FOREIGN EXCHANGE & RI SK MANGEM ENT 1 1.INTRODUCTIONForeign exchange is the process of conversion of one currency into another currency. For a country its currency becomes money and legal tender. For a foreign country it becomes the value as a commodity. This commodity character can be underst ood when we study about ‗Exchange Rate‘ mechanism. Since the commodity has a value its relation with the other currency determines the exchange value of one currency with the other. For example, the US dollar in USA is the currency in USA but for India it is just like a commodity, which has a value which varies according to demand and supply. Foreign exchange is that section of economic activity, which deals with the means, and methods by which rights to wealth expressed in terms of the currency of one country are converted into rights to wealth in terms of the current of another country. It involves the investigation of the method, which exchanges the currency of one country for that of another. Foreign exchange can also be defined as the means of payment in which currencies are converted into each other and by which international transfers are made; also the activity of transacting business in further means.
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8/10/2019 foriegn exchange and anlaysis through risk maangement
Foreign exchange is the process of conversion of one currency into another currency. For a
country its currency becomes money and legal tender. For a foreign country it becomes the valueas a commodity. This commodity character can be understood when we study about ‗Exchange
Rate‘ mechanism. Since the commodity has a value its relation with the other currency
determines the exchange value of one currency with the other. For example, the US dollar in
USA is the currency in USA but for India it is just like a commodity, which has a value which
varies according to demand and supply.
Foreign exchange is that section of economic activity, which deals with the means, and methods
by which rights to wealth expressed in terms of the currency of one country are converted into
rights to wealth in terms of the current of another country.
It involves the investigation of the method, which exchanges the currency of one country for that
of another. Foreign exchange can also be defined as the means of payment in which currencies
are converted into each other and by which international transfers are made; also the activity of
transacting business in further means.
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Changes in exchange rates induce changes in the value of a firm‘s assets, liabilities and
cash flows, especially when these are denominated in a foreign currency.
Therefore, fluctuations in the currency markets have an impact on our outgoing import
payments and incoming export funds
our foreign exchange risk is influenced by many factors such as length of exposure and
currency volatility
By managing the risk, we could maximize profits or minimize the risk
Let us consider a case where a Indian company exports electronic goods to USA and invoices the
goods in US Dollars. The Amercian importer will pay the amount in US Dollars, as the same as
his home currency. However the Indian exporter requires INR means his home currency for
procuring raw materials and for payment to the labour charges, etc. this he would need
exchanging US dollars for INR. If the INDIAN exporters invoice his goods in INR, then
importer in USA will get his dollars converted in INR and pay the exporter.
From the above example we can infer that in case goods are bought or sold outside the country,
exchange of currency in necessary.
Sometimes it also happens that transaction between two countries will be settled in the currency
of the third country. That case both the countries, which are transacting will require converting
their perspective currencies in the currency of the third country. For that also the foreign
exchange is required. For example, an Indian exporter, exporting goods to Singapore may rise an
invoice for the goods sold in US dollars and as the importer in Singapore has to make payment in
US Dollars, he will have to exchange his Singapore dollars into US dollars. The Indian exporter
on receipt of US dollars will exchange them into Indian rupees. Thus, the transaction will giverise to exchange of currencies in the exporter‘s country as well as importer‘s country. Such
transaction may give rise to conversation of currencies at two stages.
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The foreign exchange market (Currency, Forex, or FX) market is where currency
trading takes place. It is where banks and other official institutions facilitate the buying and
selling of foreign currencies. FX transactions typically involve one party purchasing a quantity of
one currency in exchange for paying a quantity of another. The foreign exchange market that we
see today started evolving during the 1970s when world over countries gradually switched to
floating exchange rate from their erstwhile exchange rate regime, which remained fixed as per
the Bretton Woods system till 1971.
Today, the FX market is one of the largest and most liquid financial markets in the world,
and includes trading between large banks, central banks, currency speculators, corporations,
governments, and other institutions. The average daily volume in the global foreign exchange
and related markets is continuously growing. Traditional daily turnover was reported to be over
USD 3.8 trillion in April 2008 by the Bank for International Settlements. Since then, the market
has continued to grow. According to Euro money‘s annual FX Poll, volumes grew a further 41%
between 2007 and 2008.
The purpose of FX market is to facilitate trade and investment. The need for a foreign
exchange market arises because of the presence of multifarious international currencies such as
US Dollar, Pound Sterling, etc., and the need for trading in such currencies.
Market Participants
Unlike a stock market, where all participants have access to the same prices, the foreign
exchange market is divided into levels of access. At the top is the inter-bank market, which is
made up of the largest investment banking firms. Within the inter-bank market, spreads, which
are the difference between the bids and ask prices, are razor sharp and usually unavailable, andnot known to players outside the inner circle. The difference between the bid and ask prices
widens (from 0-1 points to 1-2 points for some currencies such as the EUR). This is due to
volume. If a trader can guarantee large numbers of transactions for large amounts, they can
demand a smaller difference between the bid and ask price, which is referred to as a better
spread. The levels of access that make up the foreign exchange market are determined by the size
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of the ―line‖ (the amount of money with which they are trading). The top-tier inter-bank market
accounts for 53% of all transactions. After that there are usually smaller investment banks,
followed by large multi-national corporations (which need to hedge risk and pay employees in
different countries), large hedge funds, and even some of the retail FX-metal market makers.
According to Galati and Melvin, ―Pension funds, insurance companies, mutual funds, and other
institutional investors have played an increasingly important role in financial markets in general,
and in FX markets in particular, since the early 2000s.‖ (2004) In addition, he notes, ―Hedge
funds have grown markedly over the 2001 – 2004 period in terms of both number and overall
size‖ Central banks also participate in the for eign exchange market to align currencies to their
economic needs.
Banks
The inter-bank market caters for both the majority of commercial turnover and large
amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some
of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks,
trading for the bank's own account.
Until recently, foreign exchange brokers did large amounts of business, facilitating inter-
bank trading and matching anonymous counterparts for small fees. Today, however, much of this business has moved on to more efficient electronic systems. The broker squawk box lets traders
listen in on ongoing inter-bank trading and is heard in most trading rooms, but turnover is
noticeably smaller than just a few years ago.
Commercial Companies
An important part of this market comes from the financial activities of companies seeking
foreign exchange to pay for goods or services. Commercial companies often trade fairly smallamounts compared to those of banks or speculators, and their trades often have little short term
impact on market rates. Nevertheless, trade flows are an important factor in the long-term
direction of a currency's exchange rate. Some multinational companies can have an unpredictable
impact when very large positions are covered due to exposures that are ...not widely known by
other market participants.
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the import and export of currency, for the conservation of the foreign exchange resources
of the country;
The proper utilization of this foreign exchange so as to promote the economic
development of the country
The basic purpose of FERA was:
a) To help RBI in maintaining exchange rate stability.
b) To conserve precious foreign exchange.
c) To prevent/regulate foreign business in India
Progression/Transfer of FERA to FEMA
FERA in its existing form became ineffective, therefore, increasingly incompatible with thechange in economic policy in the early 1990s. While the need for sustained husbandry of foreign
exchange was recognized, there was an outcry for a less aggressive and mellower enactment,
couched in milder language. Thus, the Foreign Exchange Management Act, 1999 (FEMA) came
into being.
The scheme of FERA provided for obtaining Reserve Bank‘s permission either special or
general, in respect of most of the regulations there under. The general permissions have
been granted by Reserve bank under these provisions in respect of various matters by
issuing a large number of notifications from time to time since the Act came into force
from 1st January 1974. Special permissions were granted upon the applicants submitting
prescribed applications for the purpose. Thus, in order to understand the operative part of
the regulations one had to refer to the Exchange Control Manual as well as the various
notifications issued by RBI and the Central Government.
FEMA has brought about a sea change in this regard and except for section 3, which
relates to dealing in foreign exchange, etc. no other provisions of FEMA stipulate
obtaining RBI permission. It appears that this is a transition from the era of permissions to
regulations. The emphasis of FEMA is on RBI laying down the regulations rather than
granting permissions on case to case basis. This transition has also taken away the concept
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of ―exchange control‖ and brought in the era of ―exchange management‖. In view of this
change, the title of the legislation has rightly been changed to FEMA.
The preamble to FEMA lays down that the Act is 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. As far as facilitating external trade is concerned, section 5 of the Act removes
restrictions on drawal of foreign exchange for the purpose of current account transactions.
As external trade i.e. import / export of goods & services involve transactions on current
account, there will be no need for seeking RBI permissions in connection with remittances
involving external trade. The need to remove restrictions on current account transactions
was necessitated as the country had given notice to the IMF in August, 1994 that it had
attained Article VIII status. This notice meant that no restrictions will be imposed on
remittances of foreign exchange on account of current account transactions.
Need for FEMA
The demand for new legislation was basically on two main counts.
The FERA was introduced in 1974when India‘s foreign exchange reserves position was
not satisfactory. It required stringent controls to conserve foreign exchange and to utilize
in the best interest of the country. Very strict restrictions have outlived their utility in the
current changed scenario. Secondly there was a need to remove the draconian provisions
of FERA and have a forward-looking legislation covering foreign exchange matters.
Repeal of draconian provisions under FERA
The draconian regulations under FERA related to unbridled powers of Enforcement
Directorate. These powers enabled Enforcement Directorate to arrest any person, search
any premises, seize documents and start proceedings against any person for contraventionof FERA or for preparations of contravention of FERA. The contravention under FERA
was treated as criminal offence and the burden of proof was on the guilty.
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1.Authorised Person - "Authorised person" means an authorised dealer, moneychanger,
offshore banking unit or any other person for the time being authorised under section 10(1) to
deal in foreign exchange securities.
3
NEW TERMS INFEMA
Terms like Capital Account Transaction, currentAccount Transaction, person, service etc. werenot defined in FERA.
Terms like Capital Account Transaction, currentaccount Transaction person, service etc., have beendefined in detail in FEMA.
4DEFINITION OFAUTHORIZEDPERSON
Definition of "Authorized Person" in FERA wasa narrow one ( 2(b)
The definition of Authorized person has beenwidened to include banks, money changes, off shore banking Units etc. (2 ( c )
5
MEANING OF"RESIDENT" ASCOMPAREDWITH INCOMETAX ACT.
There was a big difference in the definition of"Resident", under FERA, and Income Tax Act
The provision of FEMA, are in consistent withincome Tax Act, in respect to the definition of term "Resident". Now the criteria of "In India for 182 days"to make a person resident has been brought underFEMA. Therefore a person who qualifies to be a non-resident under the income Tax Act, 1961 will also beconsidered a non-resident for the purposes ofapplication of FEMA, but a person who is consideredto be non-resident under FEMA may not necessarily be a non-resident under the Income Tax Act, for
instance a business man going abroad and stayingtherefore a period of 182 days or more in a financialyear will become a non-resident under FEMA.
6
PUNISHMENT Any offence under FERA, was a criminaloffence , punishable with imprisonment as percode of criminal procedure, 1973
Here, the offence is considered to be a civil offenceonly punishable with some amount of money as a penalty. Imprisonment is prescribed only when onefails to pay the penalty.
7
QUANTUM OFPENALTY.
The monetary penalty payable under FERA,was nearly the five times the amount involved.
Under FEMA the quantum of penalty has beenconsiderably decreased to three times the amountinvolved.
8
APPEAL An appeal against the order of "Adjudicatingoffice", before " Foreign Exchange RegulationAppellate Board went before High Court
The appellate authority under FEMA is the specialDirector ( Appeals) Appeal against the order ofAdjudicating Authorities and special Director(appeals) lies before "Appellate Tribunal for ForeignExchange." An appeal from an order of AppellateTribunal would lie to the High Court. (sec 17,18,35)
9
RIGHT OFASSISTANCEDURING LEGALPROCEEDINGS.
FERA did not contain any express provision onthe right of on impleaded person to take legalassistance
FEMA expressly recognizes the right of appellant totake assistance of legal practitioner or charteredaccountant (32)
10POWER OFSEARCH ANDSEIZE
FERA conferred wide powers on a policeofficer not below the rank of a DeputySuperintendent of Police to make a search
The scope and power of search and seizure has beencurtailed to a great extent
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2.Capital Account Transaction - "Capital account transaction" means a transaction which alters
the assets or liabilities, including contingent liabilities, outside India of persons resident in India
or assets or liabilities in India of person resident outside India, and includes transactions referred
to in sub-section (3) of section 6
3. Current Account Transaction - "Current account transaction" means a transaction other
than a capital account transaction and without prejudice to the generality of the foregoing such
transaction includes,-
• Payments due in connection with foreign trade, other current business, services, and short-
term banking and credit facilities in the ordinary course of business.
• Payments due as interest on loans and as net income from investments.
• Remittances for living expenses of parents, spouse and children residing abroad, and
•
Expenses in connection with foreign travel, education and medical care of parents, spouse
and children;
Foreign exchange reserves - A country's reserves of foreign currencies. Commonly
known as ―quick cash", they can be used immediately to finance imports and other foreign
payables.
Foreign portfolio investment - Investment into financial instruments such as stocks and
bonds in which the objective is not to engage in business but to merely generate dividend
income and capital gains. The larger portion of international investment flows in the world
today is FPIs.
Forward contract - An arrangement between two parties to trade specified amounts of two
Currencies at some designated future due date at an agreed price. More than a formal hedge
against unforeseen changes in currency prices, it guarantees certainty in the foreign exchange
rate at the contract's delivery date.
Authorized dealer - "authorized dealer" means a person for the time being authorised under
section 6 to deal in foreign exchange;
Drawal - "Drawal' means drawal of foreign exchange from an authorized person and
includes opening of Letter of Credit or use of International Debit Card or A TM card orany other thing by whatever name called which has the effect of creating foreign
exchange liability.
Currency [including relevant notification]
"Currency" includes all currency notes, postal notes, postal orders, money orders, cheques,
drafts, travellers cheques, letters of credit, bills of exchange and promissory notes, credit
cards or such other similar instruments, as may be notified by the Reserve Bank;
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Foreign exchange transactions taking place in foreign exchange markets can be broadly
classified into interbank transactions and Merchant transactions. The foreign exchange
transactions taking place among banks are known as interbank transactions and the rates quoted
are known as interbank rates. The foreign exchange transactions that take place between a bank
and its customer known as‘ Merchant transactions‘ and the rates quoted are known as merchant
rates.
Merchant transactions take place when as exporter approaches his bank to convert his sale proceeds to home currency or when an importer approaches his banker to convert domestic
currency into foreign currency to pay his dues on import or when a resident approaches his bank
to convert foreign currency received by him into home currency or vice versa. When a bank
buys foreign exchange from a customer it sells the same in the interbank market at a higher rate
and books profit. Similarly, when a bank sells foreign exchange to a customer, it buys from the
interbank market, loads its margin and thus makes a profit in the deal.
The modes of foreign exchange remittances
Foreign exchange transactions involve flow of foreign exchange into the country or out of the
country depending upon the nature of transactions. A purchase transaction results in inflow of
foreign exchange while a sale transaction result in inflow of foreign exchange. The former is
known as inward remittance and the latter is known as outward remittance.
Remittance could take place through various modes. Some of them are:
Demand draft
Mail transfer
Telegraphic transfer
Personal cheques
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This buying rate is also known as the ‗bid‘ rate and the selling rate as the ‗offer‘ rate. The
difference between these rates is the gross profit for the bank and known as the ‗Spread‘.
Spot and forward transactions
The transactions in the Inter Bank market May place for settlement-
On the same day; or
Two days later;
Some day late; say after a month
Where the agreement to buy and sell is agreed upon and executed on the same date, the
transaction is known as cash or ready transaction. It is also known as value today.
The transaction where the exchange of currencies takes place after the date of contract is known
as the Spot Transaction. For instance if the contract is made on Monday, the delivery should take
place on Wednesday. If Wednesday is a holiday, the delivery will take place on the next day, i.e.,
Thursday. Rupee payment is also made on the same day the foreign exchange is received.
The transaction in which the exchange of currencies takes place at a specified future date,
subsequent to the spot rate, is known as a forward transaction . The forwards transaction can be
for delivery one month or two months or three months, etc. A forward contract for delivery onemonth means the exchange of currencies will take place after one month from the date of
contract. A forwards contract for delivery two months means the exchange of currencies will
take place after two months and so on.
Spot and Forwards rates
Spot rate of exchange is the rate for immediate delivery of foreign exchange. It is prevailing at a
particular point of time. In a forward rate, the quoted is for delivery at a future date, which is
usually 30, 60, 90 or 180 days later. The forward rate may be at premium or discount to the spot
rate, Premium rate, i.e., forward rate is higher than the spot rate, implies that the foreign currency
is to appreciate its value in tae future. May be due to larger demand for goods and services of the
country of that currency. The percentage of annualized discount or premium in a forward quote,
in relation to the spot rate, is computed by the following.
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The type of settlement, either cash settlement or physical settlement.
The amount and units of the underlying asset per contract. This can be the notional
amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional
amount of the deposit over which the short term interest rate is traded, etc.
The currency in which the futures contract is quoted.
The grade of the deliverable. In the case of bonds, this specifies which bonds can be
delivered. In the case of physical commodities, this specifies not only the quality of the
underlying goods but also the manner and location of delivery.
The delivery month.
The last trading date.
Other details such as the commodity tick (a minimum amount that the price of a
commodity can fluctuate upward or downward).
Settlement
Settlement is the act of consummating the contract, and can be done in one of two ways, as
specified per type of futures contract:
Physical delivery - The amount specified of the underlying asset of the contract is
delivered by the seller of the contract to the exchange, and by the exchange to the buyersof the contract. Physical delivery is common with commodities and bonds. In practice, it
occurs only on a minority of contracts. Most are cancelled out by purchasing a covering
position i.e. buying a contract to cancel out an earlier sale (covering a short), or selling a
contract to liquidate an earlier purchase (covering a long).
Cash settlement - A cash payment is made, based on the underlying reference rate, such
as the closing value of a stock market index. A futures contract might also opt to settle
against an index based on trade in a related spot market.
Expiry is the time and the day of a particular delivery month when a futures contract stops
trading and the final settlement price for that contract is obtained. For many equity index and
interest rate futures contracts this happens on the third Friday of the trading month. On this day
the t+1 futures contract becomes the t futures contract. For example, for most Chicago
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In futures one could reduce the downside of risk and one would be happy if on the
settlement date the market price is equal or less than the settlement price. However if the market
price is more than the settlement price on the settlement date you feel sad because if you had not
entered into the futures contract you could have more profits. This led to the evolution of
options.
An option is a contract between a buyer and a seller that gives the buyer the right, but not
the obligation to buy or to sell a particular asset (the underlying asset) at a later time at an agreed
price. In return for granting the option, the seller collects a payment (the premium) from the
buyer. A call option gives the buyer the right to buy the underlying asset; a put option gives the
buyer of the option the right to sell the underlying asset. If the buyer chooses to exercise this
right, the seller is obliged to sell or buy the asset at the agreed price. The buyer may choose not
to exercise the right and let it expire. The underlying asset can be a piece of property, or shares
of stock or some other security, such as, among others, a futures contract.
For example, buying a call option provides the right to buy a specified quantity of a
security at a set agreed amount, known as the 'strike price' at some time on or before expiration,
while buying a put option provides the right to sell. Upon the option holder's choice to exercisethe option, the party who sold, or wrote, the option must fulfill the terms of the contract
Exchange-traded options form an important class of options which have standardized
contract features and trade on public exchanges, facilitating trading among independent parties.
Over-the-counter options are traded between private parties, often well-capitalized institutions
that have negotiated separate trading and clearing arrangements with each other.
Types of options
The primary types of Options are:
Exchange traded options (also called "listed options"): They are a class of exchange
traded derivatives. Exchange traded options have standardized contracts, and are settled
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directional strategies, they are so named because the potential to profit does not depend on
whether the underlying stock price will go upwards or downwards. Rather, the correct neutral
strategy to employ depends on the expected volatility of the underlying stock price.
Let us now have a look at some of the option strategies in detail
1. Straddle:
In finance, a straddle is an investment strategy involving the purchase or sale of
particular option derivatives that allows the holder to profit based on how much the price of the
underlying security moves, regardless of the direction of price movement. The purchase of
particular option derivatives is known as a long straddle, while the sale of the option derivativesis known as a short straddle.
Long Straddle
A long straddle involves going long, i.e., purchasing, both a call option and a put option.
The two options are bought at the same strike price and expire at the same time. The owner of a
long straddle makes a profit if the underlying price moves a long way from the strike price, either
above or below. Thus, an investor may take a long straddle position if he thinks the market ishighly volatile, but does not know in which direction it is going to move. This position is a
limited risk, since the most a purchaser may lose is the cost of both options. At the same time,
there is unlimited profit potential.
For example, company XYZ is set to release its quarterly financial results in two weeks.
A trader believes that the release of these results will cause a large movement in the price of
XYZ's stock, but does not know whether the price will go up or down. He can enter into a long
straddle, where he gets a profit no matter which way the price of XYZ stock moves, if the price
changes enough either way. If the price goes up enough, he uses the call option and ignores the
put option. If the price goes down, he uses the put option and ignores the call option. If the price
does not change enough, he loses money, up to the total amount paid for the two options.
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company would pay a floating USD 1M Libor+25 bps and receive a 5.5% fixed rate, locking in
20bps profit.
Fixed-for-floating rate swap, different currencies
Party P pays/receives fixed interest in currency A to receive/pay floating rate in currency
B indexed to X on a notional N at an initial exchange rate of FX for tenure of T years. For
example, you pay fixed 5.32% on the USD notional 10 million quarterly to receive JPY 3M
(TIBOR) monthly on a JPY notional 1.2 billion (at an initial exchange rate of USD/JPY 120) for
3 years. For non-deliverable swaps, the USD equivalent of JPY interest will be paid/received
(according to the FX rate on the FX fixing date for the interest payment day). No initial exchange
of the notional amount occurs unless the FX fixing date and the swap start date fall in the future.
Fixed-for-floating swaps in different currencies are used to convert a fixed rate
asset/liability in one currency to a floating rate asset/liability in a different currency, or vice
versa. For example, if a company has a fixed rate USD 10 million loan at 5.3% paid monthly and
a floating rate investment of JPY 1.2 billion that returns JPY 1M Libor +50 bps monthly, and
wants to lock in the profit in USD as they expect the JPY 1M Libor to go down or USD/JPY to
go up (JPY depreciate against USD), then they may enter into a Fixed-Floating swap in different
currency where the company pays floating JPY 1M Libor+50 bps and receives 5.6% fixed rate,locking in 30bps profit against the interest rate and the FX exposure.
Floating-for-floating rate swap, same currency
Party P pays/receives floating interest in currency A Indexed to X to receive/pay floating
rate in currency A indexed to Y on a notional N for tenure of T years. For example, you pay JPY
1M LIBOR monthly to receive JPY 1M TIBOR monthly on a notional JPY 1 billion for 3 years.
Floating-for-floating rate swaps are used to hedge against or speculate on the spread
between the two indexes widening or narrowing. For example, if a company has a floating rate
loan at JPY 1M LIBOR and the company has an investment that returns JPY 1M TIBOR + 30
bps and currently the JPY 1M TIBOR = JPY 1M LIBOR + 10bps. At the moment, this company
has a net profit of 40 bps. If the company thinks JPY 1M TIBOR is going to come down (relative
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FX risk. If this USD/JPY spot goes up at the maturity of the debt, then when the company
converts the JPY to USD to pay back its matured debt, it receives less USD and suffers a
loss.
USD and JPY interest rate risk. If the JPY rates come down, the return on the investment
in Japan might go down and this introduces an interest rate risk component.
The first exposure in the above can be hedged using long dated FX forward contracts but
this introduces a new risk where the implied rate from the FX spot and the FX forward is a fixed
rate but the JPY investment returns a floating rate. Although there are several alternatives to
hedge both the exposures effectively without introducing new risks, the easiest and the most cost
effective alternative would be to use a floating-for-floating swap in different currencies. In this,
the company raises USD by issuing USD Debt and swaps it to JPY. It receives USD floating rate(so matching the interest payments on the USD Debt) and pays JPY floating rate matching the
Fixed-for-fixed rate swap, different currencies
Party P pays/receives fixed interest in currency A to receive/pay fixed rate in currency B
for a term of T years. For example, you pay JPY 1.6% on a JPY notional of 1.2 billion and
receive USD 5.36% on the USD equivalent notional of 10 million at an initial exchange rate of
USD/JPY 120.
Uses
Interest rate swaps were originally created to allow multi-national companies to evade
exchange controls. Today, interest rate swaps are used to hedge against or speculate on changes
in interest rates.
Hedging: Today, interest rate swaps are often used by firms to alter their exposure to interest-
rate fluctuations, by swapping fixed-rate obligations for floating rate obligations, or vice versa.
By swapping interest rates, a firm is able to alter its interest rate exposures and bring them in line
with management's appetite for interest rate risk.
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The foreign exchange business is, by its nature risky because it deals primarily in risk-
measuring it, pricing it, accepting it when appropriate and managing it. Managing foreign
exchange risk is a fundamental component in the safe and sound management of companies that
have exposures in foreign currencies. It involves prudently managing foreign currency positions
in order to control, within set parameters, the impact of changes in exchange rates on the
financial position of the company. There are mainly three type of foreign exchange exposure -
translation exposure, transaction exposure and economic exposure.
Unmanaged exchange rate risk can cause significant fluctuations in the earnings and the
market value of an international firm. A very large exchange rate movement may cause special problems for a particular company, perhaps because it brings a competitive threat from a
different country. There are various tools that are available for managing the foreign exchange
risk. These include traditional tools like money market hedge, currency risk sharing, insurance
and modern derivative tools like forward, futures, options, swap and forward rate agreements
which can be used by organisation as per the specific needs and requirements to manage the
foreign exchange risk.
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