0c17b_a Grand Project Report on Foreign Exchange and Risk Management

8/12/2019 0c17b_a Grand Project Report on Foreign Exchange and Risk Management

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A grand project report on

foreign exchange And

Risk management

(In partial fulfillment of award of MBA degree)

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Objective of the study

MAIN OBJECTIVE

This project attempt to study the intricacies of the foreign exchangemarket. The main purpose of this study is to get a better idea and thecomprehensive details of foreign exchange risk management.

SUB OBJECTIVES

To know about the various concept and technicalities in foreignexchange.

To know the various functions of forex market. To get the knowledge about the hedging tools used in foreign

exchange.

LIMITATIONS OF THE STUDY

Time constraint. Resource constraint. Bias on the part of interviewers.

DATA COLLECTION

The primary data was collected through interviews ofprofessionals and observations.

The secondary data was collected from books, newspapers, otherpublications and internet.

DATA ANALYSIS

The data analysis was done on the basis of the information

available from various sources and brainstorming.

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INTRODUCTION

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FOREIGN EXCHANGE MARKET OVERVIEW

In todays world no economy is self sufficient, so there is need forexchange of goods and services amongst the different countries. So in

this global village, unlike in the primitive age the exchange of goodsand services is no longer carried out on barter basis. Every sovereigncountry in the world has a currency that is legal tender in its territoryand this currency does not act as money outside its boundaries. Sowhenever a country buys or sells goods and services from or toanother country, the residents of two countries have to exchangecurrencies. So we can imagine that if all countries have the samecurrency then there is no need for foreign exchange.

Need for Foreign Exchange

Let us consider a case where Indian company exports cotton fabrics toUSA and invoices the goods in US dollar. The American importer willpay the amount in US dollar, as the same is his home currency.However the Indian exporter requires rupees means his homecurrency for procuring raw materials and for payment to the laborcharges etc. Thus he would need exchanging US dollar for rupee. Ifthe Indian exporters invoice their goods in rupees, then importer inUSA will get his dollar converted in rupee and pay the exporter.

From the above example we can infer that in case goods are bought orsold outside the country, exchange of currency is necessary.

Sometimes it also happens that the transactions between twocountries will be settled in the currency of third country. In that caseboth the countries that are transacting will require converting theirrespective currencies in the currency of third country. For that also theforeign exchange is required.

About foreign exchange market.

Particularly for foreign exchange market there is no market placecalled the foreign exchange market. It is mechanism through whichone countrys currency can be exchange i.e. bough t or sold for thecurrency of another country. The foreign exchange market does nothave any geographic location.

Foreign exchange market is describe as an OTC (over the counter)market as there is no physical place where the participant meet to

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execute the deals, as we see in the case of stock exchange. Thelargest foreign exchange market is in London, followed by the newyork, Tokyo, Zurich and Frankfurt. The market are situated throughoutthe different time zone of the globe in such a way that one market isclosing 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 currencysued to dominate international transaction. In India, foreign exchangehas been given a statutory definition. Section 2 (b) of foreignexchange regulation ACT,1973 states:

Foreign exchange means foreign currency and includes :

All deposits, credits and balance payable in any foreigncu rrency and any draft, travelers cheques, letter ofcredit and bills of exchange. Expressed or drawn in Indiacurrency but payable in any foreign currency.

Any instrument payable, at the option of drawee orholder thereof or any other party thereto, either inIndian currency or in foreign currency or partly in oneand partly in the other.

In order to provide facilities to members of the public and foreignersvisiting India, for exchange of foreign currency into Indian currencyand vice-versa. RBI has granted to various firms and individuals,license to undertake money-changing business at seas/airport andtourism place of tourist interest in India. Besides certain authorizeddealers in foreign exchange (banks) have also been permitted to openexchange bureaus.

Following are the major bifurcations:

Full fledge moneychangers they are the firms and individualswho have been authorized to take both, purchase and sale

transaction with the public. Restricted moneychanger they are shops, emporia and hotelsetc. that have been authorized only to purchase foreign currencytowards cost of goods supplied or services rendered by them orfor conversion into rupees.

Authorized dealers they are one who can undertake all types offoreign exchange transaction. Bank are only the authorized

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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 followes:

Branch A They are the branches that have nostro and vostroaccount.

Branch B The branch that can deal in all other transaction butdo not maintain nostro and vostro a/cs fall under this category.

For Indian we can conclude that foreign exchange refers to foreignmoney, which includes notes, cheques, bills of exchange, bank balanceand deposits in foreign currencies.

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 inforeign exchange market by availing of the services of banks.Exporters require converting the dollars in to rupee and imporetersrequire converting rupee in to the dollars, as they have to pay indollars for the goods/services they have imported.

2.COMMERCIAL BANKThey are most active players in the forex market. Commercial

bank dealing with international transaction offer services forconversion of one currency in to another. They have wide network ofbranches. Typically banks buy foreign exchange from exporters andsells foreign exchange to the importers of goods. As every time theforeign 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 theresponsibility of maintaining the external value of the domesticcurrency. Generally this is achieved by the intervention of the bank.

4. EXCHANGE BROKERS

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forex brokers play very important role in the foreign exchangemarket. However the extent to which services of foreign brokers areutilized depends on the tradition and practice prevailing at a particularforex market center. In India as per FEDAI guideline the Ads are free

to deal directly among themselves without going through brokers. Thebrokers are not among to allowed to deal in their own account alloverthe 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 hardly5 to 7 % of this total turnover. The rest of trading in world forexmarket is constituted of financial transaction and speculation. As weknow that the forex market is 24-hour market, the day begins withTokyo and thereafter Singapore opens, thereafter India, followed byBahrain, Frankfurt, paris, London, new york, Sydney, and back toTokyo.

6. SPECULATORS

The speculators are the major players in the forex market.

Bank dealing are the major pseculators in the forexmarket with a view to make profit on account of favorablemovement in exchange rate, take position i.e. if they feelthat rate of particular currency is likely to go up in shortterm. They buy that currency and sell it as soon as theyare able to make quick profit.

Corporations particularly multinational corporation andtransnational corporation having business operationbeyond their national frontiers and on account of theircash flows being large and in multi currencies get in toforeign exchange exposures. With a view to makeadvantage of exchange rate movement in their favor they

either delay covering exposures or do not cover until cashflow materialize. Individual like share dealing also undertake the activity of

buying and selling of foreign exchange for booking shortterm profits. They also buy foreign currency stocks, bondsand other assets without covering the foreign exchangeexposure risk. This also result in speculations.

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Exchange rateSystem

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Countries of the world have been exchanging goods andservices amongst themselves. This has been going on from timeimmemorial. The world has come a long way from the days of bartertrade. With the invention of money the figures and problems of barter

trade have disappeared. The barter trade has given way tonexchanged of goods and services for currencies instead of goods andservices.

The rupee was historically linked with pound sterling. Indiawas a founder member of the IMF. During the existence of the fixedexchange rate system, the intervention currency of the Reserve Bankof India (RBI) was the British pound, the RBI ensured maintenance ofthe exchange rate by selling and buying pound against rupees at fixedrates. The inter bank rate therefore ruled the RBI band. During thefixed exchange rate era, there was only one major change in the parityof the rupee- devaluation in June 1966.

Different countries have adopted different exchange ratesystem at different time. The following are some of the exchange ratesystem followed by various countries.

THE GOLD STANDARD

Many countries have adopted gold standard as their monetarysystem during the last two decades of the 19 th century. This systemwas in vogue till the outbreak of world war 1. under this system theparties of currencies were fixed in term of gold. There were two maintypes of gold standard:

1) gold specie standard

Gold was recognized as means of international settlement forreceipts and payments amongst countries. Gold coins were anaccepted mode of payment and medium of exchange in domestic

market also. A country was stated to be on gold standard if thefollowing condition were satisfied:

Monetary authority, generally the central bank of the country,guaranteed to buy and sell gold in unrestricted amounts at thefixed price.

Melting gold including gold coins, and putting it to different useswas freely allowed.

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Import and export of gold was freely allowed. The total money supply in the country was determined by the

quantum of gold available for monetary purpose.

1) Gold Bullion Standard

Under this system, the money in circulation was either partlyof entirely paper and gold served as reserve asset for themoney supply.. However, paper money could be exchangedfor gold at any time. The exchange rate varied dependingupon the gold content of currencies. This was also known as

Mint Parity Theory of exchange rates.

The gold bullion standard prevailed from about 1870 until1914, and intermittently thereafter until 1944. World War Ibrought an end to the gold standard.

BRETTON WOODS SYSTEM

During the world wars, economies of almost all the countriessuffered. In ordere to correct the balance of paymentsdisequilibrium, many countries devalued their currencies.Consequently, the international trade suffered a deathblow.In 1944, following World War II, the United States and mostof its allies ratified the Bretton Woods Agreement, which setup an adjustable parity exchange-rate system under whichexchange rates were fixed (Pegged) within narrowintervention limits (pegs) by the United States and foreigncentral banks buying and selling foreign currencies. Thisagreement, fostered by a new spirit of internationalcooperation, was in response to financial chaos that hadreigned before and during the war.

In addition to setting up fixed exchange parities ( par values )of currencies in relationship to gold, the agreementextablished 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 tointervene in the market and the Bretton Wood System, withits fixed parities, was effectively buried. Thus, the worldeconomy has been living through an era of floating exchangerates since the early 1970.

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FLOATING RATE SYSTEM

In a truly floating exchange rate regime, the relative prices ofcurrencies are decided entirely by the market forces of

demand and supply. There is no attempt by the authorities toinfluence exchange rate. Where government interferesdirectly or through various monetary and fiscal measures indetermining the exchange rate, it is known as managed ofdirty float.

PURCHASING POWER PARITY (PPP)

Professor Gustav Cassel, a Swedish economist, introducedthis system. The theory, to put in simple terms states thatcurrencies are valued for what they can buy and thecurrencies have no intrinsic value attached to it. Therefore,under this theory the exchange rate was to be determinedand the sole criterion being the purchasing power of thecountries. As per this theory if there were no trade controls,then the balance of payments equilibrium would always bemaintained. Thus if 150 INR buy a fountain pen and thesamen fountain pen can be bought for USD 2, it can beinferred that since 2 USD or 150 INR can buy the samefountain pen, therefore USD 2 = INR 150.

For example India has a higher rate of inflation as compaedto country US then goods produced in India would becomecostlier as compared to goods produced in US. This wouldinduce imports in India and also the goods produced in Indiabeing costlier would lose in international competition to goodsproduced in US. This decrease in exports of India ascompared to exports from US would lead to demand for thecurrency of US and excess supply of currency of India. This inturn, cause currency of India to depreciate in comparison ofcurrency of Us that is having relatively more exports.

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FUNDAMENTALS INEXCHANGE RATE

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Exchange rate is a rate at which one currency can be exchange in toanother currency, say USD = Rs.48. This rate is the rate of conversionof US dollar in to Indian rupee and vice versa.

METHODS FOR QOUTING EXCHANGE RATES

EXCHANGE QUOTATION

DIRECT INDIRECT

VARIABLE UNIT VARIABLE UNIT

HOME CURRENCY FOREIGN CURRENCY

METODS OF QOUTING RATE

There are two methods of quoting exchange rates.

1) Direct methods

Foreign currency is kept constant and home currency is keptvariable. In direct quotation, the principle adopted by bank is to buyat a lower price and sell at higher price.

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2) In direct method:

Home currency is kept constant and foreign currency is keptvariable. 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 tworates means one for buying and another rate for selling. This helpsin eliminating the risk of being given bad rates i.e. if a party comesto know what the other party intends to do i.e. buy or sell, theformer can take the letter for a ride.

There are two parties in an exchange deal of currencies. To initiatethe deal one party asks for quote from another party and otherparty quotes a rate. The party asking for a quote is known asasking party and the party giving a quotes is known as quotingparty.

The advantage of two way quote is as under

i. The market continuously makes available price for buyers orsellers

ii. Two way price limits the profit margin of the quoting bankand comparison of one quote with another quote can be doneinstantaneously.

iii. As it is not necessary any player in the market to indicatewhether he intends to buy or sale foreign currency, thisensures that the quoting bank cannot take advantage bymanipulating the prices.

iv. It automatically insures that alignment of rates with marketrates.

v. Two way quotes lend depth and liquidity to the market, whichis so very essential for efficient market.

`

In two way quotes the first rate is the rate for buying and another forselling. We should understand here that, in India the banks, which areauthorized dealer, always quote rates. So the rates quoted- buyingand selling is for banks point of view only. It means that if exporterswant to sell the dollars then the bank will buy the dollars from him sowhile calculation the first rate will be used which is buying rate, as thebank is buying the dollars from exporter. The same case will happen

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inversely with importer as he will buy dollars from the bank and bankwill sell dollars to importer.

FACTOR AFFECTINGN EXCHANGE RATES

In free market, it is the demand and supply of the currencywhich should determine the exchange rates but demand andsupply is the dependent on many factors, which are ultimatelythe cause of the exchange rate fluctuation, some times wild.

The volatility of exchange rates cannot be traced to the singlereason and consequently, it becomes difficult to precisely definethe factors that affect exchange rates. However, the moreimportant among them are as follows:

STRENGTH OF ECONOMY

Economic factors affecting exchange rates includehedging activities, interest rates, inflationary pressures, tradeimbalance, and euro market activities. Irving fisher, an Americaneconomist, developed a theory relating exchange rates to interestrates. This proposition, known as the fisher effect, states that interestrate differentials tend to reflect exchange rate expectation.

On the other hand, the purchasing- power parity theory relatesexchange rates to inflationary pressures. In its absolute version, thistheory states that the equilibrium exchange rate equals the ratio ofdomestic to foreign prices. The relative version of the theory relateschanges in the exchange rate to changes in price ratios.

POLITICAL FACTOR

The political factor influencing exchange rates include theestablished monetary policy along with government action on itemssuch as the money supply, inflation, taxes, and deficit financing. Activegovernment intervention or manipulation, such as central bank activityin the foreign currency market, also have an impact. Other politicalfactors influencing exchange rates include the political stability of acountry and its relative economic exposure (the perceived need for

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certain levels and types of imports). Finally, there is also the influenceof the international monetary fund.

EXPACTATION OF THE FOREIGN EXCHANGE MARKET

Psychological factors also influence exchange rates. Thesefactors include market anticipation, speculative pressures, and futureexpectations.

A few financial experts are of the opinion that in todaysenvironment, the only trustworthy method of predicting exchangerates by gut feel . Bob Eveling, vice president of financial markets atSG, is corporate finances top foreign exchange fore caster for 1999.evelings gut feeling has, defined convention, and his method proveduncannily accurate in foreign exchange forecasting in 1998.SG endedthe corporate finance forecasting year with a 2.66% error overall, themost accurate among 19 banks. T he secret to evelings intuition onany currency is keeping abreast of world events. Any event,from adeclaration of war to a fainting political leader, can take its toll on acurrencys value. Today, instead of formal modals, most forecastersrely on an amalgam that is part economic fundamentals, part modeland part judgment.

Fiscal policy Interest rates Monetary policy Balance of payment Exchange control Central bank intervention Speculation Technical factors

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Hedging tools

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Introduction

Consider a hypothetical situation in which ABC trading co. has toimport a raw material for manufacturing goods. But this raw materialis required only after three months. However, in three months the

price of raw material may go up or go down due to foreign exchangefluctuations and at this point of time it can not be predicted whetherthe price would go up or come down. Thus he is exposed to risks withfluctuations in forex rate. If he buys the goods in advance then he willincur heavy interest and storage charges. However, the availability ofderivatives solves the problem of importer. He can buy currencyderivatives. Now any loss due to rise in raw material price would beoffset by profits on the futures contract and viceversa. Hence, thederivatives are the hedging tools that are available to companies tocover 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 primaryfinancial instrument, commodity or index, such as : interest rate,exchange rates, commodities, and equities.

Derivatives are risk shifting instruments. Initially, they were used toreduce exposure to changes in foreign exchange rates, interest rates,or stock indexes or commonly known as risk hedging. Hedging is themost important aspect of derivatives and also its basic economicpurpose. There has to be counter party to hedgers and they arespeculators.

Derivatives have come into existence because of the prevalence of riskin every business. This risk could be physical, operating, investmentand credit risk.

Derivatives provide a means of managing such a risk. The need tomanage 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 andfutures.

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1. Forward Contracts

Forward exchange contract is a firm and binding contract, enteredinto by the bank and its customers, for purchase of specified amount

of foreign currency at an agreed rate of exchange for delivery andpayment at a future date or period agreed upon at the time of enteringinto forward deal.

The bank on its part will cover itself either in the interbank marketor by matching a contract to sell with a contract to buy. The contractbetween customer and bank is essentially written agreement and bankgenerally stand to make a loss if the customer defaults in fulfilling hiscommitment to sell foreign currency.

A foreing exchange forward contract is a contract under which thebank agrees to sell or buy a fixed amount of currency to or from thecompany on an agreed future date in exchange for a fixed amount ofanother currency. No money is exchanged until the future date.

A company will usually enter into forward contract when it knowsthere will be a need to buy or sell for an currency on a certain date inthe future. It may bel ieve that todays forward rate will prove to bemore favourable than the spot rate prevailing on that future date.Alternatively, the company may just want to eliminate the uncertainityassociated with foreign exchange rate movements.

The forward contract commits both parties to carrying out theexchange of currencies at the agreed rate, irrespective of whateverhappens to the exchange rate.

The rate quoted for a forward contract is not an estimate of whatthe exchange rate will be on the agreed future date. It reflects theinterest rate differential between the two currencies involved. Theforward rate may be higher or lower than the market exchange rate onthe day the contract is entered into.

Forward rate has two components.

Spot rate Forward points

Forward points, also called as forward differentials, reflects theinterest differential between the pair of currencies provided capital

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flow are freely allowed. This is not true in case of US $ / rupee rate asthere is exchange control regulations prohibiting free movement ofcapital from / into India. In case of US $ / rupee it is pure demandand 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 31 st March is 48.70.

Premium for forwards are as follows.

Month Paise

April 40/42May 65/67June 87/88

If a one month forward is taken then the forward rate would be48.70 + .42 = 49.12

If a two months forward is taken then the forward rate would be48.70. + .67 = 49.37.

If a three month forward is taken then the forward rate would be48.70 + .88 = 49.58.

Example :

Lets take the same example for a b roken date Forward

Contract Spot rate = 48.70 for 31st

March.Premium for forwards are as follows

30 th April 48.70 + 0.4231 st May 48.70 + 0.6730 th June 48.87 + 0.88

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For 17 th May the premium would be (0.67 0.42) * 17/31 = 0.137

Therefore the premium up to 17 th May would be 48.70 + 0.807 =49.507.

Premium when a currency is costlier in future (forward) as comparedto spot, the currency is said to be at premium vis--vis anothercurrency.

Discount when a currency is cheaper in future (forward) as comparedto spot, the currency is said to be at discount vis--vis anothercurrency.

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 :

The company can do nothing and hope that the rate in sixmonths time will be more favorable than the current six monthsrate. This would be a successful strategy if in six months timethe rate is higher than 2.33. However, if in six months time therate is lower than 2.33, the company will have to loose money.

It can avoid the risk of rates being lower in the future byentering into a forward contract now to buy DEM 235000 fordelivery in six months time at an IEP/DEM rate of 2.33.

It can decide on some combinations of the above.

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Introduction

Consider a hypothetical situation in which ABC trading has toimport a raw material for manufacturing goods. But this raw materialis required only after 3 months. However in 3 month the prices of rawmaterial may go up or down due to foreign exchange fluctuation andat this point of time it cannot be predicated whether the prices wouldgo up or down. Thus he is exposed to risks with fluctuation in forexrates. If he buys the goods in advance then he will incur heavy interestand storage charges. However, the availability of derivatives solvesthe problem of importer. He can buy currency derivatives. Now anyloss due to rise in raw material prices would be offset by profit on thefutures contract and vice versa. Hence the derivative are the hedgingtools that are available to the companies to cover the foreign exchangeexposures faced by them.

Derivatives defined

Derivatives are financial contracts of pre-determined fixedduration, whose values are derived from the value of an underlyingprimary financial instrument, commodity or index, such as: interestrates, exchange rates, commodities, and equities.

Derivatives are risk-shifting instrument. Initially, they wereused to reduce exposure to change in foreign exchange rates, interestrates or stock indexes or commonly known as risk hedging. Hedging isthe most important aspect of derivatives and also its basic economic

purpose. There has to be counter party to hedger and they arespeculators.

Derivatives have come into existence because of theprevalence of risks in every business. These risks could be physical,operating, investment and credit risks.

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Derivatives provide a means of managing such risks. The needto manage external risk is thus one pillar of the derivative market.Parties wishing to manage their risks are called hedgers.

The common derivative products are forwards, options, swaps and

futures.

1. FORWARD CONTRACTS

Forward exchange contract is a firm and binding contract, enteredinto by the bank and its customers, for purchase of specified amountof foreign currency at an agreed upon at the time of entering intoforward deal.

The bank on its part will cover itself either in the interbank marketor by matching a contract to sell with buy. The contract betweencustomers and bank is essentially written agreement and bankgenerally stands to make a loss if the customer default in fulfilling hiscommitment to sell foreign currency.

A foreign exchange forward contract is a contract under which thebank agrees to sell or buy a fixed amount of currency to or from thecompany on an agreed future date in exchange for a fixed amountcurrency. No money is exchanged until that future date.

A company will usually enter into forward contract when it knowsthere will be a need to buy or sell foreign currency on a certain date inthe future. It may believe that todays forward rate will prove to bemore favorable than the spot rate prevailing on that future date.Alternatively, the company may just want to eliminate the uncertaintyassociated with foreign exchange rate movements.

The forward contract commits both parties to carrying out the

exchange of currencies at the agreed rate, irrespective of whateverhappens to the exchange rate.

The rate quoted for a forward contract is not an estimate of what theexchange rate will be on the agreed future date. It reflects the interestrate differential between the two currencies involved. The forward ratemay be higher or lower than the market exchange rate on the daycontract is entered into.

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Forward rate has two components1) Spot rate2) Forward points

Forward points, also called as forward differential, reflect the interestdifferential between the pair of currencies provided capital flows arefreely allowed. This is not true in case of US $/Rupee rate as there isexchange control regulating prohibiting free movement of capitalfrom/into India. In case of US $/Rupee it is pure demand and supplywhich determines forward differentials.

Forward rate are quoted by indicating spot rate and premium/discount.

In direct rate,

Forward rate = spot rate +premium/-discount

Example:

The interbank rate for 31 st march is 48.70

Premium for forward are as follows

Month Paise

April 40/42May 65/67

June 87/88

If a 1-month forward is taken then the forward rate would be48.70+0.42 = 49.12

If a 2-month forward is taken then the forward rate would be48.70 + .67 = 49.37.

If a 3-month forward is taken then the forward rate would be48.70 + .88 = 49.58.

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Example :

Lets take the same example for a broken date forward contract spotrate = 48.70 for 31 st March.

Premium for forwards are as follows

30 th April 48.70 + .4231 st May 48.70 + .6730 th June 48.70 + .88

For 17 th May the premium would be (.67 - .42) * 17/31 = .137

Therefore the premium up to 17 th May would be .67 + .137 =.807

Therefore the forward rate for 17 th May would be 48.70 + .807 =49.507.

Premium when a currency is costlier in future (forward) as comparedto spot, the currency is said to be at premium vis--vis anothercurrency.

Discount when a currency is cheaper in future (forward) as comparedto spot, the currency is said to be at discount vis--vis anothercurrency.

Example :

A company needs DEM 235000 in six months time.

Market Parameters :

Spot rate IEP/DEM = 2.3500Six months forward rate IEP/DEM = 2.3300.

Solution available :

The company can do nothing and hope that the rate in sixmonths time will be more favorable than the current sixmonths forward rate. This would be successful strategy if in asix months time the rate is higher than 2.33. However, if in asix months time the rate is lower than 2.33, the company willhave to lose money.

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It can avoid the risk of a rates being a lower in the future byentering into a forward contract now to buy DEM 235000, fordelivery in six months time at an IEP/DEM at rate of 2.33.

It 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 isinitially booked for the total amount of loan etc. to be re-paid. As andwhen installment falls due, the same is paid by the customer at theexchange rate fixed in forward exchange contract. The balance amountof the contract rolled over till the date for the next installment. Theprocess of extension continues till the loan amount has been re-paid.But the extension is available subject to the cost being paid by thecustomer. Thus, under the mechanism of roll over contracts, theexchange rate protection is provided for the entire period of thecontract and the customer has to bear the roll over charges. The costof extension (rollover) is dependent upon the forward differentialsprevailing on the date of extension. Thus, the customer effectivelyprotects himself against the adverse spot exchange rates but he takesa risk on the forward differentials. (i.e. premium/discount). Althoughspot exchange rates and forward differentials are prone to fluctuations,yet the spot exchange rates being more volatile the customer gets theprotection against the adverse movements of the exchange rates.

A corporate can book with the Authorised Dealer a forward cover onroll-over basis as necessitated by the maturity dates of the underlyingtransactions, market conditions and the need to reduce the cost to thecustomer.

Example :

An importer has entered into a 3 months forward contract in themonth of February.

Spot Rate = 48.65

Forward premium for 3 months (May) = 0.75

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Therefore rate for the contract = 48.65 + 0.75 = 49.45

Suppose, in the month of May the importer realizes that he will not beable to make the payment in May, and he can make payment only inJuly. 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 importerwill go for a roll-over forward for May over July.

The premium for May is 0.75 (sell) and the premium for July is 119.75(buy).

Therefore the additional cost i.e. (119.75 0.75) = 0.4475 will haveto 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 bepaid to the Bank by the importer.

Cancellation of Forward Contract

A corporate can freely cancel a forward contract booked if desired byit. It can again cover the exposure with the same or other AuthorisedDealer. However contracts relating to non-trade transaction\importswith one leg in Indian rupees once cancelled could not be rebooked tillnow. This regulation was imposed to stem bolatility in the foreignexchange market, which was driving down the rupee. Thus the wholeobjective 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-tradedtransactions. It has been decided to extend the freedom of re-booking

the import forward contract up to 100% of un-hedged exposuresfalling due within one year, subject to a cap of $ 100 Mio in a financialyear per corporate.

The removal of this ban would give freedom to corporate Treasurerswho sould be in apposition to reduce their foreign exchange risks bycanceling their existing forweard transactions and re-booking them at

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better rates. Thus this in not liberalization, but it is restoration of thestatus quo ante.

Also the Details of cancelled forward contracts are no more required tobe reported to the RBI.

The following are the guidelines that have to be followee in case ofcancellation of a forward contract.

1.) In case of cancellation of a contract by the client (the requestshould be made on or before the maturity date) the Authorised Dealershall recover/pay the, as the case may be, the difference between thecontracted rate and the rate at which the cancellation is effected. Therecovery/payment of exchange difference on canceling the contractmay be up front or back ended in the discretion of banks.

2.) Rate at which the cancellation is to be effected :

Purchase contracts shall be cancelled at the contractingAuthorised Dealers spot T.T. selling rate current on the date ofcancellation.

Sale contract shall be cancelled at the contracting AuthorisedDealers spot T.T. selling rate current on the date of cancellation.

Where the contract is cancelled before maturity, the appropriateforward T.T. rate shall be applied.

3.) Exchange difference not exceeding Rs. 100 is being ignored bythe contracting Bank.

4.) In the absence of any instructions from the client, the contracts,which have matured, shall be automatically cancelled on 15 th day fallson a Saturday or holiday, the contract shall be cancelled on the nextsucceeding 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 isnot entitled to the exchange difference, if any in his favor, since thecontract is cancelled on account of his default. He shall however, beliable to pay the exchange difference, against him.

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Early Delivery

Suppose an Exporter receives an Export order worth USD 500000 on30/06/2000 and expects shipment of goods to take place on30/09/2000. 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 isin a position to ship the goods on 30/08/2000. He agrees this changewith his foreign importer and documents it. The problem arises withthe Bank as the exporter has already obtained cover for 30/09/2000.He now has to amend the contract with the bank, whereby he wouldgive 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 samein the market, to cover its own risk. But because of early delivery bythe customer, the bank is left with a long mismatch of funds30/08/2000 against 30/09/2000, i.e. + USD 500000 value 30/08/2000(customer deal amended) against the deal the bank did in the interbank market to cover its original risk USD value 30/09/2000 to coverthis mismatch the bank would make use of an FX swap.

The swap will be

1.) Sell USD 500000 value 30/08/2000.

2.) Buy USD 500000 value 30/09/2000

The opposite would be true in case of an importer receiving documentsearlier than the original due date. If originally the importer had boughtUSD value 30/09/2000 on opening of the L/C and now expects receiptof documents on 30/08/2000, the importer would need to take earlydeliver y of USD from the bank. The Bank is left with a shortmismatch of funds 30/08/2000 against 30/09/2000. i.e. USD 500000

value (customer deal amended) against the deal the bank did in theinter bank market to cover its original risk + USD 500000

To cover this mismatch the vank would make use of an FX swap,which will be ;

1. Buy USD value 30/08/2000.2. Sell USD value 30/09/2000.

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The swap necessitated because of early delivery may have a swap costor a swap difference that will have to be charged / paid by thecustomer. The decision of early delivery should be taken as soon as itbecomes known, failing which an FX risk is created. This means thatthe resultant swap can be spot versus forward (where early delivery

cover is left till the very end) or forward versus forward. There is everylikelihood that the origial cover ratre will be quite different from themaket rates when early delivery is requested. The difference in rateswill create a cash outlay for the bank. The interest cost or gain on thecost outlay will be charged / paid to the customer.

Substitution of Orders

The substitution of forward contracts is allowed. In case shipmentunder a particular import or export order in respect of which forwardcover has been booked does not take place, the corporate can bepermitted to substitute another order under the same forwardcontract, provided that the proof of the genuineness of the transactionis given.

Advantages of using forward contracts :

They are useful for budgeting, as the rate at which the companywill buy or sell is fixed in advance.

There is no up-front premium to pay whn using forwardcontracts.

The contract can be drawn up so that the exchange takes placeon any agreed working day.

Disadvantages of forward contracts :

They are legally binding agreements that must be honouredregardless of the exchange rate prevailing on the actual forwardcontract date.

They may not be suitable where there is uncertainty about futurecash flows. For example, if a company tenders for a contract and

the tender is unsuccessful, all obligations under the ForwardContract must still be honoured.

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2. OPTIONS

An option is a Contractual agreement that gives the option buyerthe right, but not the obligation, to purchase (in the case of a calloption) or to sell (in the case of put option) a specified instrument at aspecified price at any time of the option buyers choosing by or beforea fixed date in the future. Upon exercise of the right by the optionholder, and option seller is obliged to deliver the specified instrumentat a specified price.

The option is sold by the seller (writer) To the buyer (holder) In return for a payment (premium) Option lasts for a certain period of time the right expires at its

maturity

Options are of two kinds

1.) Put Options2.) Call Options

PUT OPTIONS

The buyer (holder) has the right, but not an obligation, to sellthe underlying asset to the seller (writer) of the option.

CALL OPTIONS

The buyer (holder) has the right, but not the obligation to buythe underlying asset from the seller (writer) of the option.

STRIKE PRICE

Strike price is the price at which calls & puts are to be exercised(or walked away from)

AMERICAN & EUROPEAN OPTIONSAmerican Options

The buyer has the right (but no obligation) to exercise theoption at any time between purchase of the option and its maturity.

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European Options

The buyer has the right (but no obligations) to exercise theoption at maturity only.

UNDERLYING ASSETS :

Physical commodities, agriculture products like wheat, plusmetal, oil.

Currencies. Stock (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 buyersperspective.

Example :

If the strike price is USD 5 and the spot price is USD 4 then the buyerof put option has intrinsic value. By the exercising the option, thebuyer of the option, can sell the underlying asset at USD 5 whereas inthe spot market the same can be sold for USD 4.

The buyers in trinsic value is USD 1 for every unit for which he has aright to sell under the option contract.

IN, OUT, AT THE MONEY :

In-the-money : An option whose strike price is more favorable thanthe 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 is1 = US $ 1.4000, the exercise of the option by purchaser of US $ call will resultin profit of US $ 0.1000 per pound. Such types of option contract is offered at ahigher price or premium.

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Out-of-the-money : If the strike price of the option contract is less favorable thanthe 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-the-money option. In the above example, if themarket price is 1 = US $ 1.5000, the option contract is said to be at the moneyto its market place.

Summary

Prices Calls Puts

Spot>Strike in-the-money out-of-the-moneySpot=Strike at-the-money at-the-moneySpot


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(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 currentmarket price thereby make profit.

However, it may be noted that if on maturity the spot price is less thanthe 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 notthe obligation) to buy or sell a fixed amount of a currency at a givenrate on or before a certain date. The agreed exchange rate is knownas the strike rate or exercise rate.

An option is usually purchased for an up front payment known as apremium. The option then gives the company the flexibility to buy orsell at the rate agreed in the contract, or to buy or sell at market ratesif they are more favorable, i.e. not to exercise the option.

How are Currency Options are different from ForwardContracts ?

A Forward Contract is a legal commitment to buy or sell a fixedamount of a currency at a fixed rate on a given future date.

A Currency Option, on the other hand, offers protection againstunfavorable changes in exchange raters without sacrificing thechance of benefiting from more favorable rates.

Types of Options :

A Call Option is an option to buy a fixed amount of currency. A 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 exercisedat 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.

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Option premiums :

By buying an option, a company acquires greater flexibility and at thesame time receives protection against unfavorable changes inexchange rates. The protection is paid for in the form of a premium.

Example :

A company has a requirement to buy USD 1000000 in one monthstime.Market parameters :

Current Spot Rate is 1.600, one month forward rate is 1.6000

Solutions available :

Do nothing and buy at the rate on offer in one months time. Thecompany will gain if the dollar weakens (say 1.6200) but willlose if it strengthens (say 1.5800).

Enter into a forward contract and buy at a rate of 1.6000 forexercise in one months time. In company wil gain if the dollarstrengthens, but will lose if it weakens.

But a call option with a strike rate of 1.6000 for exercise in onemonths time. In this case the company can buy in one monthstime at whichever rate is more attractive. It is protected if thedollar strengthens and still has the chance to benefit if itweakens.

How does the option work ?

The company buys the option to buy USD 1000000 at a rate of 1.6000on a date one month in the future (European Style). In this example,lets assume that the option premium quoted is 0.98 % of the USDamount (in this case USD 1000000). This cost amounts to USD 9800or 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 companycan exercise its Call Option and buy USD 1000000 at 1.6000.So, the company will only have to pay IEP 625000 to buy theUSD 1000000 and saves IEP 41667 over the cost of buyingdollars at the prevailing rate. Taking the cost of the potion

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premium into account, the overall net saving for the companyis IEP 35542.

On the other hand, if the exchange rate in one months time is1.7000. The company can choose not to exercise the Call

Option and can buy USD 1000000 at the prevailing rate of1.7000. The company pays IEP 588235 for USD 1000000 andsaves IEP 36765 over the cost of forward cover at 1.6000. Thecompany has a net saving of IEP 30640 after taking the cost ofthe option premium into account.

In a world of changing and unpredictable exchange rates, thepayment of a premium can be justified by the flexibility thatoptions provide.

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0c17b_a Grand Project Report on Foreign Exchange and Risk Management

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