, 2010. (Table 1 & Chart 1).
Although both US dollar and Euro are intervention currencies and the FCA are
maintained in major currencies like US dollar, Euro, Pound Sterling, Japanese Yen
etc. the foreign exchange reserves are denominated and expressed in US dollar
only. Movements in the FCA occur mainly on account of purchases and sales of
foreign exchange by the RBI in the foreign exchange market in India. In addition,
income arising out of the deployment of the foreign exchange reserves and the
external aid receipts of the Central Government also flow into the reserves. The
movement of the US dollar against other currencies in which FCA are held also
impact the level of reserves in US dollar terms.
 Table 1 : Movement in Foreign Exchange Reserves
(US$ million)
Date FCA SDR Gold RTP Forex Reserves

30-Sep-07 239,954 2 (1) 7,367 438 247,761

31-Mar-08 299,230 18 (11) 10,039 436 309,723

30-Sep-08 277,300 4 (2) 8,565 467 286,336

31-Mar-09 241,426 1 (1) 9,577 981 251,985

30-Sep-09 264,373 5224 (3297) 10,316 1365 281,278

31-Mar-10 254,685 5006 (3297) 17,986 1380 279,057

30-Sep-10 265,231 5130 (3297) 20,516 1993 292,870

I.4.2. Sources of Accretion to the Reserves Table 2 provides
details of the major sources of accretion to foreign exchange
reserves during the period
from March 1991 to end-September 2010

Table 2: Sources of Accretion to Foreign Exchange Reserves since 1991

(US$ billion)

. Items 1991-92 to 2010-11

(Upto September 2010)

A Reserve at the end march 1991 5.8

BI Current a/c Balance -144.7
BII Capital balance 415.7
A Foreign investment 236.2
FDI FII 102.7
NRI Deposit 103.0
B External assistance 39.1
C External commercial borrowings 24.3
D Other than in capital account 76.7
E Valuation change 39.0
BII Reserves as at end-September 2010 (A+BI+BII+BIII) 16.5
I
292.9
Table 3 provides details of sources of variation in foreign exchange reserves during
2010-11 vis-à-vis the corresponding period of the previous year. On balance of
payments basis (i.e., excluding valuation effects), the foreign exchange reserves
increased by US$ 7 billion during April-September 2010 as against an increase of
US$ 9.5 billion during April-September 2009. The valuation gain, reflecting the
depreciation of the US dollar against the major international currencies, accounted
for US$ 6.8 billion during April-September 2010 as compared with a valuation gain
of US$ 19.8 billion during April-September 2009. Accordingly, valuation gain
during April-September 2010 accounted for 49.3 per cent of the total increase in
foreign exchange reserves.

Table 3: Sources of Variation in Foreign Exchange Reserves

(US$ billion)

Items 2009-10 2010-11

April-September April-September
I. Current Account Balance -13.3 -27.9
II. Capital Account (net) (a to f) 22.8 34.9
a. Foreign Investment (i+ii) 30.3 12.3 29.1
(i) Foreign Direct Investment 17.9 5.3
(ii) Portfolio Investment 23.8
Of which: 15.3 2.7
FIIs 0.7 1.0 22.3 1.6
ADRs/GDRs 2.9 6.0 0.8
b. External Commercial Borrowings -0.05 2.2 6.7
c. Banking Capital 1.0 3.0
of which: NRI Deposits -10.2 -10.7
d. Short-Term Trade Credit 19.8 29.3 6.8
e. External Assistance 13.8
f. Other items in capital account*
III. Valuation Change
Total (I+II+III) @
An analysis of the sources of reserves accretion during the entire reform period
from 1991 onwards reveals an increase in net foreign direct investment (FDI) from US$
129 million in 1991-92 to US$ 5.3 billion during April-September 2010-11. The
cumulative FDI investment up to end-September 2010 has been US$ 102.7 billion.
The cumulative net FII investments which has increased from US$ 1 million at end-
March 1993 to US$ 103.0 billion at end-September 2010, has also largely contributed
to the increase in foreign exchange reserves. The net inflows of US$ 22.3 billion by
FIIs during April-September 2010-11 led to an increase in cumulative portfolio stock
to US$ 133.5 billion at end-September 2010 from US$
109.7 billion at end-March 2010. Outstanding NRI deposits increased from US$ 14.0
billion at end-March 1991 to US$ 47.9 billion as at end-March 2010. As at end-
September 2010, the outstanding NRI deposits stood at US$ 49.9 billion.

On the current account, India's exports, which were US$ 18.3 billion during 1991-
92 increased to US$ 182.2 billion in 2009-10. During April-September 2010-11,
India's export amounted US$ 110.5 billion as compared with US$ 82.6 billion during
April-September 2009. India's imports which were US$ 24.1 billion in 1991-92
increased to US$ 300.6 billion in 2009-10. During April-September 2010- 11, India's
import amounted to US$ 177.5 billion as compared with US$ 138.4 billion during
April-September 2009. Invisibles, in particular private remittances, have contributed
significantly to the current account. Net invisibles inflows, comprising mainly of
private transfer remittances and services, increased from US$ 1.6 billion in 1991-92
to US$ 80.0 billion in 2009-10. During April- September 2010, net invisibles stood
at US$ 39.1 billion as compared with US$ 42.5 billion during April-September 2009.
India's current account balance which was in deficit at 3.0 per cent of GDP in 1990-91
turned into a surplus during the period 2001-02 to 2003-04. However, this could not be
sustained in the subsequent years. In the aftermath of the global financial crisis, the
current account deficit increased from 1.3 per cent of GDP in 2007-08 to 2.4 per cent
of GDP in 2008-09 and further to 2.9 per cent in 2009-10.
I.6 Adequacy of Reserves

Adequacy of reserves has emerged as an important parameter in gauging the ability

to absorb external shocks. With the changing profile of capital flows, the traditional
approach of assessing reserve adequacy in terms of import cover has been broadened
to include a number of parameters which take into account the size, composition and
risk profiles of various types of capital flows as well as the
types of external shocks to which the economy is vulnerable. The High Level
Committee on Balance of Payments, which was chaired by Dr. C. Rangarajan,
erstwhile Governor of the Reserve Bank of India, had suggested that, while
determining the adequacy of reserves, due attention should be paid to payment
obligations, in addition to the traditional measure of import cover of 3 to 4 months. In
1997, the Report of Committee on Capital Account Convertibility under the
chairmanship of Shri S.S.Tarapore, erstwhile Deputy Governor of the Reserve Bank
of India suggested alternative measures of adequacy of reserves which, in addition to
trade-based indicators, also included money-based and debt-based indicators. Similar
views have been held by the Committee on Fuller Capital Account Convertibility
(Chairman: Shri S.S.Tarapore, July 2006). In the recent period, assessment of reserve
adequacy has been influenced by the introduction of new measures. One such measure
requires that the usable foreign exchange reserves should exceed scheduled
amortisation of foreign currency debts (assuming no rollovers) during the following
year. The other one is based on a 'Liquidity at Risk' rule that takes into account the
foreseeable risks that a country could face. This approach requires that a country's
foreign exchange liquidity position could be calculated under a range of possible
outcomes for relevant financial variables, such as, exchange rates, commodity prices,
credit spreads etc. Reserve Bank of India has been undertaking exercises based on
intuition and risk models to estimate 'Liquidity at Risk (LAR) of the reserves.

The traditional trade-based indicator of reserve adequacy, viz, import cover of

reserves, which fell to a low of three weeks of imports at end-December 1990
reached a peak of 16.9 months of imports at the end of March 2004. At the end of
September 2010, the import cover stands at 10.3 months. The ratio of short-term

12
debt1 to the foreign exchange reserves declined from 146.5 per cent at end-March
1991 to 12.5 per cent as at end-March 2005, but increased slightly to 12.9 per cent as
at end-March 2006. However, with expansion in the coverage of short-term debt, the
ratio increased to 14.8 per cent at end-March 2008, to 17.2 per cent at end-March
2009 and 18.8 per cent at end-March 2010 and further to 22.5 per cent at end-
September 2010. The ratio of volatile capital flows (defined to include cumulative
portfolio inflows and short-term debt) to the reserves declined from 146.6 per cent as
at end-March 1991 to 47.9 per cent at end-March 2009, but increased to 58.1 per cent
as at end-March 2010 and further to 68.1 as at end- September 2010.
I.5 External Liabilities vis-à-vis Foreign Exchange Reserves

The accretion of foreign exchange reserves needs to be seen in the light of total
external liabilities of the country. India's International Investment Position (IIP)
which is a summary record of the stock of country's external financial assets and
liabilities as at end September 2010 is furnished in Table 4.

The net IIP as at end September 2010 was negative at US$ 211.1 billion, implying
that our external liabilities are more than the external assets. The net IIP as at end
September 2008 and 2009 was US$ (-) 81.1 billion and US$ (-) 103.4 billion
respectively.

Table 4: International Investment Position of India

(US$ billion)

Item provisionalSeptember 2010 (P)

A1. Total External Assets 401.7

2.3. Direct Investment Abroad 89.2
4. Portfolio Investment 1.0
B Other Investments 18.6
1. Foreign Exchange Reserves 292.9
2.3. Total External Liabilities 612.8
Direct Investment in India 191.7
Portfolio Investment 164.3 256.8
Other Investments (-)211.1
Net IIP (A-B)
I.7. Management of Gold Reserves

The Reserve Bank held 557.75 tonnes of gold forming about 7.0 per cent of the
total foreign exchange reserves in value terms as on September 30, 2010. Of these,
265.49 tonnes are held abroad (65.49 tonnes since 1991 and further 200 tonnes since
November 2009) in deposits / safe custody with the Bank of England and the Bank for
International Settlements.