FOREIGN EXCHANGE Adani Wilmar Limited

INDEX

INTRODUCTION...............................................................................................................3

FUNCTIONS OF FOREIGN EXCHANGE MARKET......................................................5

EXCHANGE RATE SYSTEM IN INDIA..........................................................................6

TYPES OF TRANSACTIONS AND SETTLEMENT DATES.........................................8

FOREIGN EXCHANGE RATES.....................................................................................11

PURCHASING POWER PARITY...................................................................................13

FOREIGN EXCHANGE PRODUCTS.............................................................................15

EXPORT IMPORT FINANCE.....................................................................................15

LETTER OF CREDIT...............................................................................................17

FINANCING EXPORTS...........................................................................................21

INTERNATIONAL FACTORING...........................................................................23

FORFEITING – AN EXPORT FINANCE OPTION................................................27

SWAPS..........................................................................................................................35

CURRENCY SWAPS...............................................................................................36

INTEREST RATE AND CURRENCY SWAPS......................................................40

ROLE OF INTERMEDIARY...................................................................................42

NRIBM SUMMER PROJECT – FOREIGN EXCHANGE 2003-2004 1

OPTIONS......................................................................................................................43

TYPES OF OPTIONS...............................................................................................57

OPTIONS – PUT AND CALL..................................................................................58

OPTION STYLES.....................................................................................................59

THE OPTIONS CLEARING CORPORATION.......................................................60

PRICING OF OPTIONS...........................................................................................61

OPTIONS – TRADING IN OPTIONS.....................................................................65

FINANCING FOREIGN OPERATIONS.........................................................................69

RAISING FOREIGN CURRENCY FINANCE................................................................71

FOREIGN EXCHANGE EXPOSURE.............................................................................74

TYPES OF EXPOSURE...............................................................................................74

MANAGEMENT OF FOREIGN EXCHANGE EXPOSURE.........................................76

CORPORATE PRACTICES IN MANAGING EXCHANGE RISK...............................78

FOREIGN EXCHANGE MANAGEMENT ACT (FEMA).............................................79

SOME SUGGESTIONS FOR MANAGING RISK..........................................................82

DERIVATIVES.................................................................................................................83

BIBLIOGRAPHY..............................................................................................................86


INTRODUCTION

FOREIGN EXCHANGE

Foreign Exchange can be defined as the system or process of converting one national currency into another and of transferring the ownership of money from one country to another. Foreign Exchange can also be said as that section of Economic Science that deals with the means and methods by which rights to wealth in one country’s currency are converted into rights to wealth in terms of another country’s currency.

In this definition the term ‘currency’ includes not only such notes and coins as are legal tender, but also all instruments – credit instruments – which are capable of being used as currency, such as bills of exchange, promissory notes, cheques, drafts, airmail transfers, telegraphic transfers and all other instruments which convey to the holder a right to wealth.

FOREIGN EXCHANGE MARKET

The Foreign Exchange market plays the part of a clearing house through which purchases and sales of foreign currencies are offset against each other. The foreign exchange market, however, is not a ‘market’ in the concrete sense of the term or a geographical entity.

This term is used in an abstract sense only, meaning a number of buyers and sellers systematically in contact with each other for the purpose of transacting foreign exchange business. This is the sense in which the term ‘market’ is used in Economics.

Structure of Foreign Exchange Market

Retail market Wholesale market

The Retail Market is a market in which travelers and tourists exchange currencies through currency notes or traveler’s cheque.

The Wholesale Market is a market wherein exchange of currencies takes place thorough commercial banks, investment banks, corporations, central banks and various institutions. So, this market is also termed as interbank market


Price Makers

Primary Price Makers Secondary Price Makers

The Primary Price Makers or professional dealers make a two way market to each other and to their clients i.e. they will quote a two way price and be prepares to take either the buy or the sell side. This group includes mainly commercial banks and some large investment dealers. A few large corporations have also assumed the role of primary dealers.

Primary price makers perform an important role in taking positions off the hands of a dealer or corporate customer and then offsetting these by doing an opposite deal with another entity, which has a matching requirement.

Eg. – a primary dealer will sell USD against the euro to one corporate customer, carry the position for a while and offset it by buying USD against the euro from another customer or professional dealer.

The primary price makers consist of three types of tiers or segments.

In the First Tier there are a few giant multinational banks that deal in a large number of currencies, in large amounts and often deal directly with each other without using brokers.

In the Second Tier are large banks that deal in a smaller number of currencies and use the services of brokers more often.

Lastly, there are small local institutions, which make the market in a very small number of major currencies against their home currency.

In retail market, there are entities, which make foreign exchange prices but do not make a two-way market. They are Secondary Price Makers. These types of entities are often driven by prices decided by Primary Price Makers.


FUNCTIONS OF FOREIGN EXCHANGE MARKET

The Foreign Exchange department is a high-specialized department in a bank. A wide variety of services are rendered by a foreign exchange department.

The principal function is the transfer of funds & currency from one nation to another.

Broadly, the functions of a foreign exchange department may be classified as follows -

FINANCING EXPORTS

The financial needs of the exporter right from the moment he conceives of the project and till he realizes export proceeds are provided by banks.

The exporter may be eligible to receive cash incentives from the Government on exports.

FINANCING IMPORTS

Letters of credit are issued by banks on behalf of their importer - customers.

The opening of the Letter of credit by the bank, whereby id undertakes to make payment to the exporter on shipment, enables the importer to conclude the deal with ease.

REMITTANCE FACILITIES

An importer in India has to pay the overseas exporter. Similarly, an Indian exporter has to receive payment from abroad.

An Indian who is now employed abroad may like to remit funds for maintenance of his family in India. The payment into or from India can be arranged through any of the credit instruments.

DEALING IN FOREIGN EXCHANGE

Banks buy and sell foreign exchange form and to the public. To carry out this function banks have to keep sufficient stock of foreign exchange.

FURNISHING CREIDT INFORMATION

With a network of correspondent relationship with banks, abroad, a bank in India is in a position to furnish business information to exporter and importer in India.


EXCHANGE RATE SYSTEM IN INDIA

Initially the Indian Re was under the fixed exchange rate system linked to the british pound . As sterling become more volatile, it came to pegged to basket of currency. Then with a view to making US$ directly available to authorized dealer for meeting their customer requirement, RBI commenced the sale of US$ for spot delivery with effect from 2nd Feb1987

ABOLITION OF STERLING RATE SCHEDULE

The abolition of system of regulating exchange rates through the sterling rate schedule enabled the banks to quote exchange rates to customer on the basis of on going market rates. Its abolition put an end to era of fixed exchange margins. RBI brought in a system where by Authorized Dealers could have an opportunity to change rates eve in the course of day if such changes were warranted by market force.

SEGREGATION OF INTEREST ELEMENT

RBI on Jan1984 delinked the interest from exchange rate. Banks started quoting exchange rate on the basis of ongoing market rates. Interest for transit period, usance period & grace period where applicable was calculated separately & recovered from the customer at the time of discounting / negotiating / purchasing the bill, with this the AD were precluded from foregoing interest.


LIBERALISED EXCHANGE RATE MANAGEMENT

The BOP crisis witnessed by country during 90-91, a committee was set up to look in to various issue involved which recommended that there should be two markets, one market in which a portion of total transaction would be settled at official exchange rate and at the other market for the balance of portion the rates would be based on supply / demand factors. Thus, the LERMS came in to effect from 1st March 92

UNIFIED EXCHANGE RATE SYSTEM

Effective from 1st March Government of India replaced dual exchange rate system by the unified exchange rate system. The earners of foreign exchange now get their entire export, converted in to Indian rupee at the market rate. Authorized Dealers are free to retain the entire foreign exchange receipts with them for permissible transactions. RBI will buy / sell foreign currency spot from AD only in cover of their actual merchant transaction & not for covering their anticipated purchase.


TYPES OF TRANSACTIONS AND SETTLEMENT DATES

TYPES OF TRANSACTION

Spot Transaction Forward Transaction

Spot Transaction

In a spot market, transactions are settled “on the spot”. Once a trade is agreed upon, the settlement – i.e. the actual exchange of money for goods – takes place with the minimum possible delay (latest within two days).

E.g - When a person selects a shirt in a shop and agrees on a price, the settlement (exchange of funds for goods) takes place immediately. That is a spot market.

There are two real–world implementations of a spot market:

Rolling settlement Real-time gross settlement (RTGS).

Rolling Settlement

In rolling settlement, trades are netted through one day, and settled x working days later; this is called T + x rolling settlement.

For example: With T+5 rolling settlement, trades are netted through Monday, and the net open position as of Monday evening is settled latest by Friday evening.

Real-Time Gross Settlement (RTGS).

In RTGS, all trades settle in a few seconds with no netting. Rolling settlement is a close approximation, and RTGS is a true spot market. Today the equity market in India, for the major part, is not a spot market.

For example: the bulk of trading on NSE takes place with netting from Wednesday to Tuesday, and then settlement takes place five days later. This is not a spot market. The “international standard” in equity markets is T+3 rolling settlement. But the currency market in India is RTGS.


Forward Transaction

In a forward contract, two parties irrevocably agree to settle a trade at a future date, for a stated price and quantity. No money changes hands at the time the trade is agreed upon for maturity.

E.g. Suppose a buyer L and a seller S agree to do a trade in 100 grams of gold on 31 Dec 2001 at Rs.5,000/tola. Here, Rs.5,000/tola is the “forward price of 31 Dec 2001 Gold”. The buyer L is said to be long and the seller S is said to be short. Once the contract has been entered into, L is obligated to pay S Rs. 500,000 on 31 Dec 2001, and take delivery of 100 tolas of gold. Similarly, S is obligated to be ready to accept Rs.500,000 on 31 Dec 2001, and give 100 tolas of gold in exchange. The deal will not effect from the spot market as on Dec. 31, 2001.

SETTLEMENT DATES

Settlement of the transactions takes place by transfers of funds between the two parties. The day on which these transfers are affected is called the settlement date or the value date.

To effect the transfer, banks in the countries of the two currencies involved, must be open for business. The relevant countries are called settlement location.

The locations of the two banks involved in the trade are the dealing locations, which need not be the same as settlement locations.

Eg. – a London bank can sell Japanese yen against US dollar to a Paris bank. Settlement locations may be New York and Tokyo, whole dealing locations are London and Paris. The transaction can be settled only on a day on which both US and Japanese banks are open.

Depending upon the time elapsed between the transaction date and the settlement date, foreign exchange transactions can be categorized into spot and forward transaction. Apart from these two categories, a third category called swaps is a combination of a spot and forward transactions or two forward transactions.


In a Spot Transaction, the settlement or value date is usually two business days ahead for European currencies or the yen traded against the dollar.

E.g. – if a London bank sells yen against dollar to a Paris bank on Monday, the London bank will turn over a yen deposit in Japan to the Paris bank on Wednesday and the Paris bank will transfer a dollar deposit in US to the London bank on the same day.

To reduce credit risk in spot transaction both transfers should take place on the same day.

Taking the previous example – if the following Wednesday happens to be a bank holiday on either Japan or US, the value date is shifted to the next available business day, in this case Thursday. If Wednesday is a holiday both in UK and France, settlement is again postponed to Thursday.

In a Forward Transaction, the value date is based on usance. The rate for forward transaction is decided by adding Forward premium/discount to the spot rate prevailing as at value date.

To arrive at the maturity date, first find the value date for a spot transaction between the same currencies done on the same day and then add one calendar month to arrive at the value date.

Eg, - for a one month forward transaction entered into on , say June 20, the corresponding spot value date is June 22, one-month forward value date is July 22, two month forward is August 22 and so on.

Standard forward contract maturities are 1,2,3,6,9 and 12 months. The value dates are obtained by adding the relevant number of calendar months to the appropriate spot value date.


FOREIGN EXCHANGE RATES

An exchange rate quotation is the price of a currency stated in terms of another. For e.g. A/ B, where currency B is being sold or bought with its value being expressed in terms of currency A. Currency B is referred to as the base currency.

Various kinds of quotes are classified as follows

AMERICAN Vs EUROPEAN QUOTE

American quote is the number of dollar expressed per unit of any other currency while a European quote is the number of units of any other currency expressed per dollare.g.- DM1.6665/$- European quote

$1.6698/Re- American quote

DIRECT Vs INDIRECT QUOTE

A direct quote is the quote where the exchange rate is expressed in terms of number of units of the domestic currency per unit of foreign currency & indirect quote is a quote where rate is expressed in terms of number of units of foreign currency for a fixed number of units of domestic currencye.g. direct quote: Rs / $ 30.720/30.7409

Indirect quote: $/100Rs 3.2530/50

BID & ASK RATE

The rate at which bank is ready to buy a currency will be different from the rate at which it stands ready to sell that currency. These rates are called bid & ask rates respectively. Mid rate is the arithmetic mean of bid & ask rate . The difference between bid & ask rate is known as spreadeg: Rs / $ 42.53/42.57

42.53 bid rate


42.57 ask rate

INTERBANK VS MERCHANT QUOTE

Merchant quote is the quote given by bank to its retail customer. A quote given by one bank to another is interbank quote

INVERSE QUOTE

For every quote A/B there exist an inverse quote B/Aeg DM/$: 1.6663/1.6668

implied ($/DM) bid=1/(DM/$)ask implied ($/DM) ask=1/(DM/$)bid

Implied inverse rate $/DM =0.5999/0.6001 Implied B/A quote 1/(A/B) ask/1/(A/B)bid

CROSS RATES

In foreign exchange market one can calculate the exchange rates between two currencies with the third currency as the intermediate currency.

E.g - DM/Rs rate will be calculated through DM/$ quote $/Rs quote. The DM/Rs rate calculated is called a cross rate or synthetic rate


PURCHASING POWER PARITY

According to this theory, the price level (changes in the price level) in different countries determine the exchange rates of these countries currency .

The basic tenet of this principle is that the exchange rate between various currencies reflect the purchasing power of these currency.

This tenet is based on the law of one price.

LAW OF ONE PRICE

According to this, in equilibrium condition the price of a commodity has to be same across the world. Also according to this law the domestic currency price of a commodity in various countries when converted in to common currency at the ruling spot exchange rate is the same through out the world.

i.e.Pa= S(A/B) * PbPa- Price of commodity x in country APb-Price of commodity in country BS(A/B)-spot exchange rate of the two countries currency

There are three forms of Purchasing Power Parity

Absolute form of PPP

If the law of one price were to hold good for each & every commodity then it will follow the - Pa =S(A/B)*PbWhere Pa & Pb prices of same basket of goods & services in country A&BS(A/B)= Pa/PbAccording to this equation, the exchange rate between two countries currency is determined by the respective price levels in the two countries.

It is difficult to test the theory empirically, as the indexes used in different countries to measure the price level are not comparable


Relative Form of PPP

It talks about the link between the changes in spot rates and in price level over a period of time.

According to this theory changes in spot rate over a period of time reflect the changes in the price level over the same period in the concerned economies.

Expectation form of PPP

The expected % change in the spot rate is equal to the difference in the expected inflation rates in the two countries.

This theory assumes that speculators are risk neutral & markets are perfect.

Reasons for Purchasing Power Parity not holding good

Constraints on Movement of commodities

Price Index construction

Effect of the statistical method employ


FOREIGN EXCHANGE PRODUCTSEXPORT IMPORT FINANCE

Exchange Control Regulations on Exports

Statutory basis for exchange control

Importer-exporter code number

Export declaration forms

Exemptions from declarations

Appropriate export declaration form

Prescribed time

Prescribed method

Submission of export documents

Extension of time limit

Follow-up of overdue export bills

Reduction in invoice value

Change of buyer

Dispatch of shipping documents

Advance remittance


Exchange Control Regulations on Imports

Obligations under FERA in import transactions

Importer exporter code number

Importability of goods

Payment for imports

Interest on import bills

Advance remittances

Postal imports

Import through couriers

Import under foreign loans/credits arranged by government

Evidence of import

Conditions of opening letter of credit

Handling of import bills

Submission of statement


LETTER OF CREDIT

A country rarely, if ever, produces everything it needs. This means that countries are dependent upon one another for those products that they need but which they themselves do not produce. The various steps covering the movement of goods between countries the payment for such goods and the relationship between the parties involved form the basis of international trade.

Following are the recognized methods of effecting payments under international trade.

ADVANCE PAYYMENT

When the buyer’s credit is doubtful or the political or economic environment in the buyer’s country is unstable seller may demand advance payment, which will be to his advantage.

Without any assurance for supply of goods, blocking his capital prior to receipt of goods or services the buyer will be at a disadvantageous position.

OPEN ACCOUNT

By an arrangement between the buyer and the seller manufactured goods will be delivered to the buyer directly or to his order and the buyer will pay at the end of the agreed period.

This type of trading requires a high degree of trust between buyer and seller and it will be more advantageous to the buyer.

BILLS ON COLLECTION BASIS

It is an arrangement by which the seller after shipping the goods submits the documents to his bank as agent for collection.

Documents are presented to the buyer through the correspondent bank of the seller’s bank, which will be released upon buyer’s payment of the amount specified.


DOCUMENTARY CREDITS (LETTERS OF CREDIT)

It is one of the most convenient methods of settling payments in international trade.

It provides complete financial security to the seller of goods.

The seller may not know the credit worthiness of the buyer and the prevailing regulations in the country of the buyer.

But once a Letter of Credit is established by the buyer’s bank on behalf of the buyer in favor of the seller and the seller submits the set of required documents to the opening bank or the nominated bank, seller is assured of payment.

Buyer also gets the advantage of his banker’s assistance in closely scrutinizing the documents and only after receiving the relevant documentary evidence from the seller by the banker nominated in the credit the nominated banker releases payment.

OPERATION OF LETTER OF CREDIT

Based on the agreement entered into between buyer and seller, buyer approaches his bank to open a letter of credit in favor of the seller of the goods in the other country.

As per the terms of the contract and the application given by the applicant to the opening bank establishes the Letter of Credit and forwards the same to its correspondent in the seller’s country which advises the Letter if Credit to the beneficiary.

At times at the insistence of the seller the buyer requests his bank to make available the confirmation of a bank in the seller’s country.

In such a case, the bank, which adds its confirmation, becomes a confirming bank.

The bills received under the Letter of Credit will be negotiated by this bank which will claim reimbursement from the bank mentioned in the Letter of Credit for this purpose.

The documents will then be sent to the opening bank which will hank over the documents to the opener after recovering the value from him.


TYPES OF LETTER OF CREDIT

REVOCABLE – IRREVOCABLE CREDIT

A letter of credit may be revocable or irrevocable. If there is no indication of this reference the credit will be deemed as irrevocable.

A Revocable Credit may be amended or cancelled at any moment without prior notice to the beneficiary. However, the issuing bank is bound to reimburse the negotiating bank for the negotiations made prior to receipt of such notice.

The Irrevocable Credit is a definite undertaking of the issuing bank an dcannot be amended or cancelled without the agreement of the issuing bank, the confirming bank and the beneficiary.

CONFIRMED CREDIT

When another bank adds its confirmation on the irrevocable letter of credit at the specific request of the issuing bank, it becomes a confirmed credit and it constitutes a definite undertaking of the confirming bank in addition to the issuing bank.

All credits need not be confirmed credits.

TRANSFERABLE CREDIT

A letter of credit is transferable only if the issuing bank expressly designates it.

The beneficiary in such credit has the right to request the nominated bank to transfer the credit in full or parts in favor of one or more second beneficiaries into another party or more than one party if partial shipment is permitted.

The transferable credit can be transferred once unless otherwise stated.


RED CLAUSE CREDIT

This credit bears a clause in red color authorizing the nominated bank to allow advance to the beneficiary/seller prior to shipment to meet his pre-shipment credit requirements.

GREEN clause credits in addition to permitting pre-shipment advance also provides expenses relating to storage charges before shipment.

BACK TO BACK CREDIT

In case it the exporter is not the actual manufacture and he gets his work done by the sub-suppliers and if the sub-suppliers demand letter of credits in their favor, the exporter who has received a letter of credit for export, approaches his banker to establish second set of letters of credit on the basis of the export letter of credit received by him.

The second set of credit opened by a bank at the request of the exporter is known as back to back credit.

The beneficiary of the original letter of credit will become the applicant for the second set of credit.

REVOLVING CREDIT

In a revolving credit the amount of drawing is re-instated and made available to the beneficiary again up to the agreed period of time on notification of payment by the applicant or merely on submission of documents.

The maximum value and period up to which the credit can be revolved will be specified in the revolving credit.

The re-instatement clause and the maximum amount of drawings under the credit should always be incorporated in revolving credit.

DEFERRED PAYMENT CREDITS AND ACCEPTANCE CREDITS

Under deferred payment credit the amount is payable in installments for a stipulated longer period.

Usually a part is paid in advance and the balance is payable in agreed installments in terms of conditions of the letter of credit


FINANCING EXPORTS

Commercial banks, the major source of export finance in India, provide finance before shipment of goods as well as after shipment of goods.

PRE-SHIPMENT FINANCE

The pre-shipment finance typically is in the form of packing credit facility.

Packing credit is bank advance provided to an exporter for the purpose of buying/manufacturing/packing/shipping goods to foreign buyers.

Packing credit, a short-term credit, is normally required to be liquidated within 180 days by negotiation of export bills or receipt of proceeds for exports.

There are three broad types of packing credit

CLEAN PACKING CREDIT

This represents an advance made to the exporter on the basis of a firm export order or a letter of credit, without any control over raw materials or goods.

Each proposal is decided on the basis of particular requirement of the trade and the creditworthiness of the exporter.

PACKING CREDIT AGAINST HYPOTHECATION OF GOODS

Under this arrangement, the goods meant for export are hypothecated to the bank as security.

When the bank advance is to be utilized, the exporter is required to furnish stock statements and continue to do so whenever there is stock movement.

PACKING CREDIT AGAINST PLEDGE OF GOODS

Under this arrangement, the goods meant for export are pledged to the bank with an approved clearing agent who ships the same on the advice of the exporter.


POST-SHIPMENT FINANCE

The finance provided after the shipment may be in the following forms

PURCHASE/DISCOUNTING OF DOCUMENTARY EXPORT BILLS

A commercial bank may purchase export bills drawn payable at sight or discount usance export bills covering confirmed sales and supported by relevant documents like the bill of lading, post parcel receipts etc.

ADVANCE AGAINST EXPORT BILLS SENT FOR COLLECTION

A commercial bank may provide finance by way of advance against export bills forwarded through it for collection after taking into account appropriate margin.

ADVANCE AGAINST DUTY DRAWBACKS, CASH SUBSIDY, ETC.

To help exporter banks advance against duty drawbacks, cash subsidy, etc., receivable by them against their exports.

EXIM BANK FINANCE

The export import bank of India (EXIM bank) was set up in 1982 to provide export and import finance, to coordinate with others providing such finance, and to promote the country’s foreign trade.

The authorized capital of the EXIM bank is Rs 200 crores and the paid-up capital is Rs 76 crores.

The EXIM bank has some borrowings from the central government at a concessional rate of interest.

To augment its resources, it may also issue bonds and debentures


INTERNATIONAL FACTORING

Factoring as a financial service is of recent origin in India, introduces in the early ‘90s and it is yet to pick up momentum.

If the purchaser of the goods delays payment it will result in locking up of working capital funds for the exporter.

Further, in this competitive environment, an exporter has to keep in mind the cost of borrowing also while pricing his commodity.

To provide an alternate route for availing finance against receivables comparatively at a cheaper cost and also with some more advantages, factoring has been introduced in India.

Factor is an authorized transactor of business of another.

In the absence of concise definition, factoring may be defined as an arrangement for financing a company’s business against the unpaid invoices drawn in favor of the customers and in which the factor becomes responsible for all credit control, sales ledger administration and debt collection activities.

In a full service factoring parlance, if the debtor fails to pay the dues to the factor, by the terms of arrangement, the factor had to absorb the losses.

The transition from simple sale on a consignment basis through the agents, gradually developing into assuming additional responsibilities by the agents let to the development of modern factoring.


FORMS OF INTERNATIONAL FACTORING

Depending upon the need of the exporter-client and his price bearing capacity various forms of international factoring are in vogue, the principal amongst them are as follows

TWO FACTOR SYSTEM

In this system, the transaction is based on operations of two factoring companies in two different countries involving four parties :

Exporter

Importer

Export factor in exporter’s country

Importer factor in importer’s country.

The main functions of the export factor relates to –

Assessment of the financial status of the exporter

Assessment of the financial status of the importer through import factor

Prepayment of the receivables to the exporter after proper documentation

Follow up of recovery with the import factor

Sharing commission with the import factor

Correspondingly the import factor will be engaged in -

Maintaining the details of sales to debtors in his country

Collections of debts from the importers and remitting the proceeds to the export factor

Providing credit protection in case of financial inability by any of the debtors.

Two factor system is probably the best mode of providing the most effective factoring to a prospective client.


SINGLE FACTORING SYSTEM

With a view to obviating the constraints in the two factor system single factoring system has been introduced by some of the factoring companies primarily in FACTORS CHAIN INTERNATIONAL GROUP. (FCI)

Under this system a special agreement is signed between two factoring companies in the exporting and importing countries on conditions for single factoring whereby as in the two factor system the credit cover is provided by the import factor.

If the export factor is not in a position to realize any debt within 60 days from the due date he requests the importing counterpart to undertake the collection responsibility, simultaneously informing the defaulting debtor about the assignment of the debt to the latter. It is now the responsibility of the import factor to continue the collection efforts and initiate legal proceedings, if necessary.

Pricing under this system is much lower compared to that of the two factor system. The variation is introduced up to extent that the role of the import factor as a collection agency starts only if there is a potential threat of non-recovery.

DIRECT EXPORT FACTORING

Under this system only one factoring company is involved i.e., export factor, which provides all elements of service of factoring namely finance to exporter, maintenance of sales ledger and collections of debts from the importers, credit protection in case of financial inability on port of any of the importers.

The basic advantage of this system is the obvious reduction in pricing structure coupled with uniform and quick service.

DIRECT IMPORT FACTORING

Under this system, the seller will choose to work directly with a factor in the importers country.

The import factor is responsible for sales ledger, administration, collection of debts and providing bad debt protection under the agreed level of risk coverage.

The disadvantage of the system is the lack of proximity between the exporter and the import factor, which may lead to problems at a later stage.


ADVANTAGES OF EXPORT FACTORING

The distinct advantage of a factoring transaction over other methods of finance provided to an exporter can be summarized as under –

Immediate finance up to a certain percentage (say 75 to 80%)

No necessity for covering the transaction by a letter of credit

Credit checking of all the prospective debtors in importing countries through factors counterparts in importing countries or established credit rating agencies

Maintenance of entire sales ledger of exporter including asset management

Bad debt protection up to 100% on all approved sales to agreed debtors ensuring total predictability of cash flow

Undertaking cover operations to minimize potential losses arising from exchange rate fluctuations

Consultancy services in areas relating to special conditions and regulations as applicable to the importing countries.


FORFEITING – AN EXPORT FINANCE OPTION

Definition

Forfeiting is a mechanism of financing exports.

By discounting export receivables

Evidenced by bills of exchange or promissory notes

Without recourse to the seller

Carrying medium to long terms maturities

On a fixed rate basis (discount)

Up to 100 percent of the contract value

The word ‘FORFEIT’ is derived from the French word ‘a forfeit’ which means the surrender of rights.

Simply put, forfeiting is the non – recourse discounting of export receivables.

In a forfeiting transaction, the exporter surrenders, without recourse to him, his rights to claim for payment on goods delivered to an importer, in return for immediate cash payment from a forfeiter.

As a result, an exporter in India can convert a credit sale into cash sale, with no recourse to him or to his banker.

All exports of capital goods and other goods made on medium to long-term credit are eligible to be financed through forfeiting.


WORKING OF FORFEITING

Receivables under a deferred payment contract for export of goods, evidenced by bills of exchange or promissory notes, can be forfeited.

Bills of exchange or promissory notes, backed by co-acceptance from a bank (which would be generally be buyer’s bank), are endorsed by the exporter, without recourse, in favor of the forfeiting agency in exchange for discounted cash proceeds.

The co-accepting bank must be acceptable to the forfeiting agency.

The bills of exchange or promissory notes should be in the prescribed format. A specimen copy of a bill of exchange and a promissory note is reproduced at the end.

The role of EXIM bank will be that of a facilitator between the Indian exporters and the overseas forfeiting agency.

Function of EXIM bank

On a request from an exporter, for an export transaction, which is eligible, to be forfeited, EXIM bank will obtain indicative and firm forfeiting quotes – discount rate, commitment and other fees – from overseas agencies.

EXIM bank will receive available bills of exchange or promissory notes, as the case may be, and sent them to the forfeiter for discounting and will arrange for the discounter proceeds to be remitted to the Indian exporter.

EXIM bank will issue appropriate certificates to enable Indian exporters to remit commitment fees and other charges.


FLOWCHART OF A FORFEITING TRANSCATION


1

INDIAN EXPORTER

FOREIGN BUYER

AVAILISING FOREIGN BUYER’S BANK

FORFEITER

INDIAN EXPORTER’S BANK

EXIM BANK

3

3

78 4

7

8

4

4

4

8

7

2

24

4

6

5

5

6

2

5

6

56

NOTES :

Details of flows in the flowchart

1. Commercial contract between the foreign buyer and the Indian exporter

2. Commitment to forfeit bills of exchange/promissory notes (‘debt instruments’)

3. Delivery of goods by the Indian exporter to the foreign buyer

4. Delivery of debt instruments

5. Endorsement of debt instruments without recourse in favor of the forfeiter

6. Cash payment of discounted debt instruments

7. Presentation of debt instruments on maturity

8. Payment of debt instruments on maturity.


SPECIMEN COPY OF A BILL OF EXCHANGE

BO

MB

AY

31

MA

RC

H, 1

994

U

S $

850.

000

On

1 A

[ril

1995

Fo

r val

ue re

ceiv

ed p

ay a

gain

st th

is b

ill o

f exc

hang

e

To th

e or

der o

f MA

CH

INER

Y E

XPO

RTS

(IN

DIA

) LTD

.

T

he su

m o

f

US

DO

LL

AR

S E

IGH

T H

UN

DR

ED

FIF

TY

TH

OU

SAN

D O

NL

Y

Effe

ctiv

e pa

ymen

t to

be m

ade

in U

NIT

ED S

TATE

S D

OLL

RS

w

ithou

t ded

uctio

n fo

r

And

free

of a

ny ta

xes,

impo

st, l

evie

s, or

dut

ies p

rese

nt o

r fut

ure

of a

ny n

atur

e

This

bill

of e

xcha

nge

is p

ayab

le a

t WEL

LIN

GTO

N B

AN

K, M

AN

CH

ESTE

R, U

NIT

ED K

ING

DO

M

D

raw

n on

JO

HN

SM

ITH

IMPO

RT

S (U

K) L

IMIT

ED

M

AC

HIN

ER

Y E

XPO

RT

S (I

ND

IA) L

TD

OX

FOR

D H

OU

SE R

UL

E D

E L

A V

IE

M

AN

CH

EST

ER

, UN

ITE

D K

ING

DO

M

AU

THO

RIZ

ED S

IGN

ATO

RY

Acc

epte

d

JOH

N S

MIT

H

IMPO

RTS

(U

K) L

TD

AU

THO

RIS

ED

SIG

NA

TOR

Y

Per A

val f

or

acco

unt o

f th

e dr

awee

Wel

lingt

on

Ban

k M

anch

este

r

Uni

ted

Kin

gdom

AU

THO

RIS

ED

SIG

NA

TOR

Y


SPECIMEN COPY OF A PROMISSORY NOTE

MA

NC

HES

TER

31

MA

RC

H, 9

194

U

S $

850,

000

On

1 A

pril,

919

5

We

prom

ise

to p

ay a

gain

st th

is p

rom

isso

ry n

ote

To th

e or

der o

f MA

CH

INER

Y E

XPO

RTS

(IN

DIA

) LTD

.

Th

e su

m o

f

US

DO

LL

AR

S E

IGH

T H

UN

DE

RE

D F

IFT

Y T

HO

USA

ND

ON

LY

Effe

ctiv

e pa

ymen

t to

be m

ade

in U

NIT

ED S

TATE

S D

OLL

AR

S

with

out d

educ

tion

for

And

free

of a

ny ta

xes,

impo

st, l

evie

s, or

dut

ies p

rese

nt o

r fut

ure

of a

ny n

atur

e

This

pro

mis

sory

not

e is

pay

able

at W

ELLI

NTO

N B

AN

K, M

AN

CH

ESTE

R, U

NIT

ED K

ING

DO

M

JO

HN

SM

ITH

IMPO

RT

S (U

K) L

TD

.

A

UTH

OR

ISED

SIG

NA

TOR

Y

Per A

val

WEL

LIN

GTO

N

BA

NK

, M

AN

CH

ESTE

R

UN

ITED

K

ING

DO

M

AU

THO

RIZ

ED

SIG

NA

TOR

Y


FORFEITING COST

A forfeiting transaction has typically three cost elements –

COMMITMENT FEE

A commitment fee is payable by the exporter to the forfeiter for a latter’s commitment to execute a specific forfeiting transaction at a firm discount rate within a specified time (normally no more than one year).

The commitment fee generally ranges between 0.5 percent and 1.5 percent per annum of the unutilized amount to be forfeited and is charged for the period between the date the commitment is given by the forfeiter and the date the discounting takes place or until the validity of the forfeit contract, whichever is earlier.

DISCOUNT FEE

Discount fee is the interest cost payable by the exporter for the entire period of credit involved and is deducted by the forfeiter from the amount paid to the exporter against the available promissory notes or bills or exchange.

The discount fee is based on the relevant market interest rates as reflected by the prevailing London Inter-bank Offered Rate (‘LIBOR’) for the credit period and currency involved, plus a premium for the risks assumed by the forfeiter.

The discount rate is applied to the aggregate principal and interest due on the debt instrument on its maturity, to arrive at the payout to the exporter.

The discount rate is established at the time of executing a forfeit contract between the exporter and the forfeiting agency.

DOCUMENTATION FEE

No documentation fee is incurred in straightforward forfeit transactions.

However, if extensive documentation and legal work is necessary, a documentation fee may be charged.


BENEFITS FROM FORFEITING

Converts a deferred payment export into a cash transaction, improving liquidity and cash flow

Frees the exporter from cross-border political or commercial risks associated with export receivables

Finance up to 100 percent of the export value is possible as compared to 80-85 percent financing available from conventional export credit programs.

As forfeiting offers without recourse finance to an exporter, is does not impact the exporter’s borrowing limits. Thus, forfeiting represents an additional source of funding, contributing to improved liquidity and cash flow.

Provides fixed rate finance; hedges against interest and exchange risks arising from deferred export credit.

Exporter is freed from credit administration and collection problems.

Forfeiting is transaction specific. Consequently long term banking relationship with the forfeiter is not necessary to arrange a forfeiting transaction.

Exporter saves on insurance costs as forfeiting obviates the need for export credit insurance.

Simplicity of documentation enables rapid conclusion of the forfeiting arrangement.


SWAPS

A swap is the exchange of one set of cash flows for another. It is a contract between two parties in which the first party promises to make a payment to the second and the second party promises to make a payment to the first.

The Interest Rate Swap is the most frequently used swap. An interest rate swap generally involves one set of payments determined by the Eurodollar (LIBOR) rate and the other set is fixed at an agreed upon rate. With a spread of predetermined amount of basis points, payments tied to floating rates are used for interest rate swaps.

Another type of swap is one where one party makes payments in one currency and another party makes payments in another currency. This is known as a Currency Swap.

When one party makes a set of payments based on the price of a commodity, such as gold, and the other party makes payments based on fixed or on some other floating rate or price, they are engaged in a 'Commodity Swap'.

An Equity Swap involves one party paying the other a rate based on the rate of return on an equity index. With equity swaps it is easy, simple, and inexpensive to reallocate a portfolio to a different equity sector.

The market for swaps is several trillion dollars. They are used by corporations and financial institutions in order to reduce financial costs or to gain from various amongst markets. They are not used by individual investors.

One drawback to swaps is that they are not guaranteed by any clearing houses. Therefore, they can be defaulted. To prevent this, parties sometimes insist that collateral be posted or the account be marked to market periodically.


CURRENCY SWAPS

A currency swap is an agreement between two parties in which one party promises to make payments in one currency and the other promises to make payments in another currency.

Currency Swaps are derivative products that help manage exchange rate and interest rate exposure on long-term liabilities.

A Currency Swap involves exchange of interest payments denominated in two different currencies for a specified term, along with exchange of principals. The rate of interest in each leg could either be a fixed rate, or a floating rate indexed to some reference rate, like the LIBOR.

Consider a corporate who has a USD loan with interest rate at a spread over 6-month LIBOR. The corporate faces the following risks:

Currency risk: If the rupee depreciates against USD, it will be more expensive for the corporate to service its loan

Interest rate risk: An upward movement in LIBOR would increase the cost of servicing the loan

In order to hedge its risks the corporate can enter into a currency swap where it moves from USD floating rate loan to a INR fixed rate loan. The currency swap could be represented as follows:

Currency Swaps therefore enable a swap into both, a different currency and a different interest rate basis.


Some of the advantages of currency swaps are

Enables moving a liability from one currency into another

Can be customized

Can be reversed at any time (at a cost or benefit)

Off Balance Sheet, and does not change the terms of the existing liability.

Currency swaps can be structured to synthetically move liabilities in one currency to another depending on which risks and what costs are acceptable. The interest rates on either of the legs can be floating or fixed.

It is also possible to move rupee liabilities into foreign currencies through currency swaps.

Corporates wishing to match currency of loan repayments with currency of receivables (for example, exporters having a long tenor Rupee liabilities) could enter into such swaps.

Corporates could also undertake such swaps if they wish to take advantage of lower interest rates in return for exchange rate risk.


Consider a corporate that has an INR 25 Crores loan at 9% fixed rate, repayable bullet at the end of two years. If this corporate wishes to swap its liability into a USD loan, the structure of the loan would be as follows:

The cash flows in this swap would be as follows:

At inception

None. The loan is notionally converted from INR into USD at current USDINR spot rate. These will then be the principal amounts on which the interest will be computed.

Every 6 months

Company pays to the bank 6 month USD LIBOR plus a spread on the notional USD principal

Company receives from the bank Rupee interest @ 9% on the notional INR principal

At maturity

Company receives INR principal from IDBI Bank

Pays USD principal to the IDBI Bank


The company therefore gains from a lower interest rate loan, for which it bears the cost of INR depreciation against USD during the tenor of the swap.

Currency swaps can be used to move from any currency to any other desired currency and interest rate.

For example, a corporate could swap its INR liability into JPY to benefit from the low JPY interest rates. The risk of adverse JPY/USD exchange rate movement can be limited to desired levels at a price. Such products can be customized to suit specific corporate interest.

It is also possible to structure swaps to hedge specific risks.

For example, there could be swap such that only the principal amount of a foreign currency loan is protected at current exchange rates (Principal Only Swap).

Coupon swaps – swaps involving only interest payments and no principal amounts – is another such variant.


INTEREST RATE AND CURRENCY SWAPS

Interest Rate Swaps

Different borrowers have different borrowing requirements. To be more specific, some borrowers such as manufacturing companies normally prefer fixed rate borrowing.

On the other hand, financial market players such as banks often need floating rate funding. In addition, it is often the case that a borrowing entity wants to access the market where it does not have a comparative advantage. Under such conditions, an interest rate swap can be used profitably.

Principle of Comparative Advantage

Suppose the interest rates applicable to two parties, A & B are as follows.

Floating Fixed

A LIBOR 8%

B LIBOR + 1% 10%

In this case, A enjoys an absolute advantage in both the markets but has a comparative advantage in the fixed rate markets where the interest differential is 2%.

Now, if A wants fixed rate funding, there is no possibility of an interest rate swap.

However, A might prefer floating rate funding and B might want a fixed rate loan.

Thus, if A borrows in the fixed rate market and B in the floating rate market, the net benefit is 2% - 1% = 1%. This benefit can be shared between A & B to reduce the cost of fixed rate funds for B and floating rate funds for A.


The existence of comparative advantage is linked to the nature of appraisal in the case of fixed rate and floating rate loans.

In the case of a fixed rate loan, the appraisal is likely to be more stringent as the lender is stuck with the loan on the same terms for a long period of time, say five years, even if the borrower defaults.

On the other hand, in the case of floating rate loans, there is much more flexibility as interest rates are adjusted from time to time. Also, in extreme cases, the lender may refuse to roll over the loan at the end of the (typical) 6 month period.

Similarities between Currency swaps and Interest rate swaps

Pricing the swap involves finding the exchange rate that gives the swap a zero initial value.

Pricing the swap later in its life means finding the present value of the payments in each currency, converting to a common currency and netting the difference.

This makes the swap either an asset or a liability to a given party and the opposite to the other party.

Dealers price and trade these swaps in essentially the same manner as interest rate swaps.

Difference between Currency swaps and Interest rate swap

One major difference is that the principal is generally exchanged at the onset and at the termination of the swap. An additional element of credit risk with the transaction is the potential for payment problems at the end of the swap.

Unlike interest rate swaps, in the case of currency swaps, both interest and principal payments are exchanged between the counter parties.

At the end of the swap the principal payments are exchanged once again.

Thus, the interest and principal liabilities are converted from one currency into another.


Currency swaps can be of various types, fixed-fixed, floating-floating and fixed-floating.

ROLE OF INTERMEDIARY

An intermediary is often needed to bring together the counterparts in a swap agreement.

In that case, part of the total benefit has to be shared with the swap broker.

Suppose the total benefit from the swap is 1%. If the intermediary charges a fee of say 0.2% and the net benefit of the swap is to be shared equally, each party will be able to lower its cost of funds by 0.4%.

Valuation of swaps

Swaps can be valued on similar lines as bonds as they essentially involve a series of cash flows at different points in time.

We first discount the inflows at an appropriate rate and determine the present value. We repeat the process for outflows. The difference is nothing but the value of the swap.

Usually, the prevailing LIBOR rate is used to discount the cash flows associated with the floating rate end of the swap and the quoted swap rate to discount those associated with the fixed rate loan.

Swap quotations

Conventionally, in the case of interest rate swaps, fixed rates are exchanged for six month LIBOR.

It is thus common to quote the fixed rates associated with the swap.

The floating rate is taken as given and is usually assumed to be equal to LIBOR.

The lower of the two rates is what will be paid in return for receiving LIBOR and the higher is what will be received in return for paying LIBOR.


OPTIONS

An option is a derivative instrument since its value is derived from the underlying asset.

It is essentially a right but not an obligation to buy or sell an asset.

Options can be a call option (right to buy) or a put option (right to sell).

An option by definition has a fixed period of life, usually 3 to 6 months. An option is a wasting asset in the sense that the value of an option diminishes as the date of maturity approaches and on the date of maturity it is equal to zero.

An investor in options has 4 choices before him.

Firstly, he can buy a call option meaning a right to buy an asset after a certain period of time.

Secondly, he can buy a put option meaning a right to sell an asset after a certain period of time.

Thirdly, he can write a call option meaning he can sell the right to buy an asset to another investor.

Lastly, he can write a put option meaning he can sell a right to sell to another investor.

Out of the above 4 cases in the first 2 cases the investor has to pay an option premium while in the last 2 cases the investor receives an option premium.

When we talk of value of an option, we are essentially referring to the value of the right which is derived from the volatility of the stock. Greater the volatility, greater the value of the option.

In the case of a stock option, its value is based on the underlying stock (equity).


In the case of an index option, its value is based on the underlying index (equity).

CALL OPTION BUYER CALL OPTION WRITER (Seller) Pays premium. Right to exercise and buy the

shares. Profits from rising prices. Limited losses, Potentially

unlimited gain. Mainly for the Importers.

Receives premium Obligation to sell shares if

exercised Profits from falling prices or

remaining neutral

Potentially unlimited losses, limited gain

PUT OPTION BUYER PUT OPTION WRITER (Seller)

Pays premium. Right to exercise and sell

shares. Profits from falling prices. Limited losses, Potentially

unlimited gain.

For Exporters mainly.

Receives premium Obligation to buy shares if

exercised Profits from rising prices or

remaining neutral

Potentially unlimited losses, limited gain

Put Options-Long & Short Positions When you expect prices to fall, then you take a long position by buying Puts. You are bearish. When you expect prices to rise, then you take a short position by selling Puts. You are bullish.

CALL OPTIONS PUT OPTIONS If you expect a fall in price (Bearish) Short Long

If you expect a rise in price (Bullish) Long Short


BULL MARKET STRATEGIES

CALLS IN A BULLISH STRATEGY

An investor with a bullish market outlook should buy call options. If you expect the market price of the underlying asset to rise, then you would rather have the right to purchase at a specified price and sell later at a higher price than have the obligation to deliver later at a higher price.

The investor's profit potential buying a call option is unlimited. The investor's profit is the market price less the exercise price less the premium.

The greater the increase in price of the underlying, the greater the investor's profit.

The investor's potential loss is limited. Even if the market takes a drastic decline in price levels, the holder of a call is under no obligation to exercise the option. He may let the option expire worthless.

The investor breaks even when the market price equals the exercise price plus the premium.


An increase in volatility will increase the value of your call and increase your return. Because of the increased likelihood that the option will become in- the-money, an increase in the underlying volatility (before expiration), will increase the value of a long options position. As an option holder, your return will also increase.

E.g Suppose there is a call option with a strike price of Rs 2000 and the option premium is Rs 100. The option will be exercised only if the value of the underlying is greater than Rs 2000 (the strike price). If the buyer exercises the call at Rs 2200 then his gain will be Rs 200. However, this would not be his actual gain for that he will have to deduct the Rs 200 (premium) he has paid.

The profit can be derived as follows Profit = Market price - Exercise price - PremiumProfit = Market price – Strike price – Premium.2200 – 2000 – 100 = Rs 100

PUTS IN A BULLISH STRATEGY

An investor with a bullish market outlook can also go short on a Put option.

Basically, an investor anticipating a bull market could write PUT OPTIONS. If the market price increases and puts become out-of-the-money, investors with long put positions will let their options expire worthless.

By writing Puts, profit potential is limited. A Put writer profits when the price of the underlying asset increases and the option expires worthless. The maximum profit is limited to the premium received.

However, the potential loss is unlimited. Because a short put position holder has an obligation to purchase if exercised. He will be exposed to potentially large losses if the market moves against his position and declines.

The break-even point occurs when the market price equals the exercise price: minus the premium.

At any price less than the exercise price minus the premium, the investor loses money on the transaction. At higher prices, his option is profitable.

An increase in volatility will increase the value of your put and decrease your return.

As an option writer, the higher price you will be forced to pay in order to buy back the option at a later date, lower is the return.


BULLISH CALL SPREAD STRATEGIES

A vertical call spread is the simultaneous purchase and sale of identical call options but with different exercise prices.

To "buy a call spread" is to purchase a call with a lower exercise price and to write a call with a higher exercise price. The trader pays a net premium for the position.

To "sell a call spread" is the opposite, here the trader buys a call with a higher exercise price and writes a call with a lower exercise price, receiving a net premium for the position.

An investor with a bullish market outlook should buy a call spread. The "Bull Call Spread" allows the investor to participate to a limited extent in a bull market, while at the same time limiting risk exposure.

To put on a bull spread, the trader needs to buy the lower strike call and sell the higher strike call. The combination of these two options will result in a bought spread.

The cost of Putting on this position will be the difference between the premium paid for the low strike call and the premium received for the high strike call.


The investor's profit potential is limited. When both calls are in-the-money, both will be exercised and the maximum profit will be realised. The investor delivers on his short call and receives a higher price than he is paid for receiving delivery on his long call.

The investor’s potential loss is limited. At the most, the investor can lose is the net premium. He pays a higher premium for the lower exercise price call than he receives for writing the higher exercise price call.

The investor breaks even when the market price equals the lower exercise price plus the net premium. At the most, an investor can lose is the net premium paid. To recover the premium, the market price must be as great as the lower exercise price plus the net premium.

E.g Let's assume that the cash price of a scrip is Rs 100 and you buy a November call option with a strike price of Rs 90 and pay a premium of Rs 14. At the same time you sell another November call option on a scrip with a strike price of Rs 110 and receive a premium of Rs 4. Here you are buying a lower strike price option and selling a higher strike price option. This would result in a net outflow of Rs 10 at the time of establishing the spread.

Now let us look at the fundamental reason for this position. Since this is a bullish strategy, the first position established in the spread is the long lower strike price call option with unlimited profit potential. At the same time to reduce the cost of purchase of the long position a short position at a higher call strike price is established. While this not only reduces the outflow in terms of premium but his profit potential as well as risk is limited. Based on the above figures the maximum profit, maximum loss and breakeven point of this spread would be as follows:Maximum profit = Higher strike price - Lower strike price - Net premium paid = 110 - 90 - 10 = 10Maximum Loss = Lower strike premium - Higher strike premium = 14 - 4 = 10Breakeven Price = Lower strike price + Net premium paid

= 90 + 10 = 100


BULLISH PUT SPREAD STRATEGIES

A vertical Put spread is the simultaneous purchase and sale of identical Put options but with different exercise prices.

To "buy a put spread" is to purchase a Put with a higher exercise price and to write a Put with a lower exercise price. The trader pays a net premium for the position.

To "sell a put spread" is the opposite: the trader buys a Put with a lower exercise price and writes a put with a higher exercise price, receiving a net premium for the position.

An investor with a bullish market outlook should sell a Put spread. The "vertical bull put spread" allows the investor to participate to a limited extent in a bull market, while at the same time limiting risk exposure.

To put on a bull spread, a trader sells the higher strike put and buys the lower strike put.

The bull spread can be created by buying the lower strike and selling the higher strike of either calls or put. The difference between the premiums paid and received makes up one leg of the spread.

The investor's profit potential is limited. When the market price reaches or exceeds the higher exercise price, both options will be out-of-the-money and will expire worthless. The trader will realize his maximum profit, the net premium


The investor's potential loss is also limited. If the market falls, the options will be in-the-money. The puts will offset one another, but at different exercise prices.

The investor breaks-even when the market price equals the lower exercise price less the net premium.

The investor achieves maximum profit i.e the premium received, when the market price moves up beyond the higher exercise price (both puts are then worthless).

E.g Lets us assume that the cash price of the scrip is Rs 100. You now buy a November put option on a scrip with a strike price of Rs 90 at a premium of Rs 5 and sell a put option with a strike price of Rs 110 at a premium of Rs 15.

The first position is a short put at a higher strike price. This has resulted in some inflow in terms of premium. But here the trader is worried about risk and so caps his risk by buying another put option at the lower strike price. As such, a part of the premium received goes off and the ultimate position has limited risk and limited profit potential. Based on the above figures the maximum profit, maximum loss and breakeven point of this spread would be as follows:

Maximum profit = Net option premium income or net credit = 15 - 5 = 10Maximum loss = Higher strike price - Lower strike price - Net premium received = 110 - 90 - 10 = 10Breakeven Price = Higher Strike price - Net premium income = 110 - 10 = 100


BEAR MARKET STRATEGIES

PUTS IN A BEARISH STRATEGY

When you purchase a put you are long and want the market to fall. A put option is a bearish position.

It will increase in value if the market falls. An investor with a bearish market outlook shall buy put options.

By purchasing put options, the trader has the right to choose whether to sell the underlying asset at the exercise price. In a falling market, this choice is preferable to being obligated to buy the underlying at a price higher.

An investor's profit potential is practically unlimited. The higher the fall in price of the underlying asset, higher the profits.

The investor's potential loss is limited. If the price of the underlying asset rises instead of falling as the investor has anticipated, he may let the option expire worthless. At the most, he may lose the premium for the option.

The trader's breakeven point is the exercise price minus the premium. To profit, the market price must be below the exercise price. Since the trader has paid a premium he must recover the premium he paid for the option.

An increase in volatility will increase the value of your put and increase your return. An increase in volatility will make it more likely that the price of the underlying instrument will move. This increases the value of the option.


CALLS IN A BEARISH STRATEGY

Another option for a bearish investor is to go short on a call with the intent to purchase it back in the future.

By selling a call, you have a net short position and needs to be bought back before expiration and cancel out your position.

For this an investor needs to write a call option. If the market price falls, long call holders will let their out-of-the-money options expire worthless, because they could purchase the underlying asset at the lower market price.

The investor's profit potential is limited because the trader's maximum profit is limited to the premium received for writing the option.

Here the loss potential is unlimited because a short call position holder has an obligation to sell if exercised, he will be exposed to potentially large losses if the market rises against his position.

The investor breaks even when the market price equals the exercise price: plus the premium. At any price greater than the exercise price plus the premium, the trader is losing money. When the market price equals the exercise price plus the premium, the trader breaks even.


An increase in volatility will increase the value of your call and decrease your return.

When the option writer has to buy back the option in order to cancel out his position, he will be forced to pay a higher price due to the increased value of the calls.

BEARISH PUT SPREAD STRATEGIES

A vertical put spread is the simultaneous purchase and sale of identical put options but with different exercise prices.

To "buy a put spread" is to purchase a put with a higher exercise price and to write a put with a lower exercise price. The trader pays a net premium for the position.

To "sell a put spread" is the opposite. The trader buys a put with a lower exercise price and writes a put with a higher exercise price, receiving a net premium for the position.

To put on a bear put spread you buy the higher strike put and sell the lower strike put. You sell the lower strike and buy the higher strike of either calls or puts to set up a bear spread.

An investor with a bearish market outlook should: buy a put spread. The "Bear Put Spread" allows the investor to participate to a limited extent in a bear market, while at the same time limiting risk exposure.


The investor's profit potential is limited. When the market price falls to or below the lower exercise price, both options will be in-the-money and the trader will realize his maximum profit when he recovers the net premium paid for the options.

The investor's potential loss is limited. The trader has offsetting positions at different exercise prices. If the market rises rather than falls, the options will be out-of-the-money and expire worthless. Since the trader has paid a net premium

The investor breaks even when the market price equals the higher exercise price less the net premium.

For the strategy to be profitable, the market price must fall. When the market price falls to the high exercise price less the net premium, the trader breaks even. When the market falls beyond this point, the trader profits.

E.g Lets assume that the cash price of the scrip is Rs 100. You buy a November put option on a scrip with a strike price of Rs 110 at a premium of Rs 15 and sell a put option with a strike price of Rs 90 at a premium of Rs 5. In this bearish position the put is taken as long on a higher strike price put with the outgo of some premium. This position has huge profit potential on downside. If the trader may recover a part of the premium paid by him by writing a lower strike price put option. The resulting position is a mildly bearish position with limited risk and limited profit profile. Though the trader has reduced the cost of taking a bearish position, he has also capped the profit potential as well. The maximum profit, maximum loss and breakeven point of this spread would be as follows:Maximum profit = Higher strike price option - Lower strike price option - Net premium paid = 110 - 90 - 10 = 10Maximum loss = Net premium paid = 15 - 5 = 10Breakeven Price = Higher strike price - Net premium paid = 110 - 10 = 100


BEARISH CALL SPREAD STRATEGIES

A vertical call spread is the simultaneous purchase and sale of identical call options but with different exercise prices.

To "buy a call spread" is to purchase a call with a lower exercise price and to write a call with a higher exercise price. The trader pays a net premium for the position.

To "sell a call spread" is the opposite: the trader buys a call with a higher exercise price and writes a call with a lower exercise price, receiving a net premium for the position.

To put on a bear call spread you sell the lower strike call and buy the higher strike call. An investor sells the lower strike and buys the higher strike of either calls or puts to put on a bear spread.

An investor with a bearish market outlook should: sell a call spread. The "Bear Call Spread" allows the investor to participate to a limited extent in a bear market, while at the same time limiting risk exposure.


The investor's profit potential is limited. When the market price falls to the lower exercise price, both out-of-the-money options will expire worthless. The maximum profit that the trader can realize is the net premium: The premium he receives for the call at the higher exercise price.

Here the investor's potential loss is limited. If the market rises, the options will offset one another. At any price greater than the high exercise price, the maximum loss will equal high exercise price minus low exercise price minus net premium.

The investor breaks even when the market price equals the lower exercise price plus the net premium. The strategy becomes profitable as the market price declines. Since the trader is receiving a net premium, the market price does not have to fall as low as the lower exercise price to breakeven.

E.g Let us assume that the cash price of the scrip is Rs 100. You now buy a November call option on a scrip with a strike price of Rs 110 at a premium of Rs 5 and sell a call option with a strike price of Rs 90 at a premium of Rs 15. In this spread you have to buy a higher strike price call option and sell a lower strike price option. As the low strike price option is more expensive than the higher strike price option, it is a net credit strategy. The final position is left with limited risk and limited profit.The maximum profit, maximum loss and breakeven point of this spread would be as follows:

Maximum profit = Net premium received = 15 - 5 = 10Maximum loss = Higher strike price option - Lower strike price option - Net premium received = 110 - 90 - 10 = 10Breakeven Price = Lower strike price + Net premium paid = 90 + 10 = 100


TYPES OF OPTIONS

Options

Call Option Put Option

Call Option

A call option gives the holder the right, not the obligation, to buy 100 shares of the underlying stock at a fixed price and for a fixed period of time.

Put Option

A put option gives the holder the right, not the obligation, to sell 100 shares of the underlying stock for a fixed price and for a fixed period of time.

This is why an option is considered to be a 'wasting' asset. Since the option only has value for a fixed period of time, its value decreases, or 'wastes' away with the passage of time.

In the case of an index option, the holder can participate in the movement of the index.

However, these options are cash settled and therefore, the holder of the option will never wind up with a position in the underlying securities.

Four Components to an Option

The underlying security

The type of option (put or call)

The strike price

The expiration date


OPTIONS – PUT AND CALL

Buying a Put Option

A put is an options contract, which grants the owner of the put the right, not the obligation, to sell the underlying security at a specific price, within a specific time frame.

The owner of a put (long the put) is expecting the underlying security to decline in price.

Unlike a call option, the put option buyer does not have unlimited profit potential. This is so because theoretically, the underlying security can rise in price infinitely. Therefore, a call option can rise in price infinitely.

However, an underlying security can never drop in price below zero. Therefore, the maximum profit a put option buyer can receive is if the underlying security drops to zero.

Another important thing to consider is that the short seller of stock is obligated to pay the dividends. The put option buyer is not obligated to do this.

Many investors who own stock in their portfolio will buy puts in order to protect their portfolio in the event the stock(s) turns decline in price. Another alternative for a portfolio diversified with many S&P 100 stocks, is to purchase OEX puts.

Buying a Call Option

A call is an options contract, which gives an investor the right, not the obligation, to purchase the underlying security at a specific price within a specific time period.

Theoretically, the profit potential is unlimited, while the risk is limited to the amount paid for the option.

An investor might purchase the call instead of the underlying security so that he is able to buy the underlying security at a reasonable price without taking the chance that he misses out on a market move.

Another investor may purchase calls if his portfolio consists of low volatile stocks, but he wants to take a small percentage of his assets and trade higher volatile stocks.


OPTION STYLES

Settlement of options is based on the expiry date. However, there are three basic styles of options you will encounter which affect settlement. The styles have geographical names, which have nothing to do with the location where a contract is agreed! The styles are:

EUROPEAN STYLE

These options give the holder the right, but not the obligation, to buy or sell the underlying instrument only on the expiry date. This means that the option cannot be exercised early. Settlement is based on a particular strike price at expiration. Currently, in India only index options are European in nature.

E.g Sam purchases 1 NIFTY AUG 1110 Call --Premium 20. The exchange will settle the contract on the last Thursday of August. Since there are no shares for the underlying, the contract is cash settled.

AMERICAN STYLE

These options give the holder the right, but not the obligation, to buy or sell the underlying instrument on or before the expiry date. This means that the option can be exercised early. Settlement is based on a particular strike price at expiration.

Options in stocks that have been recently launched in the Indian market are "American Options".

eg: Sam purchases 1 ACC SEP 145 Call --Premium 12. Here Sam can close the contract any time from the current date till the expiration date, which is the last Thursday of September.

American style options tend to be more expensive than European style because they offer greater flexibility to the buyer.

OPTION CLASS & SERIES

Generally, for each underlying, there are a number of options available: For this reason, we have the terms "class" and "series".

An option "class" refers to all options of the same type (call or put) and style (American or European) that also have the same underlying.

eg: All Nifty call options are referred to as one class.

An option series refers to all options that are identical: they are the same type, have the same underlying, the same expiration date and the same exercise price.


THE OPTIONS CLEARING CORPORATION

The Options Clearing Corporation (OCC) is the guarantor of all exchange-traded options once an option transaction has been completed.

Once a seller has written an option and a buyer has purchased that option, the OCC takes over.

It is the responsibility of the OCC who oversees the obligations to fulfill exercises.

E.g. If I want to exercise that XYZ November 100-call option, I notify my broker. My broker notifies the OCC. The OCC then randomly selects a brokerage firm, which is short one XYZ November 100-call option that it must come up with 100 shares of XYZ stock. That brokerage firm then notifies one of its customers who has written one XYZ November 100 call option that he must produce 100 shares of XYZ stock. His call has been exercised.

This margin requirement acts as a performance bond. It assures that the OCC will get its money.

At-The-Money, In-The-Money, Out-Of-The-Money

The three different terms for describing where an option is trading in relation to the price of the underlying security are 'at-the-money', 'in-the-money', and 'out-of-the money'.

E.g. Let's use XYZ November 100 call as an example.

If XYZ stock is trading at a price of 100, the November 100 call is considered to be trading 'at-the-money'.

If XYZ stock is trading at a price greater than 100, say 102, the call option is considered to be 'in-the-money'.

And if XYZ is trading at a price less than 100, say 98, the call option is considered to be trading 'out-of-the-money.

Conversely, if it was an XYZ November 100 put option we owned. If the price of XYZ stock was 102, the put option would be considered to be 'out-of-the-money.

And if XYZ stock were trading at a price of 98, the put option would be considered to be trading 'in-the-money'.

If XYZ stock were again trading at 100, the put option would be 'at-the-money'.


PRICING OF OPTIONS

Options are used as risk management tools and the valuation or pricing of the instruments is a careful balance of market factors.

There are four major factors affecting the Option premium:

Price of Underlying

Time to Expiry

Exercise Price Time to Maturity

Volatility of the Underlying

And two less important factors:

Short-Term Interest Rates

Dividends

OPTIONS PRICING FACTORS

THE INTRINSIC VALUE OF AN OPTION

The intrinsic value of an option is defined as the amount by which an option is in-the-money, or the immediate exercise value of the option when the underlying position is market-to-market.

For a call option: Intrinsic Value = Spot Price - Strike Price For a put option: Intrinsic Value = Strike Price - Spot Price

The intrinsic value of an option must be positive or zero. It cannot be negative.

For a call option, the strike price must be less than the price of the underlying asset for the call to have an intrinsic value greater than 0.

For a put option, the strike price must be greater than the underlying asset price for it to have intrinsic value.


PRICE OF UNDERLYING

The premium is affected by the price movements in the underlying instrument.

For Call options – the right to buy the underlying at a fixed strike price – as the underlying price rises so does its premium, As the underlying price falls so does the cost of the option premium.

For Put options – the right to sell the underlying at a fixed strike price – as the underlying price rises, the premium falls; as the underlying price falls the premium cost rises.

The following chart summarizes the above for Calls and Puts.

Option Underlying price Premium cost

Call

Put

THE TIME VALUE OF AN OPTION

Generally, the longer the time remaining until an option’s expiration, the higher its premium will be. This is because the longer an option’s lifetime, greater is the possibility that the underlying share price might move so as to make the option in-the-money.

All other factors affecting an option’s price remaining the same, the time value portion of an option’s premium will decrease (or decay) with the passage of time.

Note: This time decay increases rapidly in the last several weeks of an option’s life. When an option expires in-the-money, it is generally worth only its intrinsic value.

Option Time to expiry Premium cost

Call

Put


VOLATILITY

Volatility is the tendency of the underlying security’s market price to fluctuate either up or down.

It reflects a price change’s magnitude; it does not imply a bias toward price movement in one direction or the other. Thus, it is a major factor in determining an option’s premium.

The higher the volatility of the underlying stock, the higher the premium because there is a greater possibility that the option will move in-the-money.

Generally, as the volatility of an under-lying stock increases, the premiums of both calls and puts overlying that stock increase, and vice versa.

Higher volatility=Higher premiumLower volatility = Lower premium

Option Volatility Premium cost

Call

Put


INTEREST RATES

In general, interest rates have the least influence on options and equate approximately to the cost of carry of a futures contract. If the size of the options contract is very large, then this factor may take on some importance.

All other factors being equal as interest rates rise, premium costs fall and vice versa. The relationship can be thought of as an opportunity cost.

In order to buy an option, the buyer must either borrow funds or use funds on deposit. Either way the buyer incurs an interest rate cost.

If interest rates are rising, then the opportunity cost of buying options increases and to compensate the buyer premium costs fall.

Why should the buyer be compensated? Because the option writer receiving the premium can place the funds on deposit and receive more interest than was previously anticipated.

The situation is reversed when interest rates fall – premiums rise. This time it is the writer who needs to be compensated.

Option Interest rates Premium cost

Call

Put


OPTIONS – TRADING IN OPTIONS

Options Trading

Trading options is very hard work. There is also a tremendous amount of risk involved.

The statistics are that over 90% of the people who try to trade options for a living lose money at it.

One of the biggest problems is the 'Beginners Luck" factor.

The Beginners Luck factor is when a person wins big their first week or on their first few trades. They gain undeserved confidence and begin to become a little reckless. The individual feels that this is pretty easy. They feel that they can make a lot of money trading options. Life's great and all is well with the world. The individual options trader feels that he's smarter than the rest of the traders (professional and amateur) and he'll be able to retire rich in a couple of years.

However, the facts are that trading for a living is hard work. The odds are stacked against you. And most of the time, this lucky beginning options trader is going to put all his profits back and then some in a few weeks time.

The single greatest problem for the industry is that these individuals crash and burn so quickly.

Data providers and software vendors constantly have to look for a new stream of clients because so many of their present clients crash and burn. If they don't have any money left they can't trade. They don't need the software and they don't need the data service.

The reality is that there are very few traders who are consistently profitable.

The best traders have drawdown and bad periods. They can stay in the game because they are well capitalized.

So the new trader has to have enough money in his account to be able to suffer a severe drawdown and still be able to trade. Because once you lose your money and you don't have any more to trade with, the game is over.

The problem with options is that if a person is buying straight put options and call options, the underlying equity has to reach a certain price by a specified period of time.


There is a high probability that an option could expire worthless. Unlike a futures contract, you can't roll an option contract over to another expiration date.

Options as a strategy combined with the underlying security, can be a sound strategy given the right circumstances.

Very few professionals buy options outright for speculation.

If a person wants to begin trading options, consider the following.

First, don't quit your day job.

Second, invest in some good technical analysis software.

Third, set aside some money that if you lose it all, it doesn't matter (don't start with less than $15,000 - $20,000).

Fourth, start by analyzing end of day data. Use a data provider to provide end of day quotes only. Don't begin trading real time, intra-day.

Fifth, paper trade for at least six months. Develop your systems and the indicators you're going to rely on during this time.

Sixth, at the end of six months if you have a profit, consider trading for real with modest sums. If you have a loss, continue to paper trade until you can develop a winning strategy.

When a person is paper trading he must simulate real time performance as closely as possible.

Buy your options at the closing prices. Set stop loss and limit orders to sell. Don't say to yourself that you 'would have gotten out at this point'. You never do.

Set specific levels to enter and exit. Stay on top of it every day. And if the stock gaps up or down the next day after you placed your opening or closing order either disregard the trade or take the loss. Don't cheat.

Draw downs are bound to happen. In fact, it's written in just about every book on trading.

Another creative way small investors have come up with to give away their money is when they first start trading. It starts with the plan.


ADVANTAGES OF OPTION TRADING

RISK MANAGEMENT

Put options allow investors holding shares to hedge against a possible fall in their value.

This can be considered similar to taking out insurance against a fall in the share price.

TIME TO DECIDE

By taking a call option the purchase price for the shares is locked in.

This gives the call option holder until the Expiry Day to decide whether or not to exercise the option and buy the shares.

Likewise the taker of a put option has time to decide whether or not to sell the shares.

SPECULATION

The ease of trading in and out of an option position makes it possible to trade options with no intention of ever exercising them.

If an investor expects the market to rise, they may decide to buy call options. If expecting a fall, they may decide to buy put options.

Either way the holder can sell the option prior to expiry to take a profit or limit a loss.

Trading options has a lower cost than shares, as there is no stamp duty payable unless and until options are exercised.


LEVERAGE

Leverage provides the potential to make a higher return from a smaller initial outlay than investing directly.

However, leverage usually involves more risks than a direct investment in the underlying shares.

Trading in options can allow investors to benefit from a change in the price of the share without having to pay the full price of the share.

We can see below how one can leverage ones position by just paying the premium.

Option Premium StockBought on Oct 15 Rs 380 Rs 4000Sold on Dec 15 Rs 670 Rs 4500Profit Rs 290 Rs 500ROI (Not annualised) 76.3% 12.5%

INCOME GENERATION

Shareholders can earn extra income over and above dividends by writing call options against their shares.

By writing an option they receive the option premium upfront.

While they get to keep the option premium, there is a possibility that they could be exercised against and have to deliver their shares to the taker at the exercise price.

STRATEGIES

By combining different options, investors can create a wide range of potential profit scenarios. To find out more about options strategies read the module on trading strategies.


FINANCING FOREIGN OPERATIONS

A foreign affiliate, like any other business operations, requires –

a) Long Term Funds

b) Short Term and Intermediate Funds

Long Term Financing

The key issues with respect to the ling term financing of a foreign affiliate are :

What should be the stake of the parent company in the equity capital of its foreign affiliate?

What is the optimal capital structure of the foreign affiliate?

What are the sources of long term funds for the foreign affiliate?

Parent Company’s Stake in Equity

The parent company may hold the entire equity in its foreign affiliate or offer a portion of is to local investors and create a joint venture.

Optimal Capital Structure

Given the presence of taxes, agency costs, and financial distress costs, the multinational company, as a whole, does have an optimal capital structure.

If we ignore some real world imperfections, the capital structure of the affiliate is irrelevant as long as the overall capital structure of the multinational company as a whole is unchanged and the multinational company guarantees the borrowings of the affiliate.

Sources of Long Term Funds

Apart from equity capital, which is typically provides by the parent company and the local investors, the foreign affiliate requires long-term debt funds also.

These are generally obtained from local banking institutions and international financing institutions.

Sometimes, they may be issued by issuing debt securities in the capital market of the host country.


Short Term and Intermediate Financing

The foreign affiliate typically taps local sources for its short-term financing needs.

Short term financing is obtained by way of an overdraft arrangement (which is line of credit) provided by local banks.

Likewise intermediate term loans can also be obtained from local banks.

These loans usually require collateral and impose certain restrictions on the borrower’s investment policy, dividend policy, debt-equity ratio, and so on.

The foreign affiliate may also borrow in the Eurocurrency market which is the international market for short term capital.

In this market borrowings and lendings are usually for a six-month period.

However, loans are typically renewable at revised rates of interest.

The Eurocurrency market is virtually free from the governmental regulations of individual countries.


RAISING FOREIGN CURRENCY FINANCE

The major sources available to an Indian firm for raising foreign currency finance are as follows.

FOREIGN CURRENCY TERM LOANS FROM FINANCIAL INSTITUTIONS

Financial institutions provide foreign currency term loans for meeting the foreign currency expenditures towards import of plant, machinery, and equipment and also towards payment of foreign technical know-how fees. In India the most fashioned way is FCNR(B).

EXPORT CREDIT SCHEMES

Export credit agencies have been established by the governments of major industrialized countries for financing exports of capital goods and related technical services. These agencies follow certain consensus guidelines for supporting exports under a convention known as the BERNE UNION.

Two kinds of export credit are provided

Buyer’s credit

Under this arrangement, credit is provided directly to the Indian buyer for purchase of capital goods and/or services from the overseas exporter.

Supplier’s credit

This is a credit provided to the overseas exporter so that they can make available medium term finance to Indian importers.

EXTERNAL COMMERCIAL BORROWINGS

Subject to certain terms and conditions, the government of India permits Indian firms to resort to external commercial borrowings for the import of plant and machinery.


Features of Eurocurrency Loans

A Eurocurrency is simply a deposit of currency in a bank outside the country of the currency.

The main features of Eurocurrency loans, which represent the principal form of external commercial borrowings are:

Syndication

Eurocurrency loans are often syndicated loans, wherein a group of lenders, particularly banks, participate jointly in the process of lending under a single loan agreement.

Floating rate

The rate of interest on Eurocurrency loans is a floating rate. It is usually linked to LIBOR (London Inter Bank Offer Rate) or SIBOR (Singapore Inter Bank Offer Rate).

Interest period

The interest period may be 3, 6, 9, or 12 months in duration. It is largely left to the option of the borrower.

Currency option

The borrower often enjoys the multi-currency option which enables it to denominate the interest and principal in the new currency opted for.

Repayment and Prepayment

The Eurocurrency loans are repayable in installments, which are typically equal, over a period of time as agreed to by the parties. The borrower may prepay the loan after giving due notice to the lead bank.


EUROISSUES

Bonds and Euro equities collectively are referred as Euro issues.

The two principal mechanisms used by Indian companies are

Depository Receipts Mechanism

Euro convertible Issues

ISSUES IN FOREIGN DOMESTIC MARKETS

Apart from Euro issues, which are made in the euro market, Indian firms can also issue bonds and equities in the domestic capital market of a foreign country.


FOREIGN EXCHANGE EXPOSURE

TYPES OF EXPOSURE

TRANSACTION EXPOSURE

When a firm has a payable or receivable denominated in a foreign currency, a change in the exchange rate will alter the amount of local currency received or paid. Such a risk or exposure is referred to as transaction exposure.

E.g. if an Indian exporter has a receivable of $100,000 due three months hence and if in the meanwhile the dollar depreciated relative to the rupee a cash loss occurs. Conversely, if the dollar appreciated relative to the rupee, a cash gain occurs.

In the case of a payable, the outcome is of an opposite kind: a depreciation of the dollar relative to the rupee results in loss

TRANSLATION EXPOSURE

The laws in many countries require that the accounts of foreign subsidiaries and branches have to be consolidated with those of the parent company.

For such consolidation, assets and liabilities expressed in foreign currencies have to be translated into domestic currency at the exchange rate prevailing on the consolidation date.

If the value of foreign currencies changes between two successive consolidation dates translation gains or losses arise.

If an item is translated at the current exchange rate, the rate prevailing on the consolidation date, it is said to be exposed.

On the other hand, if an item is translated at the historic exchange rate, the rate that prevailed when the item came into being, it is said to be unexposed.



OPERATING EXPOSURE

Operating exposure, like transaction exposure, involves an actual or potential gain or loss.

While the former is specific to a transaction, the latter, much broader in nature, relates to an entire investment.

The essence of operating exposure is that exchange rate changes significantly alter the cost of a firm’s inputs and the prices of its output and thereby influence its competitive position substantially.

E.g. Volkswagen had a highly successful export market for its ‘Beetle’ model in the US before 1970. With the breakdown of the Brettonwood system of fixed exchange rate, the Deutsche mark appreciated significantly against the dollar. This created problems for Volkswagen as its expenses were mainly in Deutsche mark but its revenues in dollars. However, in piece sensitive US market, such an action caused a sharp decrease in sales volume from 600,000 vehicles in 1968 to 200,000 in 1976.


MANAGEMENT OF FOREIGN EXCHANGE EXPOSURE

For Indian firms, foreign exchange exposure arises mainly on account of imports, exports, and foreign currency borrowings. To cope with such exposures the following devices are commonly employed.

FORWARD MARKET HEDGE

In a forward market hedge, a net liability (asset) position is covered by an asset (liability) in the forward market.

E.g. Consider the case of an Indian firm, which has a liability of $100,000 payable in 60 days to an American supplies on account of credit purchases. The firm may employ the following steps to cover its liability position:Step 1 : Enter into a forward contract to purchase $100,000 in 60 days from a foreign exchange dealer. The 60-day forward contract rate is, say, Rs. 46.90 per dollar.Step 2 : On the sixtieth day pay the dealer Rs 4,690,000($100.000 * Rs 46.90).

By using such a mechanism, the Indian firm can eliminate the exchange risk in dollars because of its asset position in the forward dollars.

ROLLOVER CONTRACT

In the foreign exchange market in India, a forward contract for a maturity period exceeding six months is not ordinarily possible because in the inter bank market, quotations beyond six months are not available.

So, an Indian firm which has a foreign currency borrowing payable over an extended period of time, will have to go for a rollover contract, if is wants a forward cover.

Essentially this means that the borrower buys forward the entire amount to be covered for a date, which synchronizes with the next installment date.

Come that date, the borrower uses a portion of the forward contract to meet the installment amount and rolls over the balance of the contract to the next installment date – this means he sells the balance in the spot market and buys it in the forward market. This is continued till the last installment is paid.


Under the rollover contract, the basic rate of exchange is fixed.

FINANCIAL SWAPS

A financial swap basically involves an exchange of one set of financial obligation with another. The two most important financial swaps are the interest rate swaps and the currency swaps.

MONEY MARKET HEDGE

In a money market hedge, the exposed position in a foreign currency is covered through borrowing or lending in the money market.

E.g. Consider the case of a British firm which has a liability of $100,000 on account of purchases from a US supplier, which is payable after 30 days. Today’s spot rate is $1.692 per pound. The 30-day money market rates in the UK and the US are 1 % for lending and 1.5 % for borrowing.

In order to hedge, the British firm can take the following steps :

Step 1 : Determine the present value of the foreign currency liability by using the money market rate applicable to the foreign country. This works out to : $100,000/1.01 = $99010

Step 2 : Obtain $99010 on today’s spot market in exchange for 58516 pounds. Today’s spot rate is $1.692 per pound.

Step 3 : Invest $99010 in the Us money market.(this investment will compound to exactly $100,000 the known future dollar liability after 30 days.


CORPORATE PRACTICES IN MANAGING EXCHANGE RISK

Practices followed by the corporate in managing exchange risk.

Companies regard transaction exposure to be more important that translation and economic (operating) exposures.

In a majority of cases, companies do not have any definite policy for managing foreign exchange risk

The forward exchange contract is regarded as the most useful for managing foreign exchange risk.

Companies are often not aware of other hedging techniques and believe that there is need for more education in this area.

Most companies believe that they are not in the business of speculating on foreign exchange movements; further, most companies think that it is not worthwhile to eliminate all foreign exchange risks.

The introductions of LERMS has created greater awareness for developing sophisticated exchange risk management and has brought more top management involvement in this task.


FOREIGN EXCHANGE MANAGEMENT ACT (FEMA)

To regulate the foreign exchange transactions, initially the Government introduce the Foreign Exchange Regulation Act. After understanding the nerve of the foreign exchange market the Government convert it in to Foreign Exchange Management Act. The Foreign Exchange Management Bill (FEMA), was introduced by the Government of India in Parliament on august 4, 1998. The Bill aims “to consolidate and amend the law relating to foreign exchange with the objective of facilitating external trade and payments and for promoting the orderly development and maintenance of foreign exchange market in India.”

CHARACTERISTICS OF FEMA

CURRENT ACCOUNT AND CAPITAL ACCOUNT TRANSACTION

Any person may sell or draw foreign exchange to or from an authorized person if such sale or drawal is a current account transaction. However, the Central government may, in public interest and in consultation with the Reserve Bank, impose such reasonable restrictions for current account transaction as may be prescribed.

Any person may sell or draw foreign exchange to or from an authorized person for a capital account transaction.

REALISATION AND REPATRIATION OF FOREIGN EXCHANGE

If any amount of foreign exchange is due or has accrued to any person resident in India, such person shall take all reasonable steps to realize and repatriate to India such foreign exchange within such period and in such manner as may be specified by the Reserve Bank.


CONTRAVENTION AND PENALTIES

If any person contravenes any provisions of this Act he shall, upon adjudication, be liable to a penalty up to thrice the sum involved in such contravention where such amount is quantifiable, or up to two lacs rupees where the amount is not quantifiable, and such contravention is a continuing one.

ADJUDICATION AND APPEAL

Central Government may appoint Adjudication Authorities for holding an inquiry in the manner prescribed after giving the accused person a reasonable opportunity of being heard for the purpose of imposing any penalty.

DIRECTORATE OF ENFORCEMENT

The Central Government shall establish a Directorate of Enforcement with a Director and such other officers or class of officers as it thinks fit, which shall be called Officers of Enforcement, for the purpose of this Act.

The Director of Enforcement and other officers of Enforcement shall exercise the like powers which are conferred on Income-tax authorities under the Income-tax Act, 1961 and shall exercise such powers, subject to such limitations laid down under the Act.

MISCELLANEOUS

Sub-section of section 40 empowers the Central Government in the public interest and by notification to suspend or relax the provisions of the Act in certain circumstances.


FEMA – A MAJOR DEPARTURE FROM FERA

As is clear from the name of the Act itself, the emphasis is on ‘exchange management’ whereas under FERA the emphasis was in ‘exchange regulation’ or exchange control.

Under FERA it was necessary to obtain Reserve Bank’s permission, either special or general, in respect of most of the regulations there under. FEMA has brought about a sea change in this regard and except for things, which relates to dealing in foreign exchange, etc., no other provisions of FEMA stipulate obtaining Reserve Bank’s permission.

The contravention under FERA was treated as a criminal offence and the burden of proof was on the guilty, while violations of FEMA will not attract criminal proceedings. The contravention will now be treated as a civil offence. Thus FEMA removes the “threat of imprisonment.”

FEMA represents a major departure as it can be seen as an initial step towards capital account convertibility.

By removing FERA from the statute book and replacing it with the FEMA, the government seems to have finally decided to give up the bare intention of regulating foreign capital in the country.


SOME SUGGESTIONS FOR MANAGING RISK

Be selective

Seek more than one Quotation

Choose a Proper Mix of Currencies and Interest Rates

Establish Rapport with the Banker

Act Swiftly


DERIVATIVES

A derivative is a financial instrument, which derives its value from some other financial price. This “other financial price” is called the underlying.

E.g. A wheat farmer may wish to contract to sell his harvest at a future date to eliminate the risk of a change in prices by that date. The price for such a contract would obviously depend upon the current spot price of wheat. Such a transaction could take place on a wheat forward market. Here, the wheat forward is the “derivative” and wheat on the spot market is “the underlying”. The terms “derivative contract”, “derivative product”, or “derivative” are used interchangeably.

The most important derivatives are futures and options.

Exchange–traded derivatives

Derivatives, which trade on an exchange, are called “exchange–traded derivatives”. Trades on an exchange generally take place with anonymity. Trades at an exchange generally go through the clearing corporation.

“Over The Counter (OTC) derivatives”

A derivative contract, which is privately negotiated, is called an OTC derivative.

OTC trades have no anonymity, and they generally do not go through a clearing corporation.

Every derivative product can either trade OTC (i.e., through private negotiation), or on an exchange.

In one specific case, the jargon demarcates this clearly: OTC futures contracts are called “forwards” (or, exchange–traded forwards are called “futures”).

In other cases, there is no such distinguishing notation. There are “exchange–traded options” as opposed to “OTC options”; but they are both called options.


Badla trading unlike Derivatives trading Badla is a mechanism to avoid the discipline of a spot market; to do trades on the

spot market but not actually do settlement.

The “carry-forward” activities are mixed together with the spot market.

A well functioning spot market has no possibility of carry-forward.

Derivatives trades take place distinctly from the spot market.

The spot price is separately observed from the derivative price.

A modern financial system consists of a spot market, which is a genuine spot market, and a derivatives market, which is separate from the spot market.

Hedging using derivatives termed as “risk transfer”

One key motivation for derivatives is to enable the transfer of risk between individuals and firms in the economy.

This can be viewed as being like insurance; with the difference that anyone in the economy (and not just insurance companies) would be able to sell insurance.

A risk averse person buys insurance; a risk–seeking person sells insurance.

On an options market, an investor who tries to protect himself against a drop in the index buys put options on the index, and a risk-taker sells him these options.

One special motivation which drives some (but not all) trades is mutual insurance between two persons, both exposed to the same risk, in an opposite way.

In the context of currency fluctuations, exporters face losses if the rupee appreciates and importers face losses if the rupee depreciates.

By forward contracting in the dollar-rupee forward market, they supply insurance to each other and reduce risk. This is a situation where both parties in the transaction seek to avoid risk.

In these ways, derivatives supply a method for people to do hedging and reduce their risks.

As compared with an economy lacking these facilities, this is a considerable gain. The largest derivatives markets in the world are on government bonds (to help control interest rate risk), the market index (to help control risk that is associated with fluctuations in the stock market) and on exchange rates (to cope with currency risk).


Changes to market quality and price formation on the cash market once a derivative trading commences

The empirical evidence broadly suggests that market efficiency and liquidity on the spot market improve once a derivative trading comes about.

Speculators generally prefer implementing their positions using derivatives rather than using a sequence of trades on the underlying spot market.

Hence, access to derivatives increases the rate of return on information gathering, research and forecasting activities, and thus serves to spur investments into information gathering and forecasting. This helps improve market efficiency.

From a market microstructure perspective, derivatives markets may reduce the extent to which informed speculators are found on the spot market, thus reducing the adverse selection on the spot market.

Derivatives also help reduce the risks faced by liquidity providers on the spot market, by giving them avenues for hedging. These effects help improve liquidity on the spot market.

A liquid derivatives market tends to become the focus of speculation and price discovery.

When news breaks, the derivative market reacts first. The information propagates 13 down to the cash market a short while later, through the activities of arbitrageurs.


BIBLIOGRAPHY

INTERNATIONAL FINANCE BY P G APTE

MULTINATIONAL FINANCIAL MANAGEMANTBY ALAN C. SHAPIRO

FINANCIAL MANAGEMANET Theory and Practice

BY PRASANNA CHANDRA

FOREIGN EXCHANGE FOR YOU Export import finance

BY K. PARAMESWARAN

INDIAN ECONOMY BY MISHRA AND PURI

Various sites visited -

www.davv.ac.in/finance/frxmgmt.htm

www.fxcm.com

www.forexcapital.com


http://www.forexcapital.com/

http://www.fxcm.com/

http://www.davv.ac.in/finance/frxmgmt.htm

FOREIGN EXCHANGE Adani Wilmar Limited

Documents

purchasing

secondary

optimal capital

potentially

primary price

bullish market

todays spot

market price