I have observed the last twelve months data of the rupee vs.

dollar and its impact on the individuals, firms and institutions dealing in foreign exchange and analyzed few foreign exchange risk management tools. Rupees per US dollar

MONTH

MONTHLY AVERAGE (Rs.)

MONTHLY HIGH (Rs.)

55.8461 57.0943 56.2355 52.6805 51.4038 49.4893 53.2493 53.7147 52.4202 49.9006 49.4386 46.2753

MONTHLY LOW (Rs.)

54.3655 54.8488 52.5174 50.5579 49.2149 48.4779 49.2511 51.0218 48.9017 48.6256 45.6899 43.9056

JUL-2012 JUN-2012 MAY-2012 APR-2012 MAR-2012 FEB-2012 JAN-2012 DEC-2011 NOV-2011 OCT-2011 SEP-2011 AUG-2011

55.2303 55.8967 54.3665 51.6947 50.3149 49.1191 51.1348 52.3480 50.6784 49.1901 47.5249 45.3203

The above chart shows the last 12months fluctuations in Rupees in comparison with US Dollar and its monthly high and low. From the above chart we have noticed that there is a steady depreciation of rupee on the month of August 2011 to Dec 2011 and at the beginning of the year 2012 there is an appreciation in Rupee. But after February it again

started falling and reaches to Rs.55.2303 showing a drastic change of more than Rs 10 per dollar during the last 12months.This observation shows that the foreign exchange market is uncertain and unpredictable. This market movements not only effect the individuals and firms dealing in foreign currency but also the investors across the board, those who bring in foreign currency to invest in India also have to deal with the whims of foreign exchange fluctuations. A strengthening rupee aids their cause while a weakening rupee negatively impacts the return (in foreign currency terms) they make on their investments.

Recently during this rupee depreciation crisis RBI has been extremely cautious in its intervention. RBI has however reacted with timely interventions by selling dollars intermittently to tame sharp in the currency. Another step taken adopted by RBI is implementing a new policy under which rebooking of forward contract has been cancelled as exporters in order to rake more profit, were booking forward contracts then cancelling the contracts and rebooking them at better rate. This process will lead to a further depreciation in Rupee.

These are the few steps that RBI has taken to stabilize the Rupee depreciation.But tominimize the risk of foreign exchange rate fluctuations the individuals and firms trading in foreign currency should adopt some traditional risk management tools. These foreign exchange risk management tools are discussed below:

4.1 Traditional Risk Management Tools 4.1.1 Money Market Hedge

Transaction exposure can also be hedged by lending and borrowing in the domestic and foreign money marketsthat is, money market hedge. Generally speaking, the firm may borrow (lend) in foreign currency to hedge its foreign currency receivables (payables), thereby matching its assets and liabilities in the same currency.

Let us say that Bombardier of Montreal exports commuter aircraft to Austrian Airlines. A payment of 10 million will be received by Bombardier in one year. Money market and foreign exchange rates relevant to the financial contracts are: Canadian interest rate 6.10 % per annum European interest rate 9.00 % per annum Spot exchange rate $1.50/ Forward exchange rate $1.46/

Using the example presented above, Bombardier can eliminate the exchange exposure arising from the European sale by first borrowing in euros, then converting the loan proceeds into Canadian dollars, which then can be invested at the dollar interest rate. On the maturity date of the loan, Bombardier will use the euro receivable to pay off the euro loan. If Bombardier borrows a particular euro amount so that the maturity value of this loan becomes exactly equal to the euro receivable from the European sale, Bombardiers net euro exposure is reduced to zero, and Bombardier will receive the future maturity value of the dollar investment.

The first important step in money market hedging is to determine the amount of euros to borrow. Since the maturity value of borrowing should be the same as the euro receivable, the amount to borrow can be computed as the discounted present value of the euro receivable, that is, 10 million/(1.09) = 9,174,312. When Bombardier borrows 9,174,312, it then has to repay 10 million in one year, which is equivalent to its euro receivable. The step-by-step procedure of money market hedging can be illustrated as follows: Step 1: Borrow 9,174,312 in Europe Step 2: Convert 9,174,312 into $13,761,468 at the current spot exchange rate of C$1.50/ Step 3: Invest C$13,761,468 in Canadian Treasury bills. Step 4: Collect 10 million from Austrian Airways and use it to repay the euro loan. Step 5: Receive the maturity value of the dollar investment, that is, C$14,600,918 =

C$13,761,468 (1.061), which is the guaranteed Canadian dollar, proceeds from the European sale.

4.1.2 Currency Risk Sharing

It is an agreement by the parties to a transaction to share the currency risk associated with the transaction. The arrangement involves a customized hedge contract embedded in the underlying transaction. The ratio of risk share and other terms are agreed at the time of entering into the agreement.

4.1.3Insurance
Insurance is a form of risk management primarily used to hedge against the risk of a contingent loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for a premium, and can be thought of as a guaranteed small loss to prevent a large, possibly devastating loss. The insurance rate is a factor used to determine the amount to be charged for a certain amount of insurance coverage, called the premium.

4.1.4Derivative The Risk Management Tool

Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else (known as the underlying). The underlying on which a derivative is based can be an asset (e.g., commodities, equities (stocks), residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer price index (CPI) see inflation derivatives), or other items (e.g., weather conditions, or other derivatives). Credit derivatives are based on loans, bonds or other forms of credit.

The main types of derivatives are forwards, futures, options, and swaps.

Derivatives can be used to mitigate the risk of economic loss arising from changes in the value of the underlying. This activity is known as hedging. Alternatively, derivatives can be used by investors to increase the profit arising if the value of the underlying moves in the direction they expect. This activity is known as speculation.

The use of derivatives also has its benefits: Derivatives facilitate the buying and selling of risk, and thus have a positive impact on the economic system. Although someone loses money while someone else gains money with a derivative, under normal circumstances, trading in derivatives should not adversely affect the economic system because it is not zero sums in utility. Former Federal Reserve Board chairman Alan Greenspan had commented in 2003 that he believed that the use of derivatives has softened the impact of the economic downturn at the beginning of the 21st century.

Let us now try to understand how some of the main types of derivatives evolved and how they function.

4.1.5 Forward Contract

A forward contract is an agreement for the future delivery of a specified amount of goods at a predetermined price and date.

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

This process is used in financial operations to hedge risk, as a means of speculation, or to allow a party to take advantage of a quality of the underlying instrument which is timesensitive.

Forward contracts are usually not standardized as futures are; they are traded over the counter directly between buyer and seller. Forward contracts are settled at the expiration of the contract. Forward contracts are meant for delivery. This delivery is usually in the form of cash settlement as opposed to physical delivery. Credit risk is inherent in forwards. Since either party of a forward contract can default on their obligation to take delivery or to deliver an asset, forwards are more risky.

Example of how the payoff of a forward contract works

Suppose that Ankur wants to buy a house in one year's time. At the same time, suppose that Rohan currently owns a $100,000 house that he wishes to sell in one year's time. Both parties could enter into a forward contract with each other. Suppose that they both agree on the sale price in one year's time of $104,000 (more below on why the sale price should be this amount). Ankur and Rohan have entered into a forward contract. Ankur, because he is buying the underlying, is said to have entered a long forward contract. Conversely, Rohan will have the short forward contract. At the end of one year, suppose that the current market valuation of Rohan's house is $110,000. Then, because Rohan is obliged to sell to Ankur for only $104,000, Rohan will make a profit of $6,000 as Ankur can buy from Rohan for $104,000 and immediately sell to themarket for $110,000. Ankur has made the difference in profit. In contrast, Rohan has made a potential loss of $6,000, and an actual profit of $4,000.

Example of how forward prices should be agreed upon Continuing on the example above, suppose now that the initial price of Rohan's house is $100,000 and that Ankur enters into a forward contract to buy the house one year from today. But since Rohan knows that he can immediately sell for $100,000 and place the proceeds in the bank, he wants to be compensated for the delayed sale. Suppose that the risk free rate of return R (the bank rate) for one year is 4%. Then the money in the bank would grow to $104,000, risk free. So Rohan would want at least $104,000 one year from now for the contract to be worthwhile for him - the opportunity cost will be covered.

Example of how forward helps Corporate in managing foreign exchange risk Suppose an Indian firm as got an export order of USD 1million which will be received once the goods reach the destination i.e. payment at sight. The Indian firm will take six months to execute the order. Suppose the present USD/INR: 50.00/50.20. Lets say that the six month forward rate available is USD/INR: 51.50/51.65. If the company books the forward by paying some premium, after six months when it will get the payment it could convert it into INR at an exchange rate of 1$ = INR51.50 irrespective of the exchange rate prevalent at that time. If after six months the exchange rate is USD/INR: 49.00/49.10 the company makes a profit of INR 2.50 per USD (i.e. 51.50 49.00) less the premium paid and is protected from the fluctuations of the market rate. However after six months if the exchange rate is USD/INR: 53.00/53.35 the company would make a notional loss of INR 1.50 per USD (i.e. 53.00-51.50) plus the premium paid. Thus a forward agreement helps the company to make profit and protects it from downside movement of the exchange rate in the future it also prevents the firm from getting profits in case of upward movement of the exchange rates.

4.1.6 FUTURES CONTRACT

With the evolution of the derivatives market people wanted a product which could provide them a guaranteed amount/product in exchange for some amount /product in the future thereby eliminating the risk of loss in the future due to changes in the market conditions. This led to the origin of Futures.

Trading on commodities began in Japan in the 18th century with the trading of rice and silk, and similarly in Holland with tulip bulbs. Trading in the US began in the mid19thcentury, when central grain markets were established and a marketplace was created for farmers to bring their commodities and sell them either for immediate delivery (also called spot or cash market) or for forward delivery. These forward contracts were private

contracts between buyers and sellers and became the forerunner to today's exchange-traded futures contracts.

Futures contract on financial instruments was introduced in the 1970s by the Chicago Mercantile Exchange (CME) and these instruments became hugely successful and quickly overtook commodities futures in terms of trading volume and global accessibility to the markets. This innovation led to the introduction of many new futures exchanges worldwide, such as the London International Financial Futures Exchange in 1982 (now Euronext.liffe), Deutsche Terminbrse (now Eurex) and the Tokyo Commodity Exchange (TOCOM). Today, there are more than 75 futures exchanges worldwide.

A futures contract is a standardized contract, traded on a futures exchange, to buy or sell a standardized quantity of a specified commodity of standardized quality (which, in many cases, may be such non-traditional "commodities" as foreign currencies, commercial or government paper [e.g., bonds], or "baskets" of corporate equity ["stock indices"] or other financial instruments) at a certain date in the future, at a price (the futures price) determined by the forces of supply and demand of the product on the exchange at the time of the purchase or sale of the contract. They are contracts to buy or sell at a specific date in the future at a price specified today. The future date is called the delivery date or final settlement date. The official price of the futures contract at the end of a day's trading session on the exchange is called the settlement price for that day of business on the exchange.

A futures contract gives the holder the obligation to make or take delivery under the terms of the contract. Both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the underlying asset to the buyer, or, if it is a cashsettled futures contract, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset his/her position by either selling a long position or buying back (covering) a short position, effectively closing out the futures position and its contract obligations.

Futures contracts or simply futures (not future contract or future) are always traded on an exchange. The exchange's clearinghouse acts as counterparty on all contracts, sets margin requirements, and crucially also provides a mechanism for settlement.

Margining

Futures are margined daily to the daily spot price of a forward with the same agreed-upon delivery price and underlying asset (based on mark to market). Thus futures have lesser credit risk as compared to forwards. This means that there will usually be very little additional money due on the final day to settle the futures contract i.e. only the final day's gain or loss, not the lifetime gain or loss.

In addition, the daily futures-settlement failure risk is accepted by an exchange, rather than an individual party, limiting credit risk in futures.

Consider a futures contract with a $100 price: Let's say that on day 50, a futures contract with a $100 delivery price (on the same underlying asset as the future) costs $88. On day 51, that futures contract costs $90. This means that the mark-to-market would require the holder of one side of the future to pay $2 on day 51 to track the changes of the forward price ("post $2 of margin"). This money goes, via margin accounts, to the holder of the other side of the future.

Thus, while under mark to market accounting, for both assets the gain or loss accrues over the holding period, for a futures the gain or loss is realized daily, while for a forward contract the gain or loss remains unrealized until expiry.

Margin To minimize credit risk to the exchange, traders must post a margin or a performance bond, typically 5%-15% of the contract's value. Margin requirements are waived or

reduced in some cases for hedgers who have physical ownership of the covered commodity or spread among traders who have offsetting contracts balancing their position.

Clearing margin: These are financial safeguards to ensure that companies or corporations perform on their customers' open futures contracts. Clearing margins are distinct from customer margins that individual buyers and sellers of futures contracts are required to deposit with brokers.

Customer margin: Within the futures industry, financial guarantees are required of both buyers and sellers of futures contracts to ensure fulfillment of contract obligations. Futures Commission Merchants are responsible for overseeing customer margin accounts. Margins are determined on the basis of market risk and contract value. It is also referred to as performance bond margin.

Initial margin: It is the money required to open a derivatives position (in futures or forex). It is a security deposit to ensure that traders have sufficient funds to meet any potential loss from a trade. If a position involves an exchange-traded product, the amount or percentage of initial margin is set by the exchange concerned.

In case of loss or if the value of the initial margin is being eroded, the broker will make a margin call in order to restore the amount of initial margin available. Often referredto as variation margin, margin called for this reason is usually done on a daily basis, however, in times of high volatility a broker can make a margin call or calls intra-day. Calls for margin are usually expected to be paid and received on the same day. If not, the broker has the right to close sufficient positions to meet the amount called by way of margin. After the position is closed-out the client is liable for any resulting deficit in the clients account. Some Exchanges also use the term maintenance margin, which in effect defines, by how much the value of the initial margin can reduce before a margin call is made. However, most brokers only use the term initial margin or variation margin. The Initial Margin requirement is established by the Futures exchange

A futures account is marked to market daily. If the margin drops below the margin maintenance requirement established by the exchange listing the futures, a margin call will be issued to bring the account back up to the required level.

Maintenance margin: A set minimum margin per outstanding futures contract that a customer must maintain in his margin account.

Margin-equity ratio: It is a term used by speculators, representing the amount of their trading capital that is being held as margin at any particular time. The low margin requirements of futures results in substantial leverage of the investment. However, the exchanges require a minimum amount that varies depending on the contract and the trader. The broker may set the requirement higher, but may not set it lower. A trader, of course, can set it above that, if he doesn't want to be subject to margin calls.

Performance bond margin: It is the amount of money deposited by both a buyer and seller of a futures contract to ensure performance of the term of the contract. Margin in commodities is not a payment of equity or down payment on the commodity itself, butrather it is a security deposit.

Return on margin (ROM): It is often used to judge performance because it represents the gain or loss compared to the exchanges perceived risk as reflected in required margin. ROM may be calculated (realized return) / (initial margin).

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 buyers of 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.

Who Trades In Futures?

Futures traders can traditionally be placed in one of two groups: hedgers, who have an interest in the underlying commodity and are seeking to hedge out the risk of price changes; and speculators, who seek to make a profit by predicting market moves and buying a commodity "on paper" for which they have no practical use. Hedgers typically include producers and consumers of a commodity.

For example, in traditional commodity markets, farmers often sell futures contracts for the crops and livestock they produce to guarantee a certain price, making it easier for them to plan. Similarly, livestock producers often purchase futures to cover their feed costs, so that they can plan on a fixed cost for feed. In modern (financial) markets, "producers" of interest rate swaps or equity derivative products will use financial futures or equity index futures to reduce or remove the risk on the swap.

The social utility of futures markets is considered to be mainly in the transfer of risk, and increase liquidity between traders with different risk and time preferences, from a hedger to a speculator.

Currency Futures

A currency futures, also FX futures or foreign exchange futures, is a futures contract to exchange one currency for another at a specified date in the future at a price (exchange rate) that is fixed on the purchase date. Typically, one of the currencies is the US dollar. The price of a future is then in terms of US dollars per unit of other currency. This can be different from the standard way of quoting in the spot foreign exchange markets. The trade unit of each contract is a certain amount of other currency, for instance 125,000. Most contracts have physical delivery, so for those held at the end of the last trading day, actual payments are made in each currency. However, most contracts are closed out before that. Investors can close out the contract at any time prior to the contract's delivery date.

Currency futures were first created at the Chicago Mercantile Exchange (CME) in 1972, less than one year after the system of fixed exchange rates was abandoned along with the gold standard. Uses of Currency Futures

Hedging: Investors use these futures contracts to hedge against foreign exchange risk. If an investor will receive a cash flow denominated in a foreign currency on some future date, that investor can lock in the current exchange rate by entering into an offsetting currency futures position that expires on the date of the cash-flow. For example, A is a US-based investor who will receive 1,000,000 on Dec 1. The current exchange rate implied by the futures is $1.2/. A can lock in this exchange rate by selling 1,000,000 worth of futures contracts expiring on December 1. That way, A isguaranteed an exchange rate of $1.2/ regardless of exchange rate fluctuations in the meantime.

Speculation: Currency futures can also be used to speculate and, by incurring a risk, attempt to profit from rising or falling exchange rates. For example, B buys 10 September CME Euro FX Futures, at $1.2713/. At the end of the day, the futures close at $1.2784/. The change in price is $0.0071/. As each contract is over 125,000, and he has 10 contracts, his profit is $8,875. As with any future, this is paid to him immediately.

4.1.7 OPTION
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 exercise the 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.

Contract specifications

Every financial option is a contract between the two counter parties with the terms of the option specified in a term sheet. Option contracts may be quite complicated; however, at minimum, they usually contain the following specifications Whether the option holder has the right to buy (a call option) or the right to sell (a put option) The quantity and class of the underlying asset(s) (e.g. 100 shares of XYZ Co. B stock) The strike price, also known as the exercise price, which is the price at which the underlying transaction will occur upon exercise. The expiration date or expiry which is the last date the option can be exercised The settlement terms, for instance whether the writer must deliver the actual asset on exercise, or may simply tender the equivalent cash amount The premiumthe total amount to be paid by the holder to the writer of the option.

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 through a clearing house with fulfillment guaranteed by the credit of the exchange. Since the contracts are standardized, accurate pricing models are often available. Exchange

traded options include: stock options, commodity options, bond options and other interest rate options index (equity) options, and options on futures contracts. Over-the-counter options (OTC options, also called "dealer options"):They are traded between two private parties, and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. In general, at least one of the counterparties to an OTC option is a well-capitalized institution. Option types commonly traded over the counter include: interest rate options, currency cross rate options, and options on swaps.

Intrinsic Value and Time Value

The intrinsic value (or "monetary value") of an option is the value of exercising it now. Thus if the current (spot) price of the underlying security is above the agreed (strike) price, a call has positive intrinsic value (and is called "in the money.

The time value of an option is a function of the option value less the intrinsic value. It equates to uncertainty in the form of investor hope. It is also viewed as the value of not exercising the option immediately.

ATM: At-the-money: An option is at-the-money if the strike price is the same as the spot price of the underlying security on which the option is written. An at-the-money option has no intrinsic value, only time value.

ITM: In-the-money: An in-the-money option has positive intrinsic value as well as time value. A call option is in-the-money when the strike price is below the spot price. A put option is in-the-money when the strike price is above the spot price.

OTM:Out-of-the-money: An out-of-the-money option has no intrinsic value. A call option is out-of-the-money when the strike price is above the spot price of the underlying security. A put option is out-of-the-money when the strike price is below the spot price.

Call Option

Put Option

Spot Price = Strike Price Spot Price > Strike Price Spot price < Strike Price Option Strategies

At-the- money

Spot Price = Strike Price

In-the-money

Spot Price < Strike Price

Out-of-the-money

Spot price > Strike Price

An option strategy is implemented by combining one or more option positions and possibly an underlying stock position. Options strategies can favor movements in the underlying stock that are bullish, bearish or neutral. The option positions used can be long and/or short positions in calls and/or puts at various strikes.

Bullish Trading Strategies: Bullish strategies in options trading are employed when the options trader expects the underlying stock price to move upwards. It is necessary to assess how high the stock price can go and the timeframe in which the rally will occur in order to select the optimum trading strategy.

Bearish Trading Strategies: Bearish strategies in options trading are employed when the options trader expects the underlying stock price to move downwards. It is necessary to assess how low the stock price can go and the timeframe in which the decline will happen in order to select the optimum trading strategy.

Neutral Trading Strategies: Neutral options trading strategies are employed when

the options trader does not know whether the underlying stock price will rise or fall. Also known as non-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.

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

The Bank for International Settlements reports that interest rate swaps are the largest component of the global OTC derivative market. The notional amount outstanding as of December 2006 in OTC interest rate swaps was $229.8 trillion, up $60.7 trillion (35.9%) from December 2005. These contracts account for 55.4% of the entire $415 trillion OTC derivative market. As of Dec 2008 the number rose to 4896 trillion according to the same source.

Structure

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

The most common interest rate swap is one where one counterparty A pays a fixed rate (the swap rate) to counterparty B, while receiving a floating rate (usually pegged to a reference rate such as LIBOR). Illustration 1:

A pays variable rate to B (A receives fixed rate)

B pays fixed rate to A (B receives variable rate)

Let us suppose that A can raise funds in the fixed and floating markets at 14% and LIBOR + 0.25% respectively while B san raise funds in fixed and floating market at 15% and LIBOR + 0.50% respectively. These rates are applicable for a USD 1 million borrowing. If B is interested in borrowing fixed interest rate and A is interested in borrowing in floating rates.

Party

Objective

Fixed Rate

Interest

Floating Interest rate

A B

Floating rate Fixed rate

14% 15%

LIBOR + 0.25% LIBOR + 0.75%

It can be seen that the cost of borrowing for A is less than B in both markets. This difference is called quality spread and can be quantified for both fixed and floating rate market as below

Fixed Market:

15% - 14% = 1%

Floating Market: (LIBOR + 0.75%) - (LIBOR + 0.25%) = 0.50%

The advantage enjoyed by A is called absolute advantage. However it can be seen that cost of funds for B is higher in fixed rate market by 100bp whereas it is higher by 25bp in the floating rate market. Thus B has a relative advantage in the floating market which is known as comparative advantage. Give the objective A will borrow in floating rate market while B will borrow in fixed rate market. However considering the comparative advantage enjoyed by B it is possible to reduce the cost of fund for both A and B if they borrow in the

market where they enjoy comparative advantage and then swap their borrowing. The reduction in the cost depends upon the quality spread. In this case the amount of benefit that can be derived by both the parties will be the difference between the quality spread which is 50 bp (i.e. 1% - 0.50%). Assume that both the parties want to share the benefit equally between them.

Under the SWAP agreement: A Borrows funds in the fixed rate market and lends to B B Borrows funds in the floating rate market and lends to A Let us assume that B lends to A at LIBOR and A lends to B at 14%. The net cost of funds to A and B using the swap is as shown below:

Party

Paid to Counterparty

Received from counterparty

Paid Market

to

Net cost

Savings

LIBOR

14%

14%

LIBOR

[(LIBOR + .25%) LIBOR] = 0.25%

14%

LIBOR

LIBOR + 0.75%

14.75 %

(15% 14.75%) = 0.25%

As seen above funds are available to A LIBOR as against LIBOR + 0.25% and B at 14.75% instead of 15%. Thus swap enables reduction in cost of funds.

Illustration 2: A pays fixed rate to B (A receives variable rate) B pays variable rate to A (B receives fixed rate). Consider the following swap in which Party A agrees to pay Party B periodic fixed interest rate payments of 3.00%, in exchange for periodic variable interest rate payments of LIBOR + 50 bps (0.50%). Note that there is no exchange of the principal amounts and that the interest rates are on a "notional" (i.e. imaginary) principal amount. Also note that the interest payments are settled in net (e.g. if LIBOR is 1.30% then Party B receives 1.20% (3.00% - (LIBOR + 50 bps)) and Party A pays 1.20%). The fixed rate (3.00% in this example) is referred to as the swap rate At the point of initiation of the swap, the swap is priced so that it has a net present value of zero. If one party wants to pay 50 bps above the par swap rate, the other party has to pay approximately 50 bps over LIBOR to compensate for this.

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

Fixed-for-floating rate swap, same currency

Party P pays/receives fixed interest in currency A to receive/pay floating rate in currency A indexed to X on a notional N for a term of T years. For example, you pay fixed 5.32% monthly to receive USD 1M Libor monthly on a notional USD 1 million for 3years. The party that pays fixed and receives floating coupon rates is said to be long the interest swap. Interest rate swaps are simply the exchange of one set of cash flows for another.

Fixed-for-floating swaps in same currency are used to convert a fixed rate asset/liability to a floating rate asset/liability or vice versa. For example, if a company has a fixed rate USD 10 million loans at 5.3% paid monthly and a floating rate investment of USD 10 million that returns USD 1M Libor + 25 bps monthly, it may enter into a fixedfor-floating swap. In this swap, the 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 +50bps 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 to the LIBOR) or JPY 1M LIBOR is going to increase in the future (relative to the TIBOR) and wants to insulate from this risk, they can enter into a

float-float swap in same currency where they pay, say, JPY TIBOR + 30 bps and receive JPY LIBOR + 35 bps. With this, they have effectively locked in a 35 bps profit instead of running with a current 40 bps gain and index risk. The 5 bps difference (with respect to the current rate difference) comes from the swap cost which includes the market expectations of the future rate difference between these two indices and the bid/offer spread which is the swap commission for the swap dealer.

Floating-for-floating rate swaps are also seen where both sides reference the same index, but on different payment dates, or use different business day conventions. These have almost no use for speculation, but can be vital for asset-liability management. An example would be swapping 3M LIBOR being paid with prior non-business day convention, quarterly on JAJO (i.e. Jan, Apr, Jul, Oct) 30, into FMAN (i.e. Feb, May, Aug, Nov) 28 modified following.

Floating-for-floating rate swap, different currencies

Party P pays/receives floating interest in currencyA indexed to X to receive/pay floating rate in currency B indexed to Y on a notional N at an initial exchange rate of FX for a tenor T years. For example, you pay floating USD 1M LIBOR 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 4 years.

To explain the use of this type of swap, consider a US company operating in Japan. To fund their Japanese growth, they need JPY 10 billion. The easiest option for the company is to issue debt in Japan. As the company might be new in the Japanese market without a well-known reputation among the Japanese investors, this can be an expensive option. Added on top of this, the company might not have appropriate debt issuance program in Japan and they might lack sophisticated treasury operation in Japan. To overcome the above problems, it can issue USD debt and convert to JPY in the FX market. Although this option solves the first problem, it introduces two new risks to the company:

 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 returns on the JPY investment.

Uses
Interest rate swaps were originally created to allow multi-national companies to avoidexchange 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 itsinterest rate exposures and bring them in line with management's appetite for interest rate risk.

Speculation: Interest rate swaps are also used speculatively by hedge funds or other investors who expect a change in interest rates or the relationships between them. Traditionally, fixed income investors who expected the rates to fall used to purchase cash bonds, whose value increased as rates fell. Today, investors with a similar view could enter

a floating-for-fixed interest rate swap; as rates fall, investors would pay a lower floating rate in exchange for the same fixed rate.

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

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

Risks Interest rate swaps expose users to interest rate risk and credit risk. Interest rate risk originates from changes in the floating rate. In a plain vanilla fixed-for-floating swap, the party who pays the floating rate benefits when rates fall. (Note that the party that pays floating has an interest rate exposure analogous to a long bond position.) Credit risk on the swap comes into play if the swap is in the money or not. If one of the parties is in the money, then that party faces credit risk of possible default by another party.

4.1.9 Forward Rate Agreements

A forward rate agreement is a simple derivative which is used when the institution is exposed to single period interest rate risk. An FRA is a tailor-made futures contract. As the name implies, it is an agreement to fix a future interest rate today, for example the 6 month LIBOR rate for value 3 months from now. When the future date arrives the FRA contract rate is compared to actual market LIBOR. If market rates are higher than the contract rate, the borrower/FRA buyer receives the difference; if lower, he pays the difference. For the investor/FRA seller, the FRA flows would be reversed. Underlying borrowing or investment programs proceed normally at market rates, while the

compensating payment provided by the FRA brings the hedgers' all-in cost or yield back to the base rate contracted for in the FRA.

Using FRAs

Companies use FRAs to protect short term borrowing or investment programs from market surprises. For example, a borrower with debt rollovers coinciding with a scheduled meeting of the Federal Open Market Committee uses FRAs to lock rollover rates in advance.

FRAs also allow companies to take advantage when the yield curve inverts (long term rates fall below short term rates). When this happens a company which plans to borrow in the future would use FRAs to lock-in a future borrowing base rate at a level lower than today's rates. FRAs are also valuable in making temporary adjustments to long term financial positions. For example, a company which has swapped floating rate debt to fixed can use FRAs to improve the swap's performance in the short run when short term rates are expected to decline. In this instance FRAs protect the value of future swap floating rate receipts from the impact of falling rates.

Terminologies

The following some of the terms used in FRAs Buyer/ Borrower: The buyer of FRA is one who seeks protection against rise in interest rates. Seller/Lender: The seller of FRA is one who seeks protection against decrease in interest rates. Settlement date: This is the start date of the loan or deposit upon which the FRA is based. Maturity date: This is the date on which the FRA contract period ends.

 Contract period: It refers to the intervening period between the settlement date and the maturity date. Contract amount: It means the notional sum on which the FRA is based. Contract rate: It signifies the forward rate of interest for the contract period as agreed between the periods. Fixing date: It is the day which is two business days prior to the settlement date except for pound sterling for which the fixing date and settlement date are the same. Example of FRA being used when exposed to single period interest rate risk Say SBI has funded a one year USD 5 million floating rate loan on 6 month LIBOR+ basis. It is exposed to interest rate risk from 6th to the 12thmonth. Since the LIBOR for the first six month is already fixed at the time of sanction of the loan; the bank would have already locked itself into a spread. Its main course of concern will be that at the end of the first six months period its spread would be adversely affected, if the LIBOR were to go down.

If 6-12 FRA is being quoted at 5.25-5.30 percent, the bank has to sell FRA at 5.25%, since it is seeking protection against a fall in interest rates. If the actual LIBOR settles at 5.15 percent on the settlement date (i.e. six months from now), then the notional buyer/borrower (that is the quoting bank) has to compensate the SBI (i.e. the notional lender) for the difference in interest rate on the notional principal amount of USD 5 million. This is due to the fact that when the bank has sold a 6-12 FRA, the contract was that it has notionally lend an amount of USD 5 million at rate of 5.25 percent for a period starting six month and ending 12 months for now. As the interest rate has gone down and SBI is going to sustain a loss of 0.10percent; it needs to be financially compensated for the same. It is to be noted that no actual exchange of the principal amount takes place and that the notional principal amount is used for calculating the compensating amount.

The compensating amount is calculated as per normal interest calculations viz:

(Difference in the interest rates) x Notional principal amount x (number of days of contract) (5.25%-5.15%) X 5000000 X 180/360 = USD 2500

However in the FRA market this amount is settled up front i.e. before the loan period. Hence the amount has to be discounted for the six month period at the ongoing market rate, which is 5.15%

The present value of compensation amount is calculated using the formula Present value of Compensation amount = (L-R) or (R-L) x D x P/B x 100 DxL Where, L = settlement rate R = Contract reference rate D = Days in contract Period B = Days basis P = Notional principal amount Thus the present value of compensating amount is = .10 x 180 x 5000000 / (360x100) (180 x 5.15) = USD 2437.24

Hence SBI will receive USD 2437.24, representing 10basis point from the buyer of the FRA, i.e. the quoting bank. This would compensate SBI for the decrease in the spread due tom decrease in LINOR from 5.25% to 5.15%, in the underlying market. As such the bank is fixed to a LIBOR of 5.25% irrespective of the movement in the LICOR, by hedging through the FRA.

5. FINDINGS
Foreign exchange volatility can impact an organization in many ways, from creating near term cash flow and earnings volatility, to influencing competitive position and strategic opportunities over longer time horizons Due to increased global linkages and volatile exchange rates there is an increase in use of derivatives for hedging. Firms need to look at instituting a sound risk management system and also need to formulate hedging strategy carefully. In India, regulation has been steadily eased and turnover and liquidity in the foreign currency derivative markets has increased, although the use is mainly in shorter maturity contracts of one year or less. Forward and option contracts are the more popular instruments. Initially regulators had only allowed certain banks to deal in these markets however now corporate can also write option contracts. Indian firms and individuals now actively hedging their foreign exchange risks with forwards currency and interest rate swaps and different types of options such as call and put. The complex nature of the relationship between the risk elements and decision variables may often be beyond human comprehension without the aid of special diagnostic and analytical tools. Decisions and actions in the area of Foreign Exchange risk management may have impact on other segments and activities in the enterprise. However the results from this exploratory study are encouraging and interesting, leading us to conclude that there is scope for more rigorous study along these lines

6. RECOMMENDATION
Foreign Exchange Risk Management is used for curtailingthe risk of firms and individuals dealing with foreign currencies. Various risk management tools are enlightened in this report based on the type of risk involved such as translation, transaction and economic risk.

By analysing the risk involved in foreign exchange business on various parameters with the help of the Fundamental tools we come to know that this industry has a lot of potential to grow in future.So recommending investing in the foreign exchange market is no doubt a good and smart option because this industry is booming. The returns which came out of this industry were very impressive recently.

Developing industry-wide prudent foreign exchange risk exposure guidelines. Expanding availability and usage of hedging resources. Limiting foreign currency on lending and maintain foreign exchange risk exposure at discreet levels.

Disclosing foreign exchange risk levels. Establishing mandatory prudent foreign exchange risk exposure limits at national level. Companies should concentrate on managing all the exposures translation, transaction and economic rather than managing any one or two of them which most companies do.

Companies should review their exposure and hedging policy on regular basis.

Appropriate policy and other measures can then be taken to accelerate the process of further development of foreign exchange market and also upgrade foreign exchange risk management with higher professionalism and increased effectiveness.

7. CONCLUSION
The foreign exchange business is, by its nature risky because it deals primarily in riskmeasuring 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 organization as per the specific needs and requirements to manage the foreign exchange risk.