Overview On FOREX Management: Post Graduate Diploma in Management

Overview On FOREX Management
A PROJECT REPORT
Submitted by
Chirag Shah
Batch 2009-2011
in partial fulfillment for the award of the degree
POST GRADUATE DIPLOMA IN MANAGEMENT
Under the Guidance of
Prof Aditi Mahajan
THAKUR INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH
KANDIVILI
MUMBAI
Thakur Institute Of Management Studies And Research Page 1
ACKNOWLEDGEMENT
Two months of summer training at Anugrah Stock !roking Pvt "td# has $een a great va%ue
addition to m& career that wou%d not have $een 'ossi$%e without continuous guidance and
administration of certain ke& 'eo'%e# ( wou%d %ike to '%ace on record) m& sincere gratitude to each
of them#
( am gratefu% to Dr. Mrinalini oho!"ar) *irector) Thakur (nstitute Of Management Studies and
Research for giving me this o''ortunit&#
( wou%d %ike to e+'ress m& a''reciation towards Mr. Bal"i#han Sharma for giving me the
o''ortunit& to work on this 'roject# ( e+'ress m& gratitude and inde$tedness to him for guiding
me in ever& as'ect for making this effort a great success#
( sincere%& thank Prof. Aditi Mahaa!) Thakur (nstitute Of Management Studies and Research
for the va%ua$%e guidance e+tended $& them during m& entire course in the 're'aration of this
dissertation and for %etting me their va%ua$%e time when ever ( was in need#
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E"#$%ti&# S%''ar(
This 'roject gives an in-de'th ana%&sis and understanding of Foreign E+change Markets in (ndia#
(t he%'s to understand the .istor& and the evo%ution of the foreign market in (ndia#
(t gives an overview of the conditions e+isting in the current g%o$a% econom&# (t gives an
overview of the Foreign e+change market#
(t ta%ks a$out the foreign e+change management act a''%ica$%e and a%so gives detai%s a$out the
'artici'ants in the fore+ markets#
(t a%so ta%ks a$out what are the sources of demand and su''%& of foreign e+change in the market
a%% over the wor%d#
The re'ort a%so ta%ks a$out the Foreign E+change trading '%atform and how the efficienc& and the
trans'arenc& is maintained#
The re'ort focuses on cor'orate hedging for foreign e+change risk in (ndia# The re'ort contains
detai%s a$out some com'anies Foreign E+'osure and how the& have maintained it#
(t a%so ta%ks a$out the determinants to $e taken care of whi%e taking cor'orate hedging decisions#
(t gives insights a$out the Regu%ator& guide%ines for the use of Foreign E+change derivatives)
*eve%o'ment of *erivatives markets in (ndia and a%so the .edging instruments for (ndian firms#
The re'ort gives an in-de'th ana%&sis of the currenc& risk management $& ta%king a$out what
currenc& risk is) the t&'es of currenc& risk / Transaction risk )Trans%ation risk and Economic
risk# (t a%so contains detai%s a$out the com'anies in the inde+ sense+ and nift& showing their
transaction is foreign currenc& %ike the im'orts) e+'orts) "oans) (nterst 'a&ments and the other
e+'enses# (t then shows the sensitivit& ana%&sis of how the currenc& rates im'act the gains0
'rofits of the com'an&#
Contents
Foreign E+change Market Overview###############################################################################################2
Fore+ Market3 A .istorica% Pers'ective###########################################################################################4
!asic 5once'ts in Fore+ Trading###################################################################################################11
5urrenc& Traded Across 6%o$e (ndia########################################################################################17
Trading P%atforms##########################################################################################################################12
Factors Affecting Foreign E+change#############################################################################################18
Foreign E+change Management Act) 1444####################################################################################19
Partici'ants in foreign e+change market########################################################################################14
E+change rate S&stem####################################################################################################################,,
Foreign E+change Market Structure##############################################################################################,7
Fundamenta%s in E+change Rate####################################################################################################,2
Factors Affecting E+change Rates#################################################################################################,:
Sources of Su''%& and *emand in the Foreign e+change#############################################################,9
5or'orate .edging for Foreign E+change Risk in (ndia###############################################################1,
Foreign E+change Risk Management Framework########################################################################19
.edging Strategies0 (nstruments####################################################################################################7;
*eterminants of .edging *ecisions##############################################################################################71
An Overview of 5or'orate .edging in (ndia################################################################################72
5urrenc& Risk Management##########################################################################################################2;
For#i)! E"$ha!)# Mar*#t O&#r&i#+
6%o$a%%&) o'erations in the foreign e+change market started in a major wa& after the $reakdown
of the !retton <oods s&stem in 1481) which a%so marked the $eginning of f%oating e+change rate
regimes in severa% countries# Over the &ears) the foreign e+change market has emerged as the
%argest market in the wor%d# The decade of the 144;s witnessed a 'erce'ti$%e 'o%ic& shift in man&
emerging markets towards reorientation of their financia% markets in terms of new 'roducts and
instruments) deve%o'ment of institutiona% and market infrastructure and rea%ignment of regu%ator&
structure consistent with the %i$era%i=ed o'erationa% framework# The changing contours were
mirrored in a ra'id e+'ansion of foreign e+change market in terms of 'artici'ants) transaction
vo%umes) dec%ine in transaction costs and more efficient mechanisms of risk transfer#
The origin of the foreign e+change market in (ndia cou%d $e traced to the &ear 1489 when $anks
in (ndia were 'ermitted to undertake intra-da& trade in foreign e+change# .owever) it was in the
144;s that the (ndian foreign e+change market witnessed far reaching changes a%ong with the
shifts in the currenc& regime in (ndia# The e+change rate of the ru'ee) that was 'egged ear%ier
was f%oated 'artia%%& in March 144, and fu%%& in March 1441 fo%%owing the recommendations of
the Re'ort of the .igh "eve% 5ommittee on !a%ance of Pa&ments >5hairman3 *r#5# Rangarajan?#
The unification of the e+change rate was instrumenta% in deve%o'ing a market-determined
e+change rate of the ru'ee and an im'ortant ste' in the 'rogress towards current account
converti$i%it&) which was achieved in August 1447# :#1 A further im'etus to the deve%o'ment of
the foreign e+change market in (ndia was 'rovided with the setting u' of an E+'ert 6rou' on
Foreign E+change Markets in (ndia >5hairman3 Shri O#P# Sodhani?) which su$mitted its re'ort in
@une 1442# The 6rou' made severa% recommendations for dee'ening and widening of the (ndian
foreign e+change market# 5onseAuent%&) $eginning from @anuar& 144:) wide-ranging reforms
have $een undertaken in the (ndian foreign e+change market# After a%most a decade) an (nterna%
Technica% 6rou' on the Foreign E+change Market >,;;2? was constituted to undertake a
com'rehensive review of the measures initiated $& the Reserve !ank and identif& areas for
further %i$era%i=ation or re%a+ation of restrictions in a medium-term framework#
The momentous deve%o'ments over the 'ast few &ears are ref%ected in the enhanced risk-$earing
ca'acit& of $anks a%ong with rising foreign e+change trading vo%umes and finer margins# The
foreign e+change market has acAuired de'th >Redd&) ,;;2?# The conditions in the foreign
e+change market have a%so genera%%& remained order%& >Redd&) ,;;:c?# <hi%e it is not 'ossi$%e
for an& countr& to remain com'%ete%& unaffected $& deve%o'ments in internationa% markets) (ndia
was a$%e to kee' the s'i%%over effect of the Asian crisis to a minimum through constant
monitoring and time%& action) inc%uding recourse to strong monetar& measures) when necessar&)
to 'revent emergence of se%f fu%fi%%ing s'ecu%ative activities
(n toda&Bs wor%d no econom& is se%f sufficient) so there is need for e+change of goods and
services amongst the different countries# So in this g%o$a% vi%%age) un%ike in the 'rimitive age the
e+change of goods and services is no %onger carried out on $arter $asis# Ever& sovereign countr&
in the wor%d has a currenc& that is %ega% tender in its territor& and this currenc& does not act as
mone& outside its $oundaries# So whenever a countr& $u&s or se%%s goods and services from or to
another countr&) the residents of two countries have to e+change currencies# So we can imagine
that if a%% countries have the same currenc& then there is no need for foreign e+change#
N##d for For#i)! E"$ha!)#,
"et us consider a case where (ndian com'an& e+'orts cotton fa$rics to CSA and invoices the
goods in CS do%%ar# The American im'orter wi%% 'a& the amount in CS do%%ar) as the same is his
home currenc&# .owever the (ndian e+'orter reAuires ru'ees means his home currenc& for
'rocuring raw materia%s and for 'a&ment to the %a$or charges etc# Thus he wou%d need
e+changing CS do%%ar for ru'ee# (f the (ndian e+'orters invoice their goods in ru'ees) then
im'orter in CSA wi%% get his do%%ar converted in ru'ee and 'a& the e+'orter# From the a$ove
e+am'%e we can infer that in case goods are $ought or so%d outside the countr&) e+change of
currenc& is necessar&# Sometimes it a%so ha''ens that the transactions $etween two countries wi%%
$e sett%ed in the currenc& of third countr&# (n that case $oth the countries that are transacting wi%%
reAuire converting their res'ective currencies in the currenc& of third countr&# For that a%so the
foreign e+change is reAuired#
A-o%t for#i)! #"$ha!)# 'ar*#t,
Particu%ar%& for foreign e+change market there is no market '%ace ca%%ed the foreign e+change
market# (t is mechanism through which one countr&Bs currenc& can $e e+change i#e# $ought or
so%d for the currenc& of another countr&# The foreign e+change market does not have an&
geogra'hic %ocation# Foreign e+change market is descri$ed as an OT5 >over the counter? market
as there is no 'h&sica% '%ace where the 'artici'ant meets to e+ecute the dea%s) as we see in the
case of stock e+change# The %argest foreign e+change market is in "ondon) fo%%owed $& the Dew
Eork) Tok&o) Furich and Frankfurt# The markets are situated throughout the different time =one
of the g%o$e in such a wa& that one market is c%osing the other is $eginning its o'eration#
Therefore it is stated that foreign e+change market is functioning throughout ,7 hours a da&# (n
most market CS do%%ar is the vehic%e currenc&) vi=#) the currenc& sued to dominate internationa%
transaction# (n (ndia) foreign e+change has $een given a statutor& definition# Section , >$? of
foreign e+change regu%ation A5T) 1481 states3 Foreign e+change means foreign currenc&
and inc%udes3
All deposits, credits and balance payable in any foreign currency and any draft,
travelers cheques, letter of credit and bills of exchange. Expressed or drawn in India
currency but payable in any foreign currency.
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An& instrument 'a&a$%e) at the o'tion of drawee or ho%der thereof or an& other 'art& thereto)
either in (ndian currenc& or in foreign currenc& or 'art%& in one and 'art%& in the other# (n order
to 'rovide faci%ities to mem$ers of the 'u$%ic and foreigners visiting (ndia) for e+change of
foreign currenc& into (ndian currenc& and vice-versa R!( has granted to various firms and
individua%s) %icense to undertake mone&-changing $usiness at seas0air'ort and tourism '%ace of
tourist interest in (ndia# !esides certain authori=ed dea%ers in foreign e+change >$anks? have a%so
$een 'ermitted to o'en e+change $ureaus# Fo%%owing are the major $ifurcations3
F%.. f.#d)# 'o!#($ha!)#r/ / the& are the firms and individua%s who have $een authori=ed to
take $oth) 'urchase and sa%e transaction with the 'u$%ic#
R#/tri$t#d 'o!#($ha!)#r / the& are sho's) em'oria and hote%s etc# that have $een authori=ed
on%& to 'urchase foreign currenc& towards cost of goods su''%ied or services rendered $& them
or for conversion into ru'ees#
A%thori0#d d#a.#r/ / the& are one who can undertake a%% t&'es of foreign e+change transaction#
!anks are on%& the authori=ed dea%ers# The on%& e+ce'tions are Thomas cook) western union)
CAE e+change which though) and not a $ank is an A*# Even among the $anks R!( has
categori=ed them as fo%%ows3
!ranch A / The& are the $ranches that have Dostro and Gostro account#
!ranch ! / The $ranch that can dea% in a%% other transaction $ut do not maintain Dostro and
Gostro a0cBs fa%% under this categor&# For (ndian we can conc%ude that foreign e+change refers to
foreign mone&) which inc%udes notes) cheAues) $i%%s of e+change) $ank $a%ance and de'osits in
foreign currencies#
For#i)! E"$ha!)# Mar*#t, A! A//#//'#!t
The continuous im'rovement in market infrastructure has had its im'act in terms of enhanced
de'th) %iAuidit& and efficienc& of the foreign e+change market# The turnover in the (ndian foreign
e+change market has grown significant%& in $oth the s'ot and derivatives segments in the recent
'ast# A%ong with the increase in onshore turnover) activit& in the offshore market has a%so
assumed im'ortance# <ith the gradua% o'ening u' of the ca'ita% account) the 'rocess of 'rice
discover& in the (ndian foreign e+change market has im'roved as ref%ected in the $id-ask s'read
and forward 'remia $ehaviour#
For#i)! E"$ha!)# Mar*#t T%r!o&#r
As 'er the Triennia% 5entra% !ank Surve& $& the !ank for (nternationa% Sett%ements >!(S? on
HForeign E+change and *erivatives Market Activit&I) g%o$a% foreign e+change market activit&
rose marked%& $etween ,;;1 and ,;;7 >Ta$%e :#7?# The strong growth in turnover ma& $e
attri$uted to two re%ated factors# First) the 'resence of c%ear trends and higher vo%ati%it& in foreign
e+change markets $etween ,;;1 and ,;;7 %ed to trading momentum) where investors took %arge
'ositions in currencies that fo%%owed 'ersistent a''reciating trends# Second) 'ositive interest rate
differentia%s encouraged the so-ca%%ed Hcarr& tradingI) i.e., investments in high interest rate
currencies financed $& 'ositions in %ow interest rate currencies# The growth in outright forwards
$etween ,;;1 and ,;;7 ref%ects heightened interest in hedging# <ithin the EM countries)
traditiona% foreign e+change trading in Asian currencies genera%%& recorded much faster growth
than the g%o$a% tota% $etween ,;;1 and ,;;7# 6rowth rates in turnover for 5hinese renmin$i)
(ndian ru'ee) (ndonesian ru'iah) Jorean won and new Taiwanese do%%ar e+ceeded 1;; 'er cent
$etween A'ri% ,;;1 and A'ri% ,;;7 >Ta$%e :#2?# *es'ite significant growth in the foreign
e+change market turnover) the share of most of the EMEs in tota% g%o$a% turnover) however)
continued to remain %ow#
The (ndian foreign e+change market has grown manifo%d over the %ast severa% &ears# The dai%&
average turnover im'ressed a su$stantia% 'ick u' from a$out CS K 2 $i%%ion during 1448-49 to
CS K 19 $i%%ion during ,;;2-;:# The turnover has risen considera$%& to CS K ,1 $i%%ion during
,;;:-;8 >u' to Fe$ruar& ,;;8? with the dai%& turnover crossing CS K 12 $i%%ion on certain da&s
during Octo$er and Dovem$er ,;;:# The inter-$ank to merchant turnover ratio has ha%ved from
2#, during 1448-49 to ,#: during ,;;2-;:) ref%ecting the growing 'artici'ation in the merchant
segment of the foreign e+change market >Ta$%e :#: and 5hart G(#,?# Mum$ai a%one accounts for
a%most 9; 'er cent of the foreign e+change turnover#
:#:; Turnover in the foreign e+change market was :#: times of the si=e of (ndiaBs $a%ance of
'a&ments during ,;;2-;: as com'ared with 2#7 times in ,;;;-;1 >Ta$%e :#8?# <ith the dee'ening
of the foreign e+change market and increased turnover) income of commercia% $anks through
treasur& o'erations has increased considera$%&# Profit from foreign e+change transactions
accounted for more than ,; 'er cent of tota% 'rofits of the schedu%ed commercia% $anks during
,;;7-;2 and ,;;2-;:
For#" Mar*#t, A Hi/tori$a. P#r/1#$ti&#
Ear.( Sta)#/, 234562355
The evo%ution of (ndiaBs foreign e+change market ma& $e viewed in %ine with the shifts in (ndiaBs
e+change rate 'o%icies over the %ast few decades from a 'ar va%ue s&stem to a $asket-'eg and
further to a managed f%oat e+change rate s&stem# *uring the 'eriod from 1478 to 1481) (ndia
fo%%owed the 'ar va%ue s&stem of e+change rate# (nitia%%& the ru'eeBs e+terna% 'ar va%ue was fi+ed
at 7#12 grains of fine go%d# The Reserve !ank maintained the 'ar va%ue of the ru'ee within the
'ermitted margin of L1 'er cent using 'ound ster%ing as the intervention currenc&# Since the
ster%ing-do%%ar e+change rate was ke't sta$%e $& the CS monetar& authorit&) the e+change rates of
ru'ee in terms of go%d as we%% as the do%%ar and other currencies were indirect%& ke't sta$%e# The
deva%uation of ru'ee in Se'tem$er 1474 and @une 14:: in terms of go%d resu%ted in the reduction
of the 'ar va%ue of ru'ee in terms of go%d to ,#99 and 1#91 grains of fine go%d) res'ective%&# The
e+change rate of the ru'ee remained unchanged $etween 14:: and 1481 >5hart G(#1?#
6iven the fi+ed e+change regime during this 'eriod) the foreign e+change market for a%% 'ractica%
'ur'oses was defunct# !anks were reAuired to undertake on%& cover o'erations and maintain a
MsAuareB or Mnear sAuareB 'osition at a%% times# The o$jective of e+change contro%s was 'rimari%&
to regu%ate the demand for foreign e+change for various 'ur'oses) within the %imit set $& the
avai%a$%e su''%&# The Foreign E+change Regu%ation Act initia%%& enacted in 1478 was '%aced on a
'ermanent $asisin 1428# (n terms of the 'rovisions of the Act) the Reserve !ank) and in certain
cases) the 5entra% 6overnment contro%%ed and regu%ated the dea%ings in foreign e+change
'a&ments outside (ndia) e+'ort and im'ort of currenc& notes and $u%%ion) transfers of securities
$etween residents and non-residents) acAuisition of foreign securities) etc1 #
<ith the $reakdown of the !retton <oods S&stem in 1481 and the f%oatation of major currencies)
the conduct of e+change rate 'o%ic& 'osed a serious cha%%enge to a%% centra% $anks wor%d wide as
currenc& f%uctuations o'ened u' tremendous o''ortunities for market '%a&ers to trade in
currencies in a $order%ess market# (n *ecem$er 1481) the ru'ee was %inked with 'ound ster%ing#
Since ster%ing was fi+ed in terms of CS do%%ar under the Smithsonian Agreement of 1481) the
ru'ee a%so remained sta$%e against do%%ar# (n order to overcome the weaknesses associated with a
sing%e currenc& 'eg and to ensure sta$i%it& of the e+change rate) the ru'ee) with effect from
Se'tem$er 1482) was 'egged to a $asket of currencies# The currenc& se%ection and weights
assigned were %eft to the discretion of the Reserve !ank# The currencies inc%uded in the $asket as
we%% as their re%ative weights were ke't confidentia% in order to discourage s'ecu%ation# (t was
around this time that $anks in (ndia $ecame interested in trading in foreign e+change
For'ati&# P#riod, 235762338
The im'etus to trading in the foreign e+change market in (ndia came in 1489 when $anks in
(ndia were a%%owed $& the Reserve !ank to undertake intra-da& trading in foreign e+change and
were reAuired to com'%& with the sti'u%ation of maintaining MsAuareB or Mnear sAuareB 'osition
on%& at the c%ose of $usiness hours each da&# The e+tent of 'osition which cou%d $e %eft
uncovered overnight >the o'en 'osition? as we%% as the %imits u' to which dea%ers cou%d trade
during the da& were to $e decided $& the management of $anks# The e+change rate of the ru'ee
during this 'eriod was officia%%& determined $& the Reserve !ank in terms of a weighted $asket
of currencies of (ndiaBs major trading 'artners and the e+change rate regime was characterised $&
dai%& announcement $& the Reserve !ank of its $u&ing and se%%ing rates to the Authorised
*ea%ers >A*s? for undertaking merchant transactions# The s'read $etween the $u&ing and the
se%%ing rates was ;#2 'er cent and the market $egan to trade active%& within this range# A*s were
a%so 'ermitted to trade in cross currencies >one converti$%e foreign currenc& versus another?#
.owever) no M'ositionB in this regard cou%d originate in overseas markets#
As o''ortunities to make 'rofits $egan to emerge) major $anks in (ndia started Auoting two wa&
'rices against the ru'ee as we%% as in cross currencies and) gradua%%&) trading vo%umes $egan to
increase# This %ed to the ado'tion of wide%& different 'ractices >some of them $eing irregu%ar?
and the need was fe%t for a com'rehensive set of guide%ines for o'eration of $anks engaged in
foreign e+change $usiness# According%&) the M6uide%ines for (nterna% 5ontro% over Foreign
E+change !usinessB) were framed for ado'tion $& the $anks in 1491# The foreign e+change
market in (ndia ti%% the ear%& 144;s) however) remained high%& regu%ated with restrictions on
e+terna% transactions) $arriers to entr&) %ow %iAuidit& and high transaction costs# The e+change
rate during this 'eriod was managed main%& for faci%itating (ndiaBs im'orts# The strict contro% on
foreign e+change transactions through the Foreign E+change Regu%ations Act >FERA? had
resu%ted in one of the %argest and most efficient 'ara%%e% markets for foreign e+change in the
wor%d) i.e.) the hawa%a >unofficia%? market#
!& the %ate 149;s and the ear%& 144;s) it was recogni=ed that $oth macroeconomic 'o%ic& and
structura% factors had contri$uted to $a%ance of 'a&ments difficu%ties# *eva%uations $& (ndiaBs
com'etitors had aggravated the situation# A%though e+'orts had recorded a higher growth during
the second ha%f of the 149;s >from a$out 7#1 'er cent of 6*P in 1498-99 to a$out 2#9 'er cent of
6*P in 144;-41?) trade im$a%ances 'ersisted at around 1 'ercent of 6*P# This com$ined with a
'reci'itous fa%% in invisi$%e recei'ts in the form of 'rivate remittances) trave% and tourism
earnings in the &ear 144;-41 %ed to further widening of current account deficit# The weaknesses
in the e+terna% sector were accentuated $& the 6u%f crisis of 144;-41# As a resu%t) the current
account deficit widened to 1#, 'er cent of 6*P in 144;-41 and the ca'ita% f%ows a%so dried u'
necessitating the ado'tion of e+ce'tiona% corrective ste's# (t was against this $ackdro' that (ndia
em$arked on sta$i%isation and structura% reforms in the ear%& 144;s#
Po/t6R#for' P#riod, 2338 o!+ard/
This 'hase was marked $& wide ranging reform measures aimed at widening and dee'ening the
foreign e+change market and %i$era%isation of e+change contro% regimes# A credi$%e
macroeconomic) structura% and sta$i%i=ation 'rogramme encom'assing trade) industr&) foreign
investment) e+change rate) 'u$%ic finance and the financia% sector was 'ut in '%ace creating an
environment conducive for the e+'ansion of trade and investment# (t was recognised that trade
'o%icies) e+change rate 'o%icies and industria% 'o%icies shou%d form 'art of an integrated 'o%ic&
Thakur Institute Of Management Studies And Research Page 1;
framework to im'rove the overa%% 'roductivit&) com'etitiveness and efficienc& of the economic
s&stem) in genera%) and the e+terna% sector) in 'articu%ar# As a sta$i%sation measure) a two ste'
downward e+change rate adjustment $& 4 'er cent and 11 'er cent $etween @u%& 1 and 1) 1441
was resorted to counter the massive drawdown in the foreign e+change reserves) to insti%%
confidence among investors and to im'rove domestic com'etitiveness# A two-ste' adjustment of
e+change rate in @u%& 1441 effective%& $rought to c%ose the regime of a 'egged e+change rate#
After the 6u%f crisis in 144;-41) the $road framework for reforms in the e+terna% sector was %aid
out in the Re'ort of the .igh "eve% 5ommittee on !a%ance of Pa&ments >5hairman3 *r# 5#
Rangarajan?# Fo%%owing the recommendations of the 5ommittee to move towards the market-
determined e+change rate) the "i$era%ised E+change Rate Management S&stem >"ERMS? was
'ut in '%ace in March 144, initia%%& invo%ving a dua% e+change rate s&stem# Cnder the "ERMS)
a%% foreign e+change recei'ts on current account transactions >e+'orts) remittances) etc#? were
reAuired to $e surrendered to the Authorised *ea%ers >A*s? in fu%%# The rate of e+change for
conversion of :; 'er cent of the 'roceeds of these transactions was the market rate Auoted $& the
A*s) whi%e the remaining 7; 'ercent of the 'roceeds were converted at the Reserve !ankBs
officia% rate# The A*s) in turn) were reAuired to surrender these 7; 'er cent of their 'urchase of
foreign currencies to the Reserve !ank# The& were free to retain the $a%ance :; 'er cent of
foreign e+change for se%%ing in the free market for 'ermissi$%e transactions# The "ERMS was
essentia%%& a transitiona% mechanism and a downward adjustment in the officia% e+change rate
took '%ace in ear%& *ecem$er 144, and u%timate convergence of the dua% rates was made
effective from March 1) 1441) %eading to the introduction of a market-determined e+change rate
regime#
The dua% e+change rate s&stem was re'%aced $& a unified e+change rate s&stem in March 1441)
where$& a%% foreign e+change recei'ts cou%d $e converted at market determined e+change rates#
On unification of the e+change rates) the nomina% e+change rate of the ru'ee against $oth the CS
do%%ar as a%so against a $asket of currencies got adjusted %ower) which a%most nu%%ified the im'act
of the 'revious inf%ation differentia%# The restrictions on a num$er of other current account
transactions were re%a+ed# The unification of the e+change rate of the (ndian ru'ee was an
im'ortant ste' towards current account converti$i%it&) which was fina%%& achieved in August
1447) when (ndia acce'ted o$%igations under Artic%e G((( of the Artic%es of Agreement of the
(MF#
<ith the ru'ee $ecoming fu%%& converti$%e on a%% current account transactions) the risk-$earing
ca'acit& of $anks increased and foreign e+change trading vo%umes started rising# This was
su''%emented $& wide-ranging reforms undertaken $& the Reserve !ank in conjunction with the
6overnment to remove market distortions and dee'en the foreign e+change market# The 'rocess
has $een marked $& Mgradua%ismB with measures $eing undertaken after e+tensive consu%tations
with e+'erts and market 'artici'ants# The reform 'hase $egan with the Sodhani 5ommittee
>1447? which in its re'ort su$mitted in 1442 made severa% recommendations to re%a+ the
regu%ations with a view to vita%ising the foreign e+change market#
(n addition) severa% initiatives aimed at dismant%ing contro%s and 'roviding an ena$%ing
environment to a%% entities engaged in foreign e+change transactions have $een undertaken since
the mid-144;s# The focus has $een on deve%o'ing the institutiona% framework and increasing the
instruments for effective functioning) enhancing trans'arenc& and %i$era%ising the conduct of
foreign e+change $usiness so as to move awa& from micro management of foreign e+change
transactions to macro management of foreign e+change f%ows >!o+ G(#1?#
An (nterna% Technica% 6rou' on the Foreign E+change Markets >,;;2? set u' $& the Reserve
!ank made various recommendations for further %i$era%isation of the e+tant regu%ations# Some of
the recommendations such as freedom to cance% and re$ook forward contracts of an& tenor)
de%egation of 'owers to A*s for grant of 'ermission to cor'orates to hedge their e+'osure to
commodit& 'rice risk in the internationa% commodit& e+changes0markets and e+tension of the
trading hours of the inter-$ank foreign e+change market have since $een im'%emented#
A%ong with these s'ecific measures aimed at deve%o'ing the foreign e+change market) measures
towards %i$era%ising the ca'ita% account were a%so im'%emented during the %ast decade) guided to
a %arge e+tent since 1448 $& the Re'ort of the 5ommittee on 5a'ita% Account 5onverti$i%it&
>5hairman3 Shri S#S# Tara'ore?# Garious reform measures since the ear%& 144;s have had a
'rofound effect on the market structure) de'th) %iAuidit& and efficienc& of the (ndian foreign
e+change market#
Ba/i$ Co!$#1t/ i! For#" Tradi!)
,
Bid a!d A/* Rat#,
The $id0ask s'read is the difference $etween the 'rice at which a $ank or market maker wi%% se%%
>NaskN) or NofferN? and the 'rice at which a market taker wi%% $u& >N$idN? from a who%esa%e or
Thakur Institute Of Management Studies And Research Page 1,
retai% customer# The customer wi%% $u& from the market-maker at the higher NaskN 'rice) and wi%%
se%% at the %ower N$idN 'rice) thus giving u' the Ns'readN as the cost of com'%eting the trade#
Mar)i! Tradi!),
Foreign e+change is norma%%& traded on margin# A re%ative%& sma%% de'osit can contro% much
%arger 'ositions in the market# For trading the main currencies) Sa+o !ank reAuires a 1O margin
de'osit# This means that in order to trade one mi%%ion do%%ars) &ou need to '%ace just CS* 1;);;;
$& wa& of securit&#
(n other words) &ou wi%% have o$tained a gearing of u' to 1;; times# This means that a change of)
sa& ,O) in the under%&ing va%ue of &our trade wi%% resu%t in a ,;;O 'rofit or %oss on &our de'osit#
Sto16.o// di/$i1.i!#,
There are significant o''ortunities and risks in foreign e+change markets# Aggressive traders
might e+'erience 'rofit0%oss swings of ,;-1;O dai%&# This ca%%s for strict sto'-%oss 'o%icies in
'ositions that are moving against &ou#
Fortunate%&) there are no dai%& %imits on foreign e+change trading and no restrictions on trading
hours other than the weekend# This means that there wi%% near%& a%wa&s $e an o''ortunit& to react
to moves in the main currenc& markets and a %ow risk of getting caught without the o''ortunit&
of getting out# Of course) the market can move ver& fast and a sto'-%oss order is $& no means a
guarantee of getting out at the desired %eve%# For s'ecu%ative trading) it is recommended to '%ace
'rotective sto'-%oss orders#
S1ot a!d for+ard tradi!),
<hen &ou trade foreign e+change &ou are norma%%& Auoted a s'ot 'rice# This means that if &ou
take no further ste's) &our trade wi%% $e sett%ed after two $usiness da&s# This ensures that &our
trades are undertaken su$ject to su'ervision $& regu%ator& authorities for &our own 'rotection
and securit&# (f &ou are a commercia% customer) &ou ma& need to convert the currencies for
internationa% 'a&ments# (f &ou are an investor) &ou wi%% norma%%& want to swa' &our trade
forward to a %ater date# This can $e undertaken on a dai%& $asis or for a %onger 'eriod at a time#
Often investors wi%% swa' their trades forward an&where from a week or two u' to severa%
months de'ending on the time frame of the investment#
A%though a forward trade is for a future date) the 'osition can $e c%osed out at an& time - the
c%osing 'art of the 'osition is then swa''ed forward to the same future va%ue date#
C%rr#!$( Trad#d A$ro// G.o-# 9 I!dia
Th# FOUR 'aor $%rr#!$( 1air/
ECR0CS*
CS*0@PE
CS*05.F
6!P0CS*
C%rr#!$( Cro//#/
ECR05.F
ECR0@PE
6!P0@PE
ECR06!P
C%rr#!$i#/ trad#d i! I!dia,
CS*0(DR
ECR0(DR
6!P0(DR
@PE0(DR
C%rr#!$( E"$ha!)#/ i! I!dia,
1# M5X Stock E+change >M5X / SX?
,# Dationa% Stock E+change >DSE?
1# Cnited Stock E+change >CSE?
The dai%& turnover of DSE and M5X / SX together is around 1;);;; cr#
Tradi!) P.atfor'/
I!dia! P#r/1#$ti&#
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%iAuidit& and institutiona%-%eve% 'rices from the wor%dBs %eading $anks) and high%& com'etitive
s'reads on major currencies#
*esigned for institutions) mone& managers and individua%s) A%'ari *irect Pro caters for those
who want to trade high vo%umes with the fastest e+ecution s'eeds) fu%% market de'th and
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institutiona% traders and investors wanting to trade high vo%umes with the fastest e+ecution
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Fu%%& automated 'rocessing without an& manua% intervention cuts out an& o$stac%es $etween &our
trade and the market# 6oing direct) with trades e+ecuted at the highest s'eed and with minimum
%atenc& means &ou can react instant%& to o''ortunities as the& arise#
K!o+ th# d#1th of th# 'ar*#t i! f%..
Giew the most com'rehensive 'icture of the market with current orders dis'%a&ed $& 'rice and
vo%ume# This 'rovides a more trans'arent 'icture of the Fore+ market and the $est o''ortunit& to
make the most informed trading decisions 'ossi$%e#
Ma!a)# 'or# ord#r/ 'or# #ff#$ti&#.(
A com'rehensive suite of orders and order management o'tions a%%ow &ou to e+ecute
so'histicated strategies $ased on 'recise timing and mu%ti'%e order t&'es ena$%ing $etter contro%
of order timing and e+ecution#
Factors Affecting Foreign E+change
There are various factors affecting the e+change rate of a currenc&# The& can $e c%assified as
fundamenta% factors) technica% factors) 'o%itica% factors and s'ecu%ative factors#
F%!da'#!ta. fa$tor/,
Thakur Institute Of Management Studies And Research Page 1:
The fundamenta% factors are $asic economic 'o%icies fo%%owed $& the government in re%ation to
inf%ation) $a%ance of 'a&ment 'osition) unem'%o&ment) ca'acit& uti%i=ation) trends in im'ort and
e+'ort) etc# Dorma%%&) other things remaining constant the currencies of the countries that fo%%ow
sound economic 'o%icies wi%% a%wa&s $e stronger# Simi%ar%&) countries having $a%ance of 'a&ment
sur'%us wi%% enjo& a favora$%e e+change rate# 5onverse%&) for countries facing $a%ance of
'a&ment deficit) the e+change rate wi%% $e adverse#
T#$h!i$a. fa$tor/,
(nterest rates3 Rising interest rates in a countr& ma& %ead to inf%ow of hot mone& in the countr&)
there$& raising demand for the domestic currenc&# This in turn causes a''reciation in the va%ue
of the domestic currenc&#
(nf%ation rate3 .igh inf%ation rate in a countr& reduces the re%ative com'etitiveness of the e+'ort
sector of that countr&# "ower e+'orts resu%t in a reduction in demand of the domestic currenc&
and therefore the currenc& de'reciates#
E+change rate 'o%ic& and 5entra% !ank interventions3 E+change rate 'o%ic& of the countr& is the
most im'ortant factor inf%uencing determination of e+change rates# For e+am'%e) a countr& ma&
decide to fo%%ow a fi+ed or f%e+i$%e e+change rate regime) and $ased on this) e+change rate
movements ma& $e %ess0more freAuent# Further) governments sometimes 'artici'ate in foreign
e+change market through its 5entra% $ank in order to contro% the demand or su''%& of domestic
currenc&#
Po.iti$a. fa$tor/,
Po%itica% sta$i%it& a%so inf%uences the e+change rates# E+change rates are susce'ti$%e to 'o%itica%
insta$i%it& and can $e ver& vo%ati%e during times of 'o%itica% crises#
S1#$%.atio!,
S'ecu%ative activities $& traders wor%dwide a%so affect e+change rate movements# For e+am'%e) if
s'ecu%ators think that the currenc& of a countr& is overva%ued and wi%% deva%ue in near future)
the& wi%% 'u%% out their mone& from that countr& resu%ting in reduced demand for that currenc&
and de'reciating its va%ue#
For#i)! E"$ha!)# Ma!a)#'#!t A$t; 2333
The change in the entire a''roach towards e+change contro% regu%ation has $een the resu%t of the
re'%acement of the Foreign E+change Regu%ation Act) 1481) $& the Foreign E+change
Management Act) 1444# The %atter came into effect from @une 1) ,;;;# The change in the
'ream$%e itse%f signifies the dramatic change in a''roach -- from Nfor the conservation of the
foreign e+change resourcesN in FERA 1481) to Nfaci%itate e+terna% trade and 'a&mentsN under
FEMA 1444# An& FEMA vio%ations are civi%) not crimina%) offences) attracting monetar&
'ena%ties) and not arrests or im'risonment#
The scheme of FEMA and the notifications issued thereunder take into the account the
converti$i%it& of the ru'ee for a%% current account transactions# (ndeed) there is now genera%
freedom to authorised dea%ers to se%% currenc& for most current account transactions# One o%d
%imitation continues# A%% transactions in foreign e+change have to $e with authorised dea%ers) i#e#
$anks authorised to act as dea%ers in foreign e+change $& the Reserve !ank# The origina% ru%es)
regu%ations) notifications) etc#) under FEMA are contained in the A#*# >M#A# series? 5ircu%ar Do#
11 of Ma& 1:) ,;;;# Su$seAuent circu%ars have $een issued under the A#P# >*(R series?
nomenc%ature# (t is o$vious%& im'ossi$%e to incor'orate a%% the current regu%ations in a $ook of
this t&'e) 'articu%ar%& since the regu%ations kee' changing# An out%ine of the $asic framework of
e+change contro% under FEMA is in Anne+ure 2#1# !ut its contents shou%d not $e considered as
either definitive or current and those interested need to kee' u' with the various circu%ars and
other communications on the su$ject#
Parti$i1a!t/ i! for#i)! #"$ha!)# 'ar*#t
Mar*#t P.a(#r/
P%a&ers in the (ndian market inc%ude >a? A*s) most%& $anks who are authorised to dea% in foreign
e+change) >$? foreign e+change $rokers who act as intermediaries) and >c? customers /
individua%s) cor'orates) who need foreign e+change for their transactions# Though customers are
major '%a&ers in the foreign e+change market) for a%% 'ractica% 'ur'oses the& de'end u'on A*s
and $rokers# (n the s'ot foreign e+change market) foreign e+change transactions were ear%ier
dominated $& $rokers# Deverthe%ess) the situation has changed with the evo%ving market
conditions) as now the transactions are dominated $& A*s# !rokers continue to dominate the
derivatives market#
The Reserve !ank intervenes in the market essentia%%& to ensure order%& market conditions# The
Reserve !ank undertakes sa%es0'urchases of foreign currenc& in 'eriods of e+cess
demand0su''%& in the market# Foreign E+change *ea%ersB Association of (ndia >FE*A(? '%a&s a
s'ecia% ro%e in the foreign e+change market for ensuring smooth and s'eed& growth of the
foreign e+change market in a%% its as'ects# A%% A*s are reAuired to $ecome mem$ers of the
FE*A( and e+ecute an undertaking to the effect that the& wou%d a$ide $& the terms and condition
sti'u%ated $& the FE*A( for transacting foreign e+change $usiness# The FE*A( is a%so the
accrediting authorit& for the foreign e+change $rokers in the inter$ank foreign e+change market#
The %icences for A*s are issued to $anks and other institutions) on their reAuest) under Section
1;>1? of the Foreign E+change Management Act) 1444# A*s have $een divided into different
categories# A%% schedu%ed commercia% $anks) which inc%ude 'u$%ic sector $anks) 'rivate sector
$anks and foreign $anks o'erating in (ndia) $e%ong to categor& ( of A*s# A%% u'graded fu%%
f%edged mone& changers >FFM5s? and se%ect regiona% rura% $anks >RR!s? and co-o'erative
$anks $e%ong to categor& (( of A*s# Se%ect financia% institutions such as EX(M !ank $e%ong to
categor& ((( of A*s# 5urrent%&) there are 9: >5ategor& (? Ads o'erating in (ndia out of which five
are co-o'erative $anks >Ta$%e :#1?# A%% merchant transactions in the foreign e+change market
have to $e necessari%& undertaken direct%& through A*s# .owever) to 'rovide de'th and %iAuidit&
to the inter-$ank segment) Ads have $een 'ermitted to uti%ise the services of $rokers for $etter
'rice discover& in their inter-$ank transactions# (n order to further increase the si=e of the foreign
e+change market and ena$%e it to hand%e %arge f%ows) it is genera%%& fe%t that more A*s shou%d $e
encouraged to 'artici'ate in the market making# The num$er of 'artici'ants who can give two-
wa& Auotes a%so needs to $e increased#
The customer segment of the foreign e+change market com'rises major 'u$%ic sector units)
cor'orates and $usiness entities with foreign e+change e+'osure# (t is genera%%& dominated $&
se%ect %arge 'u$%ic sector units such as (ndian Oi% 5or'oration) OD65) !.E") SA(") Maruti
Cd&og and a%so the 6overnment of (ndia >for defence and civi% de$t service? as a%so $ig 'rivate
sector cor'orates %ike Re%iance 6rou') Tata 6rou' and "arsen and Tou$ro) among others# (n
recent &ears) foreign institutiona% investors >F((s? have emerged as major '%a&ers in the foreign
e+change market#
The main '%a&ers in foreign e+change market are as fo%%ows3
1# C%/to'#r/3
The customers who are engaged in foreign trade 'artici'ate in foreign e+change market $&
avai%ing of the services of $anks# E+'orters reAuire converting the do%%ars in to ru'ee and
im'orters reAuire converting ru'ee in to the do%%ars) as the& have to 'a& in do%%ars for the
goods0services the& have im'orted#
,# Co''#r$ia. Ba!*,
The& are most active '%a&ers in the fore+ market# 5ommercia% $ank dea%ings with internationa%
transaction offer services for conversion of one currenc& in to another# The& have wide network
of $ranches# T&'ica%%& $anks $u& foreign e+change from e+'orters and se%%s foreign e+change to
the im'orters of goods# As ever& time the foreign e+change $ought or overso%d 'osition# The
$a%ance amount is so%d or $ought from the market#
1# C#!tra. Ba!*,
(n a%% countries 5entra% $ank have $een charged with the res'onsi$i%it& of maintaining the
e+terna% va%ue of the domestic currenc&# 6enera%%& this is achieved $& the intervention of the
$ank#
7# E"$ha!)# Bro*#r/,
Fore+ $rokers '%a& ver& im'ortant ro%e in the foreign e+change market# .owever the e+tent to
which services of foreign $rokers are uti%i=ed de'ends on the tradition and 'ractice 'revai%ing at
a 'articu%ar fore+ market center# (n (ndia as 'er FE*A( guide%ine the Ads are free to dea% direct%&
among themse%ves without going through $rokers# The $rokers are not among to a%%owed to dea%
in their own account a%%over the wor%d and a%so in (ndia#
2# O&#r/#a/ For#" Mar*#t,
Toda& the dai%& g%o$a% turnover is estimated to $e more than CS K 1#2 tri%%ion a da&# The
internationa% trade however constitutes hard%& 2 to 8 O of this tota% turnover# The rest of trading
in wor%d fore+ market is constituted of financia% transaction and s'ecu%ation# As we know that the
fore+ market is ,7-hour market) the da& $egins with Tok&o and thereafter Singa'ore o'ens)
thereafter (ndia) fo%%owed $& !ahrain) Frankfurt) Paris) "ondon) Dew Eork) S&dne&) and $ack to
Tok&o#
:# S1#$%.ator/,
The s'ecu%ators are the major '%a&ers in the fore+ market# !ank dea%ing are the major s'ecu%ators
in the fore+ market with a view to make 'rofit on account of favora$%e movement in e+change
rate) take 'osition i#e# if the& fee% that rate of 'articu%ar currenc& is %ike%& to go u' in short term#
The& $u& that currenc& and se%% it as soon as the& are a$%e to make Auick 'rofit#
Thakur Institute Of Management Studies And Research Page ,;
Cor1oratio!</ 'articu%ar%& mu%tinationa% cor'oration and transnationa% cor'oration having
$usiness o'eration $e&ond their nationa% frontiers and on account of their cash f%ows $eing %arge
and in mu%ti currencies get in to foreign e+change e+'osures# <ith a view to make advantage of
e+change rate movement in their favor the& either de%a& covering e+'osures or do not cover unti%
cash f%ow materia%i=e#
I!di&id%a. %ike share dea%ing a%so undertake the activit& of $u&ing and se%%ing of foreign
e+change for $ooking short term 'rofits# The& a%so $u& foreign currenc& stocks) $onds and other
assets without covering the foreign e+change e+'osure risk# This a%so resu%ts in s'ecu%ations#
E"$ha!)# rat# S(/t#'
5ountries of the wor%d have $een e+changing goods and services amongst themse%ves# This has
$een going on from time immemoria%# The wor%d has come a %ong wa& from the da&s of $arter
trade# <ith the invention of mone& the figures and 'ro$%ems of $arter trade have disa''eared#
The $arter trade has given wa& ton e+changed of goods and services for currencies instead of
Thakur Institute Of Management Studies And Research Page ,1
goods and services# The ru'ee was historica%%& %inked with 'ound ster%ing# (ndia was a founder
mem$er of the (MF# *uring the e+istence of the fi+ed e+change rate s&stem) the intervention
currenc& of the Reserve !ank of (ndia >R!(? was the !ritish 'ound) the R!( ensured
maintenance of the e+change rate $& se%%ing and $u&ing 'ound against ru'ees at fi+ed rates# The
inter $ank rate therefore ru%ed the R!( $and# *uring the fi+ed e+change rate era) there was on%&
one major change in the 'arit& of the ru'ee- deva%uation in @une 14::# *ifferent countries have
ado'ted different e+change rate s&stem at different time#
The fo%%owing are some of the e+change rate s&stem fo%%owed $& various countries#
Th# Go.d Sta!dard
Man& countries have ado'ted go%d standard as their monetar& s&stem during the %ast two decades
of the 14he centur&# This s&stem was in vogue ti%% the out$reak of <or%d <ar 1# Cnder this
s&stem the 'arties of currencies were fi+ed in term of go%d# There were two main t&'es of go%d
standard3
2= Go.d /1#$i# /ta!dard
6o%d was recogni=ed as means of internationa% sett%ement for recei'ts and 'a&ments amongst
countries# 6o%d coins were an acce'ted mode of 'a&ment and medium of e+change in domestic
market a%so# A countr& was stated to $e on go%d standard if the fo%%owing condition were
satisfied3
Monetar& authorit&) genera%%& the centra% $ank of the countr&) guaranteed to $u& and se%%
go%d in unrestricted amounts at the fi+ed 'rice#
Me%ting go%d inc%uding go%d coins) and 'utting it to different uses was free%& a%%owed#
(m'ort and e+'ort of go%d was free%& a%%owed#
The tota% mone& su''%& in the countr& was determined $& the Auantum of go%d avai%a$%e for
monetar& 'ur'ose#
8= Go.d B%..io! Sta!dard,
Cnder this s&stem) the mone& in circu%ation was either 'art%& of entire%& 'a'er and go%d served as
reserve asset for the mone& su''%&# .owever) 'a'er mone& cou%d $e e+changed for go%d at an&
time# The e+change rate varied de'ending u'on the go%d content of currencies# This was a%so
known as H Mint Parit& Theor& H of e+change rates# The go%d $u%%ion standard 'revai%ed from
a$out 198; unti% 1417) and intermittent%& thereafter unti% 1477# <or%d <ar ( $rought an end to
the go%d standard#
Br#tto! Wood/ S(/t#'
*uring the wor%d wars) economies of a%most a%% the countries suffered# (n order to correct the
$a%ance of 'a&ments diseAui%i$rium) man& countries deva%ued their currencies# 5onseAuent%&) the
Thakur Institute Of Management Studies And Research Page ,,
internationa% trade suffered a death$%ow# (n 1477) fo%%owing <or%d <ar (() the Cnited States and
most of its a%%ies ratified the !retton <oods Agreement) which set u' an adjusta$%e 'arit&
e+change-rate s&stem under which e+change rates were fi+ed >Pegged? within narrow
intervention %imits >'egs? $& the Cnited States and foreign centra% $anks $u&ing and se%%ing
foreign currencies# This agreement) fostered $& a new s'irit of internationa% coo'eration) was in
res'onse to financia% chaos that had reigned $efore and during the war# (n addition to setting u'
fi+ed e+change 'arities >'ar va%ues? of currencies in re%ationshi' to go%d) the agreement
esta$%ished the (nternationa% Monetar& Fund >(MF? to act as the HcustodianI of the s&stem# Cnder
this s&stem there were uncontro%%a$%e ca'ita% f%ows) which %ead to major countries sus'ending
their o$%igation to intervene in the market and the !retton <ood S&stem) with its fi+ed 'arities)
was effective%& $uried# Thus) the wor%d econom& has $een %iving through an era of f%oating
e+change rates since the ear%& 148;#
F.oati!) Rat# S(/t#'
(n a tru%& f%oating e+change rate regime) the re%ative 'rices of currencies are decided entire%& $&
the market forces of demand and su''%&# There is no attem't $& the authorities to inf%uence
e+change rate# <here government interferesB direct%& or through various monetar& and fisca%
measures in determining the e+change rate) it is known as managed of dirt& f%oat#
PCR5.AS(D6 PO<ER PAR(TE >PPP? Professor 6ustav 5asse%) a Swedish economist)
introduced this s&stem# The theor&) to 'ut in sim'%e terms states that currencies are va%ued for
what the& can $u& and the currencies have no intrinsic va%ue attached to it# Therefore) under this
theor& the e+change rate was to $e determined and the so%e criterion $eing the 'urchasing 'ower
of the countries# As 'er this theor& if there were no trade contro%s) then the $a%ance of 'a&ments
eAui%i$rium wou%d a%wa&s $e maintained# Thus if 12; (DR $u& a fountain 'en and the same
fountain 'en can $e $ought for CS* ,) it can $e inferred that since , CS* or 12; (DR can $u&
the same fountain 'en) therefore CS* , Q (DR 12;#For e+am'%e (ndia has a higher rate of
inf%ation as com'ared to countr& CS then goods 'roduced in (ndia wou%d $ecome cost%ier as
com'ared to goods 'roduced in CS# This wou%d induce im'orts in (ndia and a%so the goods
'roduced in (ndia $eing cost%ier wou%d %ose in internationa% com'etition to goods 'roduced in
CS# This decrease in e+'orts of (ndia as com'ared to e+'orts from CS wou%d %ead to demand for
the currenc& of CS and e+cess su''%& of currenc& of (ndia# This in turn) cause currenc& of (ndia
to de'reciate in com'arison of currenc& of CS that is having re%ative%& more e+'orts#
For#i)! E"$ha!)# Mar*#t Str%$t%r#
Mar*#t S#)'#!t/
Foreign e+change market activit& in most EMEs takes '%ace onshore with man& countries
'rohi$iting onshore entities from undertaking the o'erations in offshore markets for their
currencies# S'ot market is the 'redominant form of foreign e+change market segment in
deve%o'ing and emerging market countries# A common feature is the tendenc& of
im'orters0e+'orters and other end-users to %ook at e+change rate movements as a source of return
without ado'ting a''ro'riate risk management 'ractices# This) at times) creates uneven
su''%&dem and conditions) often $ased on MMnews and viewsBB# The %ack of forward market
deve%o'ment ref%ects man& factors) inc%uding %imited e+change rate f%e+i$i%it&) the de facto
e+change rate insurance 'rovided $& the centra% $ank through interventions) a$sence of a &ie%d
curve on which to $ase the forward 'rices and sha%%ow mone& markets) in which market-making
$anks can hedge the maturit& risks im'%icit in forward 'ositions >5ana%es-Jri%jenko) ,;;7?#
Most foreign e+change markets in deve%o'ing countries are either 'ure dea%er markets or a
com$ination of dea%er and auction markets# (n the dea%er markets) some dea%ers $ecome market
makers and '%a& a centra% ro%e in the determination of e+change rates in f%e+i$%e e+change rate
regimes# The $idoffer s'read ref%ects man& factors) inc%uding the %eve% of com'etition among
market makers# (n most of the EMEs) a code of conduct esta$%ishes the 'rinci'%es that guide the
o'erations of the dea%ers in the foreign e+change markets# (t is the centra% $ank) or 'rofessiona%
dea%ers association) which norma%%& issues the code of conduct >5ana%es-Jri%jenko) ,;;7?# (n
auction markets) an auctioneer or auction mechanism a%%ocates foreign e+change $& matching
su''%& and demand orders# (n 'ure auction markets) order im$a%ances are c%eared on%& $&
e+change rate adjustments# Pure auction market structures are) however) now rare and the&
genera%%& 'revai% in com$ination with dea%er markets#
The (ndian foreign e+change market is a decentra%ised mu%ti'%e dea%ershi' market com'rising
two segments / the s'ot and the derivatives market# (n the s'ot market) currencies are traded at
the 'revai%ing rates and the sett%ement or va%ue date is two $usiness da&s ahead# The two-da&
'eriod gives adeAuate time for the 'arties to send instructions to de$it and credit the a''ro'riate
$ank accounts at home and a$road# The derivatives market encom'asses forwards) swa's and
o'tions# Though forward contracts e+ist for maturities u' to one &ear) majorit& of forward
contracts are for one month) three months) or si+ months# Forward contracts for %onger 'eriods
are not as common $ecause of the uncertainties invo%ved and re%ated 'ricing issues# A swa'
transaction in the foreign e+change market is a com$ination of a s'ot and a forward in the
o''osite direction# As in the case of other EMEs) the s'ot market is the dominant segment of the
(ndian foreign e+change market# The derivative segment of the foreign e+change market is
assuming significance and the activit& in this segment is gradua%%& rising#
F%!da'#!ta./ i! E"$ha!)# Rat#
E+change rate is a rate at which one currenc& can $e e+change in to another currenc&) sa& CS* Q
Rs#79# This rate is the rate of conversion of CS do%%ar in to (ndian ru'ee and vice versa#
M#thod/ of >%oti!) Rat#
There are two methods of Auoting e+change rates#
1? Dir#$t '#thod,
Foreign currenc& is ke't constant and home currenc& is ke't varia$%e# (n direct Auotation) the
'rinci'%e ado'ted $& $ank is to $u& at a %ower 'rice and se%% at higher 'rice#
,? I!dir#$t '#thod,
.ome currenc& is ke't constant and foreign currenc& is ke't varia$%e# .ere the strateg& used $&
$ank is to $u& high and se%% %ow# (n (ndia with effect from august ,) 1441) a%% the e+change rates
are Auoted in direct method# (t is customar& in foreign e+change market to a%wa&s Auote two
rates means one for $u&ing and another rate for se%%ing# This he%'s in e%iminating the risk of
$eing given $ad rates i#e# if a 'art& comes to know what the other 'art& intends to do i#e# $u& or
se%%) the former can take the %etter for a ride# There are two 'arties in an e+change dea% of
currencies# To initiate the dea% one 'art& asks for Auote from another 'art& and other 'art& Auotes
a rate# The 'art& asking for a Auote is known asB asking 'art& and the 'art& giving a Auotes is
known as Auoting 'art&# The advantage of two/wa& Auote is as under
The market continuous%& makes avai%a$%e 'rice for $u&ers or se%%ers
Two wa& 'rices %imit the 'rofit margin of the Auoting $ank and com'arison of one
Auote with another Auote can $e done instantaneous%&#
As it is not necessar& an& '%a&er in the market to indicate whether he intends to
$u& or sa%e foreign currenc&) this ensures that the Auoting $ank cannot take
advantage $& mani'u%ating the 'rices#
(t automatica%%& insures that a%ignment of rates with market rates#
Two wa& Auotes %end de'th and %iAuidit& to the market) which is so ver& essentia%
for efficient market# (n two wa& Auotes the first rate is the rate for $u&ing and
another for se%%ing#
<e shou%d understand here that) in (ndia the $anks) which are authori=ed dea%er) a%wa&s) Auote
rates# So the rates Auoted- $u&ing and se%%ing is for $anks 'oint of view on%&# (t means that if
e+'orters want to se%% the do%%ars then the $ank wi%% $u& the do%%ars from him so whi%e ca%cu%ation
the first rate wi%% $e used which is $u&ing rate) as the $ank is $u&ing the do%%ars from e+'orter#
The same case wi%% ha''en inverse%& with im'orter as he wi%% $u& do%%ars from the $ank and $ank
wi%% se%% do%%ars to im'orter#
Fa$tor/ Aff#$ti!) E"$ha!)# Rat#/
(n free market) it is the demand and su''%& of the currenc& which shou%d determine the e+change
rates $ut demand and su''%& is the de'endent on man& factors) which are u%timate%& the cause of
the e+change rate f%uctuation) some times wi%d# The vo%ati%it& of e+change rates cannot $e traced
to the sing%e reason and conseAuent%&) it $ecomes difficu%t to 'recise%& define the factors that
affect e+change rates# .owever) the more im'ortant among them are as fo%%ows3
R Str#!)th of E$o!o'(
Economic factors affecting e+change rates inc%ude hedging activities) interest rates) inf%ationar&
'ressures) trade im$a%ance) and euro market activities# (rving fisher) an American economist)
deve%o'ed a theor& re%ating e+change rates to interest rates# This 'ro'osition) known as the fisher
effect) states that interest rate differentia%s tend to ref%ect e+change rate e+'ectation# On the other
hand) the 'urchasing- 'ower 'arit& theor& re%ates e+change rates to inf%ationar& 'ressures# (n its
a$so%ute version) this theor& states that the eAui%i$rium e+change rate eAua%s the ratio of domestic
to foreign 'rices# The re%ative version of the theor& re%ates changes in the e+change rate to
changes in 'rice ratios#
R Po.iti$a. Fa$tor
The 'o%itica% factor inf%uencing e+change rates inc%ude the esta$%ished monetar& 'o%ic& a%ong
with government action on items such as the mone& su''%&) inf%ation) ta+es) and deficit
financing# Active government intervention or mani'u%ations) such as centra% $ank activit& in the
foreign currenc& market) a%so have an im'act# Other 'o%itica% factors inf%uencing e+change rates
inc%ude the 'o%itica% sta$i%it& of a countr& and its re%ative economic e+'osure >the 'erceived need
for certain %eve%s and t&'es of im'orts?# Fina%%&) there is a%so the inf%uence of the internationa%
monetar& fund#
R E"1#$tatio! of th# For#i)! E"$ha!)# Mar*#t
Ps&cho%ogica% factors a%so inf%uence e+change rates# These factors inc%ude market antici'ation)
s'ecu%ative 'ressures) and future e+'ectations# A few financia% e+'erts are of the o'inion that in
toda&Bs environment) the on%& Mtrustworth&B method of 'redicting e+change rates $& gut fee%# !o$
Eve%ing) vice 'resident of financia% markets at S6) is cor'orate financeBs to' foreign e+change
forecaster for 1444# eve%ingBs gut fee%ing has) defined convention) and his method 'roved
uncanni%& accurate in foreign e+change forecasting in 1449#S6 ended the cor'orate finance
forecasting &ear with a ,#::O error overa%%) the most accurate among 14 $anks# The secret to
eve%ingBs intuition on an& currenc& is kee'ing a$reast of wor%d events# An& event) from a
dec%aration of war to a fainting 'o%itica% %eader) can take its to%% on a currenc&Bs va%ue# Toda&)
instead of forma% moda%s) most forecasters re%& on an ama%gam that is 'art economic
fundamenta%s) 'art mode% and 'art judgment#
Fisca% 'o%ic&
(nterest rates
Monetar& 'o%ic&
!a%ance of 'a&ment
E+change contro%
5entra% $ank intervention
S'ecu%ation
Thakur Institute Of Management Studies And Research Page ,:
Technica% factors
So%r$#/ of S%11.( a!d D#'a!d i! th# For#i)! #"$ha!)#
E"$ha!)# Mar*#t
The major sources of su''%& of foreign e+change in the (ndian foreign e+change market are
recei'ts on account of e+'orts and invisi$%es in the current account and inf%ows in the ca'ita%
account such as foreign direct investment >F*(?) 'ortfo%io investment) e+terna% commercia%
$orrowings >E5!? and non-resident de'osits# On the other hand) the demand for foreign
e+change emanates from im'orts and invisi$%e 'a&ments in the current account) amorti=ation of
E5! >inc%uding short-term trade credits? and e+terna% aid) redem'tion of DR( de'osits and
outf%ows on account of direct and 'ortfo%io investment# (n (ndia) the 6overnment has no foreign
currenc& account) and thus the e+terna% aid received $& the 6overnment comes direct%& to the
reserves and the Reserve !ank re%eases the reAuired ru'ee funds# .ence) this 'articu%ar source of
su''%& of foreign e+change is not routed through the market and as such does not im'act the
e+change rate#
*uring %ast five &ears) sources of su''%& and demand have changed significant%&) with %arge
transactions emanating from the ca'ita% account) un%ike in the 149;s and the 144;s when current
account transactions dominated the foreign e+change market# The $ehavior as we%% as the
incentive structure of the 'artici'ants who use the market for current account transactions differs
significant%& from those who use the foreign e+change market for ca'ita% account transactions#
!esides) the change in these traditiona% determinants has a%so ref%ected itse%f in enhanced
vo%ati%it& in currenc& markets# (t now a''ears that e+'ectations and even momentar& reactions to
the news are often more im'ortant in determining f%uctuations in ca'ita% f%ows and hence it
serves to am'%if& e+change rate vo%ati%it& >Mohan) ,;;:a?# On man& occasions) the 'ressure on
e+change rate through increase in demand emanates from He+'ectations $ased on certain newsI#
Sometimes) such e+'ectations are desta$i%i=ing and often give rise to se%f-fu%fi%%ing s'ecu%ative
activities# Recogni=ing this) increased em'hasis is $eing '%aced on the management of ca'ita%
account through management of foreign direct investment) 'ortfo%io investment) e+terna%
commercia% $orrowings) nonresident de'osits and ca'ita% outf%ows# .owever) there are occasions
when %arge ca'ita% inf%ows as a%so %arge %um'iness in demand do take '%ace) in s'ite of adhering
to a%% the too%s of management of ca'ita% account# The ro%e of the Reserve !ank comes into focus
during such times when it has to 'revent the emergence of such desta$i%ising e+'ectations# (n
such cases) recourse is undertaken to direct 'urchase and sa%e of foreign currencies) steri%isation
through o'en market o'erations) management of %iAuidit& under %iAuidit& adjustment faci%it&
>"AF?) changes in reserve reAuirements and signa%ing through interest rate changes# (n the %ast
few &ears) des'ite %arge ca'ita% inf%ows) the ru'ee has shown two - wa& movements# !esides) the
demand0su''%& situation is a%so affected $& hedging activities through various instruments that
have $een made avai%a$%e to market 'artici'ants to hedge their risks#
D#ri&ati&# Mar*#t I!/tr%'#!t/
*erivatives '%a& a crucia% ro%e in deve%o'ing the foreign e+change market as the& ena$%e market
'%a&ers to hedge against under%&ing e+'osures and sha'e the overa%% risk 'rofi%e of 'artici'ants in
the market# !anks in (ndia have $een increasing%& using derivatives for managing risks and have
a%so $een offering these 'roducts to cor'orates# (n (ndia) various informa% forms of derivatives
contracts have e+isted for a %ong time though the forma% introduction of a variet& of instruments
in the foreign e+change derivatives market started on%& in the 'ost-reform 'eriod) es'ecia%%&
since the mid-144;s# 5ross-currenc& derivatives with the ru'ee as one %eg were introduced with
some restrictions in A'ri% 1448# Ru'ee-foreign e+change o'tions were a%%owed in @u%& ,;;1# The
foreign e+change derivative 'roducts that are now avai%a$%e in (ndian financia% markets can $e
grou'ed into three $road segments) viz#) forwards) o'tions >foreign currenc& ru'ee o'tions and
cross currenc& o'tions? and currenc& swa's >foreign currenc& ru'ee swa's and cross currenc&
swa's?
Avai%a$%e data indicate that the most wide%& used derivative instruments are the forwards and
foreign e+change swa's >ru'ee-do%%ar?# O'tions have a%so $een in use in the market for the %ast
four &ears# .owever) their vo%umes are not significant and $id offer s'reads are Auite wide)
indicating that the market is re%ative%& i%%iAuid# Another major factor hindering the deve%o'ment
of the o'tions market is that cor'orates are not 'ermitted to write0se%% o'tions# (f cor'orates with
under%&ing e+'osures are 'ermitted to write0se%% covered o'tions) this wou%d %ead to increase in
market vo%ume and %iAuidit&# Further) ver& few $anks are market makers in this 'roduct and
man& dea%s are done on a $ack to $ack $asis# For the 'roduct to reachthe farther segment of
cor'orates such as sma%% and medium enter'rises >SME? sector) it is im'erative that 'u$%ic sector
$anks deve%o' the necessar& infrastructure and e+'ertise to transact in o'tions# (n view of the
growing com'%e+it&) diversit& and vo%ume of derivatives used $& $anks) an (nterna% 6rou' was
constituted $& the Reserve !ank to review the e+isting guide%ines on derivatives and formu%ate
com'rehensive guide%ines on derivatives for $anks
<ith regard to forward contracts and swa's) which are re%ative%& more 'o'u%ar instruments in the
(ndian derivatives market) cance%%ation and re$ooking of forward contracts and swa's in (ndia
have $eenregu%ated# 6radua%%&) however) the Reserve !ank has $een taking measures towards
e%iminating such regu%ations# The o$jective has $een to ensure that e+cessive cance%%ation and
re$ooking do not add to the vo%ati%it& of the ru'ee# At 'resent) e+'osures arising on account of
swa's) ena$%ing a cor'orate to move from ru'ee to foreign currenc& %ia$i%it& >derived e+'osures?)
are not 'ermitted to $e hedged# <hi%e the market 'artici'ants have 'referred such a hedging
faci%it&) it is genera%%& $e%ieved that eAuating derivede+'osure in foreign currenc& with actua%
$orrowing in foreign currenc& wou%d tantamount to vio%ation of the $asic 'remise for accessing
the forward foreign e+change market in (ndia) i.e., having an under%&ing foreign e+change
e+'osure#
This feature >i.e.) Mthe ro%e of an under%&ing transaction in the $ooking of a forward contractB? is
uniAue to the (ndian derivatives market# The insistence on this reAuirement of under%&ing
e+'osure has to $e viewed against the $ackdro' of the then 'revai%ing conditions when it was
im'osed# 5or'orates in (ndia have $een 'ermitted increasing access to foreign currenc& funds
since 144,# The& were a%so accorded greater freedom to undertake active hedging#
.owever) recognising the re%ative%& nascent stage of the foreign e+change market initia%%& with
the %ack of ca'a$i%ities to hand%e massive s'ecu%ation) the Munder%&ing e+'osureB criterion was
im'osed as a 'rereAuisite# E+'orters and im'orters were 'ermitted to $ook forward contracts on
the $asis of a dec%aration of an e+'osure and on the $asis of 'ast 'erformance#
E%igi$%e %imits were gradua%%& raised to ena$%e cor'orates greater f%e+i$i%it&# The %imits are
com'uted se'arate%& for e+'ort and im'ort contracts# *ocuments are reAuired to $e furnished at
the time of maturit& of the contract# 5ontracts $ooked in e+cess of ,2 'er cent of the e%igi$%e
%imit had to $e on a de%ivera$%e $asis and cou%d not $e cance%%ed# This re%a+ation has 'roved ver&
usefu% to e+'orters of software and other services since their 'rojects are e+ecuted on the $asis of
master agreements with overseas $u&ers) which usua%%& do not indicate the vo%umes and tenor of
the e+'orts >Re'ort of (nterna% 6rou' on Foreign E+change Markets) ,;;2?# (n order to 'rovide
greater f%e+i$i%it& to e+'orters and im'orters) as announced in the Mid-term review of the Annua%
Po%ic& ,;;:-;8) this %imit has $een enhanced to 2; 'er cent#
Dotwithstanding the initiatives that have $een taken to enhance the f%e+i$i%it& for the cor'orates)
the need is fe%t to review the under%&ing e+'osure criteria for $ooking a forward contract# The
under%&ing e+'osure criteria ena$%e cor'orates to hedge on%& a 'art of their e+'osures that arise
on the $asis of the 'h&sica% vo%ume of goods >e+'orts0im'orts? to $e de%ivered7# <ith the (ndian
econom& getting increasing%& g%o$a%ised) cor'orates are a%so e+'osed to a variet& of Meconomic
e+'osuresB associated with the t&'es of foreign e+change0commodit& risks0 e+'osures arising out
of e+change rate f%uctuations#
At 'resent) the domestic 'rices of commodities such as ferrous and non-ferrous meta%s) $asic
chemica%s) 'etro-chemica%s) etc# are o$served to e+hi$it wor%d im'ort 'arit&# 6iven the two-wa&
movement of the ru'ee against the CS do%%ar and other currencies in recent &ears) it is necessar&
for the 'roducer0 consumer of such 'roducts to hedge their economic e+'osures to e+change rate
f%uctuation# !esides) 'rice-fi+ hedges are a%so avai%a$%e for traders g%o$a%%&# The& ena$%e
im'orters0e+'orters to %ock into a future 'rice for a commodit& that the& '%an to im'ort0e+'ort
without actua%%& having a cr&sta%%ised 'h&sica% e+'osure to the commodit&# Traders ma& a%so $e
affected not on%& $ecause of changes in ru'ee-do%%ar e+change rates $ut a%so $ecause of changes
in cross currenc& e+change rates# The reAuirement of Munder%&ing criteriaB is a%so often cited as
one of the reasons for the %ack of %iAuidit& in some of the derivative 'roducts in (ndia# .ence) a
fi+ation on the Munder%&ing criteriaB as (ndia g%o$a%ises ma& hinder the fu%% deve%o'ment of the
forward market# The reAuirement of 'ast 'erformance0under%&ing e+'osures shou%d $e e%iminated
in a 'hased manner# This has a%so $een the recommendation of $oth the committees on ca'ita%
account converti$i%it&# (t is cited that this 're-reAuisite has $een one of the factors contri$uting to
the shift over time towards the non de%ivera$%e forward >D*F? market at offshore %ocations to
hedge such e+'osures since such reAuirement is not sti'u%ated whi%e $ooking a D*F contract# An
attem't has $een made recent%& 'rovide im'orters the faci%it& to 'art%& hedge their economic
e+'osure $& 'ermitting them to $ook forward contracts for their customs dut& com'onent#
The Annua% Po%ic& Statement for ,;;8-;9) re%eased on A'ri% ,7) ,;;8 announced a host of
measures to e+'and the range of hedging too%s avai%a$%e to market 'artici'ants as a%so faci%itate
d&namic hedging $& residents# To hedge economic e+'osures) it has $een 'ro'osed that A*s
>5ategor&- (? ma& 'ermit >a? domestic 'roducers0users to hedge their 'rice risk on a%uminium)
co''er) %ead) nicke% and =inc in internationa% commodit& e+changes) $ased on their under%&ing
economic e+'osuresS and >$? actua% users of aviation tur$ine fue% >ATF? to hedge their economic
e+'osures in the internationa% commodit& e+changes $ased on their domestic 'urchases#
Authorised dea%er $anks ma& a''roach the Reserve !ank for 'ermission on $eha%f of customers
who are e+'osed to s&stemic internationa% 'rice risk) not covered otherwise# (n order to faci%itate
d&namic hedging of foreign e+change e+'osures of e+'orters and im'orters of goods and
services) it has $een 'ro'osed that forward contracts $ooked in e+cess of 82 'er cent of the
e%igi$%e %imits have to $e on a de%ivera$%e $asis and cannot $e cance%%ed as against the e+isting
%imit of 2; 'er cent# <ith a view to giving greater f%e+i$i%it& to cor'orates with overseas direct
investments) the forward contracts entered into for hedging overseas direct investments have
$een a%%owed to $e cance%%ed and re$ooked# (n order to ena$%e sma%% and medium enter'rises to
hedge their foreign e+change e+'osures) it has $een 'ro'osed to 'ermit them to $ook forward
contracts without under%&ing e+'osures or 'ast records of e+'orts and im'orts# Such contracts
ma& $e $ooked through A*s with whom the SMEs have credit faci%ities# The& have a%so $een
a%%owed to free%& cance% and re$ook these contracts# (n order to ena$%e resident individua%s to
manage0hedge their foreign e+change e+'osures) it has $een 'ro'osed to 'ermit resident
individua%s to $ook forward contracts without 'roduction of under%&ing documents u' to an
annua% %imit of CS K 1;;);;;) which can $e free%& cance%%ed and re$ooked#
Cor1orat# H#d)i!) for For#i)! E"$ha!)# Ri/* i! I!dia
I!trod%$tio!
(n 1481) the !retton <oods s&stem of administering fi+ed foreign e+change rates was a$o%ished
in favour of market-determination of foreign e+change ratesS a regime of f%uctuating e+change
rates was introduced# !esides market-determined f%uctuations) there was a %ot of vo%ati%it& in
other markets around the wor%d owing to increased inf%ation and the oi% shock# 5or'orates
strugg%ed to co'e with the uncertaint& in 'rofits) cash f%ows and future costs# (t was then that
financia% derivatives / foreign currenc&) interest rate) and commodit& derivatives emerged as
means of managing risks facing cor'orations#
(n (ndia) e+change rates were deregu%ated and were a%%owed to $e determined $& markets in
1441# The economic %i$era%i=ation of the ear%& nineties faci%itated the introduction of derivatives
$ased on interest rates and foreign e+change# .owever derivative use is sti%% a high%& regu%ated
area due to the 'artia% converti$i%it& of the ru'ee# 5urrent%& forwards) swa's and o'tions are
avai%a$%e in (ndia and the use of foreign currenc& derivatives is 'ermitted for hedging 'ur'oses
on%&#
The aim is to 'rovide a 'ers'ective on managing the risk that firmBs face due to f%uctuating
e+change rates# (t investigates the 'rudence in investing resources towards the 'ur'ose of
hedging and then introduces the too%s for risk management# These are then a''%ied in the (ndian
conte+t# The motivation of this stud& came from the recent rise in vo%ati%it& in the mone& markets
of the wor%d and 'articu%ar%& in the CS *o%%ar) due to which (ndian e+'orts are fast gaining a cost
disadvantage# .edging with derivative instruments is a feasi$%e so%ution to this situation#
This re'ort is organised in : sections# The ne+t section 'resents the necessit& of foreign e+change
risk management and out%ines the 'rocess of managing this risk# Section 1 discusses the various
determinants of hedging decisions $& firms) fo%%owed $& an overview of cor'orate hedging in
(ndia in Section 7# Evidence from major (ndian firms from different sectors is summari=ed here
and Section 2 conc%udes#
For#i)! E"$ha!)# Ri/* Ma!a)#'#!t, Pro$#// 9 N#$#//it(
Firms dea%ing in mu%ti'%e currencies face a risk >an unantici'ated gain0%oss? on account of
sudden0unantici'ated changes in e+change rates) Auantified in terms of e+'osures# E+'osure is
defined as a contracted) 'rojected or contingent cash f%ow whose magnitude is not certain at the
moment and de'ends on the va%ue of the foreign e+change rates# The 'rocess of identif&ing risks
faced $& the firm and im'%ementing the 'rocess of 'rotection from these risks $& financia% or
o'erationa% hedging is defined as foreign e+change risk management# This 'a'er %imits its sco'e
to hedging on%& the foreign e+change risks faced $& firms#
Ki!d/ of For#i)! E"$ha!)# E"1o/%r#
Risk management techniAues var& with the t&'e of e+'osure >accounting or economic? and term
of e+'osure# Accounting e+'osure) a%so ca%%ed trans%ation e+'osure) resu%ts from the need to
restate foreign su$sidiariesB financia% statements into the 'arentBs re'orting currenc& and is the
sensitivit& of net income to the variation in the e+change rate $etween a foreign su$sidiar& and
its 'arent# Economic e+'osure is the e+tent to which a firmTs market va%ue) in an& 'articu%ar
currenc&) is sensitive to une+'ected changes in foreign currenc&# 5urrenc& f%uctuations affect the
va%ue of the firmBs o'erating cash f%ows) income statement) and com'etitive 'osition) hence
market share and stock 'rice# 5urrenc& f%uctuations a%so affect a firmTs $a%ance sheet $&
changing the va%ue of the firmTs assets and %ia$i%ities) accounts 'a&a$%e) accounts receiva$%es)
inventor&) %oans in foreign currenc&) investments >5*s? in foreign $anksS this t&'e of economic
e+'osure is ca%%ed $a%ance sheet e+'osure# Transaction E+'osure is a form of short term
economic e+'osure due to fi+ed 'rice contracting in an atmos'here of e+change-rate vo%ati%it&#
The most common definition of the measure of e+change-rate e+'osure is the sensitivit& of the
va%ue of the firm) 'ro+ied $& the firmBs stock return) to an unantici'ated change in an e+change
rate# This is ca%cu%ated $& using the 'artia% derivative function where the de'endant varia$%e is
the firmBs va%ue and the inde'endent varia$%e is the e+change rate >Ad%er and *umas) 1497?#
N#$#//it( of 'a!a)i!) for#i)! #"$ha!)# ri/*
A ke& assum'tion in the conce't of foreign e+change risk is that e+change rate changes are not
'redicta$%e and that this is determined $& how efficient the markets for foreign e+change are#
Research in the area of efficienc& of foreign e+change markets has thus far $een a$%e to esta$%ish
on%& a weak form of the efficient market h&'othesis conc%usive%& which im'%ies that successive
changes in e+change rates cannot $e 'redicted $& ana%&=ing the historica% seAuence of e+change
rates#>Soenen) 1484?# .owever) when the efficient markets theor& is a''%ied to the foreign
e+change market under f%oating e+change rates there is some evidence to suggest that the 'resent
'rices 'ro'er%& ref%ect a%% avai%a$%e information#>6idd& and *ufe&) 144,?# This im'%ies that
e+change rates react to new information in an immediate and un$iased fashion) so that no one
'art& can make a 'rofit $& this information and in an& case) information on direction of the rates
arrives random%& so e+change rates a%so f%uctuate random%&# (t im'%ies that foreign e+change risk
management cannot $e done awa& with $& em'%o&ing resources to 'redict e+change rate
changes#
H#d)i!) a/ a too. to 'a!a)# for#i)! #"$ha!)# ri/*,
There is a s'ectrum of o'inions regarding foreign e+change hedging# Some firms fee% hedging
techniAues are s'ecu%ative or do not fa%% in their area of e+'ertise and hence do not venture into
hedging 'ractices# Other firms are unaware of $eing e+'osed to foreign e+change risks# There are
a set of firms who on%& hedge some of their risks) whi%e others are aware of the various risks the&
face) $ut are unaware of the methods to guard the firm against the risk# There is &et another set of
com'anies who $e%ieve shareho%der va%ue cannot $e increased $& hedging the firmBs foreign
e+change risks as shareho%ders can themse%ves individua%%& hedge themse%ves against the same
using instruments %ike forward contracts avai%a$%e in the market or diversif& such risks out $&
mani'u%ating their 'ortfo%io# >6idd& and *ufe&) 144,?#
There are some e+'%anations $acked $& theor& a$out the irre%evance of managing the risk of
change in e+change rates# For e+am'%e) the (nternationa% Fisher effect states that e+change rates
changes are $a%anced out $& interest rate changes) the Purchasing Power Parit& theor& suggests
that e+change rate changes wi%% $e offset $& changes in re%ative 'rice indices0inf%ation since the
"aw of One Price shou%d ho%d# !oth these theories suggest that e+change rate changes are evened
out in some form or the other#
A%so) the Cn$iased Forward Rate theor& suggests that %ocking in the forward e+change rate
offers the same e+'ected return and is an un$iased indicator of the future s'ot rate# !ut these
theories are 'erfect%& '%a&ed out in 'erfect markets under homogeneous ta+ regimes# A%so)
e+change rate-%inked changes in factors %ike inf%ation and interest rates take time to adjust and in
the meanwhi%e firms stand to %ose out on adverse movements in the e+change rates.
The e+istence of different kinds of market im'erfections) such as incom'%ete financia% markets)
'ositive transaction and information costs) 'ro$a$i%it& of financia% distress and agenc& costs and
restrictions on free trade make foreign e+change management an a''ro'riate concern for
cor'orate management# >6idd& and *ufe&) 144,? (t has a%so $een argued that a hedged firm)
$eing %ess risk& can secure de$t more easi%& and this enjo& a ta+ advantage >interest is e+c%uded
from ta+ whi%e dividends are ta+ed?# This wou%d negate the Modig%iani-Mi%%er 'ro'osition as
shareho%ders cannot du'%icate such ta+ advantages# The MM argument that shareho%ders can
hedge on their own is a%so not va%id on account of high transaction costs and %ack of know%edge
a$out financia% mani'u%ations on the 'art of shareho%ders.
There is a%so a vast 'oo% of research that 'roves the efficac& of managing foreign e+change risks
and a significant amount of evidence showing the reduction of e+'osure with the use of too%s for
managing these e+'osures# (n one of the more recent studies) A%%a&anis and Ofek >,;;1? use a
mu%tivariate ana%&sis on a sam'%e of SP 2;; non-financia% firms and ca%cu%ate a firms
e+change-rate e+'osure using the ratio of foreign sa%es to tota% sa%es as a 'ro+& and iso%ate the
im'act of use of foreign currenc& derivatives >'art of foreign e+change risk management? on a
firmBs foreign e+change e+'osures# The& find a statistica%%& significant association $etween the
a$so%ute va%ue of the e+'osures and the >a$so%ute va%ue? of the 'ercentage use of foreign
currenc& derivatives and 'rove that the use of derivatives in fact reduce e+'osure#
Ri/* Ma!a)#'#!t a!d S#tt.#'#!t of Tra!/a$tio!/ i! th# For#i)! E"$ha!)# Mar*#t
The foreign e+change market is characteri=ed $& constant changes and ra'id innovations in
trading methods and 'roducts# <hi%e the innovative 'roducts and wa&s of trading create new
'ossi$i%ities for 'rofit) the& a%so 'ose various kinds of risks to the market# 5entra% $anks a%% over
the wor%d) therefore) have $ecome increasing%& concerned of the sca%e of foreign e+change
sett%ement risk and the im'ortance of risk mitigation measures# !ehind this growing awareness
are severa% events in the 'ast in which foreign e+change sett%ement risk might have resu%ted in
s&stemic risk in g%o$a% financia% markets) inc%uding the fai%ure of !ankhaus .erstatt in 1487 and
the c%osure of !55( SA in 1441#
The foreign e+change sett%ement risk arises $ecause the de%iver& of the two currencies invo%ved
in a trade usua%%& occurs in two different countries) which) in man& cases are %ocated in different
time =ones# This risk is of 'articu%ar concern to the centra% $anks given the %arge va%ues invo%ved
in sett%ing foreign e+change transactions and the resu%ting 'otentia% for s&stemic risk# Most of the
$anks in the EMEs use some form of methodo%og& for measuring the foreign e+change
sett%ement e+'osure# Man& of these $anks use the sing%e da& method) in which the e+'osure is
measured as $eing eAua% to a%% foreign e+change recei'ts that are due on the da&# Some
institutions use a mu%ti'%e da& a''roach for measuring risk# Most of the $anks in EMEs use some
form of individua% counter'art& %imit to manage their e+'osures# These %imits are often a''%ied to
the g%o$a% o'erations of the institution# These %imits are sometimes monitored $& $anks on a
regu%ar $asis# (n certain cases) there are se'arate %imits for foreign e+change sett%ement
e+'osures) whi%e in other cases) %imits for aggregate sett%ement e+'osures are created through a
range of instruments# !i%atera% o$%igation netting) in jurisdictions where it is %ega%%& certain) is an
im'ortant wa& for trade counter'arties to mitigate the foreign e+change sett%ement risk# This
'rocess a%%ows trade counter'arties to offset their gross sett%ement o$%igations to each other in the
currencies the& have traded and sett%e these o$%igations with the 'a&ment of a sing%e net amount
in each currenc&#
Severa% emerging markets in recent &ears have im'%emented domestic rea% time gross sett%ement
>RT6S? s&stems for the sett%ement of high va%ue and time critica% 'a&ments to sett%e the domestic
%eg of foreign e+change transactions# A'art from risk reduction) these initiatives ena$%e
'artici'ants to active%& manage the time at which the& irrevoca$%& 'a& awa& when se%%ing the
domestic currenc&) and reconci%e fina% recei't when 'urchasing the domestic currenc&#
Partici'ants) therefore) are a$%e to reduce the duration of the foreign e+change sett%ement risk#
Recognising the s&stemic im'act of foreign e+change sett%ement risk) an im'ortant e%ement in
the infrastructure for the efficient functioning of the (ndian foreign e+change market has $een the
c%earing and sett%ement of inter-$ank CS*-(DR transactions# (n 'ursuance of the
recommendations of the Sodhani 5ommittee) the Reserve !ank had set u' the 5%earing
5or'oration of (ndia "td# >55("? in ,;;1 to mitigate risks in the (ndian financia% markets# The
55(" commenced sett%ement of foreign e+change o'erations for inter-$ank CS*-(DR s'ot and
forward trades from Dovem$er 9) ,;;, and for inter-$ank CS*-(DR cash and tom trades from
Fe$ruar& 2) ,;;7# The 55(" undertakes sett%ement of foreign e+change trades on a mu%ti%atera%
net $asis through a 'rocess of novation and a%% s'ot) cash and tom transactions are guaranteed for
sett%ement from the trade date#
Ever& e%igi$%e foreign e+change contract entered $etween mem$ers gets novated or re'%aced $&
two new contracts / $etween the 55(" and each of the two 'arties) res'ective%&# Fo%%owing the
mu%ti%atera% netting 'rocedure) the net amount 'a&a$%e to) or receiva$%e from) the 55(" in each
currenc& is arrived at) mem$er-wise# The Ru'ee %eg is sett%ed through the mem$ersB current
accounts with the Reserve !ank and the CS* %eg through 55("Bs account with the sett%ement
$ank at Dew Eork# The 55(" sets %imits for each mem$er $ank on the $asis of certain 'arameters
such as mem$erBs credit rating) net worth) asset va%ue and management Aua%it&# The 55(" sett%ed
over 4;;);;; dea%s for a gross vo%ume of CS K 1)19; $i%%ion in ,;;2-;:# The 55(" has
consistent%& endeavoured to add va%ue to the services and has gradua%%& $rought the entire gamut
of foreign e+change transactions under its 'urview# (ntermediation) $& the 55(" thus) 'rovides
its mem$ers the $enefits of risk mitigation) im'roved efficienc&) %ower o'erationa% cost and
easier reconci%iation of accounts with corres'ondents#
An issue re%ated to the guaranteed sett%ement of transactions $& the 55(" has $een the e+tension
of this faci%it& to a%% forward trades as we%%# Mem$er $anks current%& encounter 'ro$%ems in terms
of huge outstanding foreign e+change e+'osures in their $ooks and this comes in the wa& of their
doing more trades in the market# Risks on such huge outstanding trades were found to $e ver&
high and so were the ca'ita% reAuirements for su''orting such trades# .ence) man& mem$er
$anks have e+'ressed their desire in severa% fora that the 55(" shou%d e+tend its guarantee to
these forward trades from the trade date itse%f which cou%d %ead to significant increase in the
%iAuidit& and de'th in the forward market# The risks that $anks toda& carr& in their $ooks on
account of %arge outstanding forward 'ositions wi%% a%so $e significant%& reduced >6o'inath)
,;;2?# This has a%so $een one of the recommendations of the 5ommittee on Fu%%er 5a'ita%
Account 5onverti$i%it&# :#22 A'art from managing the foreign e+change sett%ement risk)
'artici'ants a%so need to manage market risk) %iAuidit& risk) credit risk and o'erationa% risk
efficient%& to avoid future %osses# As 'er the guide%ines framed $& the Reserve !ank for $anks to
manage risk in the inter-$ank foreign e+change dea%ings and e+'osure in derivative markets as
market makers) the $oards of directors of A*s >categor&-(? are reAuired to frame an a''ro'riate
'o%ic& and fi+ suita$%e %imits for o'erations in the foreign e+change market# The net overnight
o'en e+change 'osition and the aggregate ga' %imits need to $e a''roved $& the Reserve !ank#
The o'en 'osition is genera%%& measured se'arate%& for each foreign currenc& consisting of the
net s'ot 'osition) the net forward 'osition) and the net o'tions 'osition# Garious %imits for
e+'osure) viz#) overnight) da&%ight) sto' %oss) ga' %imit) credit %imit) va%ue at risk >GaR?) etc., for
foreign e+change transactions $& $anks are fi+ed# <ithin the contour of these %imits) front office
of the treasur& of A*s transacts in the foreign e+change market for customers and own
'ro'rietar& reAuirements# These e+'osures are accounted) confirmed and sett%ed $& $ack office)
whi%e mid-office eva%uates the 'rofit and monitors adherence to risk %imits on a continuous $asis#
(n the case of market risk) most $anks use a com$ination of measurement techniAues inc%uding
GaR mode%s# The credit risk is genera%%& measured and managed $& most $anks on an aggregate
counter-'art& $asis so as to inc%ude a%% e+'osures in the under%&ing s'ot and derivative markets#
Some $anks a%so monitor countr& risk through cross-$order countr& risk e+'osure %imits#
"iAuidit& risk is genera%%& estimated $& monitoring asset %ia$i%it& 'rofi%e in various currencies in
various $uckets and monitoring currenc&-wise ga's in various $uckets# !anks a%so track $a%ances
to $e maintained on a dai%& $asis in Dostro accounts) remittances and committed foreign
currenc& term %oans whi%e monitoring %iAuidit& risk#
To sum u') the foreign e+change market structure in (ndia has undergone su$stantia%
transformation from the ear%& 144;s# The market 'artici'ants have $ecome diversified and there
are severa% instruments avai%a$%e to manage their risks# Sources of su''%& and demand in the
foreign e+change market have a%so changed in %ine with the shifts in the re%ative im'ortance in
$a%ance of 'a&ments from current to ca'ita% account# There has a%so $een considera$%e
im'rovement in the market infrastructure in terms of trading '%atforms and sett%ement
mechanisms# Trading in (ndian foreign e+change market is %arge%& concentrated in the s'ot
segment even as vo%umes in the derivatives segment are on the rise# Some of the issues that need
attention to further im'rove the activit& in the derivatives segment inc%ude f%e+i$i%it& in the use
of various instruments) enhancing the know%edge and understanding the nature of risk invo%ved
in transacting the derivative 'roducts) reviewing the ro%e of under%&ing in $ooking forward
contracts and guaranteed sett%ements of forwards# !esides) market '%a&ers wou%d need to acAuire
the necessar& e+'ertise to use different kinds of instruments and manage the risks invo%ved#
For#i)! E"$ha!)# Ri/* Ma!a)#'#!t Fra'#+or*
Once a firm recogni=es its e+'osure) it then has to de'%o& resources in managing it# A heuristic
for firms to manage this risk effective%& is 'resented $e%ow which can $e modified to suit firm-
s'ecific needs i#e# some or a%% the fo%%owing too%s cou%d $e used#
For#$a/t/, After determining its e+'osure) the first ste' for a firm is to deve%o' a forecast on
the market trends and what the main direction0trend is going to $e on the foreign e+change
rates# The 'eriod for forecasts is t&'ica%%& : months# (t is im'ortant to $ase the forecasts on
va%id assum'tions# A%ong with identif&ing trends) a 'ro$a$i%it& shou%d $e estimated for the
forecast coming true as we%% as how much the change wou%d $e#
Ri/* E/ti'atio!, !ased on the forecast) a measure of the Value at is! >the actua% 'rofit or
%oss for a move in rates according to the forecast? and the probability of this risk shou%d $e
ascertained# The risk that a transaction wou%d fai% due to "ar!et#specific proble"s$ shou%d $e
taken into account# Fina%%&) the S&stems Risk that can arise due to inadeAuacies such as
re'orting ga's and im'%ementation ga's in the firmsB e+'osure management s&stem shou%d
$e estimated#
B#!$h'ar*i!), 6iven the e+'osures and the risk estimates) the firm has to set its %imit for
hand%ing foreign e+change e+'osure# The firm a%so has to decide whether to manage its
e+'osures on a cost centre or 'rofit centre $asis# A cost centre a''roach is a defensive one
and the main aim is ensure that cash f%ows of a firm are not adverse%& affected $e&ond a
'oint# A 'rofit centre a''roach on the other hand is a more aggressive a''roach where the
firm decides to generate a net 'rofit on its e+'osure over time#
H#d)i!), !ased on the %imits a firm set for itse%f to manage e+'osure) the firms then decides
an a''ro'riate hedging strateg&# There are various financia% instruments avai%a$%e for the firm
to choose from3 futures) forwards) o'tions and swa's and issue of foreign de$t# .edging
strategies and instruments are e+'%ored in a section#
Sto1 Lo//, The firms risk management decisions are $ased on forecasts which are $ut
estimates of reasona$%& un'redicta$%e trends# (t is im'erative to have sto' %oss arrangements
in order to rescue the firm if the forecasts turn out wrong# For this) there shou%d $e certain
monitoring s&stems in '%ace to detect critica% %eve%s in the foreign e+change rates for
a''ro'riate measure to $e taken#
R#1orti!) a!d R#&i#+, Risk management 'o%icies are t&'ica%%& su$jected to review $ased
on 'eriodic re'orting# The re'orts main%& inc%ude 'rofit0 %oss status on o'en contracts after
marking to market) the actua% e+change0 interest rate achieved on each e+'osure) and
'rofita$i%it& vis-U-vis the $enchmark and the e+'ected changes in overa%% e+'osure due to
forecasted e+change0 interest rate movements# The review ana%&ses whether the $enchmarks
set are va%id and effective in contro%%ing the e+'osures) what the market trends are and fina%%&
whether the overa%% strateg& is working or needs change#
H#d)i!) Strat#)i#/? I!/tr%'#!t/
A derivative is a financia% contract whose va%ue is derived from the va%ue of some other financia%
asset) such as a stock 'rice) a commodit& 'rice) an e+change rate) an interest rate) or even an
inde+ of 'rices# The main ro%e of derivatives is that the& rea%%ocate risk among financia% market
'artici'ants) he%' to make financia% markets more com'%ete# This section out%ines the hedging
strategies using derivatives with foreign e+change $eing the on%& risk assumed#
For+ard/
A forward is a made-to-measure agreement $etween two 'arties to $u&0se%% a s'ecified
amount of a currenc& at a s'ecified rate on a 'articu%ar date in the future# The de'reciation of
the receiva$%e currenc& is hedged against $& se%%ing a currenc& forward# (f the risk is that of a
currenc& a''reciation >if the firm has to $u& that currenc& in future sa& for im'ort?) it can
hedge $& $u&ing the currenc& forward# E#g if R(" wants to $u& crude oi% in CS do%%ars si+
months hence) it can enter into a forward contract to 'a& (DR and $u& CS* and %ock in a
fi+ed e+change rate for (DR-CS* to $e 'aid after : months regard%ess of the actua% (DR-
*o%%ar rate at the time# (n this e+am'%e the downside is an a''reciation of *o%%ar which is
'rotected $& a fi+ed forward contract# The main advantage of a forward is that it can $e
tai%ored to the s'ecific needs of the firm and an e+act hedge can $e o$tained# On the
downside) these contracts are not marketa$%e) the& canBt $e so%d to another 'art& when the&
are no %onger reAuired and are $inding#
F%t%r#/
A futures contract is simi%ar to the forward contract $ut is more %iAuid $ecause it is traded in
an organi=ed e+change i#e# the futures market# *e'reciation of a currenc& can $e hedged $&
se%%ing futures and a''reciation can $e hedged $& $u&ing futures# Advantages of futures are
that there is a centra% market for futures which e%iminates the 'ro$%em of dou$%e coincidence#
Futures reAuire a sma%% initia% out%a& >a 'ro'ortion of the va%ue of the future? with which
significant amounts of mone& can $e gained or %ost with the actua% forwards 'rice
f%uctuations# This 'rovides a sort of %everage#
The 'revious e+am'%e for a forward contract for R(" a''%ies here a%so just that R(" wi%% have
to go to a CS* futures e+change to 'urchase standardised do%%ar futures eAua% to the amount
to $e hedged as the risk is that of a''reciation of the do%%ar# As mentioned ear%ier) the
tai%ora$i%it& of the futures contract is %imited i#e# on%& standard denominations of mone& can
$e $ought instead of the e+act amounts that are $ought in forward contracts#
O1tio!/
A currenc& O'tion is a contract giving the right) not the o$%igation) to $u& or se%% a s'ecific
Auantit& of one foreign currenc& in e+change for another at a fi+ed 'riceS ca%%ed the E+ercise
Price or Strike Price# The fi+ed nature of the e+ercise 'rice reduces the uncertaint& of
e+change rate changes and %imits the %osses of o'en currenc& 'ositions# O'tions are
'articu%ar%& suited as a hedging too% for contingent cash f%ows) as is the case in $idding
'rocesses# 5a%% O'tions are used if the risk is an u'ward trend in 'rice >of the currenc&?)
whi%e Put O'tions are used if the risk is a downward trend# Again taking the e+am'%e of R("
which needs to 'urchase crude oi% in CS* in : months) if R(" $u&s a 5a%% o'tion >as the risk
is an u'ward trend in do%%ar rate?) i#e# the right to $u& a s'ecified amount of do%%ars at a fi+ed
rate on a s'ecified date) there are two scenarios# (f the e+change rate movement is favoura$%e
i#e the do%%ar de'reciates) then R(" can $u& them at the s'ot rate as the& have $ecome
chea'er# (n the other case) if the do%%ar a''reciates com'ared to toda&Bs s'ot rate) R(" can
e+ercise the o'tion to 'urchase it at the agreed strike 'rice# (n either case R(" $enefits $&
'a&ing the %ower 'rice to 'urchase the do%%ar
S+a1/
A swa' is a foreign currenc& contract where$& the $u&er and se%%er e+change eAua% initia%
'rinci'a% amounts of two different currencies at the s'ot rate# The $u&er and se%%er e+change
fi+ed or f%oating rate interest 'a&ments in their res'ective swa''ed currencies over the term
of the contract# At maturit&) the 'rinci'a% amount is effective%& re-swa''ed at a
'redetermined e+change rate so that the 'arties end u' with their origina% currencies# The
advantages of swa's are that firms with %imited a''etite for e+change rate risk ma& move to a
'artia%%& or com'%ete%& hedged 'osition through the mechanism of foreign currenc& swa's)
whi%e %eaving the under%&ing $orrowing intact# A'art from covering the e+change rate risk)
swa's a%so a%%ow firms to hedge the f%oating interest rate risk# 5onsider an e+'ort oriented
com'an& that has entered into a swa' for a notiona% 'rinci'a% of CS* 1 mn at an e+change
rate of 7,0do%%ar#
The com'an& 'a&s CS :months "(!OR to the $ank and receives 11#;;O '#a# ever& : months
on 1st @anuar& 1st @u%&) ti%% 2 &ears# Such a com'an& wou%d have earnings in *o%%ars and
can use the same to 'a& interest for this kind of $orrowing >in do%%ars rather than in Ru'ee?
thus hedging its e+'osures#
For#i)! D#-t
Foreign de$t can $e used to hedge foreign e+change e+'osure $& taking advantage of the
(nternationa% Fischer Effect re%ationshi'# This is demonstrated with the e+am'%e of an
e+'orter who has to receive a fi+ed amount of do%%ars in a few months from 'resent# The
e+'orter stands to %ose if the domestic currenc& a''reciates against that currenc& in the
meanwhi%e so) to hedge this) he cou%d take a %oan in the foreign currenc& for the same time
'eriod and convert the same into domestic currenc& at the current e+change rate# The theor&
assures that the gain rea%ised $& investing the 'roceeds from the %oan wou%d match the
interest rate 'a&ment >in the foreign currenc&? for the %oan#
5hoice of hedging instruments
The %iterature on the choice of hedging instruments is ver& scant# Among the avai%a$%e studies)
6Vc=& et a%# >1448? argues that currenc& swa's are more cost-effective for hedging foreign de$t
risk) whi%e forward contracts are more cost-effective for hedging foreign o'erations risk# This is
$ecause foreign currenc& de$t 'a&ments are %ong-term and 'redicta$%e) which fits the %ong-term
nature of currenc& swa' contracts# Foreign currenc& revenues) on the other hand) are short-term
and un'redicta$%e) in %ine with the short-term nature of forward contracts# A surve& done $&
Marsha%% >,;;;? a%so 'oints out that currenc& swa's are $etter for hedging against trans%ation
risk) whi%e forwards are $etter for hedging against transaction risk# This stud& a%so 'rovides
anecdota% evidence that 'ricing 'o%ic& is the most 'o'u%ar means of hedging economic
e+'osures#
These resu%ts however can differ for different currencies de'ending in the sensitivit& of that
currenc& to various market factors# Regu%ation in the foreign e+change markets of various
countries ma& a%so skew such resu%ts#
D#t#r'i!a!t/ of H#d)i!) D#$i/io!/
The management of foreign e+change risk) as has $een esta$%ished so far) is a fair%& com'%icated
'rocess# A firm) e+'osed to foreign e+change risk) needs to formu%ate a strateg& to manage it)
choosing from mu%ti'%e a%ternatives# This section e+'%ores what factors firms take into
consideration when formu%ating these strategies#
Prod%$tio! a!d Trad# &/. H#d)i!) D#$i/io!/
An im'ortant issue for mu%tinationa% firms is the a%%ocation of ca'ita% among different countries
'roduction and sa%es and at the same time hedging their e+'osure to the var&ing e+change rates#
Research in this area suggests that the e%ements of e+change rate uncertaint& and the attitude
toward risk are irre%evant to the mu%tinationa% firmTs sa%es and 'roduction decisions %&roll,'(()*.
On%& the revenue function and cost of 'roduction are to $e assessed) and) the 'roduction and
trade decisions in mu%ti'%e countries are inde'endent of the hedging decision.
The im'%ication of this inde'endence is that the 'resence of markets for hedging instruments
great%& reduces the com'%e+it& invo%ved in a firmBs decision making as it can se'arate 'roduction
and sa%es functions from the finance function# The firm avoids the need to form e+'ectations
a$out future e+change rates and formu%ation of risk 'references which entai%s high information
costs#
Co/t of H#d)i!)
.edging can $e done through the derivatives market or through mone& markets >foreign de$t?# (n
either case the cost of hedging shou%d $e the difference $etween va%ue received from a hedged
'osition and the va%ue received if the firm did not hedge# (n the 'resence of efficient markets) the
cost of hedging in the forward market is the difference $etween the future s'ot rate and current
forward rate '%us an& transactions cost associated with the forward contract# Simi%ar%&) the
e+'ected costs of hedging in the mone& market are the transactions cost '%us the difference
$etween the interest rate differentia% and the e+'ected va%ue of the difference $etween the current
and future s'ot rates# (n efficient markets) $oth t&'es of hedging shou%d 'roduce simi%ar resu%ts at
the same costs) $ecause interest rates and forward and s'ot e+change rates are determined
simu%taneous%&# The costs of hedging) assuming efficienc& in foreign e+change markets resu%t in
'ure transaction costs# The three main e%ements of these transaction costs are $rokerage or
service fees charged $& dea%ers) information costs such as su$scri'tion to Reuter re'orts and
news channe%s and administrative costs of e+'osure management#
Fa$tor/ aff#$ti!) th# d#$i/io! to h#d)# for#i)! $%rr#!$( ri/*
Research in the area of determinants of hedging se'arates the decision of a firm to hedge from
that of how much to hedge# There is conc%usive evidence to suggest that firms with %arger si=e)
R* e+'enditure and e+'osure to e+change rates through foreign sa%es and foreign trade are
more %ike%& to use derivatives# >Allayanis and +fe!, ,--'* First) the fo%%owing section descri$es
the factors that affect the decision to hedge and then the factors affecting the degree of hedging
are considered#
Fir' /i0#
Firm si=e acts as a 'ro+& for the cost of hedging or economies of sca%e# Risk management
invo%ves fi+ed costs of setting u' of com'uter s&stems and training0hiring of 'ersonne% in
foreign e+change management# Moreover) %arge firms might $e considered as more
creditworth& counter'arties for forward or swa' transactions) thus further reducing their cost
of hedging. .he boo! value of assets is used as a "easure of fir" size.
L#&#ra)#
According to the risk management %iterature) firms with high %everage have greater incentive
to engage in hedging $ecause doing so reduces the 'ro$a$i%it&) and thus the e+'ected cost of
financia% distress# .igh%& %evered firms avoid foreign de$t as a means to hedge and use
derivatives#
Li:%idit( a!d 1rofita-i.it(,
Firms with high%& %iAuid assets or high 'rofita$i%it& have %ess incentive to engage in hedging
$ecause the& are e+'osed to a %ower 'ro$a$i%it& of financia% distress. /iquidity is "easured
by the quic! ratio, i.e. quic! assets divided by current liabilities*. 0rofitability is "easured as
E&I. divided by boo! assets.
Sa.#/ )ro+th
Sa%es growth is a factor determining decision to hedge as o''ortunities are more %ike%& to $e
affected $& the underinvestment 'ro$%em# For these firms) hedging wi%% reduce the
'ro$a$i%it& of having to re%& on e+terna% financing) which is cost%& for information
as&mmetr& reasons) and thus ena$%e them to enjo& uninterru'ted high growth# .he "easure
of sales growth is obtained using the )#year geo"etric average of yearly sales growth rates.
As regards the degree of hedging A%%a&anis and Ofek >,;;1? conc%ude that the so%e determinants
of the degree of hedging are e+'osure factors >foreign sa%es and trade?# (n other words) given that
a firm decides to hedge) the decision of how much to hedge is affected so%e%& $& its e+'osure to
foreign currenc& movements#
This discussion high%ights how risk management s&stems have to $e a%tered according to
characteristics of the firm) hedging costs) nature of o'erations) ta+ considerations) regu%ator&
reAuirements etc# The ne+t section discusses these issues in the (ndian conte+t and regu%ator&
environment#
A! O&#r&i#+ of Cor1orat# H#d)i!) i! I!dia
The move from a fi+ed e+change rate s&stem to a market determined one as we%% as the
deve%o'ment of derivatives markets in (ndia have fo%%owed with the %i$era%i=ation of the
econom& since 144,# (n this conte+t) the market for hedging instruments is sti%% in its deve%o'ing
stages# (n order to understand the a%ternative hedging strategies that (ndian firms can ado't) it is
im'ortant to understand the regu%ator& framework for the use of derivatives here#
D#&#.o1'#!t of D#ri&ati&# Mar*#t/ i! I!dia
The economic %i$era%i=ation of the ear%& nineties faci%itated the introduction of derivatives $ased
on interest rates and foreign e+change# E+change rates were deregu%ated and market determined
in 1441# !& 1447) the ru'ee was made fu%%& converti$%e on current account# The $an on futures
trading of man& commodities was %ifted starting in the ear%& ,;;;s# As of Octo$er ,;;8) even
cor'orates have $een a%%owed to write o'tions in the atmos'here of high vo%ati%it&#4 *erivatives
on stock inde+es and individua% stocks have grown ra'id%& since ince'tion# (n 'articu%ar) sing%e
stock futures have $ecome huge%& 'o'u%ar# (nstitutiona% investors 'refer to trade in the Over-The-
5ounter>OT5? markets to interest rate futures) where instruments such as interest rate swa's and
forward rate agreements are thriving# Foreign e+change derivatives are %ess active than interest
rate derivatives in
W (ndia) even though the& have $een around for %onger# OT5 instruments in currenc& forwards
and swa's are the most 'o'u%ar# (m'orters) e+'orters and $anks use the ru'ee forward market to
hedge their foreign currenc& e+'osure# Turnover and %iAuidit& in this market has $een increasing)
a%though trading is main%& in shorter maturit& contracts of one &ear or %ess# The t&'ica% forward
contract is for one month) three months) or si+ months) with three months $eing the most
common# The (ndian ru'ee) which is $eing traded on the *u$ai 6o%d and 5ommodities
E+change >*65X?) crossed a turnover of K,1#,7 mi%%ion in @une ,;;8#
R#)%.ator( G%id#.i!#/ for th# %/# of For#i)! E"$ha!)# D#ri&ati&#/
<ith res'ect to foreign e+change derivatives invo%ving ru'ee) residents have access to foreign
e+change forward contracts) foreign currenc&-ru'ee swa' instruments and currenc& o'tions /
$oth cross currenc& as we%% as foreign currenc&-ru'ee# (n the case of derivatives invo%ving on%&
foreign currenc&) a range of 'roducts such as (nterest Rate Swa's) Forward 5ontracts and
O'tions are a%%owed# <hi%e these 'roducts can $e used for a variet& of 'ur'oses) the fundamenta%
reAuirement is the e+istence of an under%&ing e+'osure to foreign e+change risk i#e# derivatives
can $e used for hedging 'ur'oses on%&#
The R!( has a%so formu%ated guide%ines to sim'%if& 'rocedura%0documentation reAuirements for
Sma%% and Medium Enter'rises >SME? sector# (n order to ensure that SMEs understand the risks
of these 'roducts) on%& $anks with which the& have credit re%ationshi' are a%%owed to offer such
faci%ities# These faci%ities shou%d a%so have some re%ationshi' with the turnover of the entit&#
Simi%ar%&) individua%s have $een 'ermitted to hedge u'to CS* 1;;);;; on se%f dec%aration $asis#
Authorised *ea%er>A*? $anks ma& a%so enter into forward contracts with residents in res'ect of
transactions denominated in foreign currenc& $ut sett%ed in (ndian Ru'ees inc%uding hedging the
currenc& inde+ed e+'osure of im'orters in res'ect of customs dut& 'a&a$%e on im'orts and 'rice
risks on commodities with a few e+ce'tions# *omestic 'roducers0users are a%%owed to hedge
their 'rice risk on a%uminium) co''er) %ead) nicke% and =inc as we%% as aviation tur$ine fue% in
internationa% commodit& e+changes $ased on their under%&ing economic e+'osures# Authorised
dea%ers are 'ermitted to use innovative 'roducts %ike cross-currenc& o'tionsS interest rate swa's
>(RS? and currenc& swa's) ca's0co%%ars and forward rate agreements >FRAs? in the internationa%
foreign e+change market# Foreign (nstitutiona% (nvestors >F((?) 'ersons resident outside (ndia
having Foreign *irect (nvestment >F*(? in (ndia and Donresident (ndians >DR(? are a%%owed
access to the forwards market to the e+tent of their e+'osure in the cash market#
H#d)i!) I!/tr%'#!t/ for I!dia! Fir'/
The recent 'eriod has witnessed am'%ified vo%ati%it& in the (DR-CS e+change rates in the
$ackdro' of the su$-'rime crisis in the CS and increased do%%ar-inf%ows into the (ndian stock
markets# (n this conte+t) the 'a'er has attem'ted to stud& the choice of instruments ado'ted $&
'rominent firms to stem their foreign e+change e+'osures# A%% the data for this has $een
com'i%ed from the ,;;:-,;;8 Annua% Re'orts of the res'ective com'anies# A summar& of the
foreign e+change risk hedging $ehaviour of se%ect (ndian firms is given in the ta$%e#
(nstruments 5urrenc&>mn? Rs >5r? Dature of e+'osure
R#.ia!$# I!d%/tri#/ Earnings in a%% $usinesses are %inked to CS*#
5urrenc& Swa's 1;:7#74 The ke& in'ut) crude oi% is 'urchased in CS*#
O'tions 5ontracts ,414#8: A%% e+'ort revenues are in foreign currenc& and
Forward 5ontracts 28:7#1
%oca% 'rices are $ased on im'ort 'arit& 'rices as
we%%

Mar%ti Ud(o) #
Forward 5ontracts
:711 >(DR-
@PE? (m'ort0Ro&a%t& 'a&a$%e in Een and
8; >K-(DR? E+'orts Receiva$%es in do%%ars#
5urrenc& swa's
1,7#8;>CS*
-(DR? (nterest rate and fore+ risk#

#
Mahi!dra a!d
Mahi!dra
Forward 5ontracts 12; >(DR-@PE? Trade 'a&a$%es in Een and Euro and
,>(DR-ECR? e+'ort receiva$%es in do%%ars#
,8#1>K-(DR?

5urrenc& Swa's
214; >@PE-
(DR? (nterest rate and foreign e+change risk#

Ar&i!d Mi../
Forward 5ontracts 12,#49 >K-(DR? 8;1#:8

,#,2 >6!P-
(DR?
2 >(DR-K? ,1#99 Most of the revenue is either in do%%ars
or %inked to do%%ars due to e+'ort#
O'tion 5ontracts 1 , ,#2 >K-(DR? 278#1:

I!fo/(/
Forward 5ontracts 114 >K-(DR? 2,4
O'tions 5ontracts 7 >K-(DR? 19 Revenues denominated in these
9 >(DR-K? 1: currencies#
Range $arrier o'tions , >K-(DR? 481
1 >Eur-(DR?
TCS
Forward 5ontracts 12 >Eur-(DR? ,:2#82 Revenues %arge%& denominated in
,1 >6!P-(DR? foreign currenc&) 'redominant%& CSK)
6!P) and Euro# Other currencie inc%ude
O'tions 5ontracts 9 1 ; >K-(DR? 7;28 Austra%ian K) 5anadian K) South African
78#2 >Eur-(DR? Rand) and Swiss Franc

8:#2 >6!P-
(DR?

Ra!-a"(
Forward 5ontracts ,947#294 E+'osed on accounts receiva$%e and
%oans 'a&a$%e# E+'osure in CS* and
@a' Een

Dr. R#dd(</ La-/
Forward 5ontracts 149 >K-(DR? Foreign currenc& earnings through
11>Eur K? e+'ort) currenc& reAuirements for
sett%ement of %ia$i%it& for im'ort of
O'tions 5ontracts 1; >ECR-K? goods#

Di/$%//io! o! H#d)i!) -( I!dia! Fir'/
From the Ta$%e a$ove) it can $e seen that earnings of a%% the firms are %inked to either CS do%%ar)
Euro or Pound as firms transact 'rimari%& in these foreign currencies g%o$a%%&# Forward contracts
are common%& used and among these firms) Ran$a+& and R(" de'end heavi%& on these contracts
for their hedging reAuirements# As discussed ear%ier) forwards contracts can $e tai%ored to the
e+act needs of the firm and this cou%d $e the reason for their 'o'u%arit&# The tai%or a$i%it& is a
consideration as it ena$%es the firms to match their e+'osures in an e+act manner com'ared to
e+change traded derivatives %ike futures that are standardi=ed where e+act matching is difficu%t#
R(") Maruti Cd&og and Mahindra and Mahindra are the on%& firms using currenc& swa's# Swa'
usage is a %ong term strateg& for hedging and suggests that the '%anning hori=ons for these
com'anies are %onger than those of other firms# These $usinesses) $& nature invo%ve %onger
gestation 'eriods and higher initia% ca'ita% out%a&s and this cou%d e+'%ain their %ong '%anning
hori=ons#
Another o$servation is that T5S 'refers to hedge its e+'osure to the CS *o%%ar through o'tions
rather than forwards# This strateg& has $een o$served among man& firms recent%& in (ndia11#
This has $een ado'ted due to the marked high vo%ati%it& of the CS *o%%ar against the Ru'ee#
O'tions are more 'rofita$%e instruments in vo%ati%e conditions as the& offer un%imited u'side
'rofita$i%it& whi%e hedging the downside risk whereas there is a risk with forwards if the
e+'ectation of the e+change rate >the guess? is wrong as firms %ose out on some 'rofit# The use of
Range $arrier o'tions $& (nfos&s a%so suggests a strateg& to tack%e the high vo%ati%it& of the do%%ar
e+change rates# Software firms have a %imited domestic market and re%& on e+'orts for the major
'art of their revenues and hence reAuire additiona% f%e+i$i%it& in hedging when the vo%ati%it& is
high# Another im'%ication of this is that their '%anning hori=ons are shorter com'ared to ca'ita%
intensive firms#
(t is evident that most (ndian firms use forwards and o'tions to hedge their foreign currenc&
e+'osure# This im'%ies that these firms chose short-term measures to hedge as o''osed to foreign
de$t# This 'reference is 'ossi$%& a conseAuence of their costs $eing in Ru'ees) the a$sence of a
Ru'ee futures e+change in (ndia and cur$s on foreign de$t# (t a%so fo%%ows that most of these
firms $ehave %ike Det E+'orters and are adverse%& affected $& a''reciation of the %oca% currenc&#
There are a few firms which have im'ort %ia$i%ities which wou%d $e adverse%& affected $& Ru'ee
de'reciation#
.owever it must $e 'ointed out that the data set considered for this stud& does not indicate how
the use of foreign de$t $& these firms hedges their e+'osures to foreign e+change risk and
whether such a strateg& is used as a su$stitute or com'%ement to hedging with derivatives#
Co!$.%/io!
*erivative use for hedging is on%& to increase due to the increased g%o$a% %inkages and vo%ati%e
e+change rates# Firms need to %ook at instituting a sound risk management s&stem and a%so need
to formu%ate their hedging strateg& that suits their s'ecific firm characteristics and e+'osures#
(n (ndia) regu%ation has $een steadi%& eased and turnover and %iAuidit& in the foreign currenc&
derivative markets has increased) a%though the use is main%& in shorter maturit& contracts of one
&ear or %ess# Forward and o'tion contracts are the more 'o'u%ar instruments# Regu%ators had
initia%%& on%& a%%owed certain $anks to dea% in this market however now cor'orates can a%so write
o'tion contracts# There are man& variants of these derivatives which investment $anks across the
wor%d s'ecia%i=e in) and as the awareness and demand for these variants increases) R!( wou%d
have to revise regu%ations#
For now) (ndian com'anies are active%& hedging their foreign e+changes risks with forwards)
currenc& and interest rate swa's and different t&'es of o'tions such as ca%%) 'ut) cross currenc&
and range-$arrier o'tions# The high use of forward contracts $& (ndian firms a%so high%ights the
a$sence of a ru'ee futures e+change in (ndia#
.owever) the *u$ai 6o%d and 5ommodities E+change in @une) ,;;8 introduced Ru'ee- *o%%ar
futures that cou%d $e traded on its e+changes and had 'rovided another route for firms to hedge
on a trans'arent $asis# There are fears that R!(Bs a$i%it& to contro% the 'artia%%& converti$%e
currenc& wi%% $e su$dued $& this introduction $ut this issue is $e&ond the sco'e of this stud&# The
'artia% converti$i%it& of the Ru'ee wi%% $e difficu%t to contro% if man& e+changes offer such
instruments and that wi%% $e factor to consider for the R!(#
C%rr#!$( Ri/* Ma!a)#'#!t
I!trod%$tio!
The management of currenc& risk $& cor'orations has come a %ongwa& in the %ast three decades#
!efore the $reak-u' of !retton<oods currenc& riskwas not a major consideration for cor'orate
e+ecutives) nor did it have to $e# E+change rates were a%%owed to f%uctuate) $ut on%& within
reasona$%& tight $ands) whi%e the CS do%%ar itse%fwas 'egged to that most so%id of commodities)
go%d# The res'onsi$i%it& for managing currenc& risk) or rather maintaining currenc& sta$i%it&) was
%arge%& that of governments# Deed%ess to sa&) that $urden) that res'onsi$i%it& has now 'assed
from the 'u$%ic to the 'rivate sector#
The wa& the cor'oration has dea%t with currenc& risk has changed su$stantia%%& over time#
5or'orations) man& of which were re%uctant to touch an&thing $ut the most vani%%a of hedging
structures) have now great%& increased the so'histication of their currenc& risk management and
hedging strategies) 'articu%ar%& over the %ast decade# (n this regard) two deve%o'ments have
he%'ed great%& / the centra%i=ing of Treasur& o'erations) 'articu%ar%& within %arge mu%tinationa%s)
and the focus 'ut on hiring s'ecifica%%& e+'erienced and Aua%ified 'ersonne% to manage the da&-
to-da& o'erations of risk management#
C%rr#!$( Ri/*
So) what 'recise%& is currenc& riskX There is no 'oint in focusing on an issue if one cannot first
define it# A%though definitions var& within the academic communit&) a 'ractica% descri'tion of
currenc& risk wou%d $e3
.he i"pact that unexpected exchange rate changes have on the value of the corporation
5urrenc& risk is ver& im'ortant to a cor'oration as it can have a major im'act on its cash f%ows)
assets and %ia$i%ities) net 'rofit and u%timate%& its stock market va%ue# Assuming the cor'oration
has acce'ted that currenc& risk needs to $e managed s'ecifica%%& and se'arate%&) it has three
initia% 'riorities3
1# *efine what kinds of currenc& risk the cor'oration is e+'osed to
,# *efine a cor'orate Treasur& strateg& to dea% with these currenc& risks
1# *efine what financia% instruments it a%%ows itse%f to use for this 'ur'ose
5urrenc& risk is sim'%e in conce't) $ut com'%e+ in rea%it&# At its most $asic) it is the 'ossi$%e
gain or %oss resu%ting from an e+change rate move# (t can affect the va%ue of a cor'oration
direct%& as a resu%t of an unhedged e+'osure or more indirect%&#
*ifferent t&'es of currenc& risk can a%so offset each other# For instance) take a CS citi=en who
owns stock in a 6erman auto manufacturer and e+'orter to the CS# (f the Euro fa%%s against the
CS do%%ar) the CS do%%ar va%ue of the Euro-denominated stock fa%%s and therefore on the face of it
the individua% sees the CS do%%ar va%ue of their ho%ding dec%ine# .owever) the 6erman auto
e+'orter shou%d in fact $enefit from a weaker Euro as this makes the com'an&Bs e+'orts to
the CS chea'er) a%%owing them the choice of either maintaining CS 'rices to maintain margin or
cutting them further to $oost market share# Sooner or %ater) the stock market wi%% rea%i=e this and
mark u' the stock 'rice of the auto e+'orter# Thus) the stock owner ma& %ose on the currenc&
trans%ation) $ut gain on the higher stock 'rice# This is of course a ver& sim'%e e+am'%e and %ife
unfortunate%& is rare%& that sim'%e# For just as a weaker Euro makes e+'orts from the Euro-=one
chea'er) so it makes im'orts more e+'ensive# Thus) an e+'orter ma& not in fact fee% the $enefit
of the currenc& trans%ation through to market share $ecause higher im'ort 'rices force it to raise
e+'ort 'rices from where the& wou%d otherwise wou%d $e according to the e+change rate#
.he first step in successfully "anaging currency ris! is to ac!nowledge that such ris! actually
exists and that it has to $e managed in the genera% interest of the cor'oration and the
cor'orationBs shareho%ders# For some) this is of itse%f a difficu%t hurd%e as there is sti%% major
re%uctance within cor'orate management to undertake what the& see as stra&ing from their core)
under%&ing $usiness into the s'ecu%ative wor%d of currenc& markets# The truth however is that the
cor'oration is a 'artici'ant in the currenc& market whether it %ikes it or notS if it has foreign
currenc&-denominated e+'osure) that e+'osure shou%d $e managed# To do an&thing e%se is
irres'onsi$%e# The genera% trend within the cor'orate wor%d has however $een in favour of
recogni=ing the e+istence of and the need to manage currenc& risk# That recognition does not of
itse%f entai% s'ecu%ation# (ndeed) at its $est) 'rudent currenc& hedging can $e defined as the
e%imination of s'ecu%ation3
.he real speculation is in fact not "anaging currency ris!
The ne+t ste') however) is s%ight%& more com'%e+ and that is to identif& the nature and e+tent of
the currenc& risk or e+'osure# (t shou%d $e noted that the em'hasis here is for the most 'art on
non-financia% cor'orations) on manufacturers and service 'roviders rather than on $anks or other
t&'es of financia% institutions# Don-financia% cor'orations genera%%& have on%& a sma%% amount of
their tota% assets in the form of receiva$%es and other t&'es of transaction# Most of their assets are
made u' of inventor&) $ui%dings) eAui'ment and other forms of tangi$%e Hrea%I assets# (n order to
measure the effect of e+change rate moves on a cor'oration) one first has to define the t&'e and
then the amount of risk invo%ved) or the Hva%ue at riskI >GaR?# There are three main t&'es of
currenc& risk that a mu%tinationa% cor'oration is e+'osed to and has to manage#
T(1#/ of C%rr#!$( Ri/*
1# Transaction risk >receiva$%es) dividends) etc#?
,# Trans%ation risk >$a%ance sheet?
1# Economic risk >'resent va%ue of future o'erating cash f%ows?
Tra!/a$tio! Ri/*
Transaction currenc& risk is essentia%%& cash f%ow risk and re%ates to an& transaction) such as
receiva$%es) 'a&a$%es or dividends# The most common t&'e of transaction risk re%ates to e+'ort or
im'ort contracts# <hen there is an e+change rate move invo%ving the currencies of such a
contract) this re'resents a direct transactiona% currenc& risk to the cor'oration# This is the most
$asic t&'e of currenc& risk that a cor'oration faces#
Tra!/.atio! Ri/*
Trans%ation risk is s%ight%& more com'%e+ and is the resu%t of the conso%idation of 'arent com'an&
and foreign su$sidiar& financia% statements# This conso%idation means that e+change rate im'act
on the $a%ance sheet of the foreign su$sidiaries is transmitted or translated to the 'arent
com'an&Bs $a%ance# .ranslation ris! is thus balance sheet currency ris!# <hi%e most %arge
mu%tinationa% cor'orations active%& manage their transaction currenc& risk) man& are %ess aware
of the 'otentia% dangers of trans%ation risk#
The actua% trans%ation 'rocess in conso%idating financia% statements is done either at the average
e+change rate of the 'eriod or at the e+change rate at the 'eriod end) de'ending on the s'ecific
accounting regu%ations affecting the 'arent com'an&# As a direct resu%t) the conso%idated resu%ts
wi%% var& as either the average or the end-of-'eriod e+change rate varies# Thus) a%% foreign
currenc&-denominated 'rofit is e+'osed to trans%ation currenc& risk as e+change rates var&# (n
addition) the foreign currenc& va%ue of foreign su$sidiaries is a%so conso%idated on the 'arent
com'an&Bs $a%ance sheet) and that va%ue wi%% var& according%&# Trans%ation risk for a foreign
su$sidiar& is usua%%& measured $& the net assets >assets %ess %ia$i%ities? that are e+'osed to
'otentia% e+change rate moves#
Pro$%ems can occur with regard to trans%ation risk if a cor'oration has su$sidiaries whose
accounting $ooks are %oca% currenc&-denominated# For conso%idation 'ur'oses) these $ooks must
of course $e trans%ated into the currenc& of the 'arent com'an&) $ut at what e+change rateX
(ncome statements are usua%%& trans%ated at the average e+change rate over the 'eriod# .owever)
deciding at what e+change rate to trans%ate the $a%ance sheet is s%ight%& trickier# There are
genera%%& three methods used $& major mu%tinationa% cor'orations for trans%ating $a%ance sheet
risk) var&ing in how the& se'arate assets and %ia$i%ities $etween those that need to $e trans%ated at
the HcurrentI e+change rate at the time of conso%idation and those that are trans%ated at the
historica% e+change rate3
Y The a%% current >c%osing rate? method
Y The monetar&0non-monetar& method
Y The tem'ora% method
As the name might suggest) the a%% current >c%osing rate? method trans%ates a%% foreign currenc&
e+'osures at the c%osing e+change rate of the 'eriod concerned# Cnder this method) trans%ation
risk re%ates to net assets or shareho%der funds# This has $ecome the most 'o'u%ar method of
trans%ating $a%ance e+'osure of foreign su$sidiaries) $oth in the CS and wor%dwide
On the other hand) the monetar&0non-monetar& method trans%ates monetar& items such as assets)
%ia$i%ities and ca'ita% at the c%osing rate and non-monetar& items at the historica% rate# Fina%%&) the
tem'ora% method $reaks $a%ance sheet items down in terms of whether the& are first%& stated at
re'%acement cost) rea%i=a$%e va%ue) market va%ue or e+'ected future va%ue) or second%& stated at
historic cost# For the first grou') these are trans%ated at the c%osing e+change rate of the 'eriod
concerned) for the second) at the historica% e+change rate#
The CS accounting standard FAS 2, and the CJBs SSAP ,; a''%& to trans%ation risk# Cnder
FAS 2,) the trans%ation of foreign currenc& revenues and costs is made at the average e+change
rate of the 'eriod# FAS 2, genera%%& uses the a%% current method for trans%ation 'ur'oses) though
it does have severa% im'ortant 'rovisions) nota$%& regarding the treatment of currenc& hedging
contracts# Cnder SSAP ,;) the cor'oration can use either the current or average rate# 6enera%%&)
there has $een a shift among mu%tinationa% cor'orations towards using the average rather than the
c%osing rate $ecause this is seen as a truer ref%ection of the trans%ation risk faced $& the
cor'oration during the 'eriod# Trans%ation risk is a crucia% issue for cor'orations# "ater in this
cha'ter) we wi%% %ook at methods of hedging it# For now) it is im'ortant to get an idea of how it
can affect the com'an&Bs overa%% va%ue#
E"a'1.#
Take an e+am'%e of a Euro-$ased manufacturer) which has $ought a factor& in Po%and# Deed%ess
to sa&) the cost $ase in Po%and is su$stantia%%& $e%ow that of the 'arent com'an&) one of severa%
major reasons wh& the acAuisition was made in the first '%ace# From 1444 to ,;;1) the Euro was
on a major downtrend) not just against its major currenc& counter'arts $ut a%so against most
currencies of the 5entra% and East Euro'ean area) such as the Po%ish =%ot&# Thus we get the
fo%%owing sim'%e mode%3
ECR/CS* ZQ ECR/P"D Z
where3
ECR/CS* Q The Euro/CS do%%ar e+change rate
ECR/P"D Q The Euro/Po%ish =%ot& e+change rate
This is an over-sim'%ification to $e sure# For one thing) the Po%ish =%ot& was 'egged to a $asket
of Euro >22O? and CS do%%ar >72O? with a craw% and trading $ands u' unti% ,;;;) and thus was
una$%e to a''reciate des'ite the ongoing dec%ine in the va%ue of the Euro across the $oard# For
another) it does not take account of ECR/P"D vo%ati%it&# That said) genera% Euro weakness has
c%ear%& $een an im'ortant factor in the de'reciation of the Euro/=%ot& e+change rate# Dote
however that as the Euro/=%ot& e+change rate has de'reciated for this and other reasons so the
va%ue of the origina% investment in the Po%ish factor& has increased in Euro terms# Thus3
ECR/P"D ZQ ECRtranslation va%ue of Po%ish su$sidiar& [
<hatever our Euro-$ased manufacturer ma& think of Euro weakness) it is entire%& $eneficia% for
the manufacturerBs trans%ation va%ue of the Po%ish factor&0su$sidiar& when the financia%
statements are conso%idated at the end of the accounting 'eriod# The trans%ation $enefit to the
$a%ance sheet wi%% de'end on the accounting method of trans%ation# 5onverse%&) were the Euro
ever to ra%%& on a sustained $asis) this might cause the Euro/=%ot& e+change rate to ra%%&) thus in
turn reducing the trans%ation va%ue of the cor'orationBs Po%ish su$sidiar&# The conso%idation of
financia% statements wou%d mean that this not on%& has an im'act on the Euro va%ue of the Po%ish
su$sidiar& $ut a%so on the $a%ance sheet of the 'arent) Euro-$ased manufacturer# The risk of a
sudden $a%ance sheet deterioration of this kind is not neg%igi$%e where cor'orations have a $road
range of foreign su$sidiaries) with accom'an&ing transactiona% and trans%ationa% currenc& risk#
E$o!o'i$ Ri/*
The trans%ation of foreign su$sidiaries concerns the conso%idated grou' $a%ance sheet# .owever)
this does not affect the rea% HeconomicI va%ue or e+'osure of the su$sidiar&# Economic risk
focuses on how e+change rate moves change the rea% economic va%ue of the cor'oration)
focusing on the 'resent va%ue of future o'erating cash f%ows and how this changes in %ine with
e+change rate changes# More s'ecifica%%&) the economic risk of a cor'oration ref%ects the effect of
e+change rate changes on items such as e+'ort and domestic sa%es) and the cost of domestic and
im'orted in'uts# As with trans%ation risk) ca%cu%ating economic risk is com'%e+) $ut c%ear%&
necessar& to $e a$%e to assess how e+change rate changes can affect the 'resent va%ue of foreign
su$sidiaries# Economic risk is usua%%& a''%ied to the 'resent va%ue of future o'erating cash f%ows
of a cor'orationBs foreign su$sidiaries# .owever) it can a%so $e a''%ied to the 'arent com'an&Bs
o'erations and how the 'resent va%ue of those change in %ine with e+change rate changes#
Summari=ing this 'art) transaction risk dea%s with the effect of e+change rate moves on
transactiona% e+'osure such as accounts receiva$%e0'a&a$%e or dividends# Trans%ation risk focuses
on how e+change rate moves can affect foreign su$sidiar& va%uation and therefore the va%uation
of the conso%idated grou' $a%ance sheet# Fina%%&) economic risk dea%s with the effect of e+change
rate changes to the 'resent va%ue of future o'erating cash f%ows) focusing on the Hcurrenc& of
determinationI of revenues and o'erating e+'enses# .ere it is im'ortant to differentiate $etween
the currenc& in which cash f%ows are denominated and the currenc& that ma& determine the
nature and si=e of those cash f%ows# The two are not necessari%& the same# To com'%icate the
issue further) there is the sma%% matter of the 'arent com'an&Bs currenc&) which is used to
conso%idate the financia% statements# (f a 'arent com'an& has foreign currenc&-denominated de$t)
this is recorded in the 'arent com'an&Bs currenc&) $ut the va%ue of its %ega% o$%igation remains in
the currenc& denomination of the de$t# (n sum) transaction risk is just the ti' of the ice$erg\
Of necessit&) the rea%it& of currenc& risk is ver& case-s'ecific# That said) there has $een an
attem't $& the academic and economic communities to a''%& the traditiona% e+change rate
mode%s to the cor'orate wor%d for the 'ur'ose of demonstrating how e+change rates im'act a
cor'oration#
PPP >or the %aw of one 'rice? suggests that 'rice differentia%s of the same good in different
countries reAuire an e+change rate adjustment to offset them# The internationa% Fisher effect
suggests that the e+'ected change in the e+change rate is eAua% to the interest rate differentia%#
The un$iased forward rate theor& suggests that the forward e+change rate is eAua% to the
e+'ected e+change rate#
6enera%%&) these theories are grounded in the efficient market h&'othesis and therefore f%awed at
$est# Over the %ong term) these traditiona% Hru%esI of e+change rate theor& suggest that
com'etition and ar$itrage shou%d neutra%i=e the effect of e+change rate changes on returns and on
the va%uation of the cor'oration# EAua%%&) %ocking into the forward rate shou%d) according to the
un$iased forward rate theor&) offer the same return as remaining e+'osed to currenc& risk) as this
theor& suggests that the distri$ution of 'ro$a$i%it& shou%d $e eAua% on either side of the forward
rate#
The unfortunate thing a$out such mode%s) however worth& the attem't) is that the& do not and
cannot dea% with the 'ractica% rea%ities of managing currenc& risk# <hat academics regard as
Htem'orar& deviationsI from where the mode% suggests the e+change rate shou%d $e can $e
sufficient and su$stantia% enough to cause 'ainfu% and into%era$%e deterioration to $oth the P"
and the $a%ance sheetX
To conc%ude this 'art) a cor'oration shou%d define and seek to Auantif& the t&'es of currenc& risk
to which it is e+'osed in order then to $e a$%e to go a$out creating a strateg& for managing that
currenc& risk#
Cor# Pri!$i1.#/ for Ma!a)i!) C%rr#!$( Ri/*
1# D#t#r'i!# th# t(1#/ of $%rr#!$( ri/* to +hi$h th# $or1oratio! i/ #"1o/#d / !reak these
down into transaction) trans%ation and economic risk) making s'ecific reference to what
currencies are re%ated to each t&'e of currenc& risk#
,# E/ta-.i/h a /trat#)i$ $%rr#!$( ri/* 'a!a)#'#!t 1o.i$( / Once currenc& risk t&'es have
$een agreed on) cor'orate Treasur& shou%d esta$%ish and document a strategic currenc& risk
]management 'o%ic& to dea% with these t&'es of risks# This 'o%ic& shou%d inc%ude the
cor'orationBs genera% a''roach to currenc& risk) whether it wants to hedge or trade that risk and
its core hedging o$jectives#
1# Cr#at# a 'i//io! /tat#'#!t for Tr#a/%r( / (t is crucia% to create a set of va%ues and
'rinci'%es which em$od& the s'ecific a''roach taken $& the Treasur& towards managing
currenc& risk) agreed u'on $& senior management at the time of esta$%ishing and documenting
the risk management 'o%ic&#
7# D#tai. $%rr#!$( h#d)i!) a11roa$h / .aving esta$%ished the overa%% currenc& risk
management 'o%ic&) the cor'oration shou%d detai% how that 'o%ic& is to $e e+ecuted in 'ractice)
inc%uding the t&'es of financia% instruments that cou%d $e used for hedging) the 'rocess $& which
currenc& hedging wou%d $e e+ecuted and monitored and 'rocedures for monitoring and
reviewing e+isting currenc& hedges#
2# C#!tra.i0i!) Tr#a/%r( o1#ratio!/ a/ a /i!).# $#!tr# of #"$#..#!$# / Treasur& o'erations can
$e more effective%& and efficient%& managed if the& are centra%i=ed# This makes it easier to ensure
a%% 'ersonne% are c%ear a$out the Treasur&Bs mission statement and hedging a''roach# Thus) the
Treasur& can $e run as a sing%e centre of e+ce%%ence within the cor'oration) ensuring the Aua%it&
of individua% mem$ers# "arge mu%tinationa% cor'orations shou%d consider creating a 'osition of
chief dea%er to manage the dea%ing team) as the demands of a Treasurer often e+ceed the a$i%it& to
manage a%% 'ositions and e+'osures on a rea%-time $asis# The currenc& dea%ing team must have
the same %eve% of e+'ertise as their counter'art& $anks#
:# Ado1t %!ifor' /ta!dard/ for a$$o%!ti!) for $%rr#!$( ri/* / (n %ine with the centra%i=ing of
Treasur& o'erations) uniform accounting 'rocedures with regard to currenc& risk shou%d $e
ado'ted) creating and ensuring trans'arenc& of risk# 5reate $enchmarks for measuring the
'erformance of currenc& hedging#
8# Ha&# i!6ho%/# 'od#..i!) a!d for#$a/ti!) $a1a$it( / 5urrenc& forecasting is as im'ortant as
e+ecution# <hi%e Treasur& ma& re%& on its core $anks for forecasting e+change rates re%ative to
its needs) it shou%d a%so have its own forecasting a$i%it&) %inked in with its o'erationa%
o$servations which are freAuent%& more rea% time than an& $ank is ca'a$%e of# Treasur& shou%d
a%so $e a$%e to mode% a%% its hedging 'ositions using GaR and other so'histicated mode%%ing
s&stems#
9# Cr#at# a ri/* o&#r/i)ht $o''itt## / (n addition to the safeguard of a chief dea%er 'osition
for %arger mu%tinationa% cor'orations) a risk oversight committee shou%d $e esta$%ished to a''rove
'osition taking a$ove esta$%ished thresho%ds and review the risk management 'o%ic& on a regu%ar
$asis#

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