A Project report On Price risk management using currency futures for Greenback Forex Services Ltd. In partial fulfillment of the requirements of Masters of Management Studies conducted by University of Mumbai through Rizvi Institute of Management Studies and Research under the guidance of Prof. Vishal Singhi
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A
Project report
On
Price risk management using currency futures
for
Greenback Forex Services Ltd.
In partial fulfillment of the requirements of
Masters of Management Studies
conducted by
University of Mumbai
through
Rizvi Institute of Management Studies and Research
under the guidance of
Prof. Vishal Singhi
Submitted by
Kaynat Chainwala
MMS
Batch: 2011 – 2013
CERTIFICATE
This is to certify that Ms. Kaynat Chainwala, a student of Rizvi Management Institute, of MMS
III bearing Roll No. 32 and specializing in Finance has successfully completed the project titled
“Price risk management using currency futures”
under the guidance of Prof. Vishal Singhi in partial fulfillment of the requirement of Masters of
Management Studies by Rizvi Management Institutes for the academic year 2011 – 2013.
_______________
Prof. Vishal Singhi
Project Guide
_______________ ______________
Prof. Umar Farooq Dr. Kalim Khan
Academic Coordinator Director
ACKNOWLEDGEMENT
I would like to express my sincere gratitude towards thanking the following people:
Prof. Vishal Singhi, Internal Mentor, for supporting & guiding me through my summer
internship project.
I thank Dr. Kalim Khan, Director, Rizvi Institute of Management studies & Research, Mumbai,
for providing me the opportunity to have such a good experience of an internship project.
Finally, I am highly thankful to my parents, friends and my entire family, who have supported
me in this venture.
Kaynat Chainwala
Executive summary
The Indian rupee, that has weakened almost 25 per cent against the US dollar since the beginning
of the year 2012 is likely to remain volatile for some more time to come mainly due to
uncertainty in the domestic and global economic outlook. The partially convertible rupee got
battered in the month of June; 2012 and hit a record low of 56.80 against the dollar which was
almost 12 per cent down from the year's high of 50.57 recorded in March, 2012.
The rising oil import bill, increasing trade deficit, inflation, interest rates, capital outflows, slow
pace of Euro crisis which led to the recent depreciation of the Rupee especially post August 2011
have serious implications. The industry would be inhibited to go for capex due to cost escalations
as a result of import-led inflation, implied cost of borrowing in foreign currency. Exports will
become more competitive and demand should also benefit from a gradual, albeit very slow,
improvement in the global scenario. Simultaneously, the import bill of manufacturers will, or is
already rising. However, over time a realistic exchange rate should lend stability and
sustainability to economic performance.
The time has come for companies to use hedging as a well-planned ingredient and not continue
to use it as a short term strategic measure for risk management. Unlike the economic crisis of
2008 when oil prices crashed to aggravate the situation, the current volatility owed itself to
increasing demand for foreign exchange fuelled by domestic demand - for both internal like
import of gold and exports and the reluctance of the Reserve Bank of India to stem the runaway
depreciation of the rupee.
"Risk management has assumed underlined importance for the companies.”Risk
management strategies for hedging foreign exchange, interest rate and commodity price risks
have assumed an imperative adjunct of corporate strategy, more so in a globalised economic
structure.
TABLE OF CONTENTS:
RESEARCH OBJECTIVE 1
CURRENCY MARKETS
Current Status 2
Overview 5
Factors that affect currency rates 8
CURRENCY/FOREX RISK MANAGEMENT
Currency risks 10
FOREX Risk Management- Process and Necessity 13
Hedging Strategies 14
Derivatives Instruments traded in India 15
Business Growth in Currency Derivatives in India 20
CURRENCY FUTURES
Introduction 21
Rationale 23
Market players 26
Major exchanges 29
NSE
MCX-SX
USE
Trading and volumes 31
Major contracts traded on the exchange 32
Futures terminology 33
Product specification 35
Pricing futures
Cost of carry model 37
Hedging with currency futures 38
Currency futures payoffs 42
MANAGING CURRENCY RISK USING FUTURES
Using Purchasing Power Parity (PPP) 44
Using Interest Rate Parity (IRP) 45
Quantitative analysis
Open interest and volumes of contracts traded 46
Correlation between OI and volumes traded 47
Returns for the past year 48
Historical volatility 49
Research work 50
CONCLUSION 51
BIBLIOGRAPHY 52
Price risk management using currency futures
RESEARCH OBJECTIVE
The main objective of this study is to study risks and hedging techniques used to manage them.
A significant number of firms hedge their risk exposures, with wide variations in which risks get
hedged and the tools used for hedging. A significant number of firms hedge against risks, some
risks seem to be hedged more often than others.
In this report, we will look at the most widely hedged risks – Exchange rate risk.
The most widely hedged risk is Exchange rate risk because it not only affects the multinational
companies but also the domestic companies since their revenue are dependent on inputs from
foreign markets.
Derivatives have been used to manage risk for a very long time, but they were available only to a
few firms and at high cost, since they had to be customized for each user. The development of
options and futures markets in the 1970s and 1980s allowed for the standardization of derivative
products, thus allowing access to even individuals who wanted to hedge against specific risk.
The range of risks that are covered by derivatives grows each year, and there are very few
market-wide risks that you cannot hedge today using options or futures.
The introduction of currency futures in India has passed a journey of almost four years and many
changes have been implemented in the trading system in this regard. Currency futures have
significantly gained importance all over the world since the first currency futures contract was
traded in the year 1972. The futures market holds a great importance in the economy and,
therefore, it becomes imperative that we analyse this important market and seek answers to a few
basic questions. The main theme of this paper is to assess the speed in which the growth of
currency futures in India has accelerated. It also aims at examining the volatility of the currency
futures. In order to study the growth of the currency futures, the number of contracts traded and
open interest at NSE has been inclusively compared.
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“If you don’t invest in risk management, it doesn’t matter what business you’re in, it’s a risky
business.”
INDIAN CURRENCY MARKETS
CURRENT SCENARIO:
When India remained largely unaffected by the US sub-prime crisis of 2007-08 that snowballed
into a global financial crisis, it was praised for not being exposed to complex debt instruments.
That was perhaps a good thing then.
But four years later, the scenario has changed. Now, India is more integrated with the global
economy. Besides, the interest rate outlook has turned more volatile.
The rupee crossed historic 56.40 levels recently against the dollar and depreciated against other
major currencies. The volatility in rupee movements is only set to increase on account of a host
of external and domestic forces.
The importance of currency risk management — adopting new hedging methods and moving
beyond forward contracts — has increased in this scenario. Bungling on currency risk
management can adversely affect profits, sales, cost, revenue and competitiveness of companies
involved in international business
HEDGING ERRORS
Indian companies mainly use forward contract derivatives from their banks to hedge currency
exchange risk. Exchange-traded currency futures and options are yet to become popular, in spite
of the fact that these were introduced by RBI and SEBI to provide a transparent hedging system,
especially to small and medium scale units.
Indian companies went in for over-the-counter derivatives, duly encouraged by banks, only to
have their fingers burnt when the rupee rates moved against them.Such structures were
developed for speculation rather than for hedging, and now have been banned by RBI.
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Another area where currency risk has been mismanaged is foreign currency loans. Companies
have taken huge cheap dollar loans, which have turned expensive with steep depreciation of the
rupee.
PROSPECTS AHEAD
Foreign currency exposures must be divided into monthly, quarterly, half-yearly and yearly
basis. Short-term exposures up to, say, one month may be fully covered with forward contract
derivatives, and after that the strategy of partial hedging may be used to deal with volatility in the
dollar-rupee rate.
The concept of stop loss, to follow market trends for hedging, should now be used seriously.
Option and futures exchange traded derivatives, which have transparency and offsetting
characteristics, may be used when rupee volatility against the dollar increases.
Such flexibilities are not available in the case of hedging by forward contracts. Futures can also
be used to correct the forward contract hedge at low cost and effort. Importers may remain
hedged using forward derivatives contract for short and medium-term committed exposures.
Hedging with forex derivatives may create situations for marked-to-market losses. Indian
corporates should give serious attention to operational hedging techniques, especially for very
long term exposures in foreign currencies.
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GLOBAL SITUATION
Global and local macro economic factors, and risk avoidance by forex dealers, have created a
huge demand for the dollar. The global factors that have led to a strong dollar worldwide are: the
Euro debt crisis; financial uncertainty in France and Germany, the flagship Euro zone
economies; downgrading of Japan due to its high levels of debt; high oil and commodity prices;
and overall negative global sentiments. Added to these are local factors, such as a negative trade
deficit, high inflation, indifferent FII/FDI investments, growth slowdown, burgeoning fiscal
deficit, ratings downgrade, and paralysis in policymaking — all of which have led to rupee
depreciation against the dollar. But present trend of the declining rupee can be converted into big
opportunity, particularly by expanding exports in new international markets. Currency risk
management will play a crucial role in translating this potential into reality.
The rupee will not appreciate in any significant way, unless our current account achieves surplus
position. The rupee-dollar exchange rates are a critical factor in exports, imports, international
loans, foreign remittances, tourism and overseas education. The depreciating rupee poses major
challenges for importers and those servicing unhedged foreign currency loans. Future business
decisions will be influenced by the external value of the rupee against major currencies,
including the dollar.
Contrary to what is generally believed, even dollar depreciation can hurt exporters because
foreign buyers, especially in Europe and the US, exert pressure on Indian exporters to cut prices.
What's more, export-oriented large companies may have hedged their short, medium and long-
term exposures at, say, 48-50 to a dollar, when the rupee was below 45.
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Overview of CURRENCY MARKETS :
Globalization and integration of financial markets, coupled with progressive increase of cross-
border flow of capital, have transformed the dynamics of the Indian financial markets. This has
increased the need for dynamic currency risk management. The steady rise in India’s foreign
trade, along with liberalization in foreign exchange regime, has led to large inflows of foreign
currency into the system in the form of FDI and FII investments. In order to provide a liquid,
transparent and vibrant market for foreign exchange rate risk management, Securities &
Exchange Board of India (SEBI) and Reserve Bank of India (RBI) have allowed trading in
currency futures on stock exchanges for the first time in India, initially based on the USDINR
exchange rate and subsequently on three other currency pairs – EURINR, GBPINR and JPYINR.
The USDINR futures contract is being traded on MCX-SX with more than US $3.05 billion
average daily turnover. This would give Indian businesses another tool for hedging their foreign
exchange risks effectively and efficiently at transparent rates on an electronic trading platform.
The primary purpose of exchange traded currency derivatives is to provide a mechanism for
price risk management and consequently provide price curve of expected future prices to enable
the industry to protect its foreign currency exposure. The need for such instruments increases
with increase of foreign exchange volatility.
Participants in Currency Markets:
The forex market is an OTC market without any centralized clearing house. It consists of two
tiers.
• The interbank or wholesale market,
• Client or retail market
4 broad categories of participants operate within these two tiers i.e. the participants in the foreign
exchange market comprise;
(i)Corporate
(ii)Commercial banks
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(iii)Exchange brokers
(iv)Central banks
Corporates: The business houses, international investors, and multinational corporations may
operate in the market to meet their genuine trade or investment requirements. They
may also buy or sell currencies with a view to speculate or trade in currencies to the extent
permitted by the exchange control regulations. They operate by placing orders with the
commercial banks. The deals between banks and their clients form the retail segment of foreign
exchange market.
Commercial Banks: are the major players in the market. They buy and sell currencies for their
clients. They may also operate on their own. When a bank enters a market to correct excess or
sale or purchase position in a foreign currency arising from its various deals with its customers, it
is said to do a cover operation. Such transactions constitute hardly 5% of the total transactions
done by a large bank. A major portion of the volume is accounted buy trading in currencies
indulged by the bank to gain from exchange movements. For transactions involving large
volumes, banks may deal directly among themselves. For smaller transactions, the intermediation
of foreign exchange brokers may be sought.
Exchange brokers: facilitate deal between banks. In the absence of exchange brokers, banks
have to contact each other for quotes. If there are 150 banks at a centre, for obtaining the best
quote for a single currency, a dealer may have to contact 149 banks. Exchange brokers ensure
that the most favorable quotation is obtained and at low cost in terms of time and money. The
bank may leave with the broker the limit up to which and the rate at which it wishes to buy or
sell the foreign currency concerned. From the intends from other banks, the broker will be able to
match the requirements of both. The names of the counter parties are revealed to the banks only
when the deal is acceptable to them. Till then anonymity is maintained. Exchange brokers tend to
specialize in certain exotic currencies, but they also handle all major currencies.
Central banks: most all central bank and treasuries participate in the forex market. Central banks
play very important role in foreign exchange market. However, these banks do not undertake
significant volume of trading. Each central bank has official/unofficial target of the forex rate
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for its home currency. If the actual price deviates from the target rate, the central banks intervene
in the market to set a tone. E.g. FeD, ECB, RBI...
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Factors that affect currency rates:
Numerous factors determine exchange rates, and all are related to the trading relationship
between two countries.Exchange rates are relative, and are expressed as a comparison of
the currencies of two countries. The following are some of the principal determinants of the
exchange rate between two countries.
1. Differentials in Inflation
As a general rule, a country with a consistently lower inflation rate exhibit a rising currency
value, as its purchasing power increases relative to other currencies. During the last half of the
twentieth century, the countries with low inflation included Japan, Germany and Switzerland,
while the U.S. and Canada achieved low inflation only later. Those countries with higher
inflation typically see depreciation in their currency in relation to the currencies of their trading
partners. This is also usually accompanied by higher interest rates.
2. Differentials in Interest Rates
Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest
rates, central banks exert influence over both inflation and exchange rates, and changing interest
rates impact inflation and currency values. Higher interest rates offer lenders in an economy a
higher return relative to other countries. Therefore, higher interest rates attract foreign capital
and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if
inflation in the country is much higher than in others, or if additional factors serve to drive the
currency down. The opposite relationship exists for decreasing interest rates - that is, lower
interest rates tend to decrease exchange rates.
3. Current-Account Deficit
The current account is the balance of trade between a country and its trading partners, reflecting
all payments between countries for goods, services, interest and dividends. A deficit in the
current account shows the country is spending more on foreign trade than it is earning, and that it
is borrowing capital from foreign sources to make up the deficit. In other words, the country
requires more foreign currency than it receives through sales of exports, and it supplies more of
its own currency than foreigners demand for its products. The excess demand for foreign
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currency lowers the country's exchange rate until domestic goods and services are cheap enough
for foreigners, and foreign assets are too expensive to generate sales for domestic interests.
4. Public Debt
Countries will engage in large-scale deficit financing to pay for public sector projects and
governmental funding. While such activity stimulates the domestic economy, nations with large
public deficits and debts are less attractive to foreign investors. A large debt encourages
inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper
real dollars in the future. In the worst case scenario, a government may print money to pay part
of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a
government is not able to service its deficit through domestic means (selling domestic bonds,
increasing the money supply), then it must increase the supply of securities for sale to foreigners,
thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they
believe the country risks defaulting on its obligations. Foreigners will be less willing to own
securities denominated in that currency if the risk of default is great.
5. Terms of Trade
A ratio comparing export prices to import prices, the terms of trade is related to current accounts
and the balance of payments. If the price of a country's exports rises by a greater rate than that of
its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater
demand for the country's exports. This, in turn, results in rising revenues from exports, which
provides increased demand for the country's currency (and an increase in the currency's value). If
the price of exports rises by a smaller rate than that of its imports, the currency's value will
decrease in relation to its trading partners.
6. Political Stability and Economic Performance
Foreign investors inevitably seek out stable countries with strong economic performance in
which to invest their capital. A country with such positive attributes will draw investment funds
away from other countries perceived to have more political and economic risk. Political turmoil,
for example, can cause a loss of confidence in a currency and a movement of capital to the
currencies of more stable countries.
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CURRENCY /FOREX RISK MANAGEMENT
Currency risks:
“The impact that unexpected exchange rates changes have on the value of the corporation.”
Currency risk is very important to a corporation as it can have a major impact on its cash flows,
assets and liabilities, net profit and ultimately its stock market value. Assuming the corporation
has accepted that currency risk needs to be managed specifically and separately, it has three
initial priorities:
1. Define what kinds of currency risk the corporation is exposed to
2. Define a corporate Treasury strategy to deal with these currency risks
3. Define what financial instruments it allows itself to use for this purpose
Currency risk is simple in concept, but complex in reality. At its most basic, it is the possible
gain or loss resulting from an exchange rate move. It can affect the value of a corporation
directly as a result of an unhedged exposure or more indirectly. Different types of currency risk
can also offset each other. For instance, take a US citizen who owns stock in a German auto
manufacturer and exporter to the US. If the Euro falls against the US dollar, the US dollar value
of the Euro-denominated stock falls individual sees the US dollar value of their holding decline.
However, the German auto exporter should in fact benefit from a weaker Euro as this makes the
company’s exports to the US cheaper, allowing them the choice of either maintaining US prices
to maintain margin or cutting them further to boost market share. Sooner or later, the stock
market will realize this and mark up the stock price of the auto exporter. Thus, the stock owner
may lose on the currency translation, but gain on the higher stock price. This is of course a very
simple example and life unfortunately is rarely that simple. The first step in successfully
managing currency risk is to acknowledge that such risk actually exists and that it has to be
managed in the general interest of the corporation and the corporation’s shareholders. Indeed, at
its best, prudent currency hedging can be defined as the elimination of speculation. The real
speculation is in fact not managing currency risk.
The next step, however, is slightly more complex and that is to identify the nature and extent of
the currency risk or exposure. It should be noted that the emphasis here is for the most part on
non-financial corporations, on manufacturers and service providers rather than on banks or other
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types of financial institutions. Non-financial corporation’s generally having only a small amount
of their total assets in the form of receivables and other types of transaction. Most of their assets
are made up of inventory, buildings, equipment and other forms of tangible “real” assets. In
order to measure the effect of exchange rate moves on a corporation, one first has to define the
type and then the amount of risk involved, or the “value at risk” (VaR). There are three main
types of currency risk that a multinational corporation is exposed to and has to manage.