Axis Bank Report

STUDY ON HEDGING STRATEGY OF INDIAN

ORGAINZATIONS

AXIS BANK

Faculty Guide: Prof. Vrishali Bhat

Industry Guide: Mr. Sandesh C R

Submitted in partial fulfillment of the Post Graduate Programme in Management at

TAPMI, Manipal by:

Name: Anupam Chaplot

Roll No: 09210

Batch: 2009-2011

M I P – S U M M E R P R O J E C T R E P O R T

Anupam Chaplot STUDY ON HEDGING STRATEGY OF INDIAN ORGAINZATIONS Page 2

CERTIFICATE

This is to certify that the project report titled ‘Study on hedging strategy of Indian

organizations’ is a bona fide work carried out by Anupam Chaplot roll no. 09210

under my guidance for partial fulfillment of Post Graduate Diploma in

Management.

Signature

Name of Faculty Guide: Prof Vrishali Bhat


ACKNOWLEDGMENTS

I thank Prof Vrishali Bhat for guiding me through the project. I also thank her for the timely inputs and guiding the project time to time. I also thank Mr. John Augustine and Mr. Sandesh C R for their timely inputs which gave a proper shape and direction to the project.

I would also like to thank AXIS Bank for giving me an opportunity to interact with them and giving me a firsthand exposure to the intricacies of the banking domain. The executives of the bank helped me out in whichever way they could. Without their support, it would have been impossible to carry out the project successfully.

I take this opportunity to thank each and everyone who I came in touch with in this two month period.

Anupam Chaplot

09210

TAPMI


EXECUTIVE SUMMARY

Axis Bank is one of the leading private sector banks of the country. It was established in the year 1994. It was the era when new banks were coming over the horizon and establishing their mark on the Indian Banking industry. Till that time, the Indian banking system was known to be rigid, inflexible and arrogant. The only players were that of the public sector banks and they had the support of the government through thick and thin.

But the new breed of banks changed the Indian Banking landscape. With the help of the reforms and trimmed down raj era, there was a sea change that was brought out. The public sector banks started feeling the heat of the competition. To survive, even they had to change their way of business. The benefits of the policies are visible today to the customers.

Axis Bank started under the name Unit Trust of India. In 2007, it changed its name to Axis bank. In March 2009, the bank reported an income of 13745 crores and a profit of 1813 crores a 69.5% increase over the previous year. The bank also saw an increase in the term deposits (Savings Bank accounts and Current bank Account) to 46,330, up from the previous year’s value of 33,705, an increase of near to 40%

During my MIP, I got the opportunity to see the Forex operation of the bank. I worked with trade finance team of the JP Nagar branch, Bangalore of the bank. At initial part of the MIP the concentration was on understanding the forex arithmetic that include learning about the trade finance team operation and various product that the Axis bank provides.

The recent period has witnessed amplified volatility in the INR-US exchange rates in the backdrop of the sub-prime crisis in the US and increased dollar-inflows into the Indian stock markets. In this context, the project concentrated on the choice of instruments adopted by prominent firms to stem their foreign exchange exposures. Also analysis of the trend in forex market in last 4 years has been done.


Contents 1. Introduction ................................................................................................................ 7

2. Objectives: ................................................................................................................ 10

3. Scope Of The Study: .................................................................................................. 11

4. Exchange Rate: ......................................................................................................... 12

5. Foreign Exchange Market ........................................................................................ 13

5.1 Foreign Exchange Markets In India – A Brief Background ....................................14

6. Market Participants .................................................................................................. 15

7. Determinant Of The Exchange Rate: ........................................................................ 18

8. Administration Of Foreign Exchange: ...................................................................... 21

9. Foreign Currency Accounts: ..................................................................................... 23

10. Various Entities Involved In Banks Forex Operation: .............................................. 24

11. Foreign Exchange Risk: ............................................................................................ 24

11.1 Foreign Exchange Hedge...................................................................................25

11.2 Foreign Exchange Derivative .............................................................................25

12. Foreign Exchange Risk Management: Process & Necessity .................................... 25

12.1 Kinds Of Foreign Exchange Exposure ................................................................26

12.2 Necessity Of Managing Foreign Exchange Risk ..................................................26

12.3 Hedging As A Tool To Manage Foreign Exchange Risk .......................................27

13. Foreign Exchange Risk Management Framework .................................................... 27

14. Hedging Strategies/ Instruments ............................................................................... 29

14.1 Forwards: ........................................................................................................29

14.1.1 How A Forward Contract Works ........................................................................... 31

14.1.2 Example Of How Forward Prices Should Be Agreed Upon .................................. 31

14.1.3 Spot - Forward Parity ............................................................................................ 32

14.2 Futures: ............................................................................................................32

14.2.1 Uses ........................................................................................................................ 33

14.3 Options: ...........................................................................................................33

14.3.3 Hedging Using Options.......................................................................................... 34

14.4 Swaps: ..............................................................................................................37

14.4.1 Currency Swap ....................................................................................................... 37


14.4.2 Interest Rate Swap ................................................................................................. 38

14.4.3 Overnight Index Swap ............................................................................................ 39

14.5 Foreign Debt: ...................................................................................................40

15. Determinants Of Hedging Decisions ........................................................................ 41

16. An Overview Of Corporate Hedging In India ........................................................... 43

16.1 Development Of Derivative Markets In India ......................................................43

16.2 Regulatory Guidelines For The Use Of Foreign Exchange Derivatives .................44

16.3 Analysis Of Last 4 Years Currency Movement: ....................................................44

16.4 Hedging Instruments For Indian Firms ...............................................................46

16.4 Discussion On Hedging By Indian Firms ............................................................48

17. Conclusion ................................................................................................................ 49

18. Limitation: ................................................................................................................ 51

19. References: ............................................................................................................ 51


1. Introduction

Axis Bank started its operations in 1994 under the name UTI. The Bank was jointly promoted by Unit Trust of India (UTI-I), Life Insurance Corporation of India (LIC), General Insurance Corporation Ltd., National Insurance Company Ltd., The New India Assurance Company, The Oriental Insurance Corporation and United Insurance Company Ltd. It changed its name to AXIS Bank to avoid confusion with a financial entity of similar name (UTI).

As on the year ended March 31, 2009 the Bank had a total income of Rs. 13,745.04 crores and a net profit of Rs 1,812.93 crores. Shikha Sharma was named as the bank's managing director and CEO on 20 April 2009 from P.J. Nayak.

By the end of March 2009, Axis Bank had a very wide network of more than 726 branch offices and Extension Counters. Also, the number of ATMs is 3723. In the last financial year (2008-2009) the total income was Rs.13745 crores. The net profit that was post by the bank was 1813 crores.

Axis Bank has can be divided into four business segments: Retail, Corporate, Treasury, and Merchant banking. Apart from this Bank also provide insurance, investment banking and mortgage financing services.


SWOT Analysis:

International trade refers to trade between the residents of two different countries. Each country functions as a sovereign state with its own set of regulations and currency. The existence of national monetary units poses a problem in the settlement of international transactions. The exporter would like to get the payment in the currency of their country. For instance, if Amerexport of Las Vegas exports machinery to Indiimports, Mumbai, the former would like to get the payment in US dollars. Payment in Indian rupees will not serve their purpose because the Indian rupee cannot be used as currency in the USA. On the other hand, the importers in India have their savings and borrowings in India in rupees. Thus the exporter requires payment in the currency of the exporter’s country. A need therefore arises to convert the currency of the importers country into that of the exporter’s country. Foreign exchange is the mechanism by which the currency of one country gets converted into the currency of another country.

The conversion of the currency is done by banks who deal in foreign exchange. These banks maintain stocks of foreign currencies in the form of balance with banks abroad. For instance, Axis bank may maintain an account with Bank of America, New York, in which dollar balance are held. In the earlier example if Indiimports pay the equivalent rupees to Axis bank, it would arrange to pay Amerexport at New York in dollars from the dollar balances held by it with the Bank of America.

Treasury has been the biggest revenue center for the banking sector. Apart from the trade finance team the Treasury includes Authorized dealers, Merchant banker, customer desk, bullion team GFID team.

Over the last decade, the FX market has become more diverse as well as much larger. Although in the past, commercial banks dominated the market, today


participants also include commercial as well as investment banks, FX dealers and brokerage companies, multinational corporations, money managers, commodity trading advisors, insurance companies, governments, central banks, pension and hedge funds, investment companies, brokers/dealers, and other participants in the interdealer market. In addition, the size of the FX market has grown as the economy has continued to globalize. The value of transactions that are settled globally each day has risen exponentially. JP Nagar Forex of Axis Bank is an authorized dealer in foreign exchange, were a customer can deal all import and export payment and handling of documents directly through the branch. The Branch has specialized in foreign direct investments and other capital account transactions.

Among other things, the team also sends the periodical updates and views on currency movements which will help customer in planning his forex exposure.

The following are the major products offered by the branch:

1. Purchase and sale of foreign Currency Notes.

2. Collection or Purchase of Travelers Cheques

3. Collection or Purchase of foreign currency cheques.

4. Issuance of foreign demand drafts.

5. Issuance of travel currency cards

6. Issuance of traveler’s cheques.

7. Receive foreign inward remittance

8. Send foreign outward remittance

9. Maintenance of EEFC (exchange earners foreign currency Account)

10. Negotiation/purchase/ Collection of export documents.

11. Rupee packing credit

12. Pre shipment credit in foreign currency.

13. Import letter of credit/ documentary Credit.

14. Handling import documents

15. Import payments/ Advance import remittances.

16. Arrange for ECB (external commercial Borrowings)

17. Facilitate Overseas Direct investments (ODI)

18. Facilitate foreign direct investments (FDI)

19. Hedging (Booking Forward Contacts)

20. FOREX Derivatives.

The list still continues with various other technical products to cater customer’s specific requirements.


2. Objectives:

The project aims to find out what are the likely to be sales figures in the coming financial year. It also tries to find out what the underlying reasons are for these sales. In this the objectives are:

1. Understanding the fundamental of exchange arithmetic.

2. To learn about the major FOREX products provided by Banks.

3. To study the foreign exchange strategy of market leaders in various sector.

4. To find out the hedging strategies for the customers.


3. Scope of the study:

1. The project is specific to the foreign exchange risk of the firm and is not

concentrating on any other type of risk.

2. The project does not delve deep into the various complex product types that are available and possible within each of the hedging instrument classes that are discussed.

3. Only the recent trend in the industry has been studied, the data used for the study is for last 1 year only for the forex hedging instruments used by different organizations and 4 years for dollar to rupee fluctuations.


4. Exchange Rate:

Exchange rates may be fixed or flexible. An exchange rate is fixed when two countries agree to maintain a fixed rate through the use of monetary policy. Historically, the most famous fixed exchange-rate system was the gold standard; in the late 1850s, one ounce of gold was defined as being worth 20 U.S dollars and 4 pounds sterling, resulting in an exchange rate of 5 dollars per pound. An exchange rate is flexible, or "floating," when two countries agree to let international market forces determine the rate through supply and demand. The rate will fluctuate with a country's exports and imports. Most world trade currently takes place with flexible exchange rates that fluctuate within relatively fixed limits.

In finance, the exchange rates (also known as the foreign-exchange rate, forex rate or FX rate) between two currencies specify how much one currency is worth in terms of the other. It is the value of a foreign nation’s currency in terms of the home nation’s currency. For example an exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (USD, $) means that JPY 91 is worth the same as USD 1. The foreign exchange market is one of the largest markets in the world. By some estimates, about 3.2 trillion USD worth of currency changes hands every day.

The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date.

An exchange system quotation is given by stating the number of units of "quote currency" (price currency, payment currency) that can be exchanged for one unit of "base currency" (unit currency, transaction currency). For example, in a quotation that says the EUR/USD exchange rate is 1.4320 (1.4320 USD per EUR, also known as EUR/USD; see foreign exchange market), the quote currency is USD and the base currency is EUR.

There is a market convention that determines which is the base currency and which is the term currency. In most parts of the world, the order is: EUR – GBP – AUD – NZD – USD – others. Thus if you are doing a conversion from EUR into AUD, EUR is the base currency, AUD is the term currency and the exchange rate tells you how many Australian dollars you would pay or receive for 1 euro. Cyprus and Malta which were quoted as the base to the USD and others were recently removed from this list when they joined the euro. In some areas of Europe and in the non-professional market in the UK, EUR and GBP are reversed so that GBP is quoted as the base currency to the euro. In order to determine which the base currency is where both currencies are not listed (i.e. both are "other"), market convention is to use the base currency which gives an exchange rate greater than 1.000. This avoids rounding issues and exchange rates being quoted to more than 4 decimal places. There are some exceptions to this rule e.g. the Japanese often quote their currency as the base to other currencies.


Quotes using a country's home currency as the price currency (e.g., EUR 0.735342 = USD 1.00 in the euro zone) are known as direct quotation or price quotation (from that country's perspective) and are used by most countries.

Quotes using a country's home currency as the unit currency (e.g., EUR 1.00 = USD 1.35991 in the euro zone) are known as indirect quotation or quantity quotation and are used in British newspapers and are also common in Australia, New Zealand and the eurozone.

· Direct quotation: 1 foreign currency unit = x home currency units

· Indirect quotation: 1 home currency unit = x foreign currency units

Note that, using direct quotation, if the home currency is strengthening (i.e., appreciating, or becoming more valuable) then the exchange rate number decreases. Conversely if the foreign currency is strengthening, the exchange rate number increases and the home currency is depreciating.

5. Foreign exchange market

The foreign exchange market (forex, FX, or currency market) is a worldwide decentralized over-the-counter financial market for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends.

The primary purpose of the foreign exchange market is to assist international trade and investment, by allowing businesses to convert one currency to another currency. For example, it permits a US business to import European goods and pay Euros, even though the business's income is in US dollars. It also supports speculation, and facilitates the carry trade, in which investors borrow low-yielding currencies and lend (invest in) high-yielding currencies, and which (it has been claimed) may lead to loss of competitiveness in some countries.

In a typical foreign exchange transaction a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market started forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.

The foreign exchange market is unique because of its

• huge trading volume, leading to high liquidity • geographical dispersion • continuous operation: 24 hours a day except weekends, i.e. trading from 20:15

GMT on Sunday until 22:00 GMT Friday


• the variety of factors that affect exchange rates • the low margins of relative profit compared with other markets of fixed income • the use of leverage to enhance profit margins with respect to account size

As such, it has been referred to as the market closest to the ideal of perfect competition, notwithstanding market manipulation by central banks.

5.1 Foreign Exchange Markets in India – a brief background

The foreign exchange market in India started in earnest less than three decades ago when in 1978 the government allowed banks to trade foreign exchange with one another. Today over 70% of the trading in foreign exchange continues to take place in the inter-bank market. The market consists of over 90 Authorized Dealers (mostly banks) who transact currency among themselves and come out “square” or without exposure at the end of the trading day. Trading is regulated by the Foreign Exchange Dealers Association of India (FEDAI), a self regulatory association of dealers. Since 2001, clearing and settlement functions in the foreign exchange market are largely carried out by the Clearing Corporation of India Limited (CCIL) that handles transactions of approximately 3.5 billion US dollars a day, about 80% of the total transactions. The liberalization process has significantly boosted the foreign exchange market in the country by allowing both banks and corporations greater flexibility in holding and trading foreign currencies. The Sodhani Committee set up in 1994 recommended greater freedom to participating banks, allowing them to fix their own trading limits, interest rates on FCNR deposits and the use of derivative products. The growth of the foreign exchange market in the last few years has been nothing less than momentous. In the last 5 years, from 2000-01 to 2005-06, trading volume in the foreign exchange market (including swaps, forwards and forward cancellations) has more 3 than tripled, growing at a compounded annual rate exceeding 25%. In March 2006, about half (48%) of the transactions were spot trades, while swap transactions (essentially repurchase agreements with a one-way transaction – spot or forward – combined with a longer- horizon forward transaction in the reverse direction) accounted for 34% and forwards and forward cancellations made up 11% and 7% respectively. About two-thirds of all transactions had the rupee on one side. In 2004, according to the triennial central bank survey of foreign exchange and derivative markets conducted by the Bank for International Settlements (BIS (2005a)) the Indian Rupee featured in the 20th position among all currencies in terms of being on one side of all foreign transactions around the globe and its share had tripled since 1998. As a host of foreign exchange trading activity, India ranked 23rd among all countries covered by the BIS survey in 2004 accounting for 0.3% of the world turnover. Trading is relatively moderately concentrated in India with 11 banks accounting for over 75% of the trades covered by the BIS 2004 survey.


6. Market participants

Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is the inter-bank market, which is made up of the largest commercial banks and securities dealers. Within the inter-bank market, spreads, which are the difference between the bids and ask prices, are razor sharp and usually unavailable, and not known to players outside the inner circle. The difference between the bid and ask prices widens (from 0-1 pip to 1-2 pips for some currencies such as the EUR). This is due to volume. If a trader can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the foreign exchange market are determined by the size of the "line" (the amount of money with which they are trading). The top-tier inter-bank market accounts for 53% of all transactions. After that there are usually smaller banks, followed by large multi-national corporations (which need to hedge risk and pay employees in different countries), large hedge funds, and even some of the retail FX-metal market makers. According to Galati and Melvin, “Pension funds, insurance companies, mutual funds, and other institutional investors have played an increasingly important role in financial markets in general, and in FX markets in particular, since the early 2000s.” (2004) In addition, he notes, “Hedge funds have grown markedly over the 2001–2004 period in terms of both number and overall size” Central banks also participate in the foreign exchange market to align currencies to their economic needs.

Banks

The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank's own account. Until recently, foreign exchange brokers did large amounts of business, facilitating interbank trading and matching anonymous counterparts for small fees. Today, however, much of this business has moved on to more efficient electronic systems. The broker squawk box lets traders listen in on ongoing interbank trading and is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago.

Commercial companies

An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very


large positions are covered due to exposures that are not widely known by other market participants.

Central banks

National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Milton Friedman argued that the best stabilization strategy would be for central banks to buy when the exchange rate is too low, and to sell when the rate is too high—that is, to trade for a profit based on their more precise information. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, and there is no convincing evidence that they do make a profit trading.

The mere expectation or rumor of central bank intervention might be enough to stabilize a currency, but aggressive intervention might be used several times each year in countries with a dirty float currency regime. Central banks do not always achieve their objectives. The combined resources of the market can easily overwhelm any central bank. Several scenarios of this nature were seen in the 1992–93 ERM collapse and in more recent times in Southeast Asia.

Hedge funds as speculators

About 70% to 90% of the foreign exchange transactions are speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the movement of that particular currency. Hedge funds have gained a reputation for aggressive currency speculation since 1996. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favor.

Investment management firms

Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases.

Some investment management firms also have more speculative specialist currency overlay operations, which manage clients' currency exposures with the aim of generating profits as well as limiting risk. Whilst the number of this type of


specialist firms is quite small, many have a large value of assets under management (AUM), and hence can generate large trades.

Retail foreign exchange brokers

Retail traders (individuals) constitute a growing segment of this market, both in size and importance. Currently, they participate indirectly through brokers or banks. Retail brokers, while largely controlled and regulated in the USA by the CFTC and NFA have in the past been subjected to periodic foreign exchange scams. To deal with the issue, the NFA and CFTC began (as of 2009) imposing stricter requirements, particularly in relation to the amount of Net Capitalization required of its members. As a result many of the smaller, and perhaps questionable brokers are now gone.

There are two main types of retail FX brokers offering the opportunity for speculative currency trading: brokers and dealers or market makers. Brokers serve as an agent of the customer in the broader FX market, by seeking the best price in the market for a retail order and dealing on behalf of the retail customer. They charge a commission or mark-up in addition to the price obtained in the market. Dealers or market makers, by contrast, typically act as principal in the transaction versus the retail customer, and quote a price they are willing to deal at—the customer has the choice whether or not to trade at that price.

In assessing the suitability of a FX trading services, the customer should consider the ramifications of whether the service provider is acting as principal or agent. When the service provider acts as agent, the customer is generally assured of a known cost above the best inter-dealer FX rate. When the service provider acts as principal, no commission is paid, but the price offered may not be the best available in the market—since the service provider is taking the other side of the transaction, a conflict of interest may occur.

Non-bank foreign exchange companies

Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but currency exchange with payments. I.e., there is usually a physical delivery of currency to a bank account. Send Money Home offers an in-depth comparison into the services offered by all the major non-bank foreign exchange companies.

It is estimated that in the UK, 14% of currency transfers/payments are made via Foreign Exchange Companies. These companies' selling point is usually that they will offer better exchange rates or cheaper payments than the customer's bank. These companies differ from Money Transfer/Remittance Companies in that they generally offer higher-value services.


Money transfer/remittance companies

Money transfer companies/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country. In 2007, the Aite Group estimated that there were $369 billion of remittances (an increase of 8% on the previous year). The four largest markets (India, China, Mexico and the Philippines) receive $95 billion. The largest and best known provider is Western Union with 345,000 agents globally followed by UAE Exchange Financial Service Ltd

7. Determinant of the Exchange rate:

The rate of exchange in the market is the outcome of the combined effect of a multiplicity of factors constantly at play. Not all the factors are equal in importance. Some factors, especially the economic factors, are better guides in the long run. To understand short-term changes, some other immediate factors may have to be looked into. Besides, one factor which may exert a major influence during a given period may lose its importance after some time. Given below are some of the important factors that affect exchange rates.

1. Balance of Payments: 2. Inflation 3. Interest rates 4. Money supply 5. National income 6. Resource discoveries 7. Political factors 8. Capital movement 9. Psychological factors and speculations 10. Technical and market factors.

The following theories explain the fluctuations in FX rates in a floating exchange rate regime (In a fixed exchange rate regime, FX rates are decided by its government):

(a) International parity conditions: Relative Purchasing Power Parity, interest rate parity, Domestic Fisher effect, International Fisher effect. Though to some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in the real world.

(b) Balance of payments model (see exchange rate): This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for continuous appreciation of dollar during 1980s and most part of 1990s in face of soaring US current account deficit.


(c) Asset market model (see exchange rate): views currencies as an important asset

class for constructing investment portfolios. Assets prices are influenced mostly by people’s willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that “the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.” None of the models developed so far succeed to explain FX rates levels and volatility in the longer time frames. For shorter time frames (less than a few days) algorithm can be devised to predict prices. Large and small institutions and professional individual traders have made consistent profits from it. It is understood from above models that many macroeconomic factors affect the exchange rates and in the end currency prices are a result of dual forces of demand and supply. The world's currency markets can be viewed as a huge melting pot: in a large and ever-changing mix of current events, supply and demand factors are constantly shifting, and the price of one currency in relation to another shifts accordingly. No other market encompasses (and distills) as much of what is going on in the world at any given time as foreign exchange. Supply and demand for any given currency, and thus its value, are not influenced by any single element, but rather by several. These elements generally fall into three categories: economic factors, political conditions and market psychology. Economic factors These include: 1. Economic policy, disseminated by government agencies and central banks, 2. Economic conditions generally revealed through economic reports, and other economic indicators.

� Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government's central bank influences the supply and "cost" of money, which is reflected by the level of interest rates).

� Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country's currency.

� Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country's currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy. For example, trade deficits may have a negative impact on a nation's currency.

� Inflation levels and trends: Typically a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when


inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation.

� Economic growth and health: Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country's economic growth and health. Generally, the more healthy and robust a country's economy, the better its currency will perform, and the more demand for it there will be.

� Productivity of an economy: Increasing productivity in an economy should positively influence the value of its currency. Its effects are more prominent if the increase is in the traded sector. Political conditions Internal, regional, and international political conditions and events can have a profound effect on currency markets. All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation's economy. For example, destabilization of coalition governments in Pakistan and Thailand can negatively affect the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive/negative interest in a neighboring country and, in the process, affect its currency. Market psychology Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:

� Flights to quality: Unsettling international events can lead to a "flight to quality," with investors seeking a "safe haven." There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The U.S. dollar, Swiss franc and gold have been traditional safe havens during times of political or economic uncertainty.

� Long-term trends: Currency markets often move in visible long-term trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends.

� "Buy the rumor, sell the fact": This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being "oversold" or "overbought". To buy the rumor or sell the fact can also be an example of the cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices.

� Economic numbers: While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number it becomes important to market psychology and may have an immediate impact on


short-term market moves. "What to watch" can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight.

� Technical trading considerations: As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns.

8. Administration of Foreign Exchange:

The statutory basis for administration of foreign exchange in India is the foreign exchange management act, 1999. The Central Government has been empowered under section 46 of the Act to make rules to carry out the provisions of the Act. Similarly, Section 47 empowers the Reserve Bank to make regulations to carry out the provisions of the Act and the rules made there under. Further, Section 41 provides that the central government may, from time to time, give to the Reserve Bank such general or special directions as it thinks fit and the Reserve Bank shall comply with such directions. Thus, ultimately the Reserve Bank has been changed with the powers as well as the responsibility to administer foreign exchange in India.


Authorized Persons: While the RBI has the authority to administer foreign exchange in India, it is recognized that it cannot do so by itself. Foreign exchange is received or required by a large number of exporters and importers in the country spread over a vast geographical area. It would be impossible for the Reserve Bank to deal with them individually. Therefore provision has been made in the Act ( section 10), enabling the Reserve Bank to authorize any person to be known as authorized person to deal in foreign exchange or in foreign securities, as an authorized dealer, money change or off-shore banking unit or in any other manner as it deems fit.


Authorized Dealers: A major portion of actual dealing in foreign exchange from the customers (importers, exporters and others receiving or making personal remittances) is dealt with by such of the banks in India which have been authorized by RBI to deal in foreign exchange. Such of the banks and select financial institutions who have been foreign exchange authorized to deal in foreign exchange by the reserve bank are known as authorized dealers.

Foreign Exchange Dealers Association of India: An association of banks specializing in the foreign exchange activities in India. The Foreign Exchange Dealers Association of India, which was created in 1958, regulates the governing rules and determines the commissions and charges associated with the interbank foreign exchange business.

9. Foreign Currency Accounts:

Nostro and Vostro Account:

Nostro and vostro (Middle Italian, from Latin, noster and voster; English, ours and yours) are accounting terms used to distinguish an account you hold for another entity from an account another entity holds for you. The entities in question are almost always, but need not be, banks.

It helps to recall that the term account refers to a record of transactions, whether current, past or future, and whether in money, or shares, or other countable commodities. Originally a bank account just meant the record kept by a banker of the money they were holding on behalf of a customer, and how that changed as the customer made deposits and withdrawals (the money itself probably being in the form of species, such as gold and silver coin).

The terms nostro and vostro remove the potential ambiguity when referring to these two separate accounts of the same balance and set of transactions. Speaking from the bank's point-of-view:

• A nostro is our account of our money, held by you

• A vostro is our account of your money, held by us

Note that all "bank accounts" as the term is normally understood, including personal or corporate loan, and savings accounts, are treated as vostros by the bank. They also regard as vostro purely internal funds such as treasury, trading and suspense accounts; although there is no "you" in the sense of an external customer, the money is still "held by us".

Loro Account:

There is also the notion of a loro account ("theirs"), which is a record of an account held by a second bank on behalf of a third party; that is, my record of their account with you. In practice this is rarely used, the main exception being complex syndicated financing.


In the same style as above:

• A loro is our account of their money, held by you

10. Various entities involved in Banks forex operation:

Customers: Customers consist of Exporter, importers, individuals and cooperates.

Bank Branch: The branch of the bank where Forex team is available to serve the client. The people working here are also known as AD2 (authorized dealer 2).

Dealing room: In Axis bank the co-operate office has a trade finance center. Three teams are present in trade finance center. One team known as authorized dealer 1 works in front office and can directly interact with the customers. Also they are the point of contact for interbank deals. There is a compliance team which monitors all the transactions, Crosschecks if the documentations are proper or not. The Back office people do the work of finacle data entry.

11. Foreign exchange risk:

Currency risk is a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.

• Transaction risk is the risk that exchange rates will change unfavorably over time. It can be hedged against using forward currency contracts;

• Translation risk is an accounting risk, proportional to the amount of assets held in foreign currencies. Changes in the exchange rate over time will render a report inaccurate, and so assets are usually balanced by borrowings in that currency.


The exchange risk associated with a foreign denominated instrument is a key element in foreign investment. This risk flows from differential monetary policy and growth in real productivity, which results in differential inflation rates.

Currency risk exists regardless of whether you are investing domestically or abroad. If you invest in your home country, and your home currency devalues, you have lost money. Any and all stock market investments are subject to currency risk, regardless of the nationality of the investor or the investment, and whether they are the same or different. The only way to avoid currency risk is to invest in commodities, which hold value independent of any monetary system.

11.1 Foreign exchange hedge

A Foreign exchange hedge (FOREX hedge) is a method used by companies to eliminate or hedge foreign exchange risk resulting from transactions in foreign currencies. This is done using either the cash flow or the fair value method. The accounting rules for this are addressed by both the International Financial Reporting Standards (IFRS) and by the US Generally Accepted Accounting Principles (US GAAP).

A hedge is a type of derivative, or a financial instrument, that derives its value from an underlying asset. This concept is important and will be discussed later. Hedging is a way for a company to minimize or eliminate foreign exchange risk. Two common hedges are forwards and options. A Forward contract will lock in an exchange rate at which the transaction will occur in the future. An option sets a rate at which the company may choose to exchange currencies. If the current exchange rate is more favorable, then the company will not exercise this option.

11.2 Foreign exchange derivative

A Foreign exchange derivative is a financial derivative where the underlying is a particular currency and/or its exchange rate. These instruments are used either for currency speculation and arbitrage or for hedging foreign exchange risk. For detail see:

• Foreign exchange option • Forex swap • Currency future • Forwards

12. Foreign Exchange Risk Management: Process & Necessity

Firms dealing in multiple currencies face a risk (an unanticipated gain/loss) on account of sudden/unanticipated changes in exchange rates, quantified in terms of exposures. Exposure is defined as a contracted, projected or contingent cash flow whose magnitude is not certain at the moment and depends on the value of the foreign exchange rates. The process of identifying risks faced by the firm and


implementing the process of protection from these risks by financial or operational hedging is defined as foreign exchange risk management.

12.1 Kinds of Foreign Exchange Exposure

Risk management techniques vary with the type of exposure (accounting or economic) and term of exposure. Accounting exposure, also called translation exposure, results from the need to restate foreign subsidiaries’ financial statements into the parent’s reporting currency and is the sensitivity of net income to the variation in the exchange rate between a foreign subsidiary and its parent. Economic exposure is the extent to which a firm's market value, in any particular currency, is sensitive to unexpected changes in foreign currency. Currency fluctuations affect the value of the firm’s operating cash flows, income statement, and competitive position, hence market share and stock price. Currency fluctuations also affect a firm's balance sheet by changing the value of the firm's assets and liabilities, accounts payable, accounts receivables, inventory, loans in foreign currency, investments (CDs) in foreign banks; this type of economic exposure is called balance sheet exposure. Transaction Exposure is a form of short term economic exposure due to fixed price contracting in an atmosphere of exchange-rate volatility. The most common definition of the measure of exchange-rate exposure is the sensitivity of the value of the firm, proxy by the firm’s stock return, to an unanticipated change in an exchange rate. This is calculated by using the partial derivative function where the dependant variable is the firm’s value and the independent variable is the exchange rate.

12.2 Necessity of managing foreign exchange risk

A key assumption in the concept of foreign exchange risk is that exchange rate changes are not predictable and that this is determined by how efficient the markets for foreign exchange are. Research in the area of efficiency of foreign exchange markets has thus far been able to establish only a weak form of the efficient market hypothesis conclusively which implies that successive changes in exchange rates cannot be predicted by analyzing the historical sequence of exchange rates. However, when the efficient markets theory is applied to the foreign exchange market under floating exchange rates there is some evidence to suggest that the present prices properly reflect all available information. This implies that exchange rates react to new information in an immediate and unbiased fashion, so that no one party can make a profit by this information and in any case, information on direction of the rates arrives randomly so exchange rates also fluctuate randomly. It implies that foreign exchange risk management cannot be done away with by employing resources to predict exchange rate changes.


12.3 Hedging as a tool to manage foreign exchange risk

There is a spectrum of opinions regarding foreign exchange hedging. Some firms feel hedging techniques are speculative or do not fall in their area of expertise and hence do not venture into hedging practices. Other firms are unaware of being exposed to foreign exchange risks. There are a set of firms who only hedge some of their risks, while others are aware of the various risks they face, but are unaware of the methods to guard the firm against the risk. There is yet another set of companies who believe shareholder value cannot be increased by hedging the firm’s foreign exchange risks as shareholders can themselves individually hedge themselves against the same using instruments like forward contracts available in the market or diversify such risks out by manipulating their portfolio. There are some explanations backed by theory about the irrelevance of managing the risk of change in exchange rates. For example, the International Fisher effect states that exchange rates changes are balanced out by interest rate changes, the Purchasing Power Parity theory suggests that exchange rate changes will be offset by changes in relative price indices/inflation since the Law of One Price should hold. Both these theories suggest that exchange rate changes are evened out in some form or the other. Also, the Unbiased Forward Rate theory suggests that locking in the forward exchange rate offers the same expected return and is an unbiased indicator of the future spot rate. But these theories are perfectly played out in perfect markets under homogeneous tax regimes. Also, exchange rate-linked changes in factors like inflation and interest rates take time to adjust and in the meanwhile firms stand to lose out on adverse movements in the exchange rates. The existence of different kinds of market imperfections, such as incomplete financial markets, positive transaction and information costs, probability of financial distress, and agency costs and restrictions on free trade make foreign exchange management an appropriate concern for corporate management. It has also been argued that a hedged firm, being less risky can secure debt more easily and this enjoy a tax advantage (interest is excluded from tax while dividends are taxed). This would negate the Modigliani-Miller proposition as shareholders cannot duplicate such tax advantages. The MM argument that shareholders can hedge on their own is also not valid on account of high transaction costs and lack of knowledge about financial manipulations on the part of shareholders. There is also a vast pool of research that proves the efficacy of managing foreign exchange risks and a significant amount of evidence showing the reduction of exposure with the use of tools for managing these exposures.

13. Foreign Exchange Risk Management Framework

Once a firm recognizes its exposure, it then has to deploy resources in managing it. A heuristic for firms to manage this risk effectively is presented below which


can be modified to suit firm-specific needs i.e. some or all the following tools could be used.

• Forecasts: After determining its exposure, the first step for a firm is to develop a forecast on the market trends and what the main direction/trend is going to be on the foreign exchange rates. The period for forecasts is typically 6 months. It is important to base the forecasts on valid assumptions. Along with identifying trends, a probability should be estimated for the forecast coming true as well as how much the change would be.

• Risk Estimation: Based on the forecast, a measure of the Value at Risk (the actual profit or loss for a move in rates according to the forecast) and the probability of this risk should be ascertained. The risk that a transaction would fail due to market-specific problems should be taken into account. Finally, the Systems Risk that can arise due to inadequacies such as reporting gaps and implementation gaps in the firms’ exposure management system should be estimated.

• Benchmarking: Given the exposures and the risk estimates, the firm has to set its limits for handling foreign exchange exposure. The firm also has to decide whether to manage its exposures on a cost centre or profit centre basis. A cost centre approach is a defensive one and the main aim is ensure that cash flows of a firm are not adversely affected beyond a point. A profit centre approach on the other hand is a more aggressive approach where the firm decides to generate a net profit on its exposure over time.

• Hedging: Based on the limits a firm set for itself to manage exposure, the firms then decides an appropriate hedging strategy. There are various financial instruments available for the firm to choose from: futures, forwards, options and swaps and issue of foreign debt. Hedging strategies and instruments are explored in a section.

• Stop Loss: The firms risk management decisions are based on forecasts which are but estimates of reasonably unpredictable trends. It is imperative to have stop loss arrangements in order to rescue the firm if the forecasts turn out wrong. For this, there should be certain monitoring systems in place to detect critical levels in the foreign exchange rates for appropriate measure to be taken.

• Reporting and Review: Risk management policies are typically subjected to review based on periodic reporting. The reports mainly include profit/ loss status on open contracts after marking to market, the actual exchange/ interest rate achieved on each exposure and profitability vis-à-vis the benchmark and the expected changes in overall exposure due to forecasted exchange/ interest rate movements. The review analyses whether the benchmarks set are valid and effective in controlling the exposures, what the market trends are and finally whether the overall strategy is working or needs change.


14. Hedging Strategies/ Instruments

A derivative is a financial contract whose value is derived from the value of some other financial asset, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an index of prices. The main role of derivatives is that they reallocate risk among financial market participants, help to make financial markets more complete. This section outlines the hedging strategies using derivatives with foreign exchange being the only risk assumed.

14.1 Forwards:

A forward is a made-to-measure agreement between two parties to buy/sell a specified amount of a currency at a specified rate on a particular date in the future. The depreciation of the receivable currency is hedged against by selling a


currency forward. If the risk is that of a currency appreciation (if the firm has to buy that currency in future say for import), it can hedge by buying the currency forward. e.g. if RIL wants to buy crude oil in US dollars six months hence, it can enter into a forward contract to pay INR and buy USD and lock in a fixed exchange rate for INR-USD to be paid after 6 months regardless of the actual INR-Dollar rate at the time. In this example the downside is an appreciation of Dollar which is protected by a fixed forward contract. The main advantage of a forward is that it can be tailored to the specific needs of the firm and an exact hedge can be obtained. On the downside, these contracts are not marketable, they can’t be sold to another party when they are no longer required and are binding.

In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.

The price of the underlying instrument, in whatever form, is paid before control of the instrument changes. This is one of the many forms of buy/sell orders where the time of trade is not the time where the securities themselves are exchanged.

The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands on the spot date. The difference between the spot and the forward price is the forward premium or forward discount, generally considered in the form of a profit, or loss, by the purchasing party.

Forwards, like other derivative securities, can be used to hedge risk (typically currency or exchange rate risk), as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is time-sensitive.

A closely related contract is a futures contract; they differ in certain respects. Forward contracts are very similar to futures contracts, except they are not exchange traded, or defined on standardized assets. Forwards also typically have no interim partial settlements or "true-ups" in margin requirements like futures - such that the parties do not exchange additional property securing the party at gain and the entire unrealized gain or loss builds up while the contract is open. However, being traded OTC; forward contracts specification can be customized and may include mark-to-market and daily margining. Hence, a forward contract arrangement might call for the loss party to pledge collateral or additional collateral to better secure the party at gain


14.1.1 How a forward contract works

Suppose that Bob wants to buy a house a year from now. At the same time, suppose that Andy currently owns a $100,000 house that he wishes to sell a year from now. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year's time of $104,000 (more below on why the sale price should be this amount). Andy and Bob have entered into a forward contract. Bob, because he is buying the underlying, is said to have entered a long forward contract. Conversely, Andy will have the short forward contract.

At the end of one year, suppose that the current market valuation of Andy's house is $110,000. Then, because Andy is obliged to sell to Bob for only $104,000, Bob will make a profit of $6,000. To see why this is so, one need only to recognize that Bob can buy from Andy for $104,000 and immediately sells to the market for $110,000. Bob has made the difference in profit. In contrast, Andy has made a potential loss of $6,000, and an actual profit of $4,000.

The similar situation works among currency forwards, where one party opens a forward contract to buy or sell a currency (ex. a contract to buy Canadian dollars) to expire/settle at a future date, as they do not wish to be exposed to exchange rate/currency risk over a period of time. As the exchange rate between U.S. dollars and Canadian dollars fluctuates between the trade date and the earlier of the date at which the contract is closed or the expiration date, one party gains and the counterparty loses as one currency strengthens against the other. Sometimes, the buy forward is opened because the investor will actually need Canadian dollars at a future date such as to pay a debt owed that is denominated in Canadian dollars. Other times, the party opening a forward does so, not because they need Canadian dollars nor because they are hedging currency risk, but because they are speculating on the currency, expecting the exchange rate to move favorably to generate a gain on closing the contract.

In a currency forward, the notional amounts of currencies are specified (ex: a contract to buy $100 million Canadian dollars equivalent to, say $114.4 million USD at the current rate—these two amounts are called the notional amount(s)). While the notional amount or reference amount may be a large number, the cost or margin requirement to command or open such a contract is considerably less than that amount, which refers to the leverage created, which is typical in derivative contracts.

14.1.2 Example of how forward prices should be agreed upon

Continuing on the example above, suppose now that the initial price of Andy's house is $100,000 and that Bob enters into a forward contract to buy the house one year from today. But since Andy knows that he can immediately sell for $100,000 and place the proceeds in the bank, he wants to be compensated for the delayed sale. Suppose that the risk free rate of return R (the bank rate) for one year is 4%. Then the money in the bank would grow to $104,000, risk free. So


Andy would want at least $104,000 one year from now for the contract to be worthwhile for him - the opportunity cost will be covered.

14.1.3 Spot - Forward parity

Spot-forward parity provides the link between the spot market and the forward market. It describes the relationship between the spot and forward price of the underlying asset in a forward contract. While the overall effect can be described as the cost of carry, this effect can be broken down into different components, specifically whether the asset:

• pays income, and if so whether this is on a discrete or continuous basis • incurs storage costs • is regarded as o an investment asset, i.e. an asset held primarily for investment purposes (e.g. gold,

financial securities); o A consumption asset, i.e. an asset held primarily for consumption (e.g. oil, iron

ore etc.)

14.2 Futures:

A futures contract is similar to the forward contract but is more liquid because it is traded in an organized exchange i.e. the futures market. Depreciation of a currency can be hedged by selling futures and appreciation can be hedged by buying futures. Advantages of futures are that there is a central market for futures which eliminates the problem of double coincidence. Futures require a small initial outlay (a proportion of the value of the future) with which significant amounts of money can be gained or lost with the actual forwards price fluctuations. This provides a sort of leverage. The previous example for a forward contract for RIL applies here also just that RIL will have to go to a USD futures exchange to purchase standardized dollar futures equal to the amount to be hedged as the risk is that of appreciation of the dollar. As mentioned earlier, the tailor ability of the futures contract is limited i.e. only standard denominations of money can be bought instead of the exact amounts that are bought in forward contracts. A currency future, also FX future or foreign exchange future, is a futures contract to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date; see Foreign exchange derivative. Typically, one of the currencies is the US dollar. The price of a future is then in terms of US dollars per unit of other currency. This can be different from the standard way of quoting in the spot foreign exchange markets. The trade unit of each contract is then a certain amount of other currency, for instance €125,000. Most contracts have physical delivery, so for those held at the end of the last trading day, actual payments are made in each currency. However, most


contracts are closed out before that. Investors can close out the contract at any time prior to the contract's delivery date.

14.2.1 Uses

14.2.1.1 Hedging

Investors use these futures contracts to hedge against foreign exchange risk. If an investor will receive a cash flow denominated in a foreign currency on some future date, that investor can lock in the current exchange rate by entering into an offsetting currency futures position that expires on the date of the cash flow.

For example, Jane is a US-based investor who will receive €1,000,000 on December 1. The current exchange rate implied by the futures is $1.2/€. She can lock in this exchange rate by selling €1,000,000 worth of futures contracts expiring on December 1. That way, she is guaranteed an exchange rate of $1.2/€ regardless of exchange rate fluctuations in the meantime.

14.2.1.2 Speculation

Currency futures can also be used to speculate and, by incurring a risk, attempt to profit from rising or falling exchange rates.

For example, Peter buys 10 September CME Euro FX Futures, at $1.2713/€. At the end of the day, the futures close at $1.2784/€. The change in price is $0.0071/€. As each contract is over €125,000, and he has 10 contracts, his profit is $8,875. As with any future, this is paid to him immediately. Edit: Quoting for FX Futures at CME is in €/$ not $/€!

More generally, each change of $0.0001/€ (the minimum Commodity tick size), is a profit or loss of $12.50 per contract.}}

14.3 Options:

A currency Option is a contract giving the right, not the obligation, to buy or sell a specific quantity of one foreign currency in exchange for another at a fixed price; called the Exercise Price or Strike Price. The fixed nature of the exercise price reduces the uncertainty of exchange rate changes and limits the losses of open currency positions. Options are particularly suited as a hedging tool for contingent cash flows, as is the case in bidding processes. Call Options are used if the risk is an upward trend in price (of the currency), while Put Options are used if the risk is a downward trend. Again taking the example of RIL which needs to purchase crude oil in USD in 6 months, if RIL buys a Call option (as the risk is an upward trend in dollar rate), i.e. the right to buy a specified amount of dollars at a fixed rate on a specified date, there are two scenarios. If the exchange rate movement is favorable i.e. the dollar depreciates, then RIL can buy them at the spot rate as they have become cheaper. In the other case, if the dollar appreciates compared to today’s spot rate, RIL can exercise the option to purchase it at the agreed strike price. In either case RIL benefits by paying the lower price to purchase the dollar


Generally in thinking about options, one assumes that one is buying an asset: for instance, you can have a call option on oil, which allows you to buy oil at a given price. One can consider this situation more symmetrically in FX, where one exchanges: a put on GBPUSD allows one to exchange GBP for USD: it is at once a put on GBP and a call on USD.

As a vivid example: people usually consider that in a fast food restaurant, one buys hamburgers and pays in dollars, but one can instead say that the restaurant buys dollars and pays in hamburgers.

There are a number of subtleties that follow from this symmetry.

Hedging with FX options

Corporations primarily use FX options to hedge uncertain future cash flows in a foreign currency. The general rule is to hedge certain foreign currency cash flows with forwards, and uncertain foreign cash flows with options.

Suppose a United Kingdom manufacturing firm is expecting to be paid US$100,000 for a piece of engineering equipment to be delivered in 90 days. If the GBP strengthens against the US$ over the next 90 days the UK firm will lose money, as it will receive less GBP when the US$100,000 is converted into GBP. However, if the GBP weaken against the US$, then the UK firm will gain additional money: the firm is exposed to FX risk. Assuming that the cash flow is certain, the firm can enter into a forward contract to deliver the US$100,000 in 90 days time, in exchange for GBP at the current forward rate. This forward contract is free, and, presuming the expected cash arrives, exactly matches the firm's exposure, perfectly hedging their FX risk.

If the cash flow is uncertain, the firm will likely want to use options: if the firm enters a forward FX contract and the expected USD cash is not received, then the forward, instead of hedging, exposes the firm to FX risk in the opposite direction.

Using options, the UK firm can purchase a GBP call/USD put option (the right to sell part or all of their expected income for pounds sterling at a predetermined rate), which will:

• protect the GBP value that the firm will receive in 90 day's time (presuming the cash is received)

• cost at most the option premium (unlike a forward, which can have unlimited losses)

• yield a profit if the expected cash is not received but FX rates move in its favor

14.3.3 Hedging using Options

A currency option may be defined as a contract between two parties – a buyer and a seller - whereby the buyer of the option has the right but not the obligation, to buy or sell a specified currency at a specified exchange rate, at or before a specified date, from the seller of the option. While the buyer of option enjoys a


right but not obligation, the seller of the option nevertheless has an obligation in the event the buyer exercises the given right. There are two types of options:

• Call options – gives the buyer the right to buy a specified currency at a specified exchange rate, at or before a specified date.

• Put options – gives the buyer the right to sell a specified currency at a specified exchange rate, at or before a specified date. Of course the seller of the option needs to be compensated for giving such a right. The compensation is called the price or the premium of the option. Since the seller of the option is being compensated with the premium for giving the right, the seller thus has an obligation in the event the right is exercised by the buyer. In hedging using options, calls are used if the risk is an upward trend in price and puts are used if the risk in a downward trend in price. In our Bumiways example, since the risk is a depreciation of Rupees, Bumiways would need to buy put options on Rupees. If Rupees were to actually depreciate by the time Bumiways receives its Rupee revenue then Bumiways would exercise its right and exchange its Rupees at the higher exercise rate. If however Rupees were to appreciate instead, Bumiways would just let the contract expire and exchange its Rupees in the spot market for the higher exchange rate. Therefore the options market allows traders to enjoy unlimited favorable movements while limiting losses. This feature is unique to options, unlike the forward or futures contracts where the trader has to forego favorable movements and there is also no limit to losses. Options are particularly suited as a hedging tool for contingent cash flows, for example like in bidding processes. When a firm bids for a project overseas, which involves foreign exchange risk, it may quote its bidding price and at the same time protect itself from foreign exchange risk by buying put options. If the bidding was successful, the firm will be protected from a depreciation of the foreign currency. However, if the bidding was unsuccessful and the currency appreciated, then the firm may just let the contract expire. In this case the firm loses the premium paid, which is the maximum loss possible with options. If the bidding was unsuccessful and the currency depreciated, the firm may exercise its right and make some profits from this favorable movement. In the case of hedging with forward or futures, the firm would be automatically placed in a speculative position in the event of an unsuccessful bid, without a limit to its downside losses.


Possible Cash Flow Outcomes of Hedging using Options

Rupee Depreciates to RM0.05 Rupee Appreciates to RM0.20

Bid Won

Exchange the 10,101,010 Rupees @RM0.05 = RM505,050.50 Plus profit from options 6 x 2,000,000 x (RM0.10-RM0.05) = RM600,000 Less cost of hedging = RM12,000 Net Cash flow = RM1,093,050 (which guarantees the minimum revenue of RM1,000,000)

Exchange the 10,101,010 Rupees @RM0.20 = RM2,020,202 Puts options not worth exercising, therefore let them just expire. Less cost of hedging = RM12,000 Net Cash flow = RM2,008,202 (In this case the option allows Bumiways to enjoy a favorable movement)

Bid Lost

In this case Bumiways would not receive the bid amount. But however it could still exercise its rights and realize its profit from puts. Profit from options 6 x 2,000,000 x RM0.05 = RM600,000 Less cost of hedging = RM12,000 Net Cash flow = RM578,000

This is the worst case that can happen. Bid lost and also the put option position ends up being not profitable. Bumiways loses the premium paid = RM12,000. This is the maximum loss possible.

The above example illustrates how options can be used to guarantee a minimum cash flow on contingent claims. In case the bid is won, a minimum cash flow of RM 1,000,000 is guaranteed while allowing one to still enjoy a favorable movement if it does take place. If the bid is lost, the maximum loss possible is the premium paid. The options market is simply an organized insurance market. One pays a premium to protect oneself from potential losses while allowing one to enjoy potential benefits. For example when one buys car insurance, one pays its premium. If the car gets into an accident one gets compensated by the insurance company for the losses incurred. However if no accident happens, one loses the premium paid. If no accident happens but the car value appreciates in the second hand market, then one gets to enjoy the upward trend in price. An options market plays a similar role. In the case of options however the seller of an option plays the role of the insurance company. Advantages and Disadvantages of Hedging using Options The advantages of options over forwards and futures are basically the limited downside risk and the flexibility and variety of strategies possible. Also in options there is neither initial margin nor daily variation margin since the position is not marked to market. This could potentially provide significant cash flow relief to traders.


Because options are much more flexible compared to forward or futures, they are thus more expensive. The price is therefore a disadvantage.

14.4 Swaps:

A swap is a foreign currency contract whereby the buyer and seller exchange equal initial principal amounts of two different currencies at the spot rate. The buyer and seller exchange fixed or floating rate interest payments in their respective swapped currencies over the term of the contract. At maturity, the principal amount is effectively re-swapped at a predetermined exchange rate so that the parties end up with their original currencies. The advantages of swaps are that firms with limited appetite for exchange rate risk may move to a partially or completely hedged position through the mechanism of foreign currency swaps, while leaving the underlying borrowing intact. Apart from covering the exchange rate risk, swaps also allow firms to hedge the floating interest rate risk. Consider an export oriented company that has entered into a swap for a notional principal of USD 1 mn at an exchange rate of 42/dollar. The company pays US 6months LIBOR to the bank and receives 11.00% p.a. every 6 months on 1st January & 1st July, till 5 years. Such a company would have earnings in Dollars and can use the same to pay interest for this kind of borrowing (in dollars rather than in Rupee) thus hedging its exposures. In finance, a forex swap (or FX swap) is a simultaneous purchase and sale of identical amounts of one currency for another with two different value dates (normally spot to forward).

A forex swap consists of two legs:

• a spot foreign exchange transaction, and • a forward foreign exchange transaction.

These two legs are executed simultaneously for the same quantity, and therefore offset each other.

It is also common to trade forward-forward, where both transactions are for (different) forward dates.

14.4.1 Currency swap

A currency swap is a foreign-exchange agreement between two parties to exchange aspects (namely the principal and/or interest payments) of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency; see Foreign exchange derivative. Currency swaps are motivated by comparative advantage. A currency swap should be distinguished from a central bank liquidity swap.

Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps. However, unlike interest rate swaps, currency swaps can involve the exchange of the principal.


There are three different ways in which currency swaps can exchange loans:

The most simple currency swap structure is to exchange the principal only with the counterparty, at a rate agreed now, at some specified point in the future. Such an agreement performs a function equivalent to a forward contract or futures. The cost of finding a counterparty (either directly or through an intermediary), and drawing up an agreement with them, makes swaps more expensive than alternative derivatives (and thus rarely used) as a method to fix shorter term forward exchange rates. However for the longer term future, commonly up to 10 years, where spreads are wider for alternative derivatives, principal-only currency swaps are often used as a cost-effective way to fix forward rates. This type of currency swap is also known as an FX-swap.

Another currency swap structure is to combine the exchange of loan principal, as above, with an interest rate swap. In such a swap, interest cash flows are not netted before they are paid to the counterparty (as they would be in a vanilla interest rate swap) because they are denominated in different currencies. As each party effectively borrows on the other's behalf, this type of swap is also known as a back-to-back loan.

Last here, but certainly not least important, is to swap only interest payment cash flows on loans of the same size and term. Again, as this is a currency swap, the exchanged cash flows are in different denominations and so are not netted. An example of such a swap is the exchange of fixed-rate US Dollar interest payments for floating-rate interest payments in Euro. This type of swap is also known as a cross-currency interest rate swap, or cross-currency swap.

Currency swaps have two main uses:

• To secure cheaper debt (by borrowing at the best available rate regardless of currency and then swapping for debt in desired currency using a back-to-back-loan).

• To hedge against (reduce exposure to) exchange rate fluctuations.

14.4.2 Interest rate swap

An interest rate swap is a derivative in which one party exchanges a stream of interest payments for another party's stream of cash flows. Interest rate swaps can be used by hedgers to manage their fixed or floating assets and liabilities. They can also be used by speculators to replicate unfunded bond exposures to profit from changes in interest rates. Interest rate swaps are very popular and highly liquid instruments.

Structure

In an interest rate swap, each counter party agrees to pay either a fixed or floating rate denominated in a particular currency to the other counterparty. The fixed or floating rate is multiplied by a notional principal amount (say, USD 1 million). This notional amount is generally not exchanged between counterparties, but is used only for calculating the size of cash flows to be exchanged.


Being OTC instruments interest rate swaps can come in a huge number of varieties and can be structured to meet the specific needs of the counterparties. By far the most common are fixed-for-floating, fixed-for-fixed or floating-for-floating. The legs of the swap can be in the same currency or in different currencies. (A single-currency fixed-for-fixed rate swap is generally not possible; since the entire cash-flow stream can be predicted at the outset there would be no reason to maintain a swap contract as the two parties could just settle for the difference between the present values of the two fixed streams; the only exceptions would be where the notional amount on one leg is uncertain or other esoteric uncertainty is introduced).

A number of other variations are possible, although far less common. Mostly tweaks are made to ensure that a bond is hedged "perfectly", so that all the interest payments received are exactly offset by the swap. This can lead to swaps where principal is paid on one or more legs, rather than just interest (for example to hedge a coupon strip), or where the balance of the swap is automatically adjusted to match that of a prepaying bond (such as RMBS Residential mortgage-backed security).

Interest rate swaps were originally created to allow multi-national companies to evade exchange controls. Today, interest rate swaps are used to hedge against or speculate on changes in interest rates.

Interest rate swaps are also very popular due to the arbitrage opportunities they provide. Due to varying levels of creditworthiness in companies, there is often a positive quality spread differential which allows both parties to benefit from an interest rate swap.

The interest rate swap market is closely linked to the Eurodollar futures market which trades at the Chicago Mercantile Exchange.

Interest rate swaps expose users to interest rate risk and credit risk.

• Interest rate risk originates from changes in the floating rate. In a plain vanilla fixed-for-floating swap, the party who pays the floating rate benefits when rates fall. (Note that the party that pays floating has an interest rate exposure analogous to a long bond position.)

• Credit risk on the swap comes into play if the swap is in the money or not. If one of the parties is in the money, then that party faces credit risk of possible default by another party.

14.4.3 Overnight Index Swap

An overnight indexed swap (OIS) is an interest rate swap where the periodic floating rate of the swap is equal to the geometric average of an overnight index (i.e., a published interest rate) over every day of the payment period. The index is


typically an interest rate considered less risky than the corresponding interbank rate (LIBOR).

In the United States, OIS rates are calculated by reference to daily Fed funds rates.

OIS rates (or, in particular, the difference or "spread" between OIS rates and LIBOR) are an important measure of risk and liquidity in the money market, considered by many, including former US Federal Reserve chairman Alan Greenspan, to be a strong indicator for the relative stress in the money markets. A higher spread is typically interpreted as indication of a decreased willingness to lend by major banks, while a lower spread indicates higher liquidity in the market. As such, the spread can be viewed as indication of banks' perception of the creditworthiness of other financial institutions and the general availability of funds for lending purposes.

The LIBOR-OIS spread has historically hovered around 10 basis points. However, in the midst of the financial crisis of 2007–2010, the spread spiked to an all-time high of 364 basis points in October 2008, indicating a severe credit crunch. Since that time the spread has declined erratically but substantially, dropping below 100 basis points in mid-January 2009 and returning to 10-15 basis points by September 2009

14.5 Foreign Debt:

Foreign debt can be used to hedge foreign exchange exposure by taking advantage of the International Fischer Effect relationship. This is demonstrated with the example of an exporter who has to receive a fixed amount of dollars in a few months from present. The exporter stands to lose if the domestic currency appreciates against that currency in the meanwhile so, to hedge this; he could take a loan in the foreign currency for the same time period and convert the same into domestic currency at the current exchange rate. The theory assures that the gain realized by investing the proceeds from the loan would match the interest rate payment (in the foreign currency) for the loan. Forwards futures Options

COST Initial Margin/ Deposit No Yes No Variation Margin No Yes No

Need for speculators to assume the risks that hedgers seek to avoid No Yes Yes forego favorable movements Yes Yes No


Speculation Yes Yes Yes Arbitrage Yes Yes Yes Barter problems Yes No No Transaction Cost/Brokerage fee Yes Yes Yes

BENEFITS Diversification Benefits No No No Liquid market No Yes Yes

Can hedge any currency

Yes. Counter party may be difficult to find No No

Legal obligation Yes Yes No Choice of hedging instruments Currency swaps are more cost-effective for hedging foreign debt risk, while forward contracts are more cost-effective for hedging foreign operations risk. This is because foreign currency debt payments are long-term and predictable, which fits the long-term nature of currency swap contracts. Foreign currency revenues, on the other hand, are short-term and unpredictable, in line with the short-term nature of forward contracts. A survey done by Marshall (2000) also points out that currency swaps are better for hedging against translation risk, while forwards are better for hedging against transaction risk. This study also provides anecdotal evidence that pricing policy is the most popular means of hedging economic exposures. These results however can differ for different currencies depending in the sensitivity of that currency to various market factors. Regulation in the foreign exchange markets of various countries may also skew such results.

15. Determinants of Hedging Decisions

The management of foreign exchange risk, as has been established so far, is a fairly complicated process. A firm, exposed to foreign exchange risk, needs to formulate a strategy to manage it, choosing from multiple alternatives. This section explores what factors firms take into consideration when formulating these strategies. Production and Trade vs. Hedging Decisions An important issue for multinational firms is the allocation of capital among different countries production and sales and at the same time hedging their exposure to the varying exchange rates. Research in this area suggests that the elements of exchange rate uncertainty and the attitude toward risk are irrelevant to the multinational firm's sales and production decisions (Broll,1993). Only the revenue function and cost of production are to be assessed, and, the production


and trade decisions in multiple countries are independent of the hedging decision. The implication of this independence is that the presence of markets for hedging instruments greatly reduces the complexity involved in a firm’s decision making as it can separate production and sales functions from the finance function. The firm avoids the need to form expectations about future exchange rates and formulation of risk preferences which entails high information costs.

Cost of Hedging

Hedging can be done through the derivatives market or through money markets (foreign debt). In either case the cost of hedging should be the difference between value received from a hedged position and the value received if the firm did not hedge. In the presence of efficient markets, the cost of hedging in the forward market is the difference between the future spot rate and current forward rate plus any transactions cost associated with the forward contract. Similarly, the expected costs of hedging in the money market are the transactions cost plus the difference between the interest rate differential and the expected value of the difference between the current and future spot rates. In efficient markets, both types of hedging should produce similar results at the same costs, because interest rates and forward and spot exchange rates are determined simultaneously. The costs of hedging, assuming efficiency in foreign exchange markets result in pure transaction costs. The three main elements of these transaction costs are brokerage or service fees charged by dealers, information costs such as subscription to Reuter reports and news channels and administrative costs of exposure management. Factors affecting the decision to hedge foreign currency risk Research in the area of determinants of hedging separates the decision of a firm to hedge from that of how much to hedge. There is conclusive evidence to suggest that firms with larger size, R&D expenditure and exposure to exchange rates through foreign sales and foreign trade are more likely to use derivatives. (Allayanis and Ofek,2001) First, the following section describes the factors that affect the decision to hedge and then the factors affecting the degree of hedging are considered.

• Firm size: Firm size acts as a proxy for the cost of hedging or economies of scale. Risk management involves fixed costs of setting up of computer systems and training/hiring of personnel in foreign exchange management. Moreover, large firms might be considered as more creditworthy counterparties for forward or swap transactions, thus further reducing their cost of hedging. The book value of assets is used as a measure of firm size.

• Leverage: According to the risk management literature, firms with high leverage have greater incentive to engage in hedging because doing so reduces the probability, and thus the expected cost of financial distress. Highly levered firms avoid foreign debt as a means to hedge and use derivatives.


• Liquidity and profitability: Firms with highly liquid assets or high profitability

have less incentive to engage in hedging because they are exposed to a lower probability of financial distress. Liquidity is measured by the quick ratio, i.e. quick assets divided by current liabilities). Profitability is measured as EBIT divided by book assets.

• Sales growth: Sales growth is a factor determining decision to hedge as opportunities are more likely to be affected by the underinvestment problem. For these firms, hedging will reduce the probability of having to rely on external financing, which is costly for information asymmetry reasons, and thus enable them to enjoy uninterrupted high growth. As regards the degree of hedging Allayanis and Ofek (2001) conclude that the sole determinants of the degree of hedging are exposure factors (foreign sales and trade). In other words, given that a firm decides to hedge, the decision of how much to hedge is affected solely by its exposure to foreign currency movements. This discussion highlights how risk management systems have to be altered according to characteristics of the firm, hedging costs, nature of operations, tax considerations, regulatory requirements etc. The next section discusses these issues in the Indian context and regulatory environment.

16. An Overview of Corporate Hedging in India

The move from a fixed exchange rate system to a market determined one as well as the development of derivatives markets in India have followed with the liberalization of the economy since 1992. In this context, the market for hedging instruments is still in its developing stages. In order to understand the alternative hedging strategies that Indian firms can adopt, it is important to understand the regulatory framework for the use of derivatives here.

16.1 Development of Derivative Markets in India

The economic liberalization of the early nineties facilitated the introduction of derivatives based on interest rates and foreign exchange. Exchange rates were deregulated and market determined in 1993. By 1994, the rupee was made fully convertible on current account. The ban on futures trading of many commodities was lifted starting in the early 2000s. As of October 2007, even corporate have been allowed to write options in the atmosphere of high volatility. Derivatives on stock indexes and individual stocks have grown rapidly since inception. In particular, single stock futures have become hugely popular. Institutional investors prefer to trade in the Over-The-Counter (OTC) markets to interest rate futures, where instruments such as interest rate swaps and forward rate agreements are thriving. Foreign exchange derivatives are less active than interest rate derivatives in India, even though they have been around for longer. OTC instruments in currency forwards and swaps are the most popular. Importers,


exporters and banks use the rupee forward market to hedge their foreign currency exposure. Turnover and liquidity in this market has been increasing, although trading is mainly in shorter maturity contracts of one year or less. The typical forward contract is for one month, three months, or six months, with three months being the most common. The Indian rupee, which is being traded on the Dubai Gold and Commodities Exchange (DGCX), crossed a turnover of $23.24 million in June 2007.

16.2 Regulatory Guidelines for the use of Foreign Exchange

Derivatives

With respect to foreign exchange derivatives involving rupee, residents have access to foreign exchange forward contracts, foreign currency-rupee swap instruments and currency options – both cross currency as well as foreign currency-rupee. In the case of derivatives involving only foreign currency, a range of products such as Interest Rate Swaps, Forward Contracts and Options are allowed. While these products can be used for a variety of purposes, the fundamental requirement is the existence of an underlying exposure to foreign exchange risk i.e. derivatives can be used for hedging purposes only. The RBI has also formulated guidelines to simplify procedural/documentation requirements for Small and Medium Enterprises (SME) sector. In order to ensure that SMEs understand the risks of these products, only banks with which they have credit relationship are allowed to offer such facilities. These facilities should also have some relationship with the turnover of the entity. Similarly, individuals have been permitted to hedge up to USD 100,000 on self declaration basis. Authorized Dealer (AD) banks may also enter into forward contracts with residents in respect of transactions denominated in foreign currency but settled in Indian Rupees including hedging the currency indexed exposure of importers in respect of customs duty payable on imports and price risks on commodities with a few exceptions. Domestic producers/users are allowed to hedge their price risk on aluminum, copper, lead, nickel and zinc as well as aviation turbine fuel in international commodity exchanges based on their underlying economic exposures. Authorized dealers are permitted to use innovative products like cross-currency options; interest rate swaps (IRS) and currency swaps, caps/collars and forward rate agreements (FRAs) in the international foreign exchange market. Foreign Institutional Investors (FII), person’s resident outside India having Foreign Direct Investment (FDI) in India and Nonresident Indians (NRI) is allowed access to the forwards market to the extent of their exposure in the cash market.

16.3 Analysis of last 4 years currency movement:


The recent period has witnessed amplified volatility in the INR-US exchange rates in the backdrop of the sub-prime crisis in the US and increased dollar-inflows into the Indian stock markets. For the purpose of analyzing which hedging instrument will suit the need of Indian organizations better data of last 4 years have been used. As per the results forwards are better than options in most of the cases.

1

month

2

month

3

month

4

month

5

month

6

month 1 year 2 year

forward 31 35 32 33 32 31 24 15

Options 16 11 13 11 11 11 12 9

The above result has been obtained by considering the end of month rupee/dollar value. But after calculating the standard deviation in case of forward and options it has been seen that the standard deviation in case of Option is quiet less. That means Option is more effective in mitigating the risk high volatility. Also on taking the average of the values it has been found that if a company is involved in hedging its forex risk on monthly or bi-monthly basis for those companies Option is a better hedging instrument. While is an organization goes for hedging forex risk for 3 to 6 months period on monthly basis for these organization forward is more effective hedging instrument.

FORWARDS(exporter)

Duration 1 month 2 month 3 month 4 month 5 month 6 month 1 year 2 year

SD 1.06417 1.772992 2.232811 2.58581 3.027273 3.609369 6.073091 4.054013

average 0.11234 0.203696 0.281333 0.357045 0.412093 0.44881 0.183333 -2.9075

35

40

45

50

55

5/5

/20

10

4/3

/20

10

5/1

/20

10

9/1

1/2

00

9

4/9

/20

09

10

/7/2

00

9

18

/05

/20

09

12

/3/2

00

9

9/1

/20

09

10

/11

/20

08

8/9

/20

08

10

/7/2

00

8

15

/05

/20

08

12

/3/2

00

8

16

/01

/20

08

20

/11

/20

07

24

/09

/20

07

27

/07

/20

07

4/6

/20

07

5/4

/20

07

5/2

/20

07

5/1

2/2

00

6

9/1

0/2

00

6

11

/8/2

00

6

19

/06

/20

06

Ru

pe

e p

er

Do

lla

r

Currency movement

Series1


OPTIONS


SD 0.744974 1.239559 1.469036 1.516969 1.70461 1.998449 2.827656 2.023584

average 0.252979 0.255435 0.164222 0.071591 -0.02674 -0.03024 -0.66 -6.26667

Unhedged


SD 1.06417 1.772992 2.232811 2.58581 3.027273 3.609369 6.073091 4.054013

average -0.04234 -0.0637 -0.07133 -0.07705 -0.06209 -0.02881 0.656667 4.5875

16.4 Hedging Instruments for Indian Firms

The recent period has witnessed amplified volatility in the INR-US exchange rates in the backdrop of the sub-prime crisis in the US and increased dollar-inflows into the Indian stock markets. In this context, the paper has attempted to study the choice of instruments adopted by prominent firms to stem their foreign exchange exposures. All the data for this has been compiled from the 2006-2007 Annual Reports of the respective companies. A summary of the foreign exchange risk hedging behavior of select Indian firms is given in Table 1.

Infosys Derivative foreign currency (in millions) INR (crores) forward contract $245 1243 € 20.00 135 £15.00 109 option contract range barrier $113 573 seagull option $60 304

TCS Derivative foreign currency (in millions) INR (crores) forward contract $153.50 775.71 Option $907.60 4586.528464 £4.00 29.07 € 5.00 33.75

WIPRO Category Amount (in millions) Buy/Sell Forward contracts $1,374 Sell € 79 Sell £ 53 Sell $438 Buy ¥ 23,170 Buy


Options $562 Sell £ 54 Sell ¥ 6,130 Sell Cross-currency interest rate swap ¥ 35,016 -

Category Currency Cross Currency Amount (in millions) Forward contracts USD INR USD 20.00 Forward contracts EUR USD USD 1.44 Currency options USD INR USD 1038.5 Currency Swaps JPY USD JPY 10,350.00

Interest rate swap (JPY LIBOR) JPY JPY 11,800.00

Category Currency Cross Currency Amount (in millions) amount in INR Forward Contract USD INR US $ 118.94 603.08 Forward Contract USD INR US $ 569.82 2285.98 Forward Contract EURO USD 10.75 68.16 Interest swap US $ 5.00 20.06 OPTION US JPY US $ 99.69 505.49 US JPY US $ 99.69 399.94 USD INR US $ 10.00 50.71 USD INR US $ 90.00 361.06 EURO USD 13 82.43 USD CHF US $ 10.00 50.71 USD CHF US $ 10.00 40.12

TVS Category Currency Currency swaps $100 Interest rate structure $100

Bajaj Auto

Category Currency Cross Currency Amount (in millions) Buy/Sell forward contract USD INR 21 sell

Category Currency Cross Currency Amount (in millions) Forward Contract USD INR 67 Forward Contract USD INR 3 Forward Contract EURO USD 8

Forward Contract GBP USD 8


Option USD INR 537 sell spot sale contract USD INR 7.5 sell

IDEA

Particulars As at March 31, 2009 Foreign Currency Loan* Foreign Currency Loan in USD 30 Foreign Currency Loan in JPY 17,727.73 The Equivalent INR of Foreign Currency Loans 7,655.32

AIRTEL

Particular notional value for loan related exposures Forwards 58581419 Options 16087384 interest rate swaps 12572401 for trade related exposures Forwards 5347203 Options 534975

JSPL

Category USD(in millions) (Rs. in Crores) Interest rate Swaps 157.86 804.3 Options 57 290.42 Forward Contracts 226.77 1,155.39

TATA steel

USD(in millions) (Rs. in Crores) Interest rate swaps 636.11 3226.36 Forward contract short term 347.8 1764.02 long term 1967.17 9977.47

16.4 Discussion on Hedging by Indian Firms

From the above tables, it can be seen that earnings of all the firms are linked to either US dollar, Euro or Pound as firms transact primarily in these foreign currencies globally. Forward contracts are commonly used and among these firms, Ranbaxy depend heavily on these contracts for their hedging requirements. As discussed earlier, forwards contracts can be tailored to the exact needs of the firm and this could be the reason for their popularity. The tailor ability is a consideration as it enables the firms to match their exposures in an exact manner compared to exchange traded derivatives like futures that are standardized where exact matching is difficult.


Swap usage is a long term strategy for hedging and suggests that the planning horizons for these companies are longer than those of other firms. These businesses, by nature involve longer gestation periods and higher initial capital outlays and this could explain their long planning horizons. Another observation is that TCS prefers to hedge its exposure to the US Dollar through options rather than forwards. This strategy has been observed among many firms recently in India11. This has been adopted due to the marked high volatility of the US Dollar against the Rupee. Options are more profitable instruments in volatile conditions as they offer unlimited upside profitability while hedging the downside risk whereas there is a risk with forwards if the expectation of the exchange rate (the guess) is wrong as firms lose out on some profit. The use of Range barrier options by Infosys also suggests a strategy to tackle the high volatility of the dollar exchange rates. Software firms have a limited domestic market and rely on exports for the major part of their revenues and hence require additional flexibility in hedging when the volatility is high. Another implication of this is that their planning horizons are shorter compared to capital intensive firms. It is evident that most Indian firms use forwards and options to hedge their foreign currency exposure. This implies that these firms chose short-term measures to hedge as opposed to foreign debt. This preference is possibly a consequence of their costs being in Rupees, the absence of a Rupee futures exchange in India and curbs on foreign debt. It also follows that most of these firms behave like Net Exporters and are adversely affected by appreciation of the local currency. There are a few firms which have import liabilities which would be adversely affected by Rupee depreciation. However it must be pointed out that the data set considered for this study does not indicate how the use of foreign debt by these firms hedges their exposures to foreign exchange risk and whether such a strategy is used as a substitute or complement to hedging with derivatives.

17. Conclusion

Derivative use for hedging is only to increase due to the increased global linkages and volatile exchange rates. Firms need to look at instituting a sound risk management system and also need to formulate their hedging strategy that suits their specific firm characteristics and exposures. In India, regulation has been steadily eased and turnover and liquidity in the foreign currency derivative markets has increased, although the use is mainly in shorter maturity contracts of one year or less. Forward and option contracts are the more popular instruments. Regulators had initially only allowed certain banks to deal in this market however now corporate can also write option contracts. There are many variants of these derivatives which investment banks across the world specialize in, and as the


awareness and demand for these variants increases, RBI would have to revise regulations. For now, Indian companies are actively hedging their foreign exchanges risks with forwards, currency and interest rate swaps and different types of options such as call, put, cross currency and range-barrier options. The high use of forward contracts by Indian firms also highlights the absence of a rupee futures exchange in India. Currency swaps are more cost-effective for hedging foreign debt risk, while forward contracts are more cost-effective for hedging foreign operations risk. This is because foreign currency debt payments are long-term and predictable, which fits the long-term nature of currency swap contracts. Foreign currency revenues, on the other hand, are short-term and unpredictable, in line with the short-term nature of forward contracts. Forwards contracts can be tailored to the exact needs of the firm and this could be the reason for their popularity. This is a consideration as it enables the firms to match their exposures in an exact manner compared to exchange traded derivatives like futures that are standardized where exact matching is difficult. Swap usage is a long term strategy for hedging and suggests that the planning horizons for these companies are longer than those of other firms. These businesses, by nature involve longer gestation periods and higher initial capital outlays and this could explain their long planning horizons. Another observation is that TCS prefers to hedge its exposure to the US Dollar through options rather than forwards. This strategy has been observed among many firms recently in India. This has been adopted due to the marked high volatility of the US Dollar against the Rupee. Options are more profitable instruments in volatile conditions as they offer unlimited upside profitability while hedging the downside risk whereas there is a risk with forwards if the expectation of the exchange rate (the guess) is wrong as firms lose out on some profit. The use of Range barrier options by Infosys also suggests a strategy to tackle the high volatility of the dollar exchange rates. Software firms have a limited domestic market and rely on exports for the major part of their revenues and hence require additional flexibility in hedging when the volatility is high. Another implication of this is that their planning horizons are shorter compared to capital intensive firms. It is evident that most Indian firms use forwards and options to hedge their foreign currency exposure. This implies that these firms chose short-term measures to hedge as opposed to foreign debt. This preference is possibly a consequence of their costs being in Rupees, the absence of a Rupee futures exchange in India and curbs on foreign debt. It also follows that most of these firms


behave like Net Exporters and are adversely affected by appreciation of the local currency.

18. Limitation:

The limitation of this study is that only one type of risk is assumed i.e. the foreign exchange risk. Also applicability of conclusion is limited as only very few firms were reviewed over just one time period. However the results from this exploratory study are encouraging and interesting, leading us to conclude that there is scope for more rigorous study along these lines.

19. References: 1. Broll,Udo,1993, Foreign Production and International Hedging in a Multinational Firm, Open economies review 4: 425-432.

2. Allayannis, George and Ofek, Eli, 2001, Exchange rate exposure, hedging, and the use of foreign currency derivatives, Journal of International Money and Finance 20 (2001) 273–296 3. Judge, Amrit, Aug 2003, How Firms Hedge Foreign Currency Exposure: Foreign Currency Derivatives versus Foreign Currency Debt, available at http://www.mubs.mdx.ac.uk/Research/Discussion_Papers/Economics/DPAP%20 ECON%20NO.%20106.pdf (last accessed : March 2008) 4. Gambhir, Neeraj and Goel,Manoj, Foreign Exchange Derivatives Market in India - Status and Prospects, Available at: http://www.iief.com/Research/CHAP10.PDF 5. Soenen L.A and Madura, Jeff, 1991, Foreign Exchange Management :A Strategic Approach, , Long Range Planning, Vol. 24, NO. 5, pp. 119 to 124. 6. Asani Sarkar, 2006, Indian Derivative Markets from The Oxford Companion to Economics in India. Available at http://www.newyorkfed.org/research/economists/sarkar/derivatives_in_india.pdf 7. Meera, Ahamed Kameel Mydin,2004 Hedging Foreign Exchange Risk with Forwards, Futures, Options and the Gold Dinar: A Comparison Note available at: http://www.americanfinance.com/knowledge-center/articles/pdf/Malaysia%20-%20GOLD%20-%20Hedging%20With%20Dinar.pdf Books:

1. David F. DeRosa, Managing Forex Exchange Risk, McGraw-Hill Book Company Ltd, 1991.

2. A. R. Parindl, Foreign Exchange Risk, John Wiley & Sons, Ltd., 1981 3. K seethapathi, Foreign Exchange Risk, ICFAI University Press, 2005 4. Dominic Bennett, Managing Foreign Exchange Risk, Pearson Professional Ltd., 1997


5. A. V. Rajwade, Foreign Exchange International Finance & Risk Management, Academy of Business Studies, 1997 Web sites

� www.wikipedia.org � www.rbi.org.in � www.investopedia.com � www.forexsites.com

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