A

A Grand Project Report On
Foreign Exchange Risk Management
In the partial fulfilment of the requirements of Masters of Business Administration
PROJECT GUIDE:
Prof. Rajsee Joshi
SUBMITTED BY:
Siddhi Rupera (9078) Saloni Shah (9091) Batch: 2009-11
N.R.INSTITUTE OF BUSINESS MANAGEMENT GUJARAT TECHNOLOGICAL UNIVERSITY
N.R.Institute of business management
N. R. Institute of Business Management (GLS-MBA)
Certificate
This is to certify that Miss. Saloni Shah Roll No. 09091 & Miss. Siddhi Rupera Roll No. 09078, students of N. R. Institute of Business Management (GLS-MBA) have successfully completed their Project on Foreign Exchange Risk Management in partial fulfillment for the requirements of the MBA programme of Gujarat Technological University. This is their original work and has not been submitted elsewhere.
_________________ Dr. Hitesh Ruparel Director
____________________ Prof. Rajsee Joshi Assistant Professor & Project Guide
Date: _________________
Place: _________________
PREFACE
We are the students of N.R.INSTITUTE OF BUSINESS MANAGEMENT. Grand project is an important subject of the syllabus for the student of M.B.A. Studying only the management theories does not enough to students in the management field, but also necessary practical knowledge.
Grand project plays a very crucial role for student of M.B.A. The main objective of the project is to develop the students ability. It is an opportunity for the student to show their skills and efficiency. So the student will be able to develop their internal strength.
We have done our grand project report in Foreign Exchange Risk Management and also analysis of importers and exporters through Questioners.
ACKNOWLEDGEMENT
We take this opportunity to thank a few people without their help this project would have never been completed. With immense pleasure we express special and sincere thanks to our Director Dr. Hitesh Ruparel for his timely guidance and encouragement throughout the course of our work and without whose help the completion of this project would have been a dream for us.
We would also like to thank our mentor at college, Prof. Rajsee Joshi for her constant support and valuable suggestions during our Project Period..
Guidance and suggestions rendered during the course of our project and the critical evaluation of the work by them has been a valuable input in this submission. We value each persons lively association and constructive contribution.
EXECUTIVE SUMMARY
The rapid industrialization, advancement in technology and communication facilities, the availability of rapid means of transportation has all contributed towards the globalization of business across the frontiers of countries. There have been new innovations in the products developments. The government of India has also opened Indian economy. Various fiscal, trade and industrial policy decisions have been taken and new avenues provided to foreign investors like FIIs and NRIs etc. for investment especially infra-structural sectors like power, and telecommunications etc. This projects attempts to study the intricacies of the Foreign Exchange Market and to measure awareness level among the importers and exporters. The main purpose of this study is to give a better idea and the comprehensive details of foreign exchange risk management and to understand the services of a foreign exchange advisory firm. The project starts with the various concept and system used in the foreign exchange market in the world. It also highlights about the exchange rate system used in various countries till date. The project then highlights the various hedging tools used by various banks and individuals to hedge their risk. The major hedging tools included are forward, options, swaps and futures. Lastly the project highlights the risk management with particular emphasis of the risk managed by various banks and the tool used by it.
TABLE OF CONTENT
Serial No. Particular
PREFACE ACKNOWLEDGEMENT EXECUTIVE SUMMARY 1 RESEARCH METHODOLOGY
1.1 1.2 1.3 1.4 1.5 1.6 1.7 OBJECTIVES RESEARCH DESIGN DATA COLLECTION SOURCES DATA COLLECTION SCOPE OF THE STUDY LIMITATIONS OF THE STUDY BENEFICIARIES
Page No.
i ii iii 1 1 1 1 2 3 3 3 4 4 4 5 7 10 10 10 12 12 13 14 14 16 19 19 20 29 41 63
INTRODUCTION
2.1 FOREIGN EXCHANGE MARKET OVERVIEW 2.2 NEED FOR FOREIGN EXCHANGE 2.3 ABOUT FOREIGN EXCHANGE MARKET 2.4 PARTICIPANTS IN FOREIGN EXCHAGE MARKET
EXCHANGE RATE SYSTEM

3.1 INTRODUCTION 3.2 THE GOLD STANDARD 3.3 BRETTON WOODS SYSTEM 3.4 FLOATING RATE SYSTEM 3.5 PURCHASING POWER PARITY (PPP)
FUNDAMENTALS IN EXCHANGE RATE

4.1 METHODS OF QUOTING RATES 4.2 FACTORS AFFECTING EXCHANGE RATES
HEDGING TOOLS
5.1 INTRODUCTION 5.2 FORWARD CONTRACTS 5.3 OPTIONS 5.4 SWAPS 5.5 FUTURES
RISK MANAGEMENT
6.1 RISK MANAGEMENT PROCESS 6.2 TYPES OF RISKS IN FOREIGN EXCHANGE 6.3 TYPES OF RISK EXPOSURES IN FOREIGN EXCHANGE MARKET
69 70 71 73 75 88 102 104 105 107 108
7 8
ANALYSIS OF QUESTIONNAIRE STATISTICAL ANALYSIS OF QUESTIONNAIRE FINDINGS RECOMMENDATIONS CONCLUSION BIBLIOGRAPHY APPENDIX
LIST OF CHARTS
Serial No.
7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 7.9 7.10
Particular
CATEGORY OF ORGANIZATION DURATION OF BUSINESS FOREIGN CURRENCY EXPOSURE USE OF HEDGING RANKING FOR TOOLS OF HEDGING REASONS FOR NOT USING HEDGING AWARENESS ABOUT CURRENCY FUTURES USE OF CURRENCY FUTURES FREQUENCY OF USING CURRENCY FUTURES ORGANIZATIONAL PREFRENCE FOR USING CURRENCY FUTURES
Page No.
75 76 77 78 79 80 81 82 83 84
7.11
FOREX RISK MANAGEMENT COMMITTEE IN ORGANIZATION
85
7.12 8.1
MANAGEMENT OF RISKS DURATION OF BUSINESS AND PERCENT OF FOREIGN CURRENCY EXPOSURE
86 88
8.2
FOREIGN CURRENCY EXPOSURE AND USE OF HEDGING TO COVER RISK
90
8.3
FOREIGN CURRENCY EXPOSURES AND FREQUENCY OF USING CURRENCY FUTURES
99
LIST OF TABLES
Serial No.
8.1
Particular
CROSS TABULATION OF TIME OF BUSINESS AND FOREIGN CURRENCY EXPOSURE CHI-SQUARE OF TIME OF BUSINESS AND FOREIGN CURRENCY EXPOSURE CROSS TABULATION OF HEDGING AND FOREIGN CURRENCY EXPOSURE CHI-SQUARE OF HEDGING AND FOREIGN CURRENCY EXPOSURE T-TEST FOR LOW TRANSACTION COST T-TEST FOR EASY AFFORDABILITY T-TEST FOR STANDARDIZED COST T-TEST FOR TRANSPARENCY T-TEST FOR COMMISSION PAYMENT T-TEST FOR AVALIABLE DURING TRADING HOURS T-TEST FOR BASED ON FUTURE PRICE CROSS TABULATION OF FOREIGN CURRENCY EXPOSURE AND FREQUENCY OF USING CURRENCU FUTURES CHI-SQUARE OF FOREIGN CURRENCY EXPOSURE AND FREQUENCY OF USING CURRENCU FUTURES T-TEST FOR OVERALL OPINION ABOUT CURRENCY FUTURES
Page No.
89
8.2
89
8.3
91
8.4 8.5 8.6 8.7 8.8 8.9 8.10 8.11 8.12
91 92 93 94 95 96 97 98 100
8.13 8.14
100 101
CHAPTER 1: RESEARCH METHODOLOGY

11 OBJECTIVES
0 To get a better idea and the comprehensive details of foreign exchange risk management and to study the organization on How they manage the foreign exchange risk. 0To know about the various concepts and technicalities in foreign exchange. 0To measure the awareness level for managing foreign exchange among importers and exporters in Ahmedabad 0To get the knowledge about the hedging tools used in foreign exchange
12 RESEARCH DESIGN
Research design can be defined as an outline that provides the specifications for the careful collection of relevant data and appropriate analysis so as to fulfill the objectives of research with precision, economy and perfection. We have done the research with the help of descriptive research design. The research design states the different stages of descriptive research. The stages include statement of the objective, data collection; the basis of questionnaire and interviews; carrying out analysis; stating interpretations and drawing conclusions.
1.3 DATA COLLECTION SOURCES

a) Primary sources: The primary data means the data collected originally for the first time. It is an outcome of original statistical enquiry and measurement of facts for the first time. We have collected the data by the use of questionnaire method. The area of research was carried out in Ahmedabad city among the importers and exporters.
b) Secondary sources:
Secondary data are the data that are in actual existence in accessible records, having been already collected .We have collected the necessary information from Internet, Website, Books, Journals and Magazines of Foreign Exchange
1.4 DATA COLLECTION

1. Population survey: Sampling procedure: NON PROBABILITY CONVENIENCE TECHNIQUE was used for selecting samples. As the sample site was Ahmedabad , the probability of all other importers and exporters , to be selected as sample, was not same. And even in selected sample site, which so ever importers and exporters were available, was interviewed and so it is convenient sampling. 2. Sample size:
Sample size for doing survey was 30 organizations which are either in business of export & import or both. 3. Research Instrument: Questionnaire: We have included open and close ended questions in questionnaire.
4. Mode of Contact: 0 Personal interaction 0Telephonic interaction 5. Preparing the Research Report: N.R.Institute of business management
Once the data is collected, interpreted and analyzed, the last stage of our project is to prepare the research report. The research report will be prepared in a systematic format and various graphs & charts will be used to describe the data collected. Although the report writing need some skills which can be developed with practice, efforts are carried on to present the report as much objectively and clarity as possible.
15 SCOPE OF THE STUDY

0Study of the project is related to foreign exchange in which the currency futures are taken into consideration. 0Only the selected sample of the importers and exporters of Ahmedebad were the scope of the study. 0Foreign exchange risk management has very wide scope therefore all the topics are not covered in depth.
16 LIMITATIONS OF THE STUDY

0Time constraint: As the project study has to be conducted within a limited time period. 0Data constraint: Some of the importers and exporters were not ready to disclose their confidential information. 0Bias on the part of interviewers.
17 BENEFICIARIES
0Management students can be beneficiaries of this project which can be useful to get the idea of the topic. 0Importers and exporters can get better idea about the use of foreign exchange and take advantage by using hedging tools.
CHAPTER 2: INTRODUCTION
2.1 FOREIGN EXCHANGE MARKET OVERVIEW
In todays world no economy is self sufficient, so there is need for exchange of goods and services amongst the different countries. So in this global village, unlike in the primitive age the exchange of goods and services is no longer carried out on barter basis. Every sovereign country in the world has a currency that is legal tender in its territory and this currency does not act as money outside its boundaries. So whenever a country buys or sells goods and services from or to another country, the residents of two countries have to exchange currencies. So we can imagine that if all countries have the same currency then there is no need for foreign exchange.
2.2 NEED FOR FOREIGN EXCHANGE

Let us consider a case where Indian company exports cotton fabrics to USA and invoices the goods in US dollar. The American importer will pay the amount in US dollar, as the same is his home currency. However the Indian exporter requires rupees means his home currency for procuring raw materials and for payment to the labor charges etc. Thus he would need exchanging US dollar for rupee. If the Indian exporters invoice their goods in rupees, then importer in USA will get his dollar converted in rupee and pay the exporter.
From the above example we can infer that in case goods are bought or sold outside the country, exchange of currency is necessary. Sometimes it also happens that the transactions between two countries will be settled in the currency of third country. In that case both the countries that are transacting will require converting their respective currencies in the currency of third country. For that also the foreign exchange is required.
2.3 ABOUT FOREIGN EXCHANGE MARKET

Particularly for foreign exchange market there is no market place called the foreign exchange market. It is mechanism through which one countrys currency can be exchange i.e. bought or sold for the currency of another country. The foreign exchange market does not have any geographic location. Foreign exchange market is described as an OTC (over the counter) market as there is no physical place where the participant meets to execute the deals, as we see in the case of stock exchange. The largest foreign exchange market is in London, followed by the New York, Tokyo, Zurich and Frankfurt. The markets are situated throughout the different time zone of the globe in such a way that one market is closing the other is beginning its operation. Therefore it is stated that foreign exchange market is functioning throughout 24 hours a day. In most market US dollar is the vehicle currency, viz., the currency sued to dominate international transaction. In India, foreign exchange has been given a statutory definition. Section 2 (b) of foreign exchange regulation ACT, 1973 states: Foreign exchange means foreign currency and includes:
0All deposits, credits and balance payable in any foreign currency and any draft, travelers cheques, letter of credit and bills of exchange. Expressed or drawn in India currency but payable in any foreign currency. 0Any instrument payable, at the option of drawee or holder thereof or any other party thereto, either in Indian currency or in foreign currency or partly in one and partly in the other.
In order to provide facilities to members of the public and foreigners visiting India, for exchange of foreign currency into Indian currency and vice-versa. RBI has granted to various firms and individuals, license to undertake money-changing business at seas/airport and tourism place of tourist interest in India. Besides certain authorized dealers in foreign exchange (banks) have also been permitted to open exchange bureaus.
Following are the major bifurcations:
0Full fledge moneychangers They are the firms and individuals who have been authorized to take both, purchase and sale transaction with the public.
0Restricted moneychanger They are shops, emporia and hotels etc. that have been authorized only to purchase foreign currency towards cost of goods supplied or services rendered by them or for conversion into rupees.
0Authorized dealers They are one who can undertake all types of foreign exchange transaction. Banks are only the authorized dealers. The only exceptions are Thomas cook, western union, UAE exchange which though, and not a bank is an AD. Even among the banks RBI has categorized them as follows: Branch A They are the branches that have Nostro and Vostro account. Branch B The branch that can deal in all other transaction but do not maintain Nostro and Vostro a/cs fall under this category. Branch C - Such branches cannot do anything with forex business.
2.4 PARTICIPANTS IN FOREIGN EXCHANGE MARKET

The main players in foreign exchange market are as follows:
1. CUSTOMERS
The customers who are engaged in foreign trade participate in foreign exchange market by availing of the services of banks. Exporters require converting the dollars in to rupee and importers require converting rupee in to the dollars, as they have to pay in dollars for the goods/services they have imported.
2. COMMERCIAL BANKS
They are most active players in the forex market. Commercial bank dealing with international transaction offers services for conversion of one currency in to another. They have wide network of branches. Typically banks buy foreign exchange from exporters and sells foreign exchange to the importers of goods. As every time the foreign exchange bought or oversold position. The balance amount is sold or bought from the market.
3. CENTRAL BANK
In all countries Central bank have been charged with the responsibility of maintaining the external value of the domestic currency. Generally this is achieved by the intervention of the bank.
4. EXCHANGE BROKERS
Forex brokers play very important role in the foreign exchange market. However the extent to which services of foreign brokers are utilized depends on the tradition and practice prevailing at a particular forex market center. In India as per FEDAI guideline the Ads are free to deal directly among themselves without going through brokers. The brokers are not among to allowed to deal in their own account allover the world and also in India.
5. OVERSEAS FOREX MARKET
Today the daily global turnover is estimated to be more than US $ 1.5 trillion a day. The international trade however constitutes hardly 5 to 7 % of this total turnover. The rest of trading in world forex market is constituted of financial transaction and speculation. As we know that the forex market is 24-hour market, the day begins with Tokyo and thereafter Singapore opens, thereafter India, followed by Bahrain, Frankfurt, Paris, London, New York, Sydney, and back to Tokyo. 6. SPECULATORS
The speculators are the major players in the forex market. Bank dealing are the major speculators in the forex market with a view to make profit on account of favorable movement in exchange rate, take position i.e. if they feel that rate of particular current go up in short term. They buy that currency and sell it as soon as they are able to make quick profit.
Corporations particularly multinational corporation and transnational

corporation having business operation beyond their national frontiers and on account of their cash flows being large and in multi currencies get in to foreign exchange exposures. With a view to make advantage of exchange rate movement in their favor they either delay covering exposures or do not cover until cash flow materialize.
0Individual like share dealing also undertake the activity of buying and selling of foreign exchange for booking short term profits. They also buy foreign currency stocks, bonds and other assets without covering the foreign exchange exposure risk. This also results in speculations.
CHAPTER 3: EXCHANGE RATE SYSTEM

3.1 INTRODUCTION
Countries of the world have been exchanging goods and services amongst themselves. This has been going on from time immemorial. The world has come a long way from the days of barter trade. With the invention of money the figures and problems of barter trade have disappeared. The barter trade has given way ton exchanged of goods and services for currencies instead of goods and services.
The rupee was historically linked with pound sterling. India was a founder member of the IMF. During the existence of the fixed exchange rate system, the intervention currency of the Reserve Bank of India (RBI) was the British pound, the RBI ensured maintenance of the exchange rate by selling and buying pound against rupees at fixed rates. The inter bank rate therefore ruled the RBI band. During the fixed exchange rate era, there was only one major change in the parity of the rupee- devaluation in June 1966. Different countries have adopted different exchange rate system at different time. The following are some of the exchange rate system followed by various countries.
3.2 THE GOLD STANDARD

Many countries have adopted gold standard as their monetary system during the last two decades of the 19th century. This system was in vogue till the outbreak of World War 1. Under this system the parties of currencies were fixed in term of gold. There were two main types of gold standard:
1) Gold Specie Standard
Gold was recognized as means of international settlement for receipts and payments amongst countries. Gold coins were an accepted mode of payment and medium of exchange in domestic market also. A country was stated to be on gold standard if the following condition were satisfied:
0Monetary authority, generally the central bank of the country, guaranteed to buy and sell gold in unrestricted amounts at the fixed price. 0Melting gold including gold coins, and putting it to different uses was freely allowed. 0Import and export of gold was freely allowed. 0The total money supply in the country was determined by the quantum of gold available for monetary purpose.
2) Gold Bullion Standard
Under this system, the money in circulation was either partly of entirely paper and gold served as reserve asset for the money supply. However, paper money could be exchanged for gold at any time. The exchange rate varied depending upon the gold content of currencies. This was also known as Mint Parity Theory of exchange rates.
The gold bullion standard prevailed from about 1870 until 1914, and intermittently thereafter until 1944. World War I brought an end to the gold standard.
3.3 BRETTON WOODS SYSTEM

During the world wars, economies of almost all the countries suffered. In order to correct the balance of payments disequilibrium, many countries devalued their currencies. Consequently, the international trade suffered a deathblow. In 1944, following World War II, the United States and most of its allies ratified the Bretton Woods Agreement, which set up an adjustable parity exchange-rate system under which exchange rates were fixed (Pegged) within narrow intervention limits (pegs) by the United States and foreign central banks buying and selling foreign currencies. This agreement, fostered by a new spirit of international cooperation, was in response to financial chaos that had reigned before and during the war.
In addition to setting up fixed exchange parities (par values) of currencies in relationship to gold, the agreement established the International Monetary Fund (IMF) to act as the custodian of the system.
Under this system there were uncontrollable capital flows, which lead to major countries suspending their obligation to intervene in the market and the Bretton Wood System, with its fixed parities, was effectively buried. Thus, the world economy has been living through an era of floating exchange rates since the early 1970.
3.4 FLOATING RATE SYSTEM

In a truly floating exchange rate regime, the relative prices of currencies are decided entirely by the market forces of demand and supply. There is no attempt by the authorities to influence exchange rate. Where government interferes directly or through various monetary and fiscal measures in determining the exchange rate, it is known as managed of dirty float.
3.5 PURCHASING POWER PARITY (PPP)

Professor Gustav Cassel, a Swedish economist, introduced this system. The theory, to put in simple terms states that currencies are valued for what they can buy and the currencies have no intrinsic value attached to it. Therefore, under this theory the exchange rate was to be determined and the sole criterion being the purchasing power of the countries. As per this theory if there were no trade controls, then the balance of payments equilibrium would always be maintained. Thus if 150 INR buy a fountain pen and the same fountain pen can be bought for USD 2, it can be inferred that since 2 USD or 150 INR can buy the same fountain pen, therefore USD 2 = INR 150.
For example India has a higher rate of inflation as compared to country US then goods produced in India would become costlier as compared to goods produced in US. This would induce imports in India and also the goods produced in India being costlier would lose in international competition to goods produced in US. This decrease in exports of India as compared to exports from US would lead to demand for the currency of US and excess supply of currency of India. This in turn, cause currency of India to depreciate in comparison of currency of US that is having relatively more exports.
CHAPTER 4: FUNDAMENTALS IN EXCHANGE RATE

4.1 METODS OF QUOTING RATES
Exchange rate is a rate at which one currency can be exchange in to another currency, say USD = Rs.48. This rate is the rate of conversion of US dollar in to Indian rupee and vice versa.
EXCHANGE QUOTATION
__________________________
DIRECT
INDIRECT
VARIABLE UNIT
VARIABLE UNIT
HOME CURRENCY
FOREIGN CURRENCY
There are two methods of quoting exchange rates. 4.1.1 DIRECT METHOD: Foreign currency is kept constant and home currency is kept variable. In direct quotation, the principle adopted by bank is to buy at a lower price and sell at higher price. 4.1.2 INDIRECT METHOD:
Home currency is kept constant and foreign currency is kept variable. Here the strategy used by bank is to buy high and sell low. In India with effect from august 2, 1993 all the exchange rates are quoted in direct method.
It is customary in foreign exchange market to always quote two rates means one for buying and another rate for selling. This helps in eliminating the risk of being given bad rates i.e. if a party comes to know what the other party intends to do i.e. buy or sell, the former can take the letter for a ride.
There are two parties in an exchange deal of currencies. To initiate the deal one party asks for quote from another party and other party quotes a rate. The party asking for a quote is known as asking party and the party giving a quotes is known as quoting party.
The advantage of twoway quote is as under:
1. The market continuously makes available price for buyers or sellers 2. Two way prices limit the profit margin of the quoting bank and comparison of one quote with another quote can be done instantaneously. 3. As it is not necessary any player in the market to indicate whether he intends to buy or sale foreign currency, this ensures that the quoting bank cannot take advantage by manipulating the prices. 4. It automatically insures that alignment of rates with market rates. N.R.Institute of business management
5. Two way quotes lend depth and liquidity to the market, which is so very essential for efficient market.
In two way quotes the first rate is the rate for buying and another for selling. We should understand here that, in India the banks, which are authorized dealer always, quote rates. So the rates quoted- buying and selling is for banks point of view only. It means that if exporters want to sell the dollars then the bank will buy the dollars from him so while calculation the first rate will be used which is
Buying rate, as the bank is buying the dollars from exporter. The same case will happen inversely with importer as he will buy dollars from the bank and bank will sell dollars to importer.
4.2 FACTOR AFFECTINGN EXCHANGE RATES

In free market, it is the demand and supply of the currency which should determine the exchange rates but demand and supply is the dependent on many factors, which are ultimately the cause of the exchange rate fluctuation, some times wild.
The volatility of exchange rates cannot be traced to the single reason and consequently, it becomes difficult to precisely define the factors that affect exchange rates. However, the more important among them are as follows:
1) STRENGTH OF ECONOMY
Economic factors affecting exchange rates include hedging activities, interest rates, inflationary pressures, trade imbalance, and euro market activities. Irving fisher, an American economist, developed a theory relating exchange rates to interest rates. This proposition, known as the fisher effect, states that interest rate differentials tend to reflect exchange rate expectation.
On the other hand, the purchasing- power parity theory relates exchange rates to inflationary pressures. In its absolute version, this theory states that the equilibrium exchange rate equals the ratio of domestic to foreign prices. The relative version of the theory relates changes in the exchange rate to changes in price ratios.
2) POLITICAL FACTOR
The political factor influencing exchange rates include the established monetary policy along with government action on items such as the money supply, inflation, taxes, and deficit financing. Active government intervention or manipulations, such as central bank activity in the foreign currency market, also have an impact. Other political factors influencing exchange rates include the political stability of a country and its relative economic exposure (the perceived need for certain levels and types of imports). Finally, there is also the influence of the international monetary fund.
3) EXPECTATION OF THE FOREIGN EXCHANGE MARKET
Psychological factors also influence exchange rates. These factors include market anticipation,
speculative pressures, and future expectations.
A few financial experts are of the opinion that in todays environment, the only trustworthy method of predicting exchange rates by gut feel. Bob Eveling, vice president of financial markets N.R.Institute of business management
at SG, is corporate finances top foreign exchange forecaster for 1999. Evelings gut feeling has, defined convention, and his method proved uncannily accurate in foreign exchange forecasting in 1998.SG ended the corporate finance forecasting year with a 2.66% error overall, the most accurate among 19 banks. The secret to Evelings intuition on any currency is keeping abreast of world events. Any event, from a declaration of war to a fainting political leader, can take its toll on a currencys value. Today, instead of formal models, most forecasters rely on an amalgam that is part economic fundamentals, part model and part judgment. 0Fiscal policy 0Interest rates 0Monetary policy 0Balance of payment 0Exchange control 0Central bank intervention 0Speculation 0Technical factors
CHAPTER 5: HEDGING TOOLS

5.1 INTRODUCTION
Consider a hypothetical situation in which ABC trading co. has to import a raw material for manufacturing goods. But this raw material is required only after three months. However, in three months the price of raw material may go up or go down due to foreign exchange fluctuations and at this point of time it can not be predicted whether the price would go up or come down. Thus he is exposed to risks with fluctuations in forex rate. If he buys the goods in advance then he will incur heavy interest and storage charges. However, the availability of derivatives solves the problem of importer. He can buy currency derivatives. Now any loss due to rise in raw material price would be offset by profits on the futures contract and vice versa. Hence, the derivatives are the hedging tools that are available to companies to cover the foreign exchange exposure faced by them. DEFINITION OF DERIVATIVES
Derivatives are financial contracts of predetermined fixed duration, whose values are derived from the value of an underlying primary financial instrument, commodity or index, such as: interest rate, exchange rates, commodities, and equities.
Derivatives are risk shifting instruments. Initially, they were used to reduce exposure to changes in foreign exchange rates, interest rates, or stock indexes or commonly known as risk hedging. Hedging is the most important aspect of derivatives and also its basic economic purpose. There has to be counter party to hedgers and they are speculators.
Derivatives have come into existence because of the prevalence of risk in every business. This risk could be physical, operating, investment and credit risk.
Derivatives provide a means of managing such a risk. The need to manage external risk is thus one pillar of the derivative market. Parties wishing to manage their risk are called hedgers. The common derivative products are forwards, options, swaps and futures.
5.2 FORWARD CONTRACTS

Forward exchange contract is a firm and binding contract, entered into by the bank and its customers, for purchase of specified amount of foreign currency at an agreed rate of exchange for delivery and payment at a future date or period agreed upon at the time of entering into forward deal.
The bank on its part will cover itself either in the interbank market or by matching a contract to sell with a contract to buy. The contract between customer and bank is essentially written agreement and banks generally stand to make a loss if the customer defaults in fulfilling his commitment to sell foreign currency.
A foreign exchange forward contract is a contract under which the bank agrees to sell or buy a fixed amount of currency to or from the company on an agreed future date in exchange for a fixed amount of another currency. No money is exchanged until the future date.
A company will usually enter into forward contract when it knows there will be a need to buy or sell for a currency on a certain date in the future. It may believe that todays forward rate will prove to be more favorable than the spot rate prevailing on that future date. Alternatively, the company may just want to eliminate the uncertainty associated with foreign exchange rate movements.
The forward contract commits both parties to carrying out the exchange of currencies at the agreed rate, irrespective of whatever happens to the exchange rate. The rate quoted for a forward contract is not an estimate of what the exchange rate will be on the agreed future date. It reflects the interest rate differential between the two currencies involved.
The forward rate may be higher or lower than the market exchange rate on the day the contract is entered into. Forward rate has two components:
0 Spot rate 0Forward points Forward points, also called as forward differentials, reflect the interest differential between the pair of currencies provided capital flows are freely allowed. This is not true in case of US $ / rupee rate as there is exchange control regulations prohibiting free movement of capital from / into India. In case of US $ / rupee it is pure demand and supply which determines forward differential. Forward rates are quoted by indicating spot rate and premium / discount. In direct rate, Forward rate = spot rate + premium/ - discount. Example: The inter bank rate for 31st March is 44.60 Premium for forwards are as follows: Pais a
April May June
Month 40/4 2 65/6 7 87/8 8
If a one month forward is taken then the forward rate would be 44.60 + .42 = 49.12
If a two months forward is taken then the forward rate would be 44.60. + .67 = 49.37.
If a three month forward is taken then the forward rate would be 44.60 + .88 = 49.58. Example: Lets take the same example for a broken date Forward Contract Spot rate = 48.70 for 31st March. Premium for forwards are as follows: 30th April 31st May 30th June 48.70 + 0.42 48.70 + 0.67 48.87 + 0.88
For 17th May the premium would be (0.67 0.42) * 17/31 = 0.137 Therefore the premium up to 17th May would be 48.70 + 0.807 = 49.507.
Premium when a currency is costlier in future (forward) as compared to spot, the currency is said to be at premium vis--vis another currency.
Discount when a currency is cheaper in future (forward) as compared to spot, the currency is said to be at discount vis--vis another currency. Example: A company needs DEM 235000 in six months time. Market parameters: Spot rate IEP/DEM 2.3500 Six months Forward Rate IEP/DEM 2.3300
Solutions available:
0The company can do nothing and hope that the rate in six months time will be more favorable than the current six months rate. This would be a successful strategy if in six months time the rate is higher than 2.33. However, if in six months time the rate is lower than 2.33, the company will have to lose money.
0It can avoid the risk of rates being lower in the future by entering into a forward contract now to buy DEM 235000 for delivery in six months time at an IEP/DEM rate of 2.33. 0It can decide on some combinations of the above. Various options available in forward contracts:
A forward contract once booked can be cancelled, rolled over, extended and even early delivery can be made.
ROLL OVER FORWARD CONTRACTS
Rollover forward contracts are one where forward exchange contract is initially booked for the total amount of loan etc. to be re-paid. As and when installment falls due, the same is paid by the customer at the exchange rate fixed in forward exchange contract. The balance amount of the contract rolled over till the date for the next installment. The process of extension continues till the loan amount has been re-paid. But the extension is available subject to the cost being paid by the customer. Thus, under the mechanism of roll over contracts, the exchange rate protection is provided for the entire period of the contract and the customer has to bear the roll over charges. The cost of extension (rollover) is dependent upon the forward differentials prevailing on the date of extension. Thus, the customer effectively protects himself against the adverse spot exchange rates but he takes a risk on the forward differentials. (i.e. premium/discount). Although spot exchange rates and forward differentials are prone to fluctuations, yet the spot exchange
rates being more volatile the customer gets the protection against the adverse movements of the exchange rates. A corporate can book with the Authorized Dealer a forward cover on roll-over basis as necessitated by the maturity dates of the underlying transactions, market conditions and the need to reduce the cost to the customer. Example: An importer has entered into a 3 months forward contract in the month of February. Spot Rate = 48.65 Forward premium for 3 months (May) = 0.75 Therefore rate for the contract = 48.65 + 0.75 = 49.45
Suppose, in the month of May the importer realizes that he will not be able to make the payment in May, and he can make payment only in July. Now as per the guidelines of RBI and FEDAI he can cancel the contract, but he cannot re-book the contract. So for this the importer will go for a roll-over forward for May over July. The premium for May is 0.75 (sell) and the premium for July is 0.95 (buy). Therefore the additional cost i.e. (0.95 0.75) = 0.25 will have to be paid to the bank. The bank then fixes a notional rate. Lets say it is 48.66. Therefore in May he will sell 48.66 + 0.75 = 49.41 And in July he will buy 48.66 + 119.75 = 49.85 Therefore the additional cost (49.85 49.41) = 0.4475 will have to be paid to the Bank by the importer.
CANCELLATION OF FORWARD CONTRACT
A corporate can freely cancel a forward contract booked if desired by it. It can again cover the exposure with the same or other Authorized Dealer. However contracts relating to non-trade transaction\imports with one leg in Indian rupees once cancelled could not be rebooked till now. This regulation was imposed to stem volatility in the foreign exchange market, which was driving down the Rupee. Thus the whole objective behind this was to stall speculation in the currency.
But now the RBI has lifted the 4-year-old ban on companies re-booking the forward transactions for imports and non-traded transactions. It has been decided to extend the freedom of re-booking the import forward contract up to 100% of un-hedged exposures Falling due within one year, subject to a cap of $ 100 Mio in a financial year per corporate.
The removal of this ban would give freedom to corporate Treasurers who could be in apposition to reduce their foreign exchange risks by canceling their existing forward transactions and rebooking them at better rates. Thus this in not liberalization, but it is restoration of the status quo ante. Also the Details of cancelled forward contracts are no more required to be reported to the RBI. The following are the guidelines that have to be followed in case of cancellation of a forward contract:
1.) In case of cancellation of a contract by the client (the request should be made on or before the maturity date) the Authorized Dealer shall recover/pay the, as the case may be, the difference between the contracted rate and the rate at which the cancellation is effected. The recovery/payment of exchange difference on canceling the contract may be up front or back ended in the discretion of banks.
2.) Rate at which the cancellation is to be effected:
0Purchase contracts shall be cancelled at the contracting Authorized Dealers spot T.T. selling rate current on the date of cancellation. 0Sale contract shall be cancelled at the contracting Authorized Dealers spot T.T. selling rate current on the date of cancellation. 0Where the contract is cancelled before maturity, the appropriate forward T.T. rate shall be applied.
3.) Exchange difference not exceeding Rs. 100 is being ignored by the contracting Bank.
4.) In the absence of any instructions from the client, the contracts, which have matured, shall be automatically cancelled on 15th day falls on a Saturday or holiday; the contract shall be cancelled on the next succeeding working day. In case of cancellation of the contract: 1.) Swap, cost if any shall be paid by the client under advice to him.
2.) When the contract is cancelled after the due date, the client is not entitled to the exchange difference, if any in his favor, since the contract is cancelled on account of his default. He shall however, be liable to pay the exchange difference, against him.
EARLY DELIVERY
Suppose an Exporter receives an Export order worth USD 500000 on 30/06/2000 and expects shipment of goods to take place on 30/09/2000. On 30/06/200 he sells USD 500000 value 30/09/2000 to cover his FX exposure. Due to certain developments, internal or external, the exporter now is in a position to ship the goods on 30/08/2000. He agrees this change with his foreign importer and documents it. The problem arises with the Bank as the exporter has already obtained cover for 30/09/2000. He now has to amend the contract with the bank, whereby he would give early delivery of USD 500000 to the bank for value 30/08/2000. i.e., the new date of shipment.
However, when he sold USD value 30/09/2000, the bank did the same in the market, to cover its own risk. But because of early delivery by the customer, the bank is left with a long mismatch of funds 30/08/2000 against 30/09/2000, i.e. + USD 500000 value 30/08/2000 (customer deal amended) against the deal the bank did in the inter bank market to cover its original risk USD value 30/09/2000 to cover this mismatch the bank would make use of an FX swap.
The swap will be 1.) 2.) Sell USD 500000 value 30/08/2000. Buy USD 500000 value 30/09/2000
The opposite would be true in case of an importer receiving documents earlier than the original due date. If originally the importer had bought USD value 30/09/2000 on opening of the L/C and now expects receipt of documents on 30/08/2000, the importer would need to take early delivery of USD from the bank. The Bank is left with a short mismatch of funds 30/08/2000 against 30/09/2000. i.e. USD 500000 value (customer deal amended) against the deal the bank did in the inter bank market to cover its original risk + USD 500000 To cover this mismatch the bank would make use of an FX swap, which will be; 1. Buy USD value 30/08/2000. 2. Sell USD value 30/09/2000. N.R.Institute of business management
The swap necessitated because of early delivery may have a swap cost or a swap difference that will have to be charged / paid by the customer. The decision of early delivery should be taken as soon as it becomes known, failing which an FX risk is created. This means that the resultant swap can be spot versus forward (where early delivery cover is left till the very end) or forward versus forward. There is every likelihood that the original cover rate will be quite different from the market rates when early delivery is requested. The difference in rates will create a cash outlay for the bank. The interest cost or gain on the cost outlay will be charged / paid to the customer.
SUBSTITUTION OF ORDERS
The substitution of forward contracts is allowed. In case shipment under a particular import or export order in respect of which forward cover has been booked does not take place. The corporate can be permitted to substitute another order under the same forward contract, provided that the proof of the genuineness of the transaction is given. ADVANTAGES OF USING FORWARD CONTRACTS:
0They are useful for budgeting, as the rate at which the company will buy or sell is fixed in advance. 0There is no up-front premium to pay when using forward contracts. 0The contract can be drawn up so that the exchange takes place on any agreed working day.
DISADVANTAGES OF FORWARD CONTRACTS:
0They are legally binding agreements that must be honored regardless of the exchange rate prevailing on the actual forward contract date. 0They may not be suitable where there is uncertainty about future cash flows. For example, if a company tenders for a contract and the tender is unsuccessful, all obligations under the Forward Contract must still be honored. N.R.Institute of business management
5.3 OPTIONS
An option is a Contractual agreement that gives the option buyer the right, but not the obligation, to purchase (in the case of a call option) or to sell (in the case of put option) a specified instrument at a specified price at any time of the option buyers choosing by or before a fixed date in the future. Upon exercise of the right by the option holder, and option seller is obliged to deliver the specified instrument at a specified price. 0The option is sold by the seller (writer) 0To the buyer (holder) 0In return for a payment (premium) 0Option lasts for a certain period of time the right expires at its maturity Options are of two kinds
1) Put Options 2) Call Options 0 PUT OPTIONS The buyer (holder) has the right, but not an obligation, to sell the underlying asset to the seller (writer) of the option. 0CALL OPTIONS The buyer (holder) has the right, but not the obligation to buy the underlying asset from the seller (writer) of the option.
0STRIKE PRICE Strike price is the price at which calls & puts are to be exercised (or walked away from)
AMERICAN & EUROPEAN OPTIONS
0AMERICAN OPTIONS
The buyer has the right (but no obligation) to exercise the option at any time between purchase of the option and its maturity.
0EUROPEAN OPTIONS The buyer has the right (but no obligations) to exercise the option at maturity only. UNDERLYING ASSETS:
0Physical commodities, agriculture products like wheat, plus metal, oil. 0Currencies. 0Stock (Equities) INTRINSIC VALUE: It is the value or the amount by which the contract is in the option. When the strike price is better than the spot price from the buyers perspective? Example:
If the strike price is USD 5 and the spot price is USD 4 then the buyer of put option has intrinsic value. By the exercising the option, the buyer of the option, can sell the underlying asset at USD 5 whereas in the spot market the same can be sold for USD 4.
The buyers intrinsic value is USD 1 for every unit for which he has a right to sell under the option contract.
IN, OUT, AT THE MONEY: IN-THE-MONEY:
An option whose strike price is more favorable than the current market exchange rate is said to be in the money option. Immediate exercise of such option results in an exchange profit. Example:
If the US $ call price is (put) 1 = (call) US $ 1.5000 and the market price is 1 = US $ 1.4000, the exercise of the option by purchaser of US $ call will result in profit of US $ 0.1000 per pound. Such type of option contract is offered at a higher price or premium. OUT-THE-MONEY:
If the strike price of the option contract is less favorable than the current market exchange rate, the option contract is said to be out-of-the-money to its market price. AT-THE-MONEY:
If the market exchange rate and strike prices are identical then the option is called to be at-themoney option. In the above example, if the market price is 1 = US $ 1.5000, the option contract is said to be at the money to its market place.
Summary Prices Spot>Strike Spot=Strike Spot<Strike Calls In-the-money At-the-money Out-the-money Puts Out-themoney At-the-money In-the-money
NAKED OPTIONS:
A naked option is where the option position stands alone, it is not used in the conjunction with cash marked position in the underlying asset, or another potion position.
PAY-OFF FOR A NAKED LONG CALL:
A long call, i.e. the purchaser of a call (option), is an option to buy the underlying asset at the strike price. This is a strategy to take advantage of any increase in the price of the underlying asset. Example: Current spot price of the underlying asset: 100 Strike price: 100 Premium paid by the buyer of the call: 5 (Scenario-1) If the spot price at maturity is below the strike price, the option will not be exercised (since buying in the spot is more advantageous). Buyer will lose the premium paid. (Scenario-2) If the spot price is equal to strike price (on maturity), there is no reason to exercise the option. Buyer loses the premium paid. (Scenario-3) If the spot price is higher than the strike price at the time of maturity, the buyer stands to gain in exercising the option. The buyer can buy the underlying asset at strike price and sell the same at current market price thereby make profit.
However, it may be noted that if on maturity the spot price is less than the INR 43.52 (inclusive of the premium) the buyer will stand to loose.
CURRENCY OPTIONS
A currency option is a contract that gives the holder the right (but not the obligation) to buy or sell a fixed amount of a currency at a given rate on or before a certain date. The agreed exchange rate is known as the strike rate or exercise rate. An option is usually purchased for an up front payment known as a premium. The option then gives the company the flexibility to buy or sell at the rate agreed in the contract, or to buy or sell at market rates if they are more favorable, i.e. not to exercise the option. How Currency Options are different from Forward Contracts?
0A Forward Contract is a legal commitment to buy or sell a fixed amount of a currency at a fixed rate on a given future date. 0A Currency Option, on the other hand, offers protection against unfavorable changes in exchange raters without sacrificing the chance of benefiting from more favorable rates.
Types of Options:
0A Call Option is an option to buy a fixed amount of currency. 0A Put Option is an option to sell a fixed amount of currency. Both types of options are available in two styles: 1. The American style option is an option that can be exercised at any time before its expiry date. 2. The European style option is an option that can only be exercised at the specific expiry date of the option.
OPTION PREMIUMS:
By buying an option, a company acquires greater flexibility and at the same time receives protection against unfavorable changes in exchange rates. The protection is paid for in the form of a premium. Example: A company has a requirement to buy USD 1000000 in one months time. Market parameters: Current Spot Rate is 1,600 one month forward rate is 1.6000 Solutions available:
0Do nothing and buy at the rate on offer in one months time. The company will gain if the dollar weakens (say 1.6200) but will lose if it strengthens (say 1.5800).
0 Enter into a forward contract and buy at a rate of 1.6000 for exercise in one months time.
In company will gain if the dollar strengthens, but will lose if it weakens. 0But a call option with a strike rate of 1.6000 for exercise in one months time. In this case the company can buy in one months time at whichever rate is more attractive. It is protected if the dollar strengthens and still has the chance to benefit if it weakens.
How does the option work?
The company buys the option to buy USD 1000000 at a rate of 1.6000 on a date one month in the future (European Style). In this example, lets assume that the option premium quoted is 0.98 % of the USD amount (in this case USD 1000000). This cost amounts to USD 9800 or IEP 6125.
Outcomes:
If, in one months time, the exchange rate is 1.5000, the cost of buying USD 1000000 is
IEP 666,667. However, the company can exercise its Call Option and buy USD 1000000 at 1.6000. So, the company will only have to pay IEP 625000 to buy the USD 1000000 and saves IEP 41667 over the cost of buying dollars at the prevailing rate. Taking the cost of the potion premium into account, the overall net saving for the company is IEP 35542.
0On the other hand, if the exchange rate in one month time is 1.7000. The company can choose not to exercise the Call Option and can buy USD 1000000 at the prevailing rate of 1.7000. The company pays IEP 588235 for USD 1000000 and saves IEP 36765 over the cost of forward cover at 1.6000. The company has a net saving of IEP 30640 after taking the cost of the option premium into account.
In a world of changing and unpredictable exchange rates, the payment of a premium can be justified by the flexibility that options provide. MAKING THE MOST OF OPTIONS Options are particularly flexible:
The buyer can choose any strike rate and any end date. The management of an option position can be made even more flexible with the following techniques: SELLING BACK AN OPTION
The bank will at any time quote a price at which it is prepared to buy back an option it has sold. The valued of the option can be paid directly to the holder or can be incorporated in the rate on any new spot or forward deals done at the time.
EXTENDING OR SHORTENING AN OPTION The expiry date on an option can be changed, usually with payment of premium, either by the company to the bank (for an extension) or by the bank to the company (for shortening). A payment of premium can be avoided by adjusting the strike rate when the expiry date is altered.
Changing other features of an option
In principle, any feature of an option may be changed at any time (strike rate, option amount), with a resulting payment of premium in one direction or the other.
USES OF OPTIONS: 0On account of market volatility, if one is not very sure of the rates, option contract is useful to limit losses and gives access to unlimited profit potential. 0In calm markets, writing of options is a profitable business with relatively low risk. 0Options contracts are ideal when tendering for a business contract where the outcome is uncertain. 0Options are useful in carrying out ongoing transactions where exposures are uncertain in terms of timings amounts etc. 0Option provides the best tool to hedge balance sheet translation exposure. 0Options are useful for hedging foreign currency loan exposures. OPTIONS- INDIAN SCENE In the past, Indian market other than currency market has experienced derivative instruments in the form of futures, etc. The process of globalization and integration of Indian Financial sector with the global economy has opened up vast potential of the world currency markets in the business, especially the matured, highly liquid and competitive markets of currency options. The successful management of stability of rupee exchange rate against the US dollar dampened the sentiments of volatility of $/rupee rate. Stability of exchange rate stimulates N.R.Institute of business management
growth of international trade in good/services, investment flows etc. The volatility and vulnerability of rupee against the currencies other than the US dollar is beyond management in terms of exchange rate stability of rupee. The main features are:
0At present Indian residents can buy cross currency options only to hedge their foreign exchange exposures in non-US dollar currencies. 0Corporate can buy but cannot write options.
Due to certain structural deficiencies of the financial markets in India; the RBI has not permitted rupee-based currency options. Options are allowed to be bought by clients only to cover their genuine exposures. Banks selling currency options have to hedge themselves immediately on back-to-back basis. The managing committee of FEDAI adopted, with certain modifications, International Currency Options Master (ICOM) agreement of British Bankers Association, London for cross currency options market in India.
The cross currency options market is still in an infancy stage in India and the initial euphoria over cross currency subsided on account of the following factors.
0The RBI introduced cross currency options in non US dollar currencies for covering genuine exposures of the corporate. Nearly 60 to 70% of the corporate exposures are denominated in the US dollar. As a result major of the corporate exposures did not require currency options as a hedging tool. 0Reluctance of the corporates to part with the front-end fee as the price for purchase of an option contract. 0The premium or price of the currency option contract is higher than the expectation of the corporates about the volatility of currency movements. 0Rigidities attached to the cross currency option contract deals. 0Absence of long term rupee yield curve, structural deficiencies of the financial market. 0The most important problem is the absence of rupee based currency options. N.R.Institute of business management
The above factors have certainly shunted the growth of cross currency options as a first derivative product on the Indian Foreign Exchange market. Earlier Indian corporate clients had only two options to manage foreign exchange risk.
0To do nothing till the maturity of the transactions of 0To book a forward contract and settle the transaction at contracted date of maturity of the contract.
However, today corporate have additional tool at their disposal in the form of cross currency option for managing their currency exposures.
Introduction of cross currency options is a certain raiser and its subsequent development application in the currency market will bring in onslaught of complex derivative products for both the corporates as well as the bankers.
Example:
Suppose French company expects to pay against it imports, USD 10,000,000 in six months time. They expect US $ to fall but do not want to take the chance of being wrong. Current market rates
Spot USD/FRF 6 months USD/FRF 6.9450
6.9150
A 6 month at the money USD call/FRF put option contract costs 1 % The strike price would therefore be 6.9450 Option Premium is 10,000,000 * 1 % = FRF 691,500
The choices that the company has are:
0 Do nothing (aggressive). 0Buy USD/sell FRF Forward (defensive) @ 6.9450 0Hedge is means of the option (selective) USD Put/CHF call costs 1 % In six months time Case I: Spot USD/FRF = 7.0550 0Choice 1
Where the company did nothing they buy USD from the market and pay USD 10,000,000 * 7.0550 = FRF 70,550,000.
Choice 2
Where the company bought forward they pay 10,000,000 * 6.9450 = FRF 69,450,000.
Choice 3
Where the company hedged the option they exercise the option to buy USD and pay FRF 69,450,000 plus Option Premium FRF 691,500.
Case II: Spot USD/FRF = 6.9450
Choice 1
Where the company did nothing they buy USD from the market and pay 10,000,000 * 6.9450 = FRF 69,450,000.
Choice 2
Where the company bought forward USD they pay 10,000,000 * 6.9450 = FRF 69, 45,000.
Choice 3
Where the company hedge with option, whether the exercise the option or not they pay FRF 69,450,000 + the option premium = FRF 70,141,500. Case III: Spot USD/FRF = 6.8500
Choice 1
Where the company bought forward USD from the market and pay 10,000,000 * 6.8500 = FRF 68,500,000.
Choice 2
Where the company bought forward USD they pay 10,000,000 * 6.9450 = FRF 69, 45,000.
Choice 3
Where the company hedge with option, they dont exercise the option but buy USD from the market and pay FRF 68,500,00 + the option premium = FRF 69,191,500. Choice Case 1 Case 2 USD/FRF7.0550 USD/FRF 6.9450 1 . Nothing 70,550,000 2 . Forward 69,450,000 3 . Option 70,141,500 Choice 2 is best 69,450,000 64,450,000 70,141,000 Case 3 USD/FRF 6.8500 68,500,000 69,450,000 69,191,500
Choices 1 & 2 are best Choice 1 is best
Thus the general rule for hedging exposures with options is that with hindsight one can deduce that there was always a better strategy. The question to be asked is what the risk is and does the option premium justify it? Beside, always look at an option as an insurance policy, it never qualifies as a good investment but always provides protection against the unknown.
5.4 SWAPS
WHY DID SWAPS EMERGE? In the late 1970s, the first currency swap was engineered to circumvent the currency control imposed in the UK. A tax was levied on overseas investments to discourage capital outflows. Therefore, a British company could not transfer funds overseas in order to expand its foreign operations without paying sizeable penalty. Moreover, this British company had to take an additional currency risks arising from servicing a sterling debt with foreign currency cash flows. To overcome such a predicament, back-to-back loans were used to exchange debts in different currencies. For example, a British company wanting to raise capital in the France would raise the capital in the UK and exchange its obligations with a French company, which was in a reciprocal position. Though this type of arrangement was providing relief from existing protections, one could imagine, the task of locating companies with matching needs was quite difficult in as much as the cost of such transactions was high. In addition, back-to-back loans required drafting multiple loan agreements to strate respective loan obligations with clarity. However this type of arrangement leads to development of more sophisticated swap market of today. WHAT ARE SWAPS? A contract between two parties, referred to as counter parties, to exchange two streams of payments for agreed period of time. The payments, commonly called legs or sides, are calculated based on the underlying notional using applicable rates. Swaps contracts also include other provisional specified by the counter parties. Swaps are not debt instrument to raise capital, but a tool used for financial management. Swaps are arranged in many different currencies and different periods of time. US $ swaps are most common followed by Japanese yen, sterling and Deutsche marks. The length of past swaps transacted has ranged from 2 to 25 years.
PRESENT SCENARIO IN THE INDIAN MARKET
Genesis of the Interest Rate Swaps in India

Interest rates in India have been RBI determined for decades now. In the past five years, we have seen this situation changing. Gradually, India is moving towards a market determined interest rate regime. RBI is gradually freeing interest rates, and this has forced banks to manage risks on their own. Moreover, the Indian companies were used to the earlier easy go approach and surety in interest rates that they can borrow on. But now, corporate have a plethora of rates at which they can borrow. They have the option of loans linked to fixed or floating rates. Thus, Indian companies have to be se efficient with regards to management for financial uncertainties, like s is elsewhere in the world. With all this deregulation and integration with global practices, there was a felt needs for Instruments to hedge against various risks. Derivatives for the money market were the next logical step in the process. This is exactly what RBI has done.
The RBI Governors Statement on Mid Term Review of Monetary and Credit Policy for 199899 announced on October 30, 1998, indicated that to further deepening the money market and to enable banks, primary dealers (PDs) and all India financial instituti9ons (FIs) to hedge interest risks, the RBI had decided to create an environment that would favor the introduction of Interest Rate Swaps.
Accordingly, on July 7, 1999 RBI issued final guidelines to introduce IRS and Forward Rate Agreements (FRAs). The players are allowed to practice IRS/FRAs as product for their own balance sheet management and for market making purposes.
The RBI has been criticized for being hasty in introducing such interest rate derivatives. It was said that our debt market is not mature enough to incorporate and deal with such products. Though the Indian debt market has not been properly developed, blaming the RBI move does not seem to be proper because there products will have to be introduced sooner or later and the present time appears to be as good a time as any other. Moreover, this move may also help in quickening the development of a mature debt and money market. N.R.Institute of business management
The legal framework: RBI Guidelines (summary) A brief summary of RBI guidelines regarding IRS issued on July 7, 1999 follows:
0Interest rate swap refers to a financial contract between two parties exchanging a stream of interest payments for a notional principal amount on multiple occasions during a specified period. 0Forward rate agreement (FRA) is being defined as the same on settlement date for a specified period from start date to maturity date. The players: Scheduled commercial banks excluding regional rural banks, primary dealers (PDs) and all India financial institutions have been allowed to undertake IRS as a product of their own asset liability management and market-making purposes. Types: Banks/PDs/FIs undertake different types of plain vanilla FRAs/IRS for interest rate risks arising on account of landings or borrowings made at fixed or variable interest rates. However, swaps having explicit/implicit option features like caps, floors or collars are not permitted. Benchmark Rate: The players can use any domestic money or debt market rates as reference rate for entering into FRA/IRS, provided methodology of computing the rate is objective, transparent and mutually acceptable to counter parties. The reason stated for the same is that the benchmark rate is expected to evolve on its own in the market.
Size of the notional principal amount: There will be no limit on the maximum or minimum size of the notional principal amount of FRA/IRS or the tenor of the IRS/FRAs. Regarding the exposure limits the banks; FIs and PDs have to arrive at the credit equivalent amount for the purpose of reckoning exposure to counter party. Exposure: The exposure should be within the sub limits and the participants concerned should fix this for the FRAs/IRS to corporate/FIs, banks/PDs. In case of the banks and the FIs, the credit exposure should be within the single/group borrower limits as prescribed by the RBI. Facilitators The problem of locating potential counter parties was solved through dealers and brokers. A swap dealer takes on one side of the transaction as counter party. Dealers work for investment, commercial or merchant banks. By positioning the Swap, dealers earn bid-ask spread for the service. In other words, the swap dealer earns the difference between the amount received from a party and the amount paid to the other party. In an ideal situation, the dealer would offset his risks by matching one step with another to streamline his payments. If the dealer were a counter party paying fixed rate payments and receiving floating rate payments, he would prefer to be a counter party receiving fixed payments and paying floating rate payments in another swap. A perfectly netted position as just described is not necessary. Dealers have the flexibility to cover their exposure by matching multiple parties and by using other tools such as futures to cover an exposed position until the book is complete.
Swap Market Participations

Since swaps are privately negotiated products, there is no restriction on who can use the market: however, parties with low credit quality have difficulty entering the market. This is due to fact that they cannot be matched with counter parties who are willing to take on their risks. In the U.S. many parties require their counter parties to have minimum assets of $ 10 million. This requirement has become a standardized representation of eligible swap participants . N.R.Institute of business management
The following list includes a Sample of Swaps Market Participants: 1. Multinational Companies. Shell, IBM, Ronda, Unilever, Procter & Gamble, Pepsi Co.
2. Banks. Banks participate in the swap market either as an intermediary for two or more parties or as counter party for their own financial management. 3. Sovereign and public sector institutions. Japan, Republic of Italy, Electricity de France, Sallie Mae(U.S. Student Loan Marketing Association). 4. Super nationals World Bank, European Investment Bank, Asian Development Bank. 5. Money Managers Insurance companies, Pension funds.
Secondary Factors in the Development of the Swap Market

As international barriers to financial markets began to disappear, swap dealers were able to switch between different indexes and different markets. By arbitraging capital and credit markets, they were able to borrow at the best index available and then swap to the desired index.
Heavy borrowing by the US government and government agencies in the 80s played a major role in the development of the swap market. Borrowing at the floating rates and swapping to the fixed rates met the needs of the corporations and in effect added to the depth and the liquidity of the swap market.
Taking a view on the future direction of the interest rates, swaps can be proved to very attractive instruments, and under a variety of yield curve conditions, they are among the cheapest to transact. Speculative trading of the swaps added enormously to the depth and liquidity of the market.
Foreign Exchange Swap

Swaps are derivatives that involve a private agreement between two parties to exchange cash flows in the future according to a prearranged formula. The underlying instruments are liabilities or assets with interest expenses or incomes. Swaps can be broadly classified into two types Interest Rate Swaps and Currency Swaps. The first recorded swaps were negotiated in 1981. Since then, the markets have grown very rapidly.
A basic foreign exchange swap another, where the twois the simultaneous purchase and sale of one currency for have different contracts amount on different dates). dates (different positions of same or different
Cash Management Swap

It is used to realize efficient cash management or to adjust the maturity dates of existing forward contracts.
Handling Surplus and Deficit Cash Positions
The international scope of business conducted by financial and non-financial organization will often require the management of cash flows in more than one currency. From time to time, an entity will find itself with surplus cash balance in one currency and deficit balances in another currency.
Swapping Forward Contracts Forward at Historical Rates.

Corporations often face considerable uncertainty in timing and /of amount when forecasting currency cash flows. Forward contracts that were dealt to hedge such flows may mature on a date that does not match the actual cash flow. In such cases, the maturity of the original forward contract crates cash flows for which there is no immediate offset.
Once again, the cash manager can borrow to fund the deficit, invest the surplus, or execute a cash management swap. Another method to deal with this type of situation is to swap contracts at historical rates. The new forward contract consists of the maturing forward rate adjusted by the current points and a working capital interest factor.
Historical rate rollovers have the same basic economic as market rate saps. The also eliminate the need for any cash settlements on the original maturity date and avoid the accounting problems frequently associated with the FX gain/loss account. On small forward contracts, the actual dollar amount of the net settlement maybe small, and cost of settling may be excessive given the amount involved. In other cases, an entity may not have the cash to settle on the swap but still want the swap done.
As a general comment, usage of historical rate swaps varies from market to market, but this type of swap is not a heavily traded transaction. One of the major reasons is its susceptibility to abuse.
There are basically two types of swap transactions:
0Interest Rate Swap 0Currency Swap
5.4.1 INTEREST RATE SWAPS The most common type of interest rate swaps are plain vanilla IRS. Here, one party A agrees to pay to the other party B, cash flows equal to interest at a predetermined fixed rate on a notional principal for a number of years. Simultaneously, A agrees to pay party B cash flows equal to interest at a floating rate on the same notional principal for the same period of time. The currencies of the two sets of interest cash flows are the same. Moreover, only the difference in the interest payments is paid/received; the principal is used only to calculate the interest amounts and is never exchanged. It is an arrangement whereby one party exchanges one set of interest payment for another e.g. fixed or floating. An exchange between two parties of interest obligations (payment of interest) in the same currency on an agreed amount of notional principal for an agreed period of time.
Example: Two counter parties are involved in a swap agreement, corporate A and corporate B and a dealer arranges the swap (taking a spread). Amount to be borrowed: USD 100 Mn. For 15 years. Following are the rates at which A and B can raise funds:
Fixed Corporate A Corporate B 5% 7%
Floating 6M LIBOR + 50bp 6M LIBOR + 100bp
It can be observed that Corporate A has advantage in borrowing in both fixed and floating market. (Fixed market 2 % and Floating market 50bp). However, by swapping interest rate obligation both A and B can borrow at lower rates.
Corporate A borrows fixed @ 5 % Corporate B borrows floating @ 6 month LIBOR + 100bp.
By entering into a swap agreement: A will become floating ratepayer; and B will become fixed rate player. Cash flow under the swap agreement; Corporate A PAY 6 M LIBOR* 5%&
5% -----
RECEIVE
Net cost: 6 M LIBOR (Pay 5 % cancels Receive 5 %) Corporate B PAY 5.5 %* 6 M LIBOR + 100bp & Net Cost: 6.5 % PAY/RECEIVE TO/FROM DEALER & PAY TO THE LENDER IN CASH MARKET RECEIVE 6 M LIBOR * -----
NOTE: 1. Corporate have to borrow in cash market and meet their obligations. 2. It is assumed that the dealer takes a spread of 50bp.
0Corporate A achieves floating rate at 6 M LIBOR better by 50bp than without swap. 0Corporate B achieves fixed rate at 6.5 % better by 50bp than without swap. 0Dealer makes 50bp.
Types of IRS
We have discussed the plain vanilla swaps till now. These swaps can be subdivided into swaps made directly between two parties or with an exchange. Moreover, they can be classified on the basis of the floating reference rate used, which may be LIBOR, CP rate, T-Bill rate, etc. Apart from plain vanilla IRS discussed above, there are several other types of swaps. Basis Swaps: Where both the legs are floating interest rates. Amortizing Swaps: Where the principal reduces in a predetermined way to correspond to the amortization schedule on a loan. Step-up Swaps: Where principal increases in a predetermined way Deferred/Forward Swaps: Where parties do not begin to exchange interest payments until some future date. Combinations with currency Swaps: Where fixed rate in one currency is exchanged with floating rate in another currency. Extendable Swaps: Where one party has the option to extend the life of the swap beyond the specified period. Put table Swaps: Where one party has the option to terminate the swap early. Swaptions: Which are options on swaps? N.R.Institute of business management
Constant Maturity Swaps (CMSs): Where LIBOR is used as reference rate. Constant Maturity Treasury Swaps (CMTs): Where LIBOR is exchanged for a particular Treasury rate. Indexed principal Swaps: Where the principal reduces based on an index of interest rate levels. Differential Swaps: Where a floating rate in domestic currency is exchanged for a floating rate in foreign currency, with both interest rates applied on same domestic principal. Back valued Swaps: Where past effective dates are used. Prepaid Swaps: Where the fixed leg payer pays his obligations in advance, and only receives payments till maturity, zero coupon swaps are exactly opposite to prepaid swaps, where the whole payment is given at the maturity.
Trends in Indian Markets
Before coming to the actual trends in the market, let us look at the players. Most of the active participation is by foreign banks, followed by Indian banks, Corporates and finally, FIs. The absence of nationalized banks from the IRS scene is noteworthy. Today, if a corporate wishes to enter an IRS deal, it will have to submit the following to its banker: 0Certified copy of the firms Memorandum and Articles of Association. 0Board resolution authorizing derivative deals. 0An ISDA Master Agreement. 0Risk disclosure statement. 0Certificate wing underlying loan exposure. 0A certificate stating that IRS is for hedging risks, not for speculation. Thus, we see that IRS today can be used by corporate only for an actual hedging exercise, and it has to have board permission. Moreover, the deal would be within the exposure limits of that firm for the bank with which it is dealing. These measures are to ensure that corporates do not undertake speculative activities, and start dealing only after they have proper risk management systems in place.
On the first day of trading, more than 30 deals were recorded, worth over Rs. 600 Crores in notional principal terms. Rs. 500 Crores of this was accounted for by corporate deals. The rush was because the European and private banks wanted to be a part of the history, dealing on first day, rather than actual hedging. It has also been reported that some deals were circular between three players, with no real effect in any players position. No deal was stuck for more than a years tenor.
Since the first day, there have been almost no deals, and the markets are cold. The reasons for this are many. At the short-term level, almost all the players expect the interest rates to go down in the next few months. This means that there are no conflicting views among players about
interest rates, and so IRS deals are not very tempting. Again, there are very few floating rate loans around. These and other fundamental reasons have been discussed in the next secti9on.
In spite of these, there are many underlying reasons for going for IRS. Today, the major financial intermediaries viz. Indian banks, foreign banks, financial institutions, and corporates have radically different sets of asset-liability structures. Thus for ALM alone, IRS are a good options. For example, the FIs have much of their liabilities as bullet repayment bonds, and the bulk of their assets by way of installment repayment loans. Thus, chances are that their liabilities portfolio is longer than their assets portfolio. Commercial banks, on the other hand, have bulk of their liability portfolio in relatively short-term maturities, and assets are at longer maturities with fixed interest rates. Thus, banks and FIs alone can enter in a lot of mutually beneficial deals.
Corporate would also like to hedge their interest rate risks, and convert their fixed rate loans to floating rates, now that the options are available. However, their needs would be medium term in nature (2 to 8 years), and as yet there are no takers for these long maturities.
The market is only about 2 months old now, and is yet to evolve. The likely problem in its evolution and the future is discussed in the following sections. FUTURE OUTLOOK FOR IRS IN INDIA
As India shifts from RBI controlled to market driven interest rate regime, volatility in the interest rate is bound to increase. This implies greater use of risk hedging mechanism like IRS. As the obstacles discussed in Section 5 are tackled, we shall see the evolution of the money market derivative markets. The speed of this evolution depends on how quickly the fundamental problems are addressed and the market revives. The major concern, of course, will be the emergence of a floating rate loan market, as at least one leg of the IRS has necessarily to be a floating rate. This is the single major reason why thee are no only many IRS deals, but also even no possibilities of deals ill the current scenario for corporates.
Then, we have seen that the stage is set for the financial institutions, commercial banks and corporates to enter into swaps as soon as they have risk management systems in place and the market matures. In the short run however, there will not be much activity as the fundamentals are unlikely to change quickly. A major concern is the govt. borrowing, which distorts the interest rates and has a major impact on the market. In a mature market, no player should be so big that it can affect the interest rates in a large way, causing rates, which do not really reflect the sentiments of the markets. On the other hand, this same point causes volatility in the markets, which is another reason to hedge against risks, where IRS comes in. We wait to see how the markets evolve.
Also likely in the medium term is the emergence of various types of swaps not currently allowed in India. Like IRS/FRAs kicked off the derivative market in India, Swaptions may well kick off the options market in India, though today, it looks as though equity options will come up earlier. As awareness increases, and it dawns on the players that swaps are excellent hedging instruments, the market can only improve.
Finally, we come to speculation. This is likely to stay away from Indian markets, at least for the corporates till a long time to come. RBI, or the govt. does not encourage speculation in any other markets by the corporates or individuals. This is likely to continue, as
The current guidelines show. Moreover, for speculation, one needs volatility and diverse views which are not present today. As these emerge, some players may be allowed to speculate, but the limits are likely to be strict and discouraging.
Overall, IRS is here to stay, and players will soon learn to use them effectively. Though in infancy now, the markets may evolve sooner than one may expect.
5.4.2 CURRENCY SWAPS Each entity has a different access and different long term needs in the international markets. Companies receive more favorable credit ratings in their country of domicile that in the country in which they need to raise capital. Investors are likely to demand a lower return from a domestic company, which they are more familiar with than from a foreign company. In some cases a company may be unable to raise capital in a certain currency.
Currency swaps are also used to lower than risk of currency exposure or to change returns on investment into another, more favorable currency. Therefore, currency swaps are used to exchange assets or capital in one currency for another for the purpose of financial management.
A currency swap transaction involves an exchange of a major currency against the U.S. dollar. In order to swap two other non-U.S. currencies, a dealer may need to arrange two separate swaps. Although, any currency can be used in swaps, many counter parties are unable to exchange of the principals takes place at the commencement and the termination of the swaps in addition to exchange of interest payments on agreed intervals. The exchange of principal and interest is necessary because counter parties may need to utilize the respective exchanged currencies.
The uses of currency swaps are summarized below:
0Lowering funding cost 0Entering restricted capital markets 0Reducing currency risk 0Supply-demand imbalances in the markets As for interest rate swaps, many variants of the plain vanilla currency swaps were created to meet some of the common financial management needs.
Amortizing currency swaps

The notional principals of these swaps are scheduled to decrease over the life of the swaps. Therefore, principals are exchanged accordingly.
Accreting currency swaps

The notional principals of these swaps increase periodically. Principals are exchanged as scheduled.
Floating-for-floating rate currency swaps

As indicated by the name, this swap involves the exchange of a floating interest rate payment schedule in one currency against another floating interest rate payment schedule in another currency.
Features:
0Converts a stream of payments (fixed or floating) in one currency into a stream of another currency. 0Usually involves an exchange of principal at the end of the term at an exchange rate agreed at the outset of the deal.
Flow Chart:
6 month GBP Libor

BANK CUSTOMER
Fixed USD
6-MONTH GBP LIBOR TO LENDER
Borrow requires USD but has to borrow GBP lender Following are risks associated with swaps:
0Interest rate risk 0Exchange rate risk 0Default risk 0Sovereign risk 0Mismatch risk (for dealers only)
In 1987, a set of principal were arranged by the central banking authorities of the Group of Ten plus Luxembourg known as the Easle Supervisors Committee to standardize capital requirements across nations. According to this set of requirements, called the Easle Accord, dealers of swaps and other off balance sheet instruments are imposed risk-adjusted capital requirements.
CAPS & COLLARS
0Caps are like insurance 0Protect against rise in rates of interest 0Benefits of falling rates available
Interest Rate Cap is agreement between a corporate and a bank borrower with floating rate debt. Under the terms of the agreement, the bank undertakes to bear extra cost on account of interest rate going up beyond the agreed rate during the agreed period. For this undertaking, the borrower pays premium.
This instrument caps the interest payment of the borrower as any rise above the cap will be borne by the bank which sells cap to the borrower.
FLOORS It is a hedging product for investors for protection against falls in interest rates. Interest Rate floors, when it protects against fall in interest rates, investors benefit from rising interest rates. Investor has to pay premium to the seller of Interest rate floor.
This instrument defines the floor i.e. the minimum rate of interest the investor would earn in case the interest rate falls beyond the agreed limit.
COLLARS Where a corporate takes a view that the interest rate will remain in range, the corporate can combine cap and floor to achieve this objective. The corporate will buy Interest Rate Collar of between 7 % and 9 % if it believes that the interest rates would move between 7 % and 9 %. Corporate looses the benefit if rate falls below 7 %. However, as against this loss the corporate pays fewer premiums and is protected against the upside risk. (Of interest rates rising).
A SWAP DEAL There are 2 companies XYZ Co. and ABC Co. XYZ has borrowed capital from PQR at LIBOR + 0.5 (floating) and ABC has borrowed from DEF at 9.5 % (fixed). Both the partied want to cover their positions in a way that XYZ wants to convert its floating rate to Fixed and ABC wants to convert its Fixed rate to floating rate. By doing this each of them wants to minimize the cost of capital.
Here this is a 3 party deal, where bank behaves, as an intermediary. The role of the bank is to make a swap in a way that all the 3 parties earn equally. XYZ Fixed Floating 11 % LIBOR + 0.05 ABC 9.5 % (more credit worthy) LIBOR
XYZ borrows money from bank at 9.75 % and pays at LIBOR 0.25 % ABC borrows from Bank at floating rate LIBOR 0.25 % and pays at 9.5 %
Solution A Swap Deal
BANK
XYZ ABC
XYZ Pays -Libor-0.75% ABC -9.5% Bank Receives Pays Receives Pays Earnings = -
Receives +Libor 0.25% -Libor+0.25%
Pays -9.75% = 10.75 +9.5% = -0.25%
9.75% -Libor +0.25% 9.5% +Libor-0.25% 0.25%
Thus in the whole deal all the three parties earn 0.25%
EXAMPLES FROM INDIAN MARKET
SBI-HUDCO Bank of India has entered into a long-term rupee- Japanese yen swap with Housing and Urban Development Corporation (HUDCO).
According to a press release, HUDCO has swapped its foreign currency liability of Yen 2089 billions for equivalent rupee resources with SBI for a tenor of 10 years. Under the arrangement, HUDCO will deposit its yen with SBI on the day of transaction and SBI in return will pay the equivalent rupee resources to HUDCO.
According to officials, the swap will be done at the prevailing exchange rate on the day of the transaction. According to officials, HUDCO will use the rupee resources for lending to their projects in India. The overseas branches of SBI in Japan to fund their own assts will use yen. As per the swap agreement, SBI would provide the long-term hedge to HUDCO for a period of 10 years to cover the exchange risk of the foreign liability.
As a result of this, the swap will neutralize both the exchange rate risk and interest rate risk of HUDCO on yen loan by converting the yen flows into risk neutral fixed interest rate rupee flows for the company. At the end of 10 years, HUDCO will take back the yen by giving the rupee equivalent to SBI.
Earlier SBI had stuck a rupee -dollar swap of sizable transaction with ICICI. At present, the bank is considering similar deals with companies, which do not have international presence to manage the fo9reign currency risk effectively, said an official.
The bank is actively involved in developing the derivative market in India by facilitating the use of hedging instruments such as currency swaps. This has been possible after the permission was granted by the RBI to enable the corporate to obtain suitable hedge for their exposures arising out of their foreign currency loans.
Nalco contains loss on yen loan via swap deal
NATIONAL Aluminum Co (Nalco) has hedged its Yen 20-billion loan by swapping 50 percent of the principal into US dollars when the yen was at 144.15 against the dollar.
Last week the yen tumbled to 147 to a dollar. The yen bullet loan is due for redemption on September 1998. By covering its exposure, Nalco has insulated itself against possible foreign exchange fluctuations.
The benefits arising from sharp depreciation of the yen against the US dollar was partially nullified by the simultaneous depreciation of rupee. Depreciation of one yen to Rs.1.30 to neutralizes the effect on the loan, said Mr. C. Venkatramana, finance director, Nalco.
In other words, there will be no impact on the bottom line of Nalco as far as the fluctuation is within this range mentioned above.
Further, Nalco has parked about Yen 10 billion and $ 16 million in the exchange earners foreign currency (EEFC) account abroad. The EEFC corpus would more than mitigate the forex risk and its impact on the loan.
5.5 FUTURES
In a futures contract there is an agreement to buy or sell a specified quantity of financial instrument in a designated Future month at a price agreed upon by the buyer and seller.
A Future contract is evolved out of a forward contract and posses many of the same characteristics. In essence, they are like liquid forward contracts. Unlike forward contracts however, futures contracts trade on organized exchanges called futures markets. The characteristics of a future contract are
Standardization
The future contracts are standardized in terms of quantity and quality and future delivery date.
Margining
The other characteristic of a futures contract is the margining process. The margin differs from exchange to exchange and may change as the exchanges perception of risk changes. This is known as the initial margin. In addition to this there is also daily variation margin and this process is known as marking to market.
Participants
The majority of users are large corporations and financial institutions either as traders or hedgers.
Futures are exchange traded

In futures market there is availability of clearing house for settlement of transactions.
CURRENCY FUTURES
Currency futures markets were developed in response to the shift from fixed to flexible exchange rates in 1971. They became particularly popular after rates were allowed to float free in 1973, because of the resulting increased volatility in exchange rates.
A currency future is the price of a particular currency for settlement in a specified future date. A currency future contract is an agreement to buy or sell, on the future exchange, a standard quantity of foreign currency at a future date at the agreed price. The counterpart to futures contracts is the future exchange, which ensures that all contracts will honor. This effectively eliminates the credit risk to a very large extent.
Currency futures are traded on futures exchanges and the most popular exchange are the ones where the contracts are fungible or transferable freely. The Singapore International Monetary Exchange (SIMEX) and the International Monetary Market, Chicago (IMM) are the most popular futures exchanges. There are smaller futures exchanges in London, Sydney, Tokyo, Frankfurt, Paris, Brussels, Zurich, Milan, New York and Philadelphia.
Pricing of Futures Contract Futures Price = Spot Price + Cost of Carrying (Interest)
Cost of carrying is the sum of all costs incurred to carry till the maturity of the futures contract less any revenue, which may result in this period.
In India there is no futures market available for the Indian Corporates to hedge their currency risks through futures.
The advantages of Future Contract
0Low Credit Risk: In case of futures the credit risk is low as the clearing house is the counter party to every future. 0 Gearing: Only small margin money is required to hedge large amounts. The disadvantages of Future Contract
0Basic Risk: As futures contract are standardized they do not provide a perfect hedge. 0Margining Process: The administration is difficult. It is observed that a futures contract is a type of forward contract, but there are several characteristics that distinguish from forward contracts.
Standardized Vs. Customized Contract :

Forward contract is customized while the future is standardized.
Counter Party Risk:

In case of futures contract, once the trade is agreed upon the exchange becomes the counter party, thus reducing the risk to almost nil. In case of forward contract, parties take the credit risk to each other.
Liquidity :
Futures contract are much more liquid and their price is much more transparent as compared to forwards.
Squaring Off:
A forward contract can be reversed only with the same counter party with whom it was entered into. A futures contract can be reversed with any member of the exchange.
CONTRIBUTION OF DERIVATIVES IN THE GROWTH OF FOREX MARKET.
The tremendous growth of the financial derivatives market and reports of major losses associated with derivative products have resulted in a great deal of confusion about these complex instruments. Are derivatives a cancerous growth that is slowly but surely destroying global financial markets? Are people who use derivative products irresponsible because they use financial derivatives as part of their overall risk management strategy?
Thos who oppose financial derivatives fear a financial disaster of tremendous proportions a disaster that could paralyze the worlds financial markets and force governments to intervene to restore stability and prevent massive economic collapse, all at taxpayers expense. Critics believe that derivatives create risks that are uncontrollable and not well understood.
People have certain believes about derivatives which hampers the growth of the derivatives market. They are:
0Derivatives are new, complex, high-tech financial products. 0Derivatives are purely speculative, highly leveraged instruments. 0The enormous size of the financial derivatives market dwarfs Bank Capital, Thereby Making Derivatives Trading an Unsafe and Unsound Banking Practice. 0Only large multinational corporations and large banks have a purpose for using derivatives. 0Financial derivatives are simply the latest risk management fad. 0Derivatives take money out of productive processes and never put anything back 0Only risk-seeking organizations should use derivatives 0The risks associated with financial derivatives are new and unknown 0Derivatives ink market participants more tightly together, thereby increasing systematic risks. This is what some people believe, but its not the case.
Actually the financial derivatives have changed the face of finance by creating new ways to understand, measure, and manage financial risks. Ultimately, derivatives offer organizations the opportunity to break financial risks into smaller components and then to buy and sell those components to best meet specific risk-management objectives. Moreover, under a marketoriented philosophy, derivatives allow for the free trading of individual risk components, thereby improving market efficiency. Using financial derivatives should be considered a part of any businesss risk-management strategy to ensure that value-enhancing investment opportunities can be pursued. Thus, financial derivatives should be considered for inclusion in any corporations risk-control arsenal. Derivatives allow for the efficient transfer of financial risks and can help to ensure that value-enhancing opportunities will not be ignored. Used properly, derivatives can reduce risks and increase returns.
Derivatives also have a dark side. It is important that derivatives players fully understand the complexity of financial derivatives contracts and the accompanying risks. Users should be certain that the proper safeguards are built into trading practices and that appropriate incentives are in place so that corporate traders do not take unnecessary risks.
The use of financial derivatives should be integrated into an organizations overall riskmanagement strategy and be in harmony with its broader corporate philosophy and objectives. There is no need to fear financial derivatives when they are used properly and with the firms corporate goals as guides.
CHAPTER 6: RISK MANAGEMENT

WHAT IS THE NEED FOR FORWARD EXCHANGE CONTRACT? The risk on account of exchange rate fluctuations, in international trade transactions increases if the time period needed for completion of transaction is longer. It is not uncommon in international trade, on account of logistics; the time frame cannot be foretold with clock precision. Exporters and importers alike cannot be precise as to the time when the shipment will be made as sometimes space on the ship is not available, while at the other, there are delays on account of congestion of port etc.
In international trade there is considerable time lag between entering into a sales/purchase contract, shipment of goods, and payment. In the meantime, if exchange rate moves against the party who has to exchange his home currency into foreign currency, he may end up in loss. Consequently, buyers and sellers want to protect them against exchange rate risk. One of the methods by which they can protect themselves is entering into a foreign exchange forward contract. RISK MANAGEMENT FROM EXPORTERS POINT OF VIEW
If on the 1st January 2000 exporter signs an export contract. He expects to get the dollar remittance during the June. Now lets assume that on first January exchange rate between dollar and rupee is 48.7500 and due to the adverse fluctuation of exchange rate the actual rate in June is 48.500 so we can infer from the above that the export may loose 24 paisa per dollar. As per instrument available in India exporter may enter a forward exchange contract with a bank. While entering the contract with bank, bank will give him a forward rate for June adding the premium to the spot rate of first January. Let suppose it is 48.8400 so exporter can earn 9 paisa my exchange rate between dollar and rupee is 48.7500 and due to the adverse fluctuation of exchange rate the actual rate in June is 8.5000 so we can infer from the above that the export may loose 24 paisa per dollar. As per instrument available in India exporter may either a forward exchange contract with a bank. While entering the contract with bank, bank will give him a N.R.Institute of business management
forward rate for June adding the premium to the spot rate of first January. Let suppose it is 48.8400 so exporter can earn 9 paisa may cancel and rebook the contract as many as times they want. IMPORTERS POINT OF VIEW
Let suppose on first January an importer signs a deal with foreign party. He expects to pay the bill in March on first January the exchange rate is 457500 and the importer expects that the dollar will depreciate in the month of March. So the importer will enter into the agreement with bank for the forward exchange contract. The bank will give him the forward rate. If the rate is lower than the todays rate then the importer will enter into the contract with bank and the rate is high then he will not enter into the contract.
In India importers cannot cancel the contract. They can cancel the contract at once and roll over for the future date. This way importers and exporters can minimize the risk due to the adverse foreign exchange rate movement.
6.1 RISK MANAGEMENT PROCESS

In a foreign exchange market, there exists price risk or market risk. Fluctuation in price of currencies due to several factors to which business is exposed, Which can lead to unforeseen losses or windfall profit. The risk management process consists of the following elements: I. Risk appreciation & identification
Risk appreciation is the realization that a risk exists. It is accepted that exchange rates change and in a volatile way. Risk identification is however, not so simple .for example, a business which imports raw materials and sale finished goods in the domestic market. Certainly, it has currency exposures if N.R.Institute of business management
the rupee falls, the cost of raw materials would go up and so will the price of finished goods which makes it difficult for the business to be competitive. Thus risk identification is required.
II. Risk measurement
One of the broad measures in the risk measurement is the net open position (i.e. receipts minus payment) in each currency. For working out the net position, anticipated imports/exports. As indeed economic exposure can be taken into account. This is a speculative exposure and should be limited according to the management attitude to risk, the vulnerability of the business to adverse movement, etc. III. Risk control
Risk control is ensuring that only affordable risks are taken and ensuring that the risk management parameters lay down are followed. Actual reports needs to be compared with the prescribed limits.
6.2 TYPES OF RISK IN FOREIGN EXCHANGE

MARKET RISK OR PRICE RISK
The risk arising out of the movement in rates of foreign exchange currencies is the market risk or pricing risk. This risk arises out of the open currency position which is unchanged. Given the magnitude of exchange rate fluctuation the possibilities of substantial losses highly exists.
CREDIT RISK
The credit risk arise when counter party, whether a customer or a bank, fails to meet his obligation and the resulting open position has to be covered at the ongoing rate. If the rate has moved against, a loss can result and vise versa. N.R.Institute of business management
OPERATIONS RISK
Operations risk can arise because of failure of computer systems. A loss can also occur due to human error, fraud or lack of effective internal controls. Operative risk could also arise because most deals are done over the telephone and there could also arise because most deals are done over the telephone and there could be misunderstanding over what was agreed in terms of rate.
LIQUIDITY RISK
The risk arises when for whatever reason market turn illiquid and positions cannot be liquidated except at a huge price concession. In volatile markets, the bid-offer spread tends to widen. Example; USD; INR market, in normal conditions, the inter bank bid-offer spread is 0.5 to 1 paisa. But, when there is volatility or illiquidity due to demand-supply imbalance, the spread often widens to 5 paisa or more. SETTLEMENT RISK
The risk is of the counter party failure during settlement, because of the time difference in the markets, in which cash flows in the currencies have to be paid and received.
This risk has made many banks impose a settlement limit on counter parties for aggregate settlements on any value date.
6.3 TYPES OF EXPOSURES IN FOREIGN EXCHANGE MARKET

There are 3 types of exposures existing in a foreign exchange market.
1. TRANSACTION EXPOSURE
Transaction exposures are the most common. Suppose that a company is exporting in euro and, while costing the transaction, materializes, i.e. the export is affected and the euros sold for rupees, the exchange rate has moved to Rs. 40 per euro. In this case, the profitability of the export transaction can be completely wiped out by the movement in the exchange rate. This is termed as the transaction exposure which arises whenever a business has foreign currency denominated receipts or payments. 2. TRANSLATION EXPOSURE
Translation exposure arises from the need to translate foreign currency assets or liabilities into the home currency for the purpose of finalizing the accounts for any given period. A typical example of a translation exposure is the treatment of foreign currency loans.
Consider that a company has taken a medium term dollar loan to finance the import of capital goods worth $ 1mn. When the import materialized, the exchange rate was Rs. 40 per dollar. The imported fixed asset was, therefore, capitalized in the books of company at Rs. 400 lakhs, for finalizing its accounts for the year in which asset was purchased. However, at the time of finalization of accounts, exchange rate has moved to Rs. 45 per dollar, involving translation loss of Rs. 50 lakhs, in this case, under the Income Tax Act, the loss cannot be written off; it has to be capitalized by increasing the book value of fixed asset purchased by drawing upon the loan. The book value of asset thus becomes Rs. 450 lakhs and consequently higher depreciation will have to be provided for thus reducing the net profit. If the foreign currency loan is used for working capital. In that case the entire transaction loss would have to be debited to profit and loss a/c in the year in which it occurs.
The effect of transaction and translation exposure could be positive as well if the amount is favorable. The translation exposure of course becomes a transaction exposure at some stage the dollar loan has to be repaid by undertaking the transaction of purchasing dollars against rupees.
3. ECONOMIC EXPOSURE
Both transaction and translation exposures are accounting concepts whereas economic exposure is different than an accounting concept. A company could have an economic exposure to the euro; rupee rate even if it does not have any transaction or translation I euro currency; this will be the case when its competitors are using European imports. If the euro weakens, the company loses its competitiveness against the competitors and vice versa. Generally, all businesses have economic exposures to exchange rates. Economic exposure to an exchange rate is the risk that a change in the rate affects the companys competitive position in the market, or costs, and hence indirectly, its bottom line. Thus, economic exposures affect the profitability over a longer time span than transaction exposure.
CHAPTER 7: ANALYSIS OF QUESTIONNAIRE

QUESTION 1: CATEGORY OF ORGANIZATION
Category of organization
20%
33%
e x p o rt e r i m p o rt e r
47 %
bot h
(
C h a rt : 7. 1)
INTERPRETATION: We have collected response from 30 respondents to know their feedback about the Prospect of Currency futures in Ahmedabad from the perspective of Exporters and Importers. Out of them, the composition of them is as follow:
20% were Exporters & Importers, 33% i.e. 9 were exporters and 47% i.e. 4 were importers.
QUESTION 2: DURATION OF BUSINESS
Time of Business
10 8 6 4 2 0 below 1year 1-3 years 3-5 years above 5 years 4 8 9 9
(Chart: 7.2) INTERPRETATION:
From the above chart ,it is seen that out of 30 respondants 9 importers and exporters has their business between 3 to 5 years and 9 out of them has more than 5 years experience in the business. There are some small importers and exporters having less than 1 year of experience
QUESTION 3 : FOREIGN CURRENCY EXPOSURE
Foreign Currency Exposure

10 8 6 4 2 0 less 10-25% than 10% 25-50% 50-75% more than 75%
(Chart: 7.3)
INTERPRETATION:
We have tried to concentrate more on those prospective respondents who are having major foreign currency exposure so that we will get an accurate feedback from them. Therefore, the final composition turns out to be, 26% has more than 75% of exposure 23.33% has 50-75% of exposure.
QUESTION 4: USE OF HEDGING
Do you hedge?
no yes 7%
93%

The analysis of above graph indicates how many people actually do hedging to cover their foreign currency exposure. Out of total 30 respondents, most of the respondents actually do hedging to cover their foreign currency exposure and the rest of them do not hedge their exposure. The use of hedging strategy may help them to keep their billing amount low/ at par with the international competitors.
QUESTION 5 : RANKING FOR TOOLS OF HEDGING
Forward
future 11 7 4 6
swap 6 10 9 3
options 7 7 10 4 4 4 5 15
rank 1 rank2 rank 3 rank 4
100% 90% 80% 70% 60% 50% 40% 30% rank 1 20% 10% 0% Forwa rd future swa p options rank 3 rank2 rank 4
Out of respondents who hedge their foreign currency exposure, 40% of them has ranked forward contract as their first preference. Options is ranked fourth by 55% of importers and exporters as we can see from the above chart. Futures contract is traded on organized exchanges and they have been gaining ground very rapidly. Futures is ranked as first preference by 20% and as 4th by 10% of importers and exporters.
REASONS FOR NOT USING HEDGING
Reasons of not using Hedging

13%
30%
27% 30%
expensive for small transactio ns fear of increase in risk

unneces sary in some situatio ns
others
Taking the present situation in to consideration about importers and exporters , sometimes they dont use hedging. Major reasons for which they dont use can be seen in the chart. 30% of traders considers hedging tools as expensive , 27% consider it unnecessary in some situations. One of the reason is fear of increase in risk due to unpredictable factors has 30% weightage
QUESTION 6 : AWARENESS ABOUT CURRENCY FUTURES
Awareness
23% no 77 % y es
(Chart: 7.7)
INTERPRETATION:
The reason behind why majority of respondents who hedge their foreign currency exposure, use forward contract only is the lack of awareness about the newly introduced futures contracts traded on organized exchanges. However, exchanges and brokerage firms have been organizing seminars to make exporters and importers aware about the product and induce them to use this product instead of forward contracts.
QUESTION 7 : USE OF CURRENCY FUTURES
Use of currency futures

30% 70 % n o y es
(Chart: 7.8)
INTERPRETATION:
Out of 30 respondents 21 respondents were of the opinion that they have used currency futures in the past or they are been using it, whereas 9 respondents said that they have never used currency futures.
QUESTION 8 : FREQUENCY OF USING CURRENCY FUTURES
FREQUENCY OF USING
7 7 6 5 4 3 2 1 0 1-15 days 15-30 days 30-90 days 90-180 days 180365 days 6 5 3 7
The frequency of usage of currency futures contracts depends on various factors like total turnover in term of foreign currency, credit period provided by exporters and credit period enjoyed by importers. Our respondents are having frequency of usage of currency futures as follows, 23.33% use it as frequently as 15-30 days and 30-90 days. 10% of them use them sometimes 180-365 days.
QUESTION 10 : ORGANIZATIONAL PREFRENCE FOR USING CURRENCY FUTURES
Organizational Prefrence
10 10 8
7 6 4 2 0 banks foreign exchange broking firms firms 4
As the future contract has to be done through some agencies which deals with futures and forward contract,we have taken the information about through which agencies do they carry on hedging. Out of 21 respondants 10 has prefrence for broking firms and some carry on through banks. Nowadays banks has also started dealing with foreign currency technicques.
QUESTION 12 : FOREX RISK MANAGEMENT COMMITTEE IN ORGANIZATION
Foreign Exchange Risk Committee

33% no yes 67%
(Chart: 7.11)
INTERPRETATION:
As we have targeted exporters and importers in the Ahmedabad, 67% are having Risk Management Committee in place to take care of foreign currency dealing and advice them on foreign currency transaction.
MANAGEMENT OF RISKS
100 %
90% 80% 70% 60% 50% 40%

20%
30%
10 %
y es n o
0%
Overall view about management of risk of dealing in foreign currency by traders is to manage and reduce the market risk. In order to reduce the risk they enter into the futures contract so that risk can be covered and sometimes reduced to the minimum. Risk management committee also concentrates on reducing the credit risk, liquidity risk and operations risk.
QUESTION 13: ASSISTANCE OF ANY CONSULTANT FOR PURPOSE OF RISK ASSESSMENT, HEDGING, CURRENCY MOMENTS, ETC
Some of the small importers and exporters hire risk consultant for guidance who organize their portfolio considering sectorial risk. Others have management committee so they dont use consultancy services. Importers and exporters use banks, broking firm, and consultants for guidance
CHAPTER 8: STATISTICAL ANALYSIS OF THE QUESTIONNAIRE

1. CHI-SQUARE TEST ON DURATION OF BUSINESS AND PERCENT OF FOREIGN CURRENCY EXPOSURE
H0: There is no significant effect of duration of business on foreign currency exposure. H1: There is significant effect of duration of business on foreign currency exposure.
(Chart: 8.1)
time of business * foreign currency exposure Cross tabulation Count foreign currency exposure less than 10% 10-25% 25-50% Time of business below 1year 1-3 years 3-5 years above 5 years Total 2 2 0 0 4 2 3 0 0 5 0 3 4 0 7 0 0 5 2 7 0 0 0 7 7 4 8 9 9 30 50-75% more than 75% Total
(Table: 8.1)
Chi-Square Tests Asymp. Sig. (2Value Pearson Chi-Square Likelihood Ratio Linear-by-Linear Association N of Valid Cases 43.583a 50.399 23.328 30 df 12 12 1 sided) .000 .000 .000
a. 20 cells (100.0%) have expected count less than 5. The minimum expected count is .53.
(Table: 8.2)
INTERPRETATION:
From the above analysis, sig=0.000 therefore H0 is rejected. There is significant effect of duration of business on percent of foreign currency exposure. Most of the traders who has more than 3 years of business are having exposure of more than 50% of foreign currency exposure. We can conclude that when there is more experience in business there is more currency exposure. N.R.Institute of business management
2. CHI-SQUARE TEST ON FOREIGN CURRENCY EXPOSURE AND USE OF HEDGING TO COVER RISK.
H0: There is no significant effect of foreign currency exposure on use of hedging H1: There is significant effect of foreign currency exposure on use of hedging
(Chart: 8.2)
foreign currency exposure * do you hedge Cross tabulation Count do you hedge no foreign currency exposure less than 10% 10-25% 25-50% 50-75% more than 75% Total 2 0 0 0 0 2 yes 2 5 7 7 7 28 Total 4 5 7 7 7 30
(Table: 8.3)
Chi-Square Tests Asymp. Sig. (2Value Pearson Chi-Square Likelihood Ratio Linear-by-Linear Association N of Valid Cases 13.929a 9.151 5.927 30 df 4 4 1 sided) .008 .057 .015
(Table: 8.4)
INTERPRETATION:
Ho is rejected. Therefore there is significant effect of foreign currency exposure on use of hedging.
3. T-TEST ON THE ADVANTAGES CURRENCY FUTURES 31 ADVANTAGES A) Low transaction cost
AND
DISADVANTAGES
OF
H0 (u<2.5): Low transaction cost is not significant advantage of currency futures. H1 (u>2.5): Low transaction cost is significant advantage of currency futures.
One-Sample Test Test Value = 2.5
95% Confidence Interval of the Difference t advan(low transaction cost) 1.710 Df 29 Sig. (2-tailed) Mean Difference .098 .433 Lower -.08 Upper .95
(Table: 8.5)
INTERPRETATION:
Ho is accepted. Therefore traders opinion about considering low transaction cost as advantage is towards disagree ness.
B) Easy affordability H0 (u<2.5): Easy affordability is not significant advantage of currency futures H1 (u>2.5): Easy affordability is significant advantage of currency futures
One-Sample Test Test Value = 2.5 95% Confidence Interval of the Difference T advan(easy affordability) 5.396 Df 29 Sig. (2-tailed) .000 Mean Difference 1.167 Lower .72 Upper 1.61
(Table: 8.6)
INTERPRETATION:
H0 is rejected. Therefore traders opinion about considering easy affordability as advantage is towards agree ness.
C) Standardized contract H0 (u<2.5): Standardized contract is not significant advantage of currency futures H1 (u>2.5): Standardized contract is significant advantage of currency futures
One-Sample Test Test Value = 2.5 95% Confidence Interval of the Difference T advan(standardized contract) 2.529 Df 29 Sig. (2-tailed) Mean Difference .017 .500 Lower .10 Upper .90
(Table: 8.7)
INTERPRETATION:
H0 is rejected. Therefore traders opinion about considering standardized contract as advantage is towards agree ness.
D) Transparency H0 (u<2.5): Transparency is not significant advantage of currency futures H1 (u>2.5): Transparency is significant advantage of currency futures
One-Sample Test Test Value = 2.5 95% Confidence Interval of the Difference T advan(transparency) .551 Df 29 Sig. (2-tailed) Mean Difference .586 .133 Lower -.36 Upper .63
(Table: 8.8)
INTERPRETATION:
Ho is accepted. Therefore traders opinion about considering transparency as advantage is towards disagree ness.
3.2 DISADVANTAGES A) Have to pay commission

H0 (u<2.5): Have to pay commission is not significant disadvantage of currency futures. H1 (u>2.5): Have to pay commission is significant disadvantage of currency futures.
95% Confidence Interval of the Difference T disadv(have to pay commission) 2.458 df 29 Sig. (2-tailed) Mean Difference .020 .533 Lower .09 Upper .98
(Table: 8.9)
INTERPRETATION:
Ho is rejected. Therefore traders opinion about considering has to pay commission as disadvantage is towards agree ness.
B) Available only during trading hours H0 (u<2.5): Available only during trading hours is not significant disadvantage of currency futures. H1 (u>2.5): Available only during trading hours is significant disadvantage of currency futures.
95% Confidence Interval of the Difference T disadv(avaliable only during trading hours) 2.339 df 29 Sig. (2-tailed) Mean Difference .026 .433 Lower .05 Upper .81
(Table: 8.10)
INTERPRETATION:
Ho is rejected. Therefore traders opinion about considering available during trading hours as disadvantage is towards agree ness.
C) Based on future price H0 (u<2.5): Based on future price is not significant disadvantage of currency futures. H1 (u>2.5): Based on future price is significant disadvantage of currency futures.
One-Sample Test Test Value = 2.5 95% Confidence Interval of the Difference T disadv(based on future price) 1.194 Df 29 Sig. (2-tailed) Mean Difference .242 .267 Lower -.19 Upper .72
(Table: 8.11)
INTERPRETATION:
Ho is accepted. Therefore traders opinion about considering based on future price as disadvantage is towards disagree ness.
4. CHI-SQUARE TEST ON FOREIGN CURRENCY EXPOSURES AND FREQUENCY OF USING CURRENCY FUTURES
H0: There is no significant impact of foreign currency exposure on frequency of using currency futures. H1: There is significant impact of foreign currency exposure on frequency of using currency futures.
(Chart: 8.3)
foreign currency exposure * frequency Cross tabulation Count Frequency 1-15 days foreign currencyless than 10% exposure 10-25% 25-50% 50-75% more than 75% Total 0 1 0 4 1 6 15-30 days 0 1 2 1 3 7 30-90 days 1 1 2 2 1 7 90-180 days 1 1 2 0 1 5 180-365 days 0 1 1 0 1 3 Total 2 5 7 7 7 28
(Table: 8.12)
Chi-Square Tests Asymp. Sig. (2Value Pearson Chi-Square 13.463a Likelihood Ratio Linear-by-Linear Association N of Valid Cases 16.108 1.845 28 16 16 1 .445 .174 df sided) .639
(Table: 8.13)
INTERPRETATION:
H0 is rejected. Therefore there is impact of foreign currency exposure on frequency of using currency futures. It is implied that the more exports and imports will increase the risk so they use currency futures more frequently as per the transaction. N.R.Institute of business management
5. OVERALL OPINION ABOUT FUTURES ONE SAMPLE T-TEST
CURRENCY
H0 (u<2.5): The overall opinion about currency futures is not significant towards satisfaction. H1 (u>2.5): The overall opinion about currency futures is significant towards satisfaction
95% Confidence Interval of the Difference T overall opinion 1.767 Df 29 Sig. (2-tailed) .088 Mean Difference .367 Lower -.06 Upper .79
(Table: 8.14)
INTERPRETATION:
H0 is rejected. Therefore the overall opinion about currency futures is towards satisfaction. The importers and exporters are satisfied towards the use of currency futures. Some of those who dont use currency futures are dissatisfied because they are not ignorant about the advantage of currency futures. 1) Major reason for satisfaction is best way to minimize risk. 2) Reason for dissatisfaction is doesnt help in buying US dollars as it is always traded on premium.
FINDINGS
1) Our research shows that most of the importers and exporters are experienced above 3 years and their turnover or foreign currency exposure is more than 50%. 2) The use of hedging strategy may help them to keep their billing amount low/ at par with the international competitors. 3) The forward contract is ranked as first by 40% of traders.
4) The broking firms are mostly used for currency future transactions. Some importers also use banks as agencies.
5) 67% of the importers and exporters have foreign exchange risk management committee and others hire consultants.
6) Most of the traders who has more than 3 years of business are having exposure of more than 50% of foreign currency exposure. We can conclude that when there is more experience in business there is more currency exposure.
7) Considering the advantages of currency futures traders opinion towards agree ness is easy affordability and standardized contract. Traders opinion towards disagree ness is low transaction cost and transparency.
8) Considering the disadvantages of currency futures traders opinion towards agree ness is have to pay commission and available only during trading hours. Traders opinion towards disagree ness based on future price.
9) As per the analysis the foreign currency exposure has a high impact on the frequency of using currency futures. The more exposure means the number of days for using currency futures increases. Major reason for satisfaction is best way to minimize risk.
10) Government invites and offer to utilize the foreign Currency but people are not utilizing it. 11) Importer and Exporters will have more scope of hedging their transactions.
12) Due to lack of knowledge, Exporters & Importers are not fully relying on Currency Futures. 13) There is no relevance on the use of currency future and foreign currency exposure because the small importers and exporters are also using the hedging techniques. 14) The satisfied reason for using currency futures is the best way to minimize the risk and the dissatisfied reason for using currency futures is that it does not help in buying US dollars as it is always traded on premium.
RECOMMENDATIONS
1) The organizations should increase their level of awareness about the various foreign derivatives that they can use to mitigate their foreign exchange risk.
2) The importers and exporters should have the market knowledge so that they can stop making unnecessary losses. 3) The importers and exporters should be explained the importance of professional consultants and advisors. Foreign exchange business is not only a matter of luck and explaining the implications of lack of market knowledge.
4) Forex data including trade volume for derivatives such as foreign currency options should be available in the market on regular basis.
5) Organizations should have Forex risk management committee who regularly looks after issues related to foreign exchange.
6) Apart from mitigating the foreign exchange risk the companies can also manage their counter party risk by using letter of credit.
CONCLUSION
At last we conclude that the importers and exporters have their business mostly above 5 years. 26% of the importers have the foreign currency exposure more than 75 % of the turnover. Futures is ranked as first preference by 20% and as 4th by 10% of importers and exporters. The major reasons for not using Hedge we analyzed are Expensive for small transaction and fear of increase in risk. 67% of organizations have foreign exchange committee in the organizations itself. Some small firms hire consultants for guidance and to manage the portfolio. Those importers and exporters who have foreign exchange committee they dont require to hire the consultants.
From the statistical analysis we can conclude that there is the positive relationship between the experience and the currency futures. The more the experience. The more use of currency futures. Traders opinion about Low transaction cost as advantage is towards disagree ness. Traders opinion about easy affordability as advantage is towards agree ness. Traders opinion about considering has to pay commission as disadvantage is towards agree ness. Traders opinion about considering available during trading hours as disadvantage is towards agree ness. Traders opinion about considering based on future price as disadvantage is towards disagree ness. The overall opinion about currency futures is towards satisfaction. The importers and exporters are satisfied towards the use of currency futures. Some of those who dont use currency futures are dissatisfied because they are not ignorant about the advantage of currency futures. The Major reason for satisfaction is the best way to minimize the risk and the Reason for dissatisfaction is it does not help in buying the US dollars as it always traded on premium.
The importers and exporters should have the market knowledge so that they can stop making unnecessary losses. Apart from mitigating the foreign exchange risk the companies can also manage their counter party risk by using letter of credit. The organizations should increase their level of awareness about the various foreign derivatives that they can use to mitigate their foreign exchange risk. The importers and exporters should be explained the importance of professional consultants and advisors. Foreign exchange business is not only a matter of luck and explaining the implications of lack of market knowledge.
Through the project, we could understand the vital role of Foreign Exchange Management in any organization. Foreign Exchange Risk Management is a broader concept it involves the risk associated with foreign exchange due to market fluctuations and through this project we got the idea how organizations manage the risk.
BIBLIOGRAPHY
0 http://www.goforex.net/m 0http://www.rbi.org.in/ 0http://www.fedai.org.in/ 0http://www.forextheory.com/ 0http://www.forexcap.com/ 0http://www.forexindia.org/ 0http://www.sebi.com/ 0http://www.nseindia.com/ 0http://www.bseindia.org/ 0http://www.bis.org/ 0http://www.rbi.org.in/Scripts/BS_viewfemanewnotification.aspx 0Hull, J. C., & Hull, J. C. (2009). Fundamentals of Futures and Options Market. Pearson Education ,20-64. 0Jain, N. (2007). Foreign Exchange & Risk Management. 0Jeevananand. (2008). Foreign Exchange & Risk Management.
0 Magazine RIMS/risk management society http://www.rmmagazine.com/MGTemplate.cfm?section=AboutRM
APPENDIX
QUESTIONNAIRE ON STUDY OF FOREIGN EXCHANGE RISK MANAGEMENT
We are the students of GLS MBA programme. We are conducting research of foreign exchange. This information will be confidential Name of the Organization : _____________________________________ Name of the Contact Person: _____________________________________ Designation : _____________________________________ 1) Please tick mark category of your organization: ( ) Exporter ( ) Importer ( ) Exporter & Importer 2) How long are you in this business? ( ) Below 1year ( ) 1-3 years ( ) 3-5 years ( ) Above 5 years 3) How many percent foreign currency exposures do you have? ( ) 50-75% ( ) Less Than 10% ) More than ( ) 10-25% ( 75% ( ) 25-50% 4) Do you Hedge to cover your foreign exposure? ( ) Yes ( ) No 5) Which type do you use?(Rank) Forward Contract Swap Option Future Contract s If no, which are the reasons for not using? ( ) Expensive for small transaction ( ) Fear of increase in risk ( ) Unnecessary in some situations Other ___________________________ 6) Are you aware about the concept of Currency Futures? ( ) Yes ( ) No
7) Have you ever used Currency Futures? ( ) Yes ( ) No 8) If yes, how frequently? ( ) Every 1-15 Days ( ) Every 15-30 Days ( ) Every 30-90 Days
( ) Every 90-180 Days ) Every 180-365 ( Days
9) What is your opinion about advantages & disadvantages of the Currency Futures? Advantages Low transaction cost Easy affordability Standardized contract Transparency Disadvantages Have to pay commission Available only during trading hours Based on future price Strongly Disagre e Disagree Neutral Agree Strongly Agree Strongly Disagree Disagree Neutral Agree Strongly Agree
10) If you use currency futures, which organization(s) do you prefer for your transactions? ( ) Banks ( ) Foreign exchange firms ( ) Asset management company
11) What is your overall opinion about the Currency Futures? ( ( ( ( ( ) Extremely dissatisfied ) Dissatisfied ) Neutral ) Satisfied ) Extremely satisfied
Please State Your Reasons _______________________________________________________________________ _ ____________________________________________________________
12) Do you have a Forex Risk Management Committee in your organization? ( ) Yes ( ) No If yes, which type of risk are managed through committee (Multiple tick) Market risk Credit risk Operations risk Liquidity risk 13) Are you taking assistance of any consultant for the purpose of Risk Assessment, Hedging, Currency Movements, etc.? ( ) Yes ( ) No If yes, please give details? _______________________________________________________________________ _ _______________________________________________________________________ _

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A Grand Project Report On

Foreign Exchange Risk Management

In the partial fulfilment of the requirements of Masters of Business Administration

N.R.INSTITUTE OF BUSINESS MANAGEMENT GUJARAT TECHNOLOGICAL UNIVERSITY

N.R.Institute of business management

N. R. Institute of Business Management (GLS-MBA)

_________________ Dr. Hitesh Ruparel Director

____________________ Prof. Rajsee Joshi Assistant Professor & Project Guide

N.R.Institute of business management

N.R.Institute of business management

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N.R.Institute of business management

EXCHANGE RATE SYSTEM

FUNDAMENTALS IN EXCHANGE RATE

N.R.Institute of business management

69 70 71 73 75 88 102 104 105 107 108

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FOREX RISK MANAGEMENT COMMITTEE IN ORGANIZATION

MANAGEMENT OF RISKS DURATION OF BUSINESS AND PERCENT OF FOREIGN CURRENCY EXPOSURE

FOREIGN CURRENCY EXPOSURE AND USE OF HEDGING TO COVER RISK

FOREIGN CURRENCY EXPOSURES AND FREQUENCY OF USING CURRENCY FUTURES

N.R.Institute of business management

8.4 8.5 8.6 8.7 8.8 8.9 8.10 8.11 8.12

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CHAPTER 1: RESEARCH METHODOLOGY

1.3 DATA COLLECTION SOURCES

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1.4 DATA COLLECTION

15 SCOPE OF THE STUDY

16 LIMITATIONS OF THE STUDY

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2.2 NEED FOR FOREIGN EXCHANGE

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2.3 ABOUT FOREIGN EXCHANGE MARKET

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Following are the major bifurcations:

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2.4 PARTICIPANTS IN FOREIGN EXCHANGE MARKET

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5. OVERSEAS FOREX MARKET

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Corporations particularly multinational corporation and transnational

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CHAPTER 3: EXCHANGE RATE SYSTEM

3.2 THE GOLD STANDARD

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1) Gold Specie Standard

2) Gold Bullion Standard

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3.3 BRETTON WOODS SYSTEM

3.4 FLOATING RATE SYSTEM

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3.5 PURCHASING POWER PARITY (PPP)

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CHAPTER 4: FUNDAMENTALS IN EXCHANGE RATE

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The advantage of twoway quote is as under:

4.2 FACTOR AFFECTINGN EXCHANGE RATES

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3) EXPECTATION OF THE FOREIGN EXCHANGE MARKET

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CHAPTER 5: HEDGING TOOLS