Forex

FOREX RISK MANAGEMENT

Presented by

forex-Capital Services Pvt. Ltd.

Forex Portfolio Managers & Advisors

OBJECTIVES BEHIND FOREX MANAGEMENT

COST REDUCTION CONTAIN LOSSES OPTIMISING EXCHANGE GAIN PROTECT OPERATING PROFIT ACHIEVE BUDGETS AND TARGETS INSURE AGAINST ADVERSE

EXCHANGE RATE MOVEMENTS

HOW TO ACHIEVE THESE OBJECTIVES?

Determine the nature of exposure Evaluate the risks and rewards Decide targets & strategies to safeguard against

currency risk Formulate policies for day-to-day operations Strong MIS Reporting system Periodical review of performance & strategy Single treasury concept for forex & money

market

KEY FACTORS FOR AN EFFECTIVE STRATEGY

• Management’s attitude towards risk • Type of exposure – Tenure & Cost• Firm’s willingness to devote the amount and

quality of resource to exposure management function

• Access to various markets & instruments such as forwards, options, futures etc and there implications

• Choice of currency - Dollar / Non- Dollar• Gross or Net Exposure to be managed

NATURE OF RISKCURRENCY RISK

- Dollar vs. INR - a) Spot b) Forward

- Cross Currency - DUAL Exposure INTEREST RATE RISK

Domestic & International OTHER ECONOMIC RISK- Competitor’s pricing strategy- Fluctuations in price of raw material- Policy changes

FACTORS AFFECTING RISK

Economic - Domestic & InternationalPolitical / Country RiskRegulatorySpilloverOther untoward events

IDENTIFYING RISKS

Strong information system for Currency exposure

Continuous flow of information, review of factors affecting risk

Continuous process involving reading, interaction, experience etc.

Prediction extremely difficult

MANAGEMENT’S APPROACH TOWARDS

FX-MANAGEMENT CONSERVATIVE APPROACH

Hedge the exposure as it arises Yields and costs of transactions are known Less risk of cash flow destabilization Less of management time and effort required Unlikely to yield optimum results Any opportunity arising in the market cannot be encashed

MODERATE APPROACH Partial/Selective hedging Scope for taking advantage of opportunity gains Helps in averaging out total cost Management time and effort required

AGGRESSIVE APPROACH Active trading in currency Continuous cancellation and rebooking Aim is to treat treasury as a separate profit center Active treasury and management efforts must High Risk :High Reward scenario Proper evaluation of risk extremely important bearing in mind risk-taking appetite of the company.

INDIFFERENT APPROACH No conscious decision to manage exposure No hedging - everything left to chance Risk of destabilization of cash flows very high Merit – ZERO investment of time and effort Worst approach – Highly speculative

EXCHANGE RATE AND OPERATING EXPOSURE

• Changes in revenues, costs, cash-flows and profits• Effects competitiveness of the firm, attractiveness of

various markets, relative cost of sourcing inputs• Information required on output market structure,

competitor’s cost structure, their likely response to exchange rate changes, own cost structure

• Participation of personnel across various functions like marketing, purchase, production and finance

TOOLS FOR HEDGING CURRENCY EXPOSURE

FINANCIAL ENGINEERING PRODUCTS – Forwards, Options, Swaps, Futures, FRA’s Exotic structured products etc

INTERNAL HEDGING STRATEGIES• NETTING – receivables/payables can be netted out by

matching amount. It reduces the amount of exposure to be covered hence reducing the banking costs

• LEADING & LAGGING – shift the timing of exposures by leading or lagging payables or receivables

• INVOICING – choice of currency for invoicing• ASSET & LIABILITY MANAGEMENT – for e.g increase

exposed cash inflows in stronger currencies and vice-versa• PRICE VARIATION

FINANCIAL ENGINEERING

PRODUCTSForwards, Futures, Options, Swaps

Some Myths• Complex pricing• Greater loss due to complexities• Difficult to manage • Upfront Premia – Mental Block• Zero Cost Options!! – Is there any free lunch anywhere??

Choosing the right product• Usage depends on market perception and individual

requirement.

OPTIONS

A contract between two parties which gives them the right but not the obligation to buy/sell at an agreed price at a future date– Call Option: Right to buy– Put Option: Right to sell– Exercise price: Set price between two parties– Option premium: The price buyer pays to the seller.– Loss potential: Limited to premium.– Downside risks protected, upside gains unlimited.– Profit potential: Limited or unlimited depending on the strategy.

Options are best bet if markets are volatile and risks are asymmetric.

SWAPS• Swap is an agreement between two parties to exchange their

liability (Interest, Principal)

• Interest rate swap exchange of periodic interest payments (No exchange of principal). Eg. from fixed rate of interest to floating rate and vice versa.

• Currency Swap exchange of interest and principal in two different currencies.

USAGE• Asset/Liability management• Issuing or reducing the burden of debt

(Please see our FOREX EDUCATION section for detailed understanding of Derivative Products)

RISK/REWARD

Risk/Reward profile of parties in Interest rate swap

Interest Rate Decreases

Interest Rate Increases

Floating rate payer

Gain Loss

Fixed rate payer

Loss Gain

3F’s OF THE FX MARKET

• FORWARDS – contract to sell/buy specific amount of currency at a future date against expected receivables/payables at a pre-determined rate

• FORWARD RATE AGREEMENT (FRA) This is interest rate agreement for future dates between two parties on LIBOR/LIBID

• FUTURES - simultaneous right and obligation to buy/sell a standard quantity of a specific financial instrument at a specified future date and at a price agreed between parties at the time of contract.

FORWARDS & FUTURES

Forwards FuturesOTC contracts Exchange traded contracts

Tailored contracts Standardized contracts

Settlement at maturity Daily cash settlement

Credit approval and lines required

Margin cost involved

Bid/Offer spread may vary with customer

Equal access regardless of size

Low commission bid/offer spread on FRAs. Low commission but variable bid/offer spread on forex forwards.

Low commission cost and narrow bid/offer spread on Eurodollar futures. Relatively high commission but narrow bid/offer spread of forex futures.

OPERATIONAL STRATEGY

Setting optimum target rate Protecting benchmark rateStrong management information systemMinimizing exchange riskWhile hedging protect operational profitReducing interest burden Implementing sales policy on cost basisMinimizing foreign currency loan liability Trading positionsSafeguard Operating Profit & TargetStop Loss / Take Profit LimitLead & Lag PolicyContinuous In & OutOptionsReview bench rate as per market trend

RECOMMENDING A STRATEGY

Strategy for Current accountPrevailing market conditionsMarket perceptions/viewsSafeguarding operating profitQuantify ExpectationsChoice of currency, Quantum of cover

Quantify and analyse cost of exposure with projection And actual Strategy for Capital account

Tenure and costs involvedCurrency of Cash flowReducing cost of interestAnalyzing debt v/s cost and return

FEATURES OF MIS REPORTS

Streamline information Quick glance at current position Tool for day-to-day monitoring Summary for top management Strong back office & reporting system Cost benefit analysis Clinical precision in interpretation of data Identifying exchange risk Monitoring P&L of treasury Evaluation of performance

ADVANTAGES OF INTEGRATED TREASURY

MANAGEMENT• Reduces cost of domestic funds and forex

• Competitive cost advantage

• Optimum opportunity gains

• Asset/Liability management

• Easy availability of funds

• An edge over others

REGULATORY IMPLICATIONS

Regulatory implications are controlled mainly by four agencies:

MoF: Formulates the policies and directives. RBI:

ECD: Based on govt. policies, issues instructions and notifications.

IECD: Manages export import credit regulations. FEDAI:Association of bankers which implements & decides

operational procedures on the basis of RBI directions. Banks & Institutions: Based on overall directives as above

under liberalized scenario decides their own policies and guidelines.

SUGGESTIONS & RECOMMENDATIONS

Hedging & Trading positions should be separately identified

Firm decision should be taken on cost baseLong-term & short-term views should be

taken separately based on long & short term trend

Need base hedging policy should be adopted, instead of market driven sentiment

Trading & hedging policy should be clearly identified

An approved Forex policy should be formulated

A core committee for periodical reviewSet up strong back office and reporting

systemSet up treasury as a separate profit center

THANK YOU FOR SITTING THROUGH THIS PRESENTATION

For any further queries please contact

forex -Capital Services (P) Ltd.S – 472, Greater Kailash - II

New Delhi –110048

Tel: 011-51513202 / 51637735

Fax: 011-51637739

Email: [email protected]

www.forexcap.com