Forex & Risk

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 & Broking Pvt Ltd. has been a great value
addition to my career that would not have been possible without continuous guidance and
administration of certain key people. I would like to place on record, my sincere gratitude to each
of them.
I am grateful to Dr. Mrinalini Kohojkar, Director, Thakur Institute Of Management Studies and
Research for giving me this opportunity.
I would like to express my appreciation towards Mr. Balkishan Sharma for giving me the
opportunity to work on this project. I express my gratitude and indebtedness to him for guiding
me in every aspect for making this effort a great success.
I sincerely thank Prof. Aditi Mahajan, Thakur Institute Of Management Studies and Research
for the valuable guidance extended by them during my entire course in the preparation of this
dissertation and for letting me their valuable time when ever I was in need.
Page 2
Executive Summary
This project gives an in-depth analysis and understanding of Foreign Exchange Markets in India.
It helps to understand the History and the evolution of the foreign market in India.
It gives an overview of the conditions existing in the current global economy. It gives an
overview of the Foreign exchange market.
It talks about the foreign exchange management act applicable and also gives details about the
participants in the forex markets.
It also talks about what are the sources of demand and supply of foreign exchange in the market
all over the world.
The report also talks about the Foreign Exchange trading platform and how the efficiency and the
transparency is maintained.
The report focuses on corporate hedging for foreign exchange risk in India. The report contains
details about some companies Foreign Exposure and how they have maintained it.
It also talks about the determinants to be taken care of while taking corporate hedging decisions.
It gives insights about the Regulatory guidelines for the use of Foreign Exchange derivatives,
Development of Derivatives markets in India and also the Hedging instruments for Indian firms.
The report gives an in-depth analysis of the currency risk management by talking about what
currency risk is, the types of currency risk Transaction risk ,Translation risk and Economic
risk. It also contains details about the companies in the index sensex and nifty showing their
transaction is foreign currency like the imports, exports, Loans, Interst payments and the other
expenses. It then shows the sensitivity analysis of how the currency rates impact the gains/
profits of the company.
Page 3
Contents
Foreign Exchange Market Overview...............................................................................................5
Forex Market: A Historical Perspective...........................................................................................9
Basic Concepts in Forex Trading...................................................................................................13
Currency Traded Across Globe & India........................................................................................14
Trading Platforms..........................................................................................................................15
Factors Affecting Foreign Exchange.............................................................................................17
Foreign Exchange Management Act, 1999....................................................................................18
Participants in foreign exchange market........................................................................................19
Exchange rate System....................................................................................................................22
Foreign Exchange Market Structure..............................................................................................24
Fundamentals in Exchange Rate....................................................................................................25
Factors Affecting Exchange Rates.................................................................................................26
Sources of Supply and Demand in the Foreign exchange.............................................................28
Corporate Hedging for Foreign Exchange Risk in India...............................................................32
Foreign Exchange Risk Management Framework........................................................................38
Hedging Strategies/ Instruments....................................................................................................40
Determinants of Hedging Decisions..............................................................................................43
An Overview of Corporate Hedging in India................................................................................45
Currency Risk Management..........................................................................................................50
Page 4
Foreign Exchange Market Overview

Globally, operations in the foreign exchange market started in a major way after the breakdown
of the Bretton Woods system in 1971, which also marked the beginning of floating exchange rate
regimes in several countries. Over the years, the foreign exchange market has emerged as the
largest market in the world. The decade of the 1990s witnessed a perceptible policy shift in many
emerging markets towards reorientation of their financial markets in terms of new products and
instruments, development of institutional and market infrastructure and realignment of regulatory
structure consistent with the liberalized operational framework. The changing contours were
mirrored in a rapid expansion of foreign exchange market in terms of participants, transaction
volumes, decline in transaction costs and more efficient mechanisms of risk transfer.
The origin of the foreign exchange market in India could be traced to the year 1978 when banks
in India were permitted to undertake intra-day trade in foreign exchange. However, it was in the
1990s that the Indian foreign exchange market witnessed far reaching changes along with the
shifts in the currency regime in India. The exchange rate of the rupee, that was pegged earlier
was floated partially in March 1992 and fully in March 1993 following the recommendations of
the Report of the High Level Committee on Balance of Payments (Chairman: Dr.C. Rangarajan).
The unification of the exchange rate was instrumental in developing a market-determined
exchange rate of the rupee and an important step in the progress towards current account
convertibility, which was achieved in August 1994. 6.3 A further impetus to the development of
the foreign exchange market in India was provided with the setting up of an Expert Group on
Foreign Exchange Markets in India (Chairman: Shri O.P. Sodhani), which submitted its report in
June 1995. The Group made several recommendations for deepening and widening of the Indian
foreign exchange market. Consequently, beginning from January 1996, wide-ranging reforms
have been undertaken in the Indian foreign exchange market. After almost a decade, an Internal
Technical Group on the Foreign Exchange Market (2005) was constituted to undertake a
comprehensive review of the measures initiated by the Reserve Bank and identify areas for
further liberalization or relaxation of restrictions in a medium-term framework.
The momentous developments over the past few years are reflected in the enhanced risk-bearing
capacity of banks along with rising foreign exchange trading volumes and finer margins. The
foreign exchange market has acquired depth (Reddy, 2005). The conditions in the foreign
exchange market have also generally remained orderly (Reddy, 2006c). While it is not possible
for any country to remain completely unaffected by developments in international markets, India
was able to keep the spillover effect of the Asian crisis to a minimum through constant
monitoring and timely action, including recourse to strong monetary measures, when necessary,
to prevent emergence of self fulfilling speculative activities
Page 5
In todays world no economy is self sufficient, so there is need for exchange of goods and
services amongst the different countries. So in this global village, unlike in the primitive age the
exchange of goods and services is no longer carried out on barter basis. Every sovereign country
in the world has a currency that is legal tender in its territory and this currency does not act as
money outside its boundaries. So whenever a country buys or sells goods and services from or to
another country, the residents of two countries have to exchange currencies. So we can imagine
that if all countries have the same currency then there is no need for foreign exchange.
Need for Foreign Exchange:
Let us consider a case where Indian company exports cotton fabrics to USA and invoices the
goods in US dollar. The American importer will pay the amount in US dollar, as the same is his
home currency. However the Indian exporter requires rupees means his home currency for
procuring raw materials and for payment to the labor charges etc. Thus he would need
exchanging US dollar for rupee. If the Indian exporters invoice their goods in rupees, then
importer in USA will get his dollar converted in rupee and pay the exporter. From the above
example we can infer that in case goods are bought or sold outside the country, exchange of
currency is necessary. Sometimes it also happens that the transactions between two countries will
be settled in the currency of third country. In that case both the countries that are transacting will
require converting their respective currencies in the currency of third country. For that also the
foreign exchange is required.
About foreign exchange market:
Particularly for foreign exchange market there is no market place called the foreign exchange
market. It is mechanism through which one countrys currency can be exchange i.e. bought or
sold for the currency of another country. The foreign exchange market does not have any
geographic location. Foreign exchange market is described as an OTC (over the counter) market
as there is no physical place where the participant meets to execute the deals, as we see in the
case of stock exchange. The largest foreign exchange market is in London, followed by the New
York, Tokyo, Zurich and Frankfurt. The markets are situated throughout the different time zone
of the globe in such a way that one market is closing the other is beginning its operation.
Therefore it is stated that foreign exchange market is functioning throughout 24 hours a day. In
most market US dollar is the vehicle currency, viz., the currency sued to dominate international
transaction. In India, foreign exchange has been given a statutory definition. Section 2 (b) of
foreign exchange regulation ACT, 1973 states:
Foreign exchange means foreign currency
and includes:
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.
Page 6
Any instrument payable, at the option of drawee or holder thereof or any other party thereto,
either in Indian currency or in foreign currency or partly in one and partly in the other. In order
to provide facilities to members of the public and foreigners visiting India, for exchange of
foreign currency into Indian currency and vice-versa RBI has granted to various firms and
individuals, license to undertake money-changing business at seas/airport and tourism place of
tourist interest in India. Besides certain authorized dealers in foreign exchange (banks) have also
been permitted to open exchange bureaus. Following are the major bifurcations:
Full fledge moneychangers they are the firms and individuals who have been authorized to
take both, purchase and sale transaction with the public.
Restricted moneychanger they are shops, emporia and hotels etc. that have been authorized
only to purchase foreign currency towards cost of goods supplied or services rendered by them
or for conversion into rupees.
Authorized dealers they are one who can undertake all types of foreign exchange transaction.
Banks are only the authorized dealers. The only exceptions are Thomas cook, western union,
UAE exchange which though, and not a bank is an AD.
Even among the banks RBI has
categorized them as follows:
Branch A They are the branches that have Nostro and Vostro account.
Branch B The branch that can deal in all other transaction but do not maintain Nostro and
Vostro a/cs fall under this category. For Indian we can conclude that foreign exchange refers to
foreign money, which includes notes, cheques, bills of exchange, bank balance and deposits in
foreign currencies.
Foreign Exchange Market: An Assessment
The continuous improvement in market infrastructure has had its impact in terms of enhanced
depth, liquidity and efficiency of the foreign exchange market. The turnover in the Indian foreign
exchange market has grown significantly in both the spot and derivatives segments in the recent
past. Along with the increase in onshore turnover, activity in the offshore market has also
assumed importance. With the gradual opening up of the capital account, the process of price
discovery in the Indian foreign exchange market has improved as reflected in the bid-ask spread
and forward premia behaviour.
Foreign Exchange Market Turnover
As per the Triennial Central Bank Survey by the Bank for International Settlements (BIS) on
Foreign Exchange and Derivatives Market Activity, global foreign exchange market activity
rose markedly between 2001 and 2004 (Table 6.4). The strong growth in turnover may be
attributed to two related factors. First, the presence of clear trends and higher volatility in foreign
exchange markets between 2001 and 2004 led to trading momentum, where investors took large
positions in currencies that followed persistent appreciating trends. Second, positive interest rate
Page 7
differentials encouraged the so-called carry trading, i.e., investments in high interest rate
currencies financed by positions in low interest rate currencies. The growth in outright forwards
between 2001 and 2004 reflects heightened interest in hedging. Within the EM countries,
traditional foreign exchange trading in Asian currencies generally recorded much faster growth
than the global total between 2001 and 2004. Growth rates in turnover for Chinese renminbi,
Indian rupee, Indonesian rupiah, Korean won and new Taiwanese dollar exceeded 100 per cent
between April 2001 and April 2004 (Table 6.5). Despite significant growth in the foreign
exchange market turnover, the share of most of the EMEs in total global turnover, however,
continued to remain low.
The Indian foreign exchange market has grown manifold over the last several years. The daily
average turnover impressed a substantial pick up from about US $ 5 billion during 1997-98 to
US $ 18 billion during 2005-06. The turnover has risen considerably to US $ 23 billion during
2006-07 (up to February 2007) with the daily turnover crossing US $ 35 billion on certain days
during October and November 2006. The inter-bank to merchant turnover ratio has halved from
5.2 during 1997-98 to 2.6 during 2005-06, reflecting the growing participation in the merchant
segment of the foreign exchange market (Table 6.6 and Chart VI.2). Mumbai alone accounts for
almost 80 per cent of the foreign exchange turnover.
6.60 Turnover in the foreign exchange market was 6.6 times of the size of Indias balance of
payments during 2005-06 as compared with 5.4 times in 2000-01 (Table 6.7). With the deepening
of the foreign exchange market and increased turnover, income of commercial banks through
treasury operations has increased considerably. Profit from foreign exchange transactions
accounted for more than 20 per cent of total profits of the scheduled commercial banks during
2004-05 and 2005-06
Forex Market: A Historical Perspective
Page 8
Early Stages: 1947-1977

The evolution of Indias foreign exchange market may be viewed in line with the shifts in Indias
exchange rate policies over the last few decades from a par value system to a basket-peg and
further to a managed float exchange rate system. During the period from 1947 to 1971, India
followed the par value system of exchange rate. Initially the rupees external par value was fixed
at 4.15 grains of fine gold. The Reserve Bank maintained the par value of the rupee within the
permitted margin of 1 per cent using pound sterling as the intervention currency. Since the
sterling-dollar exchange rate was kept stable by the US monetary authority, the exchange rates of
rupee in terms of gold as well as the dollar and other currencies were indirectly kept stable. The
devaluation of rupee in September 1949 and June 1966 in terms of gold resulted in the reduction
of the par value of rupee in terms of gold to 2.88 and 1.83 grains of fine gold, respectively. The
exchange rate of the rupee remained unchanged between 1966 and 1971 (Chart VI.1).
Given the fixed exchange regime during this period, the foreign exchange market for all practical
purposes was defunct. Banks were required to undertake only cover operations and maintain a
square or near square position at all times. The objective of exchange controls was primarily
to regulate the demand for foreign exchange for various purposes, within the limit set by the
available supply. The Foreign Exchange Regulation Act initially enacted in 1947 was placed on a
permanent basisin 1957. In terms of the provisions of the Act, the Reserve Bank, and in certain
cases, the Central Government controlled and regulated the dealings in foreign exchange
payments outside India, export and import of currency notes and bullion, transfers of securities
between residents and non-residents, acquisition of foreign securities, etc3 .
With the breakdown of the Bretton Woods System in 1971 and the floatation of major currencies,
the conduct of exchange rate policy posed a serious challenge to all central banks world wide as
currency fluctuations opened up tremendous opportunities for market players to trade in
currencies in a borderless market. In December 1971, the rupee was linked with pound sterling.
Since sterling was fixed in terms of US dollar under the Smithsonian Agreement of 1971, the
rupee also remained stable against dollar. In order to overcome the weaknesses associated with a
single currency peg and to ensure stability of the exchange rate, the rupee, with effect from
September 1975, was pegged to a basket of currencies. The currency selection and weights
assigned were left to the discretion of the Reserve Bank. The currencies included in the basket as
well as their relative weights were kept confidential in order to discourage speculation. It was
around this time that banks in India became interested in trading in foreign exchange
Formative Period: 1978-1992
The impetus to trading in the foreign exchange market in India came in 1978 when banks in
India were allowed by the Reserve Bank to undertake intra-day trading in foreign exchange and
were required to comply with the stipulation of maintaining square or near square position
only at the close of business hours each day. The extent of position which could be left
uncovered overnight (the open position) as well as the limits up to which dealers could trade
Page 9
during the day were to be decided by the management of banks. The exchange rate of the rupee
during this period was officially determined by the Reserve Bank in terms of a weighted basket
of currencies of Indias major trading partners and the exchange rate regime was characterised by
daily announcement by the Reserve Bank of its buying and selling rates to the Authorised
Dealers (ADs) for undertaking merchant transactions. The spread between the buying and the
selling rates was 0.5 per cent and the market began to trade actively within this range. ADs were
also permitted to trade in cross currencies (one convertible foreign currency versus another).
However, no position in this regard could originate in overseas markets.
As opportunities to make profits began to emerge, major banks in India started quoting two way
prices against the rupee as well as in cross currencies and, gradually, trading volumes began to
increase. This led to the adoption of widely different practices (some of them being irregular)
and the need was felt for a comprehensive set of guidelines for operation of banks engaged in
foreign exchange business. Accordingly, the Guidelines for Internal Control over Foreign
Exchange Business, were framed for adoption by the banks in 1981. The foreign exchange
market in India till the early 1990s, however, remained highly regulated with restrictions on
external transactions, barriers to entry, low liquidity and high transaction costs. The exchange
rate during this period was managed mainly for facilitating Indias imports. The strict control on
foreign exchange transactions through the Foreign Exchange Regulations Act (FERA) had
resulted in one of the largest and most efficient parallel markets for foreign exchange in the
world, i.e., the hawala (unofficial) market.
By the late 1980s and the early 1990s, it was recognized that both macroeconomic policy and
structural factors had contributed to balance of payments difficulties. Devaluations by Indias
competitors had aggravated the situation. Although exports had recorded a higher growth during
the second half of the 1980s (from about 4.3 per cent of GDP in 1987-88 to about 5.8 per cent of
GDP in 1990-91), trade imbalances persisted at around 3 percent of GDP. This combined with a
precipitous fall in invisible receipts in the form of private remittances, travel and tourism
earnings in the year 1990-91 led to further widening of current account deficit. The weaknesses
in the external sector were accentuated by the Gulf crisis of 1990-91. As a result, the current
account deficit widened to 3.2 per cent of GDP in 1990-91 and the capital flows also dried up
necessitating the adoption of exceptional corrective steps. It was against this backdrop that India
embarked on stabilisation and structural reforms in the early 1990s.
Post-Reform Period: 1992 onwards
This phase was marked by wide ranging reform measures aimed at widening and deepening the
foreign exchange market and liberalisation of exchange control regimes. A credible
macroeconomic, structural and stabilization programme encompassing trade, industry, foreign
investment, exchange rate, public finance and the financial sector was put in place creating an
environment conducive for the expansion of trade and investment. It was recognised that trade
policies, exchange rate policies and industrial policies should form part of an integrated policy
Page 10
framework to improve the overall productivity, competitiveness and efficiency of the economic
system, in general, and the external sector, in particular. As a stabilsation measure, a two step
downward exchange rate adjustment by 9 per cent and 11 per cent between July 1 and 3, 1991
was resorted to counter the massive drawdown in the foreign exchange reserves, to instill
confidence among investors and to improve domestic competitiveness. A two-step adjustment of
exchange rate in July 1991 effectively brought to close the regime of a pegged exchange rate.
After the Gulf crisis in 1990-91, the broad framework for reforms in the external sector was laid
out in the Report of the High Level Committee on Balance of Payments (Chairman: Dr. C.
Rangarajan). Following the recommendations of the Committee to move towards the marketdetermined exchange rate, the Liberalised Exchange Rate Management System (LERMS) was
put in place in March 1992 initially involving a dual exchange rate system. Under the LERMS,
all foreign exchange receipts on current account transactions (exports, remittances, etc.) were
required to be surrendered to the Authorised Dealers (ADs) in full. The rate of exchange for
conversion of 60 per cent of the proceeds of these transactions was the market rate quoted by the
ADs, while the remaining 40 percent of the proceeds were converted at the Reserve Banks
official rate. The ADs, in turn, were required to surrender these 40 per cent of their purchase of
foreign currencies to the Reserve Bank. They were free to retain the balance 60 per cent of
foreign exchange for selling in the free market for permissible transactions. The LERMS was
essentially a transitional mechanism and a downward adjustment in the official exchange rate
took place in early December 1992 and ultimate convergence of the dual rates was made
effective from March 1, 1993, leading to the introduction of a market-determined exchange rate
regime.
The dual exchange rate system was replaced by a unified exchange rate system in March 1993,
whereby all foreign exchange receipts could be converted at market determined exchange rates.
On unification of the exchange rates, the nominal exchange rate of the rupee against both the US
dollar as also against a basket of currencies got adjusted lower, which almost nullified the impact
of the previous inflation differential. The restrictions on a number of other current account
transactions were relaxed. The unification of the exchange rate of the Indian rupee was an
important step towards current account convertibility, which was finally achieved in August
1994, when India accepted obligations under Article VIII of the Articles of Agreement of the
IMF.
With the rupee becoming fully convertible on all current account transactions, the risk-bearing
capacity of banks increased and foreign exchange trading volumes started rising. This was
supplemented by wide-ranging reforms undertaken by the Reserve Bank in conjunction with the
Government to remove market distortions and deepen the foreign exchange market. The process
has been marked by gradualism with measures being undertaken after extensive consultations
with experts and market participants. The reform phase began with the Sodhani Committee
(1994) which in its report submitted in 1995 made several recommendations to relax the
regulations with a view to vitalising the foreign exchange market.
Page 11
In addition, several initiatives aimed at dismantling controls and providing an enabling

environment to all entities engaged in foreign exchange transactions have been undertaken since
the mid-1990s. The focus has been on developing the institutional framework and increasing the
instruments for effective functioning, enhancing transparency and liberalising the conduct of
foreign exchange business so as to move away from micro management of foreign exchange
transactions to macro management of foreign exchange flows (Box VI.3).
An Internal Technical Group on the Foreign Exchange Markets (2005) set up by the Reserve
Bank made various recommendations for further liberalisation of the extant regulations. Some of
the recommendations such as freedom to cancel and rebook forward contracts of any tenor,
delegation of powers to ADs for grant of permission to corporates to hedge their exposure to
commodity price risk in the international commodity exchanges/markets and extension of the
trading hours of the inter-bank foreign exchange market have since been implemented.
Along with these specific measures aimed at developing the foreign exchange market, measures
towards liberalising the capital account were also implemented during the last decade, guided to
a large extent since 1997 by the Report of the Committee on Capital Account Convertibility
(Chairman: Shri S.S. Tarapore). Various reform measures since the early 1990s have had a
profound effect on the market structure, depth, liquidity and efficiency of the Indian foreign
exchange market.
Basic Concepts in Forex Trading

:
Bid and Ask Rate:

The bid/ask spread is the difference between the price at which a bank or market maker will sell
("ask", or "offer") and the price at which a market taker will buy ("bid") from a wholesale or
Page 12
retail customer. The customer will buy from the market-maker at the higher "ask" price, and will
sell at the lower "bid" price, thus giving up the "spread" as the cost of completing the trade.
Margin Trading:
Foreign exchange is normally traded on margin. A relatively small deposit can control much
larger positions in the market. For trading the main currencies, Saxo Bank requires a 1% margin
deposit. This means that in order to trade one million dollars, you need to place just USD 10,000
by way of security.
In other words, you will have obtained a gearing of up to 100 times. This means that a change of,
say 2%, in the underlying value of your trade will result in a 200% profit or loss on your deposit.
Stop-loss discipline:
There are significant opportunities and risks in foreign exchange markets. Aggressive traders
might experience profit/loss swings of 20-30% daily. This calls for strict stop-loss policies in
positions that are moving against you.
Fortunately, there are no daily limits on foreign exchange trading and no restrictions on trading
hours other than the weekend. This means that there will nearly always be an opportunity to react
to moves in the main currency markets and a low risk of getting caught without the opportunity
of getting out. Of course, the market can move very fast and a stop-loss order is by no means a
guarantee of getting out at the desired level. For speculative trading, it is recommended to place
protective stop-loss orders.
Spot and forward trading:
When you trade foreign exchange you are normally quoted a spot price. This means that if you
take no further steps, your trade will be settled after two business days. This ensures that your
trades are undertaken subject to supervision by regulatory authorities for your own protection
and security. If you are a commercial customer, you may need to convert the currencies for
international payments. If you are an investor, you will normally want to swap your trade
forward to a later date. This can be undertaken on a daily basis or for a longer period at a time.
Often investors will swap their trades forward anywhere from a week or two up to several
months depending on the time frame of the investment.
Although a forward trade is for a future date, the position can be closed out at any time - the
closing part of the position is then swapped forward to the same future value date.
Page 13
Currency Traded Across Globe & India

The FOUR major currency pairs
EUR/USD
USD/JPY
USD/CHF
GBP/USD
Currency Crosses
EUR/CHF
EUR/JPY
GBP/JPY
EUR/GBP
Currencies traded in India:
USD/INR
EUR/INR
GBP/INR
JPY/INR
Currency Exchanges in India:
1. MCX Stock Exchange (MCX SX)
2. National Stock Exchange (NSE)
3. United Stock Exchange (USE)
The daily turnover of NSE and MCX SX together is around 30,000 cr.
Page 14
Trading Platforms
Indian Perspective
Trade Station
It is the premier brokerage trading platform for rule-based trading. And we have the awards to
prove it.
Whether you trade stocks, options, futures or forex, Trade Station offers uniquely powerful
strategy creation and testing tools, customizable analytics and fully automated trading
technology in a single trading platform.
Features
1. Create an unlimited number of trading strategies
2. Back test and optimize the strategies
3. Monitor multiple markets
Systematic
1.
Fully automated portfolio solution
2.
Web-based easy-to-use trading
Low cost trading

4. Transparent trade results
3.
5.
Diversification and risk management options
Comprehensive online video tutorials and FAQ

7. One account, two platforms - works in parallel with MetaTrader 4
6.
8.
Choice of over 70 independent trading strategies and 20 predefined portfolios
9.
No subscription or maintenance fees
10.
USD 500 minimum deposit
Minimum trade size 0.1 lot

12. 29 currency pairs
11.
Unlimited access to Alpari Academy and Alpari Research

14. Fully automated trading
13.
15.
Trade notifications by e-mail for opened/closed trades
16.
Available in 9 languages
Page 15
Alpari Direct Pro

Alpari Direct Pro is an institutional-level platform that offers the most direct route to optimum
liquidity and institutional-level prices from the worlds leading banks, and highly competitive
spreads on major currencies.
Designed for institutions, money managers and individuals, Alpari Direct Pro caters for those
who want to trade high volumes with the fastest execution speeds, full market depth and
sophisticated order management options.
Features
Fast-track to liquidity
Alpari Direct Pro is an advanced institutional-level platform designed for money managers,
institutional traders and investors wanting to trade high volumes with the fastest execution
speeds (market execution), full market depth and sophisticated order management.
Non-Dealing Desk execution
Fully automated processing without any manual intervention cuts out any obstacles between your
trade and the market. Going direct, with trades executed at the highest speed and with minimum
latency means you can react instantly to opportunities as they arise.
Know the depth of the market in full
View the most comprehensive picture of the market with current orders displayed by price and
volume. This provides a more transparent picture of the Forex market and the best opportunity to
make the most informed trading decisions possible.
Manage more orders more effectively
A comprehensive suite of orders and order management options allow you to execute
sophisticated strategies based on precise timing and multiple order types enabling better control
of order timing and execution.
Factors Affecting Foreign Exchange

There are various factors affecting the exchange rate of a currency. They can be classified as
fundamental factors, technical factors, political factors and speculative factors.
Fundamental factors:
Page 16
The fundamental factors are basic economic policies followed by the government in relation to
inflation, balance of payment position, unemployment, capacity utilization, trends in import and
export, etc. Normally, other things remaining constant the currencies of the countries that follow
sound economic policies will always be stronger. Similarly, countries having balance of payment
surplus will enjoy a favorable exchange rate. Conversely, for countries facing balance of
payment deficit, the exchange rate will be adverse.
Technical factors:
Interest rates: Rising interest rates in a country may lead to inflow of hot money in the country,
thereby raising demand for the domestic currency. This in turn causes appreciation in the value
of the domestic currency.
Inflation rate: High inflation rate in a country reduces the relative competitiveness of the export
sector of that country. Lower exports result in a reduction in demand of the domestic currency
and therefore the currency depreciates.
Exchange rate policy and Central Bank interventions: Exchange rate policy of the country is the
most important factor influencing determination of exchange rates. For example, a country may
decide to follow a fixed or flexible exchange rate regime, and based on this, exchange rate
movements may be less/more frequent. Further, governments sometimes participate in foreign
exchange market through its Central bank in order to control the demand or supply of domestic
currency.
Political factors:
Political stability also influences the exchange rates. Exchange rates are susceptible to political
instability and can be very volatile during times of political crises.
Speculation:
Speculative activities by traders worldwide also affect exchange rate movements. For example, if
speculators think that the currency of a country is overvalued and will devalue in near future,
they will pull out their money from that country resulting in reduced demand for that currency
and depreciating its value.
Foreign Exchange Management Act, 1999

The change in the entire approach towards exchange control regulation has been the result of the
replacement of the Foreign Exchange Regulation Act, 1973, by the Foreign Exchange
Page 17
Management Act, 1999. The latter came into effect from June 1, 2000. The change in the
preamble itself signifies the dramatic change in approach -- from "for the conservation of the
foreign exchange resources" in FERA 1973, to "facilitate external trade and payments" under
FEMA 1999. Any FEMA violations are civil, not criminal, offences, attracting monetary
penalties, and not arrests or imprisonment.
The scheme of FEMA and the notifications issued thereunder take into the account the
convertibility of the rupee for all current account transactions. Indeed, there is now general
freedom to authorised dealers to sell currency for most current account transactions. One old
limitation continues. All transactions in foreign exchange have to be with authorised dealers, i.e.
banks authorised to act as dealers in foreign exchange by the Reserve Bank. The original rules,
regulations, notifications, etc., under FEMA are contained in the A.D. (M.A. series) Circular No.
11 of May 16, 2000. Subsequent circulars have been issued under the A.P. (DIR series)
nomenclature. It is obviously impossible to incorporate all the current regulations in a book of
this type, particularly since the regulations keep changing. An outline of the basic framework of
exchange control under FEMA is in Annexure 5.3. But its contents should not be considered as
either definitive or current and those interested need to keep up with the various circulars and
other communications on the subject.
Participants in foreign exchange market

Market Players
Page 18
Players in the Indian market include (a) ADs, mostly banks who are authorised to deal in foreign
exchange, (b) foreign exchange brokers who act as intermediaries, and (c) customers
individuals, corporates, who need foreign exchange for their transactions. Though customers are
major players in the foreign exchange market, for all practical purposes they depend upon ADs
and brokers. In the spot foreign exchange market, foreign exchange transactions were earlier
dominated by brokers. Nevertheless, the situation has changed with the evolving market
conditions, as now the transactions are dominated by ADs. Brokers continue to dominate the
derivatives market.
The Reserve Bank intervenes in the market essentially to ensure orderly market conditions. The
Reserve Bank undertakes sales/purchases of foreign currency in periods of excess
demand/supply in the market. Foreign Exchange Dealers Association of India (FEDAI) plays a
special role in the foreign exchange market for ensuring smooth and speedy growth of the
foreign exchange market in all its aspects. All ADs are required to become members of the
FEDAI and execute an undertaking to the effect that they would abide by the terms and condition
stipulated by the FEDAI for transacting foreign exchange business. The FEDAI is also the
accrediting authority for the foreign exchange brokers in the interbank foreign exchange market.
The licences for ADs are issued to banks and other institutions, on their request, under Section
10(1) of the Foreign Exchange Management Act, 1999. ADs have been divided into different
categories. All scheduled commercial banks, which include public sector banks, private sector
banks and foreign banks operating in India, belong to category I of ADs. All upgraded full
fledged money changers (FFMCs) and select regional rural banks (RRBs) and co-operative
banks belong to category II of ADs. Select financial institutions such as EXIM Bank belong to
category III of ADs. Currently, there are 86 (Category I) Ads operating in India out of which five
are co-operative banks (Table 6.3). All merchant transactions in the foreign exchange market
have to be necessarily undertaken directly through ADs. However, to provide depth and liquidity
to the inter-bank segment, Ads have been permitted to utilise the services of brokers for better
price discovery in their inter-bank transactions. In order to further increase the size of the foreign
exchange market and enable it to handle large flows, it is generally felt that more ADs should be
encouraged to participate in the market making. The number of participants who can give twoway quotes also needs to be increased.
The customer segment of the foreign exchange market comprises major public sector units,
corporates and business entities with foreign exchange exposure. It is generally dominated by
select large public sector units such as Indian Oil Corporation, ONGC, BHEL, SAIL, Maruti
Udyog and also the Government of India (for defence and civil debt service) as also big private
sector corporates like Reliance Group, Tata Group and Larsen and Toubro, among others. In
recent years, foreign institutional investors (FIIs) have emerged as major players in the foreign
exchange market.
The main players in foreign exchange market are as follows:
Page 19
1. Customers:
The customers who are engaged in foreign trade participate in foreign exchange market by
availing of the services of banks. Exporters require converting the dollars in to rupee and
importers require converting rupee in to the dollars, as they have to pay in dollars for the
goods/services they have imported.
2. Commercial Bank:
They are most active players in the forex market. Commercial bank dealings with international
transaction offer services for conversion of one currency in to another. They have wide network
of branches. Typically banks buy foreign exchange from exporters and sells foreign exchange to
the importers of goods. As every time the foreign exchange bought or oversold position. The
balance amount is sold or bought from the market.
3. Central Bank:
In all countries Central bank have been charged with the responsibility of maintaining the
external value of the domestic currency. Generally this is achieved by the intervention of the
bank.
4. Exchange Brokers:
Forex brokers play very important role in the foreign exchange market. However the extent to
which services of foreign brokers are utilized depends on the tradition and practice prevailing at
a particular forex market center. In India as per FEDAI guideline the Ads are free to deal directly
among themselves without going through brokers. The brokers are not among to allowed to deal
in their own account allover the world and also in India.
5. Overseas Forex Market:
Today the daily global turnover is estimated to be more than US $ 1.5 trillion a day. The
international trade however constitutes hardly 5 to 7 % of this total turnover. The rest of trading
in world forex market is constituted of financial transaction and speculation. As we know that the
forex market is 24-hour market, the day begins with Tokyo and thereafter Singapore opens,
thereafter India, followed by Bahrain, Frankfurt, Paris, London, New York, Sydney, and back to
Tokyo.
6. Speculators:
The speculators are the major players in the forex market. Bank dealing are the major speculators
in the forex market with a view to make profit on account of favorable movement in exchange
rate, take position i.e. if they feel that rate of particular currency is likely to go up in short term.
They buy that currency and sell it as soon as they are able to make quick profit.
Page 20
Corporations particularly multinational corporation and transnational corporation having

business operation beyond their national frontiers and on account of their cash flows being large
and in multi currencies get in to foreign exchange exposures. With a view to make advantage of
exchange rate movement in their favor they either delay covering exposures or do not cover until
cash flow materialize.
Individual like share dealing also undertake the activity of buying and selling of foreign
exchange for booking short term profits. They also buy foreign currency stocks, bonds and other
assets without covering the foreign exchange exposure risk. This also results in speculations.
Exchange rate System

Countries of the world have been exchanging goods and services amongst themselves. This has
been going on from time immemorial. The world has come a long way from the days of barter
trade. With the invention of money the figures and problems of barter trade have disappeared.
The barter trade has given way ton exchanged of goods and services for currencies instead of
Page 21
goods and services. The rupee was historically linked with pound sterling. India was a founder
member of the IMF. During the existence of the fixed exchange rate system, the intervention
currency of the Reserve Bank of India (RBI) was the British pound, the RBI ensured
maintenance of the exchange rate by selling and buying pound against rupees at fixed rates. The
inter bank rate therefore ruled the RBI band. During the fixed exchange rate era, there was only
one major change in the parity of the rupee- devaluation in June 1966. Different countries have
adopted different exchange rate system at different time.
The following are some of the exchange rate system followed by various countries.
The Gold Standard
Many countries have adopted gold standard as their monetary system during the last two decades
of the 19he century. This system was in vogue till the outbreak of World War 1. Under this
system the parties of currencies were fixed in term of gold. There were two main types of gold
standard:
1) Gold specie standard
Gold was recognized as means of international settlement for receipts and payments amongst
countries. Gold coins were an accepted mode of payment and medium of exchange in domestic
market also. A country was stated to be on gold standard if the following condition were
satisfied:
Monetary authority, generally the central bank of the country, guaranteed to buy and sell
gold in unrestricted amounts at the fixed price.
Melting gold including gold coins, and putting it to different uses was freely allowed.
Import and export of gold was freely allowed.
The total money supply in the country was determined by the quantum of gold available for
monetary purpose.
2) Gold Bullion Standard:
Under this system, the money in circulation was either partly of entirely paper and gold served as
reserve asset for the money supply. However, paper money could be exchanged for gold at any
time. The exchange rate varied depending upon the gold content of currencies. This was also
known as Mint Parity Theory of exchange rates. The gold bullion standard prevailed from
about 1870 until 1914, and intermittently thereafter until 1944. World War I brought an end to
the gold standard.
Bretton Woods System
During the world wars, economies of almost all the countries suffered. In order to correct the
balance of payments disequilibrium, many countries devalued their currencies. Consequently, the
Page 22
international trade suffered a deathblow. In 1944, following World War II, the United States and
most of its allies ratified the Bretton Woods Agreement, which set up an adjustable parity
exchange-rate system under which exchange rates were fixed (Pegged) within narrow
intervention limits (pegs) by the United States and foreign central banks buying and selling
foreign currencies. This agreement, fostered by a new spirit of international cooperation, was in
response to financial chaos that had reigned before and during the war. In addition to setting up
fixed exchange parities (par values) of currencies in relationship to gold, the agreement
established the International Monetary Fund (IMF) to act as the custodian of the system. Under
this system there were uncontrollable capital flows, which lead to major countries suspending
their obligation to intervene in the market and the Bretton Wood System, with its fixed parities,
was effectively buried. Thus, the world economy has been living through an era of floating
exchange rates since the early 1970.
Floating Rate System
In a truly floating exchange rate regime, the relative prices of currencies are decided entirely by
the market forces of demand and supply. There is no attempt by the authorities to influence
exchange rate. Where government interferes directly or through various monetary and fiscal
measures in determining the exchange rate, it is known as managed of dirty float.
PURCHASING POWER PARITY (PPP) Professor Gustav Cassel, a Swedish economist,
introduced this system. The theory, to put in simple terms states that currencies are valued for
what they can buy and the currencies have no intrinsic value attached to it. Therefore, under this
theory the exchange rate was to be determined and the sole criterion being the purchasing power
of the countries. As per this theory if there were no trade controls, then the balance of payments
equilibrium would always be maintained. Thus if 150 INR buy a fountain pen and the same
fountain pen can be bought for USD 2, it can be inferred that since 2 USD or 150 INR can buy
the same fountain pen, therefore USD 2 = INR 150.For example India has a higher rate of
inflation as compared to country US then goods produced in India would become costlier as
compared to goods produced in US. This would induce imports in India and also the goods
produced in India being costlier would lose in international competition to goods produced in
US. This decrease in exports of India as compared to exports from US would lead to demand for
the currency of US and excess supply of currency of India. This in turn, cause currency of India
to depreciate in comparison of currency of US that is having relatively more exports.
Foreign Exchange Market Structure

Market Segments
Foreign exchange market activity in most EMEs takes place
prohibiting onshore entities from undertaking the operations
currencies. Spot market is the predominant form of foreign
developing and emerging market countries. A common
onshore with many countries

in offshore markets for their
exchange market segment in
feature is the tendency of
Page 23
importers/exporters and other end-users to look at exchange rate movements as a source of return
without adopting appropriate risk management practices. This, at times, creates uneven
supplydem and conditions, often based on news and views. The lack of forward market
development reflects many factors, including limited exchange rate flexibility, the de facto
exchange rate insurance provided by the central bank through interventions, absence of a yield
curve on which to base the forward prices and shallow money markets, in which market-making
banks can hedge the maturity risks implicit in forward positions (Canales-Kriljenko, 2004).
Most foreign exchange markets in developing countries are either pure dealer markets or a
combination of dealer and auction markets. In the dealer markets, some dealers become market
makers and play a central role in the determination of exchange rates in flexible exchange rate
regimes. The bidoffer spread reflects many factors, including the level of competition among
market makers. In most of the EMEs, a code of conduct establishes the principles that guide the
operations of the dealers in the foreign exchange markets. It is the central bank, or professional
dealers association, which normally issues the code of conduct (Canales-Kriljenko, 2004). In
auction markets, an auctioneer or auction mechanism allocates foreign exchange by matching
supply and demand orders. In pure auction markets, order imbalances are cleared only by
exchange rate adjustments. Pure auction market structures are, however, now rare and they
generally prevail in combination with dealer markets.
The Indian foreign exchange market is a decentralised multiple dealership market comprising
two segments the spot and the derivatives market. In the spot market, currencies are traded at
the prevailing rates and the settlement or value date is two business days ahead. The two-day
period gives adequate time for the parties to send instructions to debit and credit the appropriate
bank accounts at home and abroad. The derivatives market encompasses forwards, swaps and
options. Though forward contracts exist for maturities up to one year, majority of forward
contracts are for one month, three months, or six months. Forward contracts for longer periods
are not as common because of the uncertainties involved and related pricing issues. A swap
transaction in the foreign exchange market is a combination of a spot and a forward in the
opposite direction. As in the case of other EMEs, the spot market is the dominant segment of the
Indian foreign exchange market. The derivative segment of the foreign exchange market is
assuming significance and the activity in this segment is gradually rising.
Fundamentals in Exchange Rate

Exchange rate is a rate at which one currency can be exchange in to another currency, say USD =
Rs.48. This rate is the rate of conversion of US dollar in to Indian rupee and vice versa.
Methods of Quoting Rate
There are two methods of quoting exchange rates.
Page 24
1) Direct method:
Foreign currency is kept constant and home currency is kept variable. In direct quotation, the
principle adopted by bank is to buy at a lower price and sell at higher price.
2) Indirect method:
Home currency is kept constant and foreign currency is kept variable. Here the strategy used by
bank is to buy high and sell low. In India with effect from august 2, 1993, all the exchange rates
are quoted in direct method. It is customary in foreign exchange market to always quote two
rates means one for buying and another rate for selling. This helps in eliminating the risk of
being given bad rates i.e. if a party comes to know what the other party intends to do i.e. buy or
sell, the former can take the letter for a ride. There are two parties in an exchange deal of
currencies. To initiate the deal one party asks for quote from another party and other party quotes
a rate. The party asking for a quote is known as asking party and the party giving a quotes is
known as quoting party. The advantage of twoway quote is as under
The market continuously makes available price for buyers or sellers
Two way prices limit the profit margin of the quoting bank and comparison of one
quote with another quote can be done instantaneously.
As it is not necessary any player in the market to indicate whether he intends to
buy or sale foreign currency, this ensures that the quoting bank cannot take
advantage by manipulating the prices.
It automatically insures that alignment of rates with market rates.
Two way quotes lend depth and liquidity to the market, which is so very essential
for efficient market. In two way quotes the first rate is the rate for buying and
another for selling.
We should understand here that, in India the banks, which are authorized dealer, always, quote
rates. So the rates quoted- buying and selling is for banks point of view only. It means that if
exporters want to sell the dollars then the bank will buy the dollars from him so while calculation
the first rate will be used which is buying rate, as the bank is buying the dollars from exporter.
The same case will happen inversely with importer as he will buy dollars from the bank and bank
will sell dollars to importer.
Factors Affecting Exchange Rates

In free market, it is the demand and supply of the currency which should determine the exchange
rates but demand and supply is the dependent on many factors, which are ultimately the cause of
the exchange rate fluctuation, some times wild. The volatility of exchange rates cannot be traced
to the single reason and consequently, it becomes difficult to precisely define the factors that
affect exchange rates. However, the more important among them are as follows:
Page 25
Strength of Economy
Economic factors affecting exchange rates include hedging activities, interest rates, inflationary
pressures, trade imbalance, and euro market activities. Irving fisher, an American economist,
developed a theory relating exchange rates to interest rates. This proposition, known as the fisher
effect, states that interest rate differentials tend to reflect exchange rate expectation. On the other
hand, the purchasing- power parity theory relates exchange rates to inflationary pressures. In its
absolute version, this theory states that the equilibrium exchange rate equals the ratio of domestic
to foreign prices. The relative version of the theory relates changes in the exchange rate to
changes in price ratios.
Political Factor
The political factor influencing exchange rates include the established monetary policy along
with government action on items such as the money supply, inflation, taxes, and deficit
financing. Active government intervention or manipulations, such as central bank activity in the
foreign currency market, also have an impact. Other political factors influencing exchange rates
include the political stability of a country and its relative economic exposure (the perceived need
for certain levels and types of imports). Finally, there is also the influence of the international
monetary fund.
Expectation of the Foreign Exchange Market
Psychological factors also influence exchange rates. These factors include market anticipation,
speculative pressures, and future expectations. A few financial experts are of the opinion that in
todays environment, the only trustworthy method of predicting exchange rates by gut feel. Bob
Eveling, vice president of financial markets at SG, is corporate finances top foreign exchange
forecaster for 1999. evelings gut feeling has, defined convention, and his method proved
uncannily accurate in foreign exchange forecasting in 1998.SG ended the corporate finance
forecasting year with a 2.66% error overall, the most accurate among 19 banks. The secret to
evelings intuition on any currency is keeping abreast of world events. Any event, from a
declaration of war to a fainting political leader, can take its toll on a currencys value. Today,
instead of formal modals, most forecasters rely on an amalgam that is part economic
fundamentals, part model and part judgment.
Fiscal policy
Interest rates
Monetary policy
Balance of payment
Exchange control
Central bank intervention
Speculation
Page 26
Technical factors
Sources of Supply and Demand in the Foreign exchange

Exchange Market
The major sources of supply of foreign exchange in the Indian foreign exchange market are
receipts on account of exports and invisibles in the current account and inflows in the capital
account such as foreign direct investment (FDI), portfolio investment, external commercial
borrowings (ECB) and non-resident deposits. On the other hand, the demand for foreign
exchange emanates from imports and invisible payments in the current account, amortization of
Page 27
ECB (including short-term trade credits) and external aid, redemption of NRI deposits and
outflows on account of direct and portfolio investment. In India, the Government has no foreign
currency account, and thus the external aid received by the Government comes directly to the
reserves and the Reserve Bank releases the required rupee funds. Hence, this particular source of
supply of foreign exchange is not routed through the market and as such does not impact the
exchange rate.
During last five years, sources of supply and demand have changed significantly, with large
transactions emanating from the capital account, unlike in the 1980s and the 1990s when current
account transactions dominated the foreign exchange market. The behavior as well as the
incentive structure of the participants who use the market for current account transactions differs
significantly from those who use the foreign exchange market for capital account transactions.
Besides, the change in these traditional determinants has also reflected itself in enhanced
volatility in currency markets. It now appears that expectations and even momentary reactions to
the news are often more important in determining fluctuations in capital flows and hence it
serves to amplify exchange rate volatility (Mohan, 2006a). On many occasions, the pressure on
exchange rate through increase in demand emanates from expectations based on certain news.
Sometimes, such expectations are destabilizing and often give rise to self-fulfilling speculative
activities. Recognizing this, increased emphasis is being placed on the management of capital
account through management of foreign direct investment, portfolio investment, external
commercial borrowings, nonresident deposits and capital outflows. However, there are occasions
when large capital inflows as also large lumpiness in demand do take place, in spite of adhering
to all the tools of management of capital account. The role of the Reserve Bank comes into focus
during such times when it has to prevent the emergence of such destabilising expectations. In
such cases, recourse is undertaken to direct purchase and sale of foreign currencies, sterilisation
through open market operations, management of liquidity under liquidity adjustment facility
(LAF), changes in reserve requirements and signaling through interest rate changes. In the last
few years, despite large capital inflows, the rupee has shown two - way movements. Besides, the
demand/supply situation is also affected by hedging activities through various instruments that
have been made available to market participants to hedge their risks.
Derivative Market Instruments

Derivatives play a crucial role in developing the foreign exchange market as they enable market
players to hedge against underlying exposures and shape the overall risk profile of participants in
the market. Banks in India have been increasingly using derivatives for managing risks and have
also been offering these products to corporates. In India, various informal forms of derivatives
contracts have existed for a long time though the formal introduction of a variety of instruments
in the foreign exchange derivatives market started only in the post-reform period, especially
since the mid-1990s. Cross-currency derivatives with the rupee as one leg were introduced with
some restrictions in April 1997. Rupee-foreign exchange options were allowed in July 2003. The
Page 28
foreign exchange derivative products that are now available in Indian financial markets can be
grouped into three broad segments, viz., forwards, options (foreign currency rupee options and
cross currency options) and currency swaps (foreign currency rupee swaps and cross currency
swaps)
Available data indicate that the most widely used derivative instruments are the forwards and
foreign exchange swaps (rupee-dollar). Options have also been in use in the market for the last
four years. However, their volumes are not significant and bid offer spreads are quite wide,
indicating that the market is relatively illiquid. Another major factor hindering the development
of the options market is that corporates are not permitted to write/sell options. If corporates with
underlying exposures are permitted to write/sell covered options, this would lead to increase in
market volume and liquidity. Further, very few banks are market makers in this product and
many deals are done on a back to back basis. For the product to reachthe farther segment of
corporates such as small and medium enterprises (SME) sector, it is imperative that public sector
banks develop the necessary infrastructure and expertise to transact in options. In view of the
growing complexity, diversity and volume of derivatives used by banks, an Internal Group was
constituted by the Reserve Bank to review the existing guidelines on derivatives and formulate
comprehensive guidelines on derivatives for banks
With regard to forward contracts and swaps, which are relatively more popular instruments in the
Indian derivatives market, cancellation and rebooking of forward contracts and swaps in India
have beenregulated. Gradually, however, the Reserve Bank has been taking measures towards
eliminating such regulations. The objective has been to ensure that excessive cancellation and
rebooking do not add to the volatility of the rupee. At present, exposures arising on account of
swaps, enabling a corporate to move from rupee to foreign currency liability (derived exposures),
are not permitted to be hedged. While the market participants have preferred such a hedging
facility, it is generally believed that equating derivedexposure in foreign currency with actual
borrowing in foreign currency would tantamount to violation of the basic premise for accessing
the forward foreign exchange market in India, i.e., having an underlying foreign exchange
exposure.
This feature (i.e., the role of an underlying transaction in the booking of a forward contract) is
unique to the Indian derivatives market. The insistence on this requirement of underlying
exposure has to be viewed against the backdrop of the then prevailing conditions when it was
imposed. Corporates in India have been permitted increasing access to foreign currency funds
since 1992. They were also accorded greater freedom to undertake active hedging.
However, recognising the relatively nascent stage of the foreign exchange market initially with
the lack of capabilities to handle massive speculation, the underlying exposure criterion was
imposed as a prerequisite. Exporters and importers were permitted to book forward contracts on
the basis of a declaration of an exposure and on the basis of past performance.
Page 29
Eligible limits were gradually raised to enable corporates greater flexibility. The limits are
computed separately for export and import contracts. Documents are required to be furnished at
the time of maturity of the contract. Contracts booked in excess of 25 per cent of the eligible
limit had to be on a deliverable basis and could not be cancelled. This relaxation has proved very
useful to exporters of software and other services since their projects are executed on the basis of
master agreements with overseas buyers, which usually do not indicate the volumes and tenor of
the exports (Report of Internal Group on Foreign Exchange Markets, 2005). In order to provide
greater flexibility to exporters and importers, as announced in the Mid-term review of the Annual
Policy 2006-07, this limit has been enhanced to 50 per cent.
Notwithstanding the initiatives that have been taken to enhance the flexibility for the corporates,
the need is felt to review the underlying exposure criteria for booking a forward contract. The
underlying exposure criteria enable corporates to hedge only a part of their exposures that arise
on the basis of the physical volume of goods (exports/imports) to be delivered4. With the Indian
economy getting increasingly globalised, corporates are also exposed to a variety of economic
exposures associated with the types of foreign exchange/commodity risks/ exposures arising out
of exchange rate fluctuations.
At present, the domestic prices of commodities such as ferrous and non-ferrous metals, basic
chemicals, petro-chemicals, etc. are observed to exhibit world import parity. Given the two-way
movement of the rupee against the US dollar and other currencies in recent years, it is necessary
for the producer/ consumer of such products to hedge their economic exposures to exchange rate
fluctuation. Besides, price-fix hedges are also available for traders globally. They enable
importers/exporters to lock into a future price for a commodity that they plan to import/export
without actually having a crystallised physical exposure to the commodity. Traders may also be
affected not only because of changes in rupee-dollar exchange rates but also because of changes
in cross currency exchange rates. The requirement of underlying criteria is also often cited as
one of the reasons for the lack of liquidity in some of the derivative products in India. Hence, a
fixation on the underlying criteria as India globalises may hinder the full development of the
forward market. The requirement of past performance/underlying exposures should be eliminated
in a phased manner. This has also been the recommendation of both the committees on capital
account convertibility. It is cited that this pre-requisite has been one of the factors contributing to
the shift over time towards the non deliverable forward (NDF) market at offshore locations to
hedge such exposures since such requirement is not stipulated while booking a NDF contract. An
attempt has been made recently provide importers the facility to partly hedge their economic
exposure by permitting them to book forward contracts for their customs duty component.
The Annual Policy Statement for 2007-08, released on April 24, 2007 announced a host of
measures to expand the range of hedging tools available to market participants as also facilitate
dynamic hedging by residents. To hedge economic exposures, it has been proposed that ADs
(Category- I) may permit (a) domestic producers/users to hedge their price risk on aluminium,
Page 30
copper, lead, nickel and zinc in international commodity exchanges, based on their underlying
economic exposures; and (b) actual users of aviation turbine fuel (ATF) to hedge their economic
exposures in the international commodity exchanges based on their domestic purchases.
Authorised dealer banks may approach the Reserve Bank for permission on behalf of customers
who are exposed to systemic international price risk, not covered otherwise. In order to facilitate
dynamic hedging of foreign exchange exposures of exporters and importers of goods and
services, it has been proposed that forward contracts booked in excess of 75 per cent of the
eligible limits have to be on a deliverable basis and cannot be cancelled as against the existing
limit of 50 per cent. With a view to giving greater flexibility to corporates with overseas direct
investments, the forward contracts entered into for hedging overseas direct investments have
been allowed to be cancelled and rebooked. In order to enable small and medium enterprises to
hedge their foreign exchange exposures, it has been proposed to permit them to book forward
contracts without underlying exposures or past records of exports and imports. Such contracts
may be booked through ADs with whom the SMEs have credit facilities. They have also been
allowed to freely cancel and rebook these contracts. In order to enable resident individuals to
manage/hedge their foreign exchange exposures, it has been proposed to permit resident
individuals to book forward contracts without production of underlying documents up to an
annual limit of US $ 100,000, which can be freely cancelled and rebooked.
Corporate Hedging for Foreign Exchange Risk in India

Introduction
In 1971, the Bretton Woods system of administering fixed foreign exchange rates was abolished
in favour of market-determination of foreign exchange rates; a regime of fluctuating exchange
rates was introduced. Besides market-determined fluctuations, there was a lot of volatility in
other markets around the world owing to increased inflation and the oil shock. Corporates
struggled to cope with the uncertainty in profits, cash flows and future costs. It was then that
financial derivatives foreign currency, interest rate, and commodity derivatives emerged as
means of managing risks facing corporations.
In India, exchange rates were deregulated and were allowed to be determined by markets in
1993. The economic liberalization of the early nineties facilitated the introduction of derivatives
Page 31
based on interest rates and foreign exchange. However derivative use is still a highly regulated
area due to the partial convertibility of the rupee. Currently forwards, swaps and options are
available in India and the use of foreign currency derivatives is permitted for hedging purposes
only.
The aim is to provide a perspective on managing the risk that firms face due to fluctuating
exchange rates. It investigates the prudence in investing resources towards the purpose of
hedging and then introduces the tools for risk management. These are then applied in the Indian
context. The motivation of this study came from the recent rise in volatility in the money markets
of the world and particularly in the US Dollar, due to which Indian exports are fast gaining a cost
disadvantage. Hedging with derivative instruments is a feasible solution to this situation.
This report is organised in 6 sections. The next section presents the necessity of foreign exchange
risk management and outlines the process of managing this risk. Section 3 discusses the various
determinants of hedging decisions by firms, followed by an overview of corporate hedging in
India in Section 4. Evidence from major Indian firms from different sectors is summarized here
and Section 5 concludes.
Foreign Exchange Risk Management: Process & Necessity
Firms dealing in multiple currencies face a risk (an unanticipated gain/loss) on account of
sudden/unanticipated changes in exchange rates, quantified in terms of exposures. Exposure is
defined as a contracted, projected or contingent cash flow whose magnitude is not certain at the
moment and depends on the value of the foreign exchange rates. The process of identifying risks
faced by the firm and implementing the process of protection from these risks by financial or
operational hedging is defined as foreign exchange risk management. This paper limits its scope
to hedging only the foreign exchange risks faced by firms.
Kinds of Foreign Exchange Exposure
Risk management techniques vary with the type of exposure (accounting or economic) and term
of exposure. Accounting exposure, also called translation exposure, results from the need to
restate foreign subsidiaries financial statements into the parents reporting currency and is the
sensitivity of net income to the variation in the exchange rate between a foreign subsidiary and
its parent. Economic exposure is the extent to which a firm's market value, in any particular
currency, is sensitive to unexpected changes in foreign currency. Currency fluctuations affect the
value of the firms operating cash flows, income statement, and competitive position, hence
market share and stock price. Currency fluctuations also affect a firm's balance sheet by
changing the value of the firm's assets and liabilities, accounts payable, accounts receivables,
inventory, loans in foreign currency, investments (CDs) in foreign banks; this type of economic
exposure is called balance sheet exposure. Transaction Exposure is a form of short term
economic exposure due to fixed price contracting in an atmosphere of exchange-rate volatility.
Page 32
The most common definition of the measure of exchange-rate exposure is the sensitivity of the
value of the firm, proxied by the firms stock return, to an unanticipated change in an exchange
rate. This is calculated by using the partial derivative function where the dependant variable is
the firms value and the independent variable is the exchange rate (Adler and Dumas, 1984).
Necessity of managing foreign exchange risk
A key assumption in the concept of foreign exchange risk is that exchange rate changes are not
predictable and that this is determined by how efficient the markets for foreign exchange are.
Research in the area of efficiency of foreign exchange markets has thus far been able to establish
only a weak form of the efficient market hypothesis conclusively which implies that successive
changes in exchange rates cannot be predicted by analyzing the historical sequence of exchange
rates.(Soenen, 1979). However, when the efficient markets theory is applied to the foreign
exchange market under floating exchange rates there is some evidence to suggest that the present
prices properly reflect all available information.(Giddy and Dufey, 1992). This implies that
exchange rates react to new information in an immediate and unbiased fashion, so that no one
party can make a profit by this information and in any case, information on direction of the rates
arrives randomly so exchange rates also fluctuate randomly. It implies that foreign exchange risk
management cannot be done away with by employing resources to predict exchange rate
changes.
Hedging as a tool to manage foreign exchange risk:
There is a spectrum of opinions regarding foreign exchange hedging. Some firms feel hedging
techniques are speculative or do not fall in their area of expertise and hence do not venture into
hedging practices. Other firms are unaware of being exposed to foreign exchange risks. There are
a set of firms who only hedge some of their risks, while others are aware of the various risks they
face, but are unaware of the methods to guard the firm against the risk. There is yet another set of
companies who believe shareholder value cannot be increased by hedging the firms foreign
exchange risks as shareholders can themselves individually hedge themselves against the same
using instruments like forward contracts available in the market or diversify such risks out by
manipulating their portfolio. (Giddy and Dufey, 1992).
There are some explanations backed by theory about the irrelevance of managing the risk of
change in exchange rates. For example, the International Fisher effect states that exchange rates
changes are balanced out by interest rate changes, the Purchasing Power Parity theory suggests
that exchange rate changes will be offset by changes in relative price indices/inflation since the
Law of One Price should hold. Both these theories suggest that exchange rate changes are evened
out in some form or the other.
Also, the Unbiased Forward Rate theory suggests that locking in the forward exchange rate
offers the same expected return and is an unbiased indicator of the future spot rate. But these
theories are perfectly played out in perfect markets under homogeneous tax regimes. Also,
Page 33
exchange rate-linked changes in factors like inflation and interest rates take time to adjust and in
the meanwhile firms stand to lose out on adverse movements in the exchange rates.
The existence of different kinds of market imperfections, such as incomplete financial markets,
positive transaction and information costs, probability of financial distress and agency costs and
restrictions on free trade make foreign exchange management an appropriate concern for
corporate management. (Giddy and Dufey, 1992) It has also been argued that a hedged firm,
being less risky can secure debt more easily and this enjoy a tax advantage (interest is excluded
from tax while dividends are taxed). This would negate the Modigliani-Miller proposition as
shareholders cannot duplicate such tax advantages. The MM argument that shareholders can
hedge on their own is also not valid on account of high transaction costs and lack of knowledge
about financial manipulations on the part of shareholders.
There is also a vast pool of research that proves the efficacy of managing foreign exchange risks
and a significant amount of evidence showing the reduction of exposure with the use of tools for
managing these exposures. In one of the more recent studies, Allayanis and Ofek (2001) use a
multivariate analysis on a sample of S&P 500 non-financial firms and calculate a firms
exchange-rate exposure using the ratio of foreign sales to total sales as a proxy and isolate the
impact of use of foreign currency derivatives (part of foreign exchange risk management) on a
firms foreign exchange exposures. They find a statistically significant association between the
absolute value of the exposures and the (absolute value) of the percentage use of foreign
currency derivatives and prove that the use of derivatives in fact reduce exposure.
Risk Management and Settlement of Transactions in the Foreign Exchange Market
The foreign exchange market is characterized by constant changes and rapid innovations in
trading methods and products. While the innovative products and ways of trading create new
possibilities for profit, they also pose various kinds of risks to the market. Central banks all over
the world, therefore, have become increasingly concerned of the scale of foreign exchange
settlement risk and the importance of risk mitigation measures. Behind this growing awareness
are several events in the past in which foreign exchange settlement risk might have resulted in
systemic risk in global financial markets, including the failure of Bankhaus Herstatt in 1974 and
the closure of BCCI SA in 1991.
The foreign exchange settlement risk arises because the delivery of the two currencies involved
in a trade usually occurs in two different countries, which, in many cases are located in different
time zones. This risk is of particular concern to the central banks given the large values involved
in settling foreign exchange transactions and the resulting potential for systemic risk. Most of the
banks in the EMEs use some form of methodology for measuring the foreign exchange
settlement exposure. Many of these banks use the single day method, in which the exposure is
measured as being equal to all foreign exchange receipts that are due on the day. Some
institutions use a multiple day approach for measuring risk. Most of the banks in EMEs use some
Page 34
form of individual counterparty limit to manage their exposures. These limits are often applied to
the global operations of the institution. These limits are sometimes monitored by banks on a
regular basis. In certain cases, there are separate limits for foreign exchange settlement
exposures, while in other cases, limits for aggregate settlement exposures are created through a
range of instruments. Bilateral obligation netting, in jurisdictions where it is legally certain, is an
important way for trade counterparties to mitigate the foreign exchange settlement risk. This
process allows trade counterparties to offset their gross settlement obligations to each other in the
currencies they have traded and settle these obligations with the payment of a single net amount
in each currency.
Several emerging markets in recent years have implemented domestic real time gross settlement
(RTGS) systems for the settlement of high value and time critical payments to settle the domestic
leg of foreign exchange transactions. Apart from risk reduction, these initiatives enable
participants to actively manage the time at which they irrevocably pay away when selling the
domestic currency, and reconcile final receipt when purchasing the domestic currency.
Participants, therefore, are able to reduce the duration of the foreign exchange settlement risk.
Recognising the systemic impact of foreign exchange settlement risk, an important element in
the infrastructure for the efficient functioning of the Indian foreign exchange market has been the
clearing and settlement of inter-bank USD-INR transactions. In pursuance of the
recommendations of the Sodhani Committee, the Reserve Bank had set up the Clearing
Corporation of India Ltd. (CCIL) in 2001 to mitigate risks in the Indian financial markets. The
CCIL commenced settlement of foreign exchange operations for inter-bank USD-INR spot and
forward trades from November 8, 2002 and for inter-bank USD-INR cash and tom trades from
February 5, 2004. The CCIL undertakes settlement of foreign exchange trades on a multilateral
net basis through a process of novation and all spot, cash and tom transactions are guaranteed for
settlement from the trade date.
Every eligible foreign exchange contract entered between members gets novated or replaced by
two new contracts between the CCIL and each of the two parties, respectively. Following the
multilateral netting procedure, the net amount payable to, or receivable from, the CCIL in each
currency is arrived at, member-wise. The Rupee leg is settled through the members current
accounts with the Reserve Bank and the USD leg through CCILs account with the settlement
bank at New York. The CCIL sets limits for each member bank on the basis of certain parameters
such as members credit rating, net worth, asset value and management quality. The CCIL settled
over 900,000 deals for a gross volume of US $ 1,180 billion in 2005-06. The CCIL has
consistently endeavoured to add value to the services and has gradually brought the entire gamut
of foreign exchange transactions under its purview. Intermediation, by the CCIL thus, provides
its members the benefits of risk mitigation, improved efficiency, lower operational cost and
easier reconciliation of accounts with correspondents.
Page 35
An issue related to the guaranteed settlement of transactions by the CCIL has been the extension
of this facility to all forward trades as well. Member banks currently encounter problems in terms
of huge outstanding foreign exchange exposures in their books and this comes in the way of their
doing more trades in the market. Risks on such huge outstanding trades were found to be very
high and so were the capital requirements for supporting such trades. Hence, many member
banks have expressed their desire in several fora that the CCIL should extend its guarantee to
these forward trades from the trade date itself which could lead to significant increase in the
liquidity and depth in the forward market. The risks that banks today carry in their books on
account of large outstanding forward positions will also be significantly reduced (Gopinath,
2005). This has also been one of the recommendations of the Committee on Fuller Capital
Account Convertibility. 6.55 Apart from managing the foreign exchange settlement risk,
participants also need to manage market risk, liquidity risk, credit risk and operational risk
efficiently to avoid future losses. As per the guidelines framed by the Reserve Bank for banks to
manage risk in the inter-bank foreign exchange dealings and exposure in derivative markets as
market makers, the boards of directors of ADs (category-I) are required to frame an appropriate
policy and fix suitable limits for operations in the foreign exchange market. The net overnight
open exchange position and the aggregate gap limits need to be approved by the Reserve Bank.
The open position is generally measured separately for each foreign currency consisting of the
net spot position, the net forward position, and the net options position. Various limits for
exposure, viz., overnight, daylight, stop loss, gap limit, credit limit, value at risk (VaR), etc., for
foreign exchange transactions by banks are fixed. Within the contour of these limits, front office
of the treasury of ADs transacts in the foreign exchange market for customers and own
proprietary requirements. These exposures are accounted, confirmed and settled by back office,
while mid-office evaluates the profit and monitors adherence to risk limits on a continuous basis.
In the case of market risk, most banks use a combination of measurement techniques including
VaR models. The credit risk is generally measured and managed by most banks on an aggregate
counter-party basis so as to include all exposures in the underlying spot and derivative markets.
Some banks also monitor country risk through cross-border country risk exposure limits.
Liquidity risk is generally estimated by monitoring asset liability profile in various currencies in
various buckets and monitoring currency-wise gaps in various buckets. Banks also track balances
to be maintained on a daily basis in Nostro accounts, remittances and committed foreign
currency term loans while monitoring liquidity risk.
To sum up, the foreign exchange market structure in India has undergone substantial
transformation from the early 1990s. The market participants have become diversified and there
are several instruments available to manage their risks. Sources of supply and demand in the
foreign exchange market have also changed in line with the shifts in the relative importance in
balance of payments from current to capital account. There has also been considerable
improvement in the market infrastructure in terms of trading platforms and settlement
mechanisms. Trading in Indian foreign exchange market is largely concentrated in the spot
segment even as volumes in the derivatives segment are on the rise. Some of the issues that need
Page 36
attention to further improve the activity in the derivatives segment include flexibility in the use
of various instruments, enhancing the knowledge and understanding the nature of risk involved
in transacting the derivative products, reviewing the role of underlying in booking forward
contracts and guaranteed settlements of forwards. Besides, market players would need to acquire
the necessary expertise to use different kinds of instruments and manage the risks involved.
Foreign Exchange Risk Management Framework

Once a firm recognizes its exposure, it then has to deploy resources in managing it. A heuristic
for firms to manage this risk effectively is presented below which can be modified to suit firmspecific needs i.e. some or all the following tools could be used.
Forecasts: After determining its exposure, the first step for a firm is to develop a forecast on
the market trends and what the main direction/trend is going to be on the foreign exchange
rates. The period for forecasts is typically 6 months. It is important to base the forecasts on
valid assumptions. Along with identifying trends, a probability should be estimated for the
forecast coming true as well as how much the change would be.
Risk Estimation: Based on the forecast, a measure of the Value at Risk (the actual profit or
loss for a move in rates according to the forecast) and the probability of this risk should be
ascertained. The risk that a transaction would fail due to market-specific problems4 should be
taken into account. Finally, the Systems Risk that can arise due to inadequacies such as
reporting gaps and implementation gaps in the firms exposure management system should
be estimated.
Benchmarking: Given the exposures and the risk estimates, the firm has to set its limit for
handling foreign exchange exposure. The firm also has to decide whether to manage its
Page 37
exposures on a cost centre or profit centre basis. A cost centre approach is a defensive one
and the main aim is ensure that cash flows of a firm are not adversely affected beyond a
point. A profit centre approach on the other hand is a more aggressive approach where the
firm decides to generate a net profit on its exposure over time.
Hedging: Based on the limits a firm set for itself to manage exposure, the firms then decides
an appropriate hedging strategy. There are various financial instruments available for the firm
to choose from: futures, forwards, options and swaps and issue of foreign debt. Hedging
strategies and instruments are explored in a section.
Stop Loss: The firms risk management decisions are based on forecasts which are but
estimates of reasonably unpredictable trends. It is imperative to have stop loss arrangements
in order to rescue the firm if the forecasts turn out wrong. For this, there should be certain
monitoring systems in place to detect critical levels in the foreign exchange rates for
appropriate measure to be taken.
Reporting and Review: Risk management policies are typically subjected to review based
on periodic reporting. The reports mainly include profit/ loss status on open contracts after
marking to market, the actual exchange/ interest rate achieved on each exposure, and
profitability vis--vis the benchmark and the expected changes in overall exposure due to
forecasted exchange/ interest rate movements. The review analyses whether the benchmarks
set are valid and effective in controlling the exposures, what the market trends are and finally
whether the overall strategy is working or needs change.
Page 38
Hedging Strategies/ Instruments

A derivative is a financial contract whose value is derived from the value of some other financial
asset, such as a stock price, a commodity price, an exchange rate, an interest rate, or even an
index of prices. The main role of derivatives is that they reallocate risk among financial market
participants, help to make financial markets more complete. This section outlines the hedging
strategies using derivatives with foreign exchange being the only risk assumed.
Forwards
A forward is a made-to-measure agreement between two parties to buy/sell a specified
amount of a currency at a specified rate on a particular date in the future. The depreciation of
the receivable currency is hedged against by selling a currency forward. If the risk is that of a
currency appreciation (if the firm has to buy that currency in future say for import), it can
hedge by buying the currency forward. E.g if RIL wants to buy crude oil in US dollars six
months hence, it can enter into a forward contract to pay INR and buy USD and lock in a
fixed exchange rate for INR-USD to be paid after 6 months regardless of the actual INRDollar rate at the time. In this example the downside is an appreciation of Dollar which is
protected by a fixed forward contract. The main advantage of a forward is that it can be
tailored to the specific needs of the firm and an exact hedge can be obtained. On the
downside, these contracts are not marketable, they cant be sold to another party when they
are no longer required and are binding.
Page 39
Futures
A futures contract is similar to the forward contract but is more liquid because it is traded in
an organized exchange i.e. the futures market. Depreciation of a currency can be hedged by
selling futures and appreciation can be hedged by buying futures. Advantages of futures are
that there is a central market for futures which eliminates the problem of double coincidence.
Futures require a small initial outlay (a proportion of the value of the future) with which
significant amounts of money can be gained or lost with the actual forwards price
fluctuations. This provides a sort of leverage.
The previous example for a forward contract for RIL applies here also just that RIL will have
to go to a USD futures exchange to purchase standardised dollar futures equal to the amount
to be hedged as the risk is that of appreciation of the dollar. As mentioned earlier, the
tailorability of the futures contract is limited i.e. only standard denominations of money can
be bought instead of the exact amounts that are bought in forward contracts.
Options
A currency Option is a contract giving the right, not the obligation, to buy or sell a specific
quantity of one foreign currency in exchange for another at a fixed price; called the Exercise
Price or Strike Price. The fixed nature of the exercise price reduces the uncertainty of
exchange rate changes and limits the losses of open currency positions. Options are
particularly suited as a hedging tool for contingent cash flows, as is the case in bidding
processes. Call Options are used if the risk is an upward trend in price (of the currency),
while Put Options are used if the risk is a downward trend. Again taking the example of RIL
which needs to purchase crude oil in USD in 6 months, if RIL buys a Call option (as the risk
is an upward trend in dollar rate), i.e. the right to buy a specified amount of dollars at a fixed
rate on a specified date, there are two scenarios. If the exchange rate movement is favourable
i.e the dollar depreciates, then RIL can buy them at the spot rate as they have become
cheaper. In the other case, if the dollar appreciates compared to todays spot rate, RIL can
exercise the option to purchase it at the agreed strike price. In either case RIL benefits by
paying the lower price to purchase the dollar
Swaps
A swap is a foreign currency contract whereby the buyer and seller exchange equal initial
principal amounts of two different currencies at the spot rate. The buyer and seller exchange
fixed or floating rate interest payments in their respective swapped currencies over the term
of the contract. At maturity, the principal amount is effectively re-swapped at a
predetermined exchange rate so that the parties end up with their original currencies. The
advantages of swaps are that firms with limited appetite for exchange rate risk may move to a
partially or completely hedged position through the mechanism of foreign currency swaps,
Page 40
while leaving the underlying borrowing intact. Apart from covering the exchange rate risk,
swaps also allow firms to hedge the floating interest rate risk. Consider an export oriented
company that has entered into a swap for a notional principal of USD 1 mn at an exchange
rate of 42/dollar.
The company pays US 6months LIBOR to the bank and receives 11.00% p.a. every 6 months
on 1st January & 1st July, till 5 years. Such a company would have earnings in Dollars and
can use the same to pay interest for this kind of borrowing (in dollars rather than in Rupee)
thus hedging its exposures.
Foreign Debt
Foreign debt can be used to hedge foreign exchange exposure by taking advantage of the
International Fischer Effect relationship. This is demonstrated with the example of an
exporter who has to receive a fixed amount of dollars in a few months from present. The
exporter stands to lose if the domestic currency appreciates against that currency in the
meanwhile so, to hedge this, he could take a loan in the foreign currency for the same time
period and convert the same into domestic currency at the current exchange rate. The theory
assures that the gain realised by investing the proceeds from the loan would match the
interest rate payment (in the foreign currency) for the loan.
Choice of hedging instruments

The literature on the choice of hedging instruments is very scant. Among the available studies,
Gczy et al. (1997) argues that currency swaps are more cost-effective for hedging foreign debt
risk, while forward contracts are more cost-effective for hedging foreign operations risk. This is
because foreign currency debt payments are long-term and predictable, which fits the long-term
nature of currency swap contracts. Foreign currency revenues, on the other hand, are short-term
and unpredictable, in line with the short-term nature of forward contracts. A survey done by
Marshall (2000) also points out that currency swaps are better for hedging against translation
risk, while forwards are better for hedging against transaction risk. This study also provides
anecdotal evidence that pricing policy is the most popular means of hedging economic
exposures.
These results however can differ for different currencies depending in the sensitivity of that
currency to various market factors. Regulation in the foreign exchange markets of various
countries may also skew such results.
Page 41
Determinants of Hedging Decisions

The management of foreign exchange risk, as has been established so far, is a fairly complicated
process. A firm, exposed to foreign exchange risk, needs to formulate a strategy to manage it,
choosing from multiple alternatives. This section explores what factors firms take into
consideration when formulating these strategies.
Production and Trade vs. Hedging Decisions
An important issue for multinational firms is the allocation of capital among different countries
production and sales and at the same time hedging their exposure to the varying exchange rates.
Research in this area suggests that the elements of exchange rate uncertainty and the attitude
toward risk are irrelevant to the multinational firm's sales and production decisions (Broll,1993).
Only the revenue function and cost of production are to be assessed, and, the production and
trade decisions in multiple countries are independent of the hedging decision.
The implication of this independence is that the presence of markets for hedging instruments
greatly reduces the complexity involved in a firms decision making as it can separate production
and sales functions from the finance function. The firm avoids the need to form expectations
about future exchange rates and formulation of risk preferences which entails high information
costs.
Page 42
Cost of Hedging
Hedging can be done through the derivatives market or through money markets (foreign debt). In
either case the cost of hedging should be the difference between value received from a hedged
position and the value received if the firm did not hedge. In the presence of efficient markets, the
cost of hedging in the forward market is the difference between the future spot rate and current
forward rate plus any transactions cost associated with the forward contract. Similarly, the
expected costs of hedging in the money market are the transactions cost plus the difference
between the interest rate differential and the expected value of the difference between the current
and future spot rates. In efficient markets, both types of hedging should produce similar results at
the same costs, because interest rates and forward and spot exchange rates are determined
simultaneously. The costs of hedging, assuming efficiency in foreign exchange markets result in
pure transaction costs. The three main elements of these transaction costs are brokerage or
service fees charged by dealers, information costs such as subscription to Reuter reports and
news channels and administrative costs of exposure management.
Factors affecting the decision to hedge foreign currency risk
Research in the area of determinants of hedging separates the decision of a firm to hedge from
that of how much to hedge. There is conclusive evidence to suggest that firms with larger size,
R&D expenditure and exposure to exchange rates through foreign sales and foreign trade are
more likely to use derivatives. (Allayanis and Ofek, 2001) First, the following section describes
the factors that affect the decision to hedge and then the factors affecting the degree of hedging
are considered.
Firm size
Firm size acts as a proxy for the cost of hedging or economies of scale. Risk management
involves fixed costs of setting up of computer systems and training/hiring of personnel in
foreign exchange management. Moreover, large firms might be considered as more
creditworthy counterparties for forward or swap transactions, thus further reducing their cost
of hedging. The book value of assets is used as a measure of firm size.
Leverage
According to the risk management literature, firms with high leverage have greater incentive
to engage in hedging because doing so reduces the probability, and thus the expected cost of
financial distress. Highly levered firms avoid foreign debt as a means to hedge and use
derivatives.
Liquidity and profitability:

Firms with highly liquid assets or high profitability have less incentive to engage in hedging
because they are exposed to a lower probability of financial distress. Liquidity is measured
Page 43
by the quick ratio, i.e. quick assets divided by current liabilities). Profitability is measured as
EBIT divided by book assets.
Sales growth
Sales growth is a factor determining decision to hedge as opportunities are more likely to be
affected by the underinvestment problem. For these firms, hedging will reduce the
probability of having to rely on external financing, which is costly for information
asymmetry reasons, and thus enable them to enjoy uninterrupted high growth. The measure
of sales growth is obtained using the 3-year geometric average of yearly sales growth rates.
As regards the degree of hedging Allayanis and Ofek (2001) conclude that the sole determinants
of the degree of hedging are exposure factors (foreign sales and trade). In other words, given that
a firm decides to hedge, the decision of how much to hedge is affected solely by its exposure to
foreign currency movements.
This discussion highlights how risk management systems have to be altered according to
characteristics of the firm, hedging costs, nature of operations, tax considerations, regulatory
requirements etc. The next section discusses these issues in the Indian context and regulatory
environment.
An Overview of Corporate Hedging in India

The move from a fixed exchange rate system to a market determined one as well as the
development of derivatives markets in India have followed with the liberalization of the
economy since 1992. In this context, the market for hedging instruments is still in its developing
stages. In order to understand the alternative hedging strategies that Indian firms can adopt, it is
important to understand the regulatory framework for the use of derivatives here.
Development of Derivative Markets in India
The economic liberalization of the early nineties facilitated the introduction of derivatives based
on interest rates and foreign exchange. Exchange rates were deregulated and market determined
in 1993. By 1994, the rupee was made fully convertible on current account. The ban on futures
trading of many commodities was lifted starting in the early 2000s. As of October 2007, even
corporates have been allowed to write options in the atmosphere of high volatility.9 Derivatives
on stock indexes and individual stocks have grown rapidly since inception. In particular, single
stock futures have become hugely popular. Institutional investors prefer to trade in the Over-TheCounter(OTC) markets to interest rate futures, where instruments such as interest rate swaps and
Page 44
forward rate agreements are thriving. Foreign exchange derivatives are less active than interest
rate derivatives in
\ India, even though they have been around for longer. OTC instruments in currency forwards
and swaps are the most popular. Importers, exporters and banks use the rupee forward market to
hedge their foreign currency exposure. Turnover and liquidity in this market has been increasing,
although trading is mainly in shorter maturity contracts of one year or less. The typical forward
contract is for one month, three months, or six months, with three months being the most
common. The Indian rupee, which is being traded on the Dubai Gold and Commodities
Exchange (DGCX), crossed a turnover of $23.24 million in June 2007.
Regulatory Guidelines for the use of Foreign Exchange Derivatives
With respect to foreign exchange derivatives involving rupee, residents have access to foreign
exchange forward contracts, foreign currency-rupee swap instruments and currency options
both cross currency as well as foreign currency-rupee. In the case of derivatives involving only
foreign currency, a range of products such as Interest Rate Swaps, Forward Contracts and
Options are allowed. While these products can be used for a variety of purposes, the fundamental
requirement is the existence of an underlying exposure to foreign exchange risk i.e. derivatives
can be used for hedging purposes only.
The RBI has also formulated guidelines to simplify procedural/documentation requirements for
Small and Medium Enterprises (SME) sector. In order to ensure that SMEs understand the risks
of these products, only banks with which they have credit relationship are allowed to offer such
facilities. These facilities should also have some relationship with the turnover of the entity.
Similarly, individuals have been permitted to hedge upto USD 100,000 on self declaration basis.
Authorised Dealer(AD) banks may also enter into forward contracts with residents in respect of
transactions denominated in foreign currency but settled in Indian Rupees including hedging the
currency indexed exposure of importers in respect of customs duty payable on imports and price
risks on commodities with a few exceptions. Domestic producers/users are allowed to hedge
their price risk on aluminium, copper, lead, nickel and zinc as well as aviation turbine fuel in
international commodity exchanges based on their underlying economic exposures. Authorised
dealers are permitted to use innovative products like cross-currency options; interest rate swaps
(IRS) and currency swaps, caps/collars and forward rate agreements (FRAs) in the international
foreign exchange market. Foreign Institutional Investors (FII), persons resident outside India
having Foreign Direct Investment (FDI) in India and Nonresident Indians (NRI) are allowed
access to the forwards market to the extent of their exposure in the cash market.
Hedging Instruments for Indian Firms
The recent period has witnessed amplified volatility in the INR-US exchange rates in the
backdrop of the sub-prime crisis in the US and increased dollar-inflows into the Indian stock
markets. In this context, the paper has attempted to study the choice of instruments adopted by
prominent firms to stem their foreign exchange exposures. All the data for this has been
Page 45
compiled from the 2006-2007 Annual Reports of the respective companies. A summary of the
foreign exchange risk hedging behaviour of select Indian firms is given in the table.
Instruments
Reliance Industries
Currency Swaps
Options Contracts
Currency(mn)
Rs (Cr)
1064.49
2939.76
Forward Contracts
5764.1
Maruti Udyog
.
6411
(INRJPY)
70 ($-INR)
124.70(USD
-INR)
Forward Contracts
Currency swaps
.
Mahindra
Mahindra
Forward Contracts
Currency Swaps
Arvind Mills
Forward Contracts
Option Contracts
Infosys
Forward Contracts
Options Contracts
Range barrier options
TCS
Forward Contracts
Options Contracts
Nature of exposure
Earnings in all businesses are linked to USD.
The key input, crude oil is purchased in USD.
All export revenues are in foreign currency and
local prices are based on import parity prices as
well
Import/Royalty payable in Yen and

Exports Receivables in dollars.
Interest rate and forex risk.
and
350 (INR-JPY)
2(INR-EUR)
27.3($-INR)
5390
INR)
Trade payables in Yen and Euro and

export receivables in dollars.
(JPYInterest rate and foreign exchange risk.
152.98 ($-INR) 703.67

2.25
(GBPINR)
5 (INR-$)
21.88
1 2 2.5 ($-INR)
547.16
119 ($-INR)
4 ($-INR)
8 (INR-$)
2 ($-INR)
3 (Eur-INR)
529
18
36
971
15 (Eur-INR)
21 (GBP-INR)
265.75
8 3 0 ($-INR)
4057
Most of the revenue is either in dollars

or linked to dollars due to export.
Revenues denominated in these

currencies.
Revenues largely denominated in

foreign currency, predominantly US$,
GBP, and Euro. Other currencie include
Australian $, Canadian $, South African
Page 46
47.5 (Eur-INR)
76.5
(GBPINR)
Ranbaxy
Forward Contracts
Dr. Reddys Labs

Forward Contracts
Options Contracts
Rand, and Swiss Franc
2894.589
398 ($-INR)
11(Eur $)
30 (EUR-$)
Exposed on accounts receivable and

loans payable. Exposure in USD and
Jap Yen
Foreign currency earnings through

export, currency requirements for
settlement of liability for import of
goods.
Discussion on Hedging by Indian Firms

From the Table above, it can be seen that earnings of all the firms are linked to either US dollar,
Euro or Pound as firms transact primarily in these foreign currencies globally. Forward contracts
are commonly used and among these firms, Ranbaxy and RIL depend heavily on these contracts
for their hedging requirements. As discussed earlier, forwards contracts can be tailored to the
exact needs of the firm and this could be the reason for their popularity. The tailor ability is a
consideration as it enables the firms to match their exposures in an exact manner compared to
exchange traded derivatives like futures that are standardized where exact matching is difficult.
RIL, Maruti Udyog and Mahindra and Mahindra are the only firms using currency swaps. Swap
usage is a long term strategy for hedging and suggests that the planning horizons for these
companies are longer than those of other firms. These businesses, by nature involve longer
gestation periods and higher initial capital outlays and this could explain their long planning
horizons.
Another observation is that TCS prefers to hedge its exposure to the US Dollar through options
rather than forwards. This strategy has been observed among many firms recently in India11.
This has been adopted due to the marked high volatility of the US Dollar against the Rupee.
Options are more profitable instruments in volatile conditions as they offer unlimited upside
profitability while hedging the downside risk whereas there is a risk with forwards if the
expectation of the exchange rate (the guess) is wrong as firms lose out on some profit. The use of
Range barrier options by Infosys also suggests a strategy to tackle the high volatility of the dollar
exchange rates. Software firms have a limited domestic market and rely on exports for the major
part of their revenues and hence require additional flexibility in hedging when the volatility is
Page 47
high. Another implication of this is that their planning horizons are shorter compared to capital
intensive firms.
It is evident that most Indian firms use forwards and options to hedge their foreign currency
exposure. This implies that these firms chose short-term measures to hedge as opposed to foreign
debt. This preference is possibly a consequence of their costs being in Rupees, the absence of a
Rupee futures exchange in India and curbs on foreign debt. It also follows that most of these
firms behave like Net Exporters and are adversely affected by appreciation of the local currency.
There are a few firms which have import liabilities which would be adversely affected by Rupee
depreciation.
However it must be pointed out that the data set considered for this study does not indicate how
the use of foreign debt by these firms hedges their exposures to foreign exchange risk and
whether such a strategy is used as a substitute or complement to hedging with derivatives.
Conclusion
Derivative use for hedging is only to increase due to the increased global linkages and volatile
exchange rates. Firms need to look at instituting a sound risk management system and also need
to formulate their hedging strategy that suits their specific firm characteristics and exposures.
In India, regulation has been steadily eased and turnover and liquidity in the foreign currency
derivative markets has increased, although the use is mainly in shorter maturity contracts of one
year or less. Forward and option contracts are the more popular instruments. Regulators had
initially only allowed certain banks to deal in this market however now corporates can also write
option contracts. There are many variants of these derivatives which investment banks across the
world specialize in, and as the awareness and demand for these variants increases, RBI would
have to revise regulations.
For now, Indian companies are actively hedging their foreign exchanges risks with forwards,
currency and interest rate swaps and different types of options such as call, put, cross currency
and range-barrier options. The high use of forward contracts by Indian firms also highlights the
absence of a rupee futures exchange in India.
However, the Dubai Gold and Commodities Exchange in June, 2007 introduced Rupee- Dollar
futures that could be traded on its exchanges and had provided another route for firms to hedge
on a transparent basis. There are fears that RBIs ability to control the partially convertible
currency will be subdued by this introduction but this issue is beyond the scope of this study. The
partial convertibility of the Rupee will be difficult to control if many exchanges offer such
instruments and that will be factor to consider for the RBI.
Page 48
Currency Risk Management

Introduction
The management of currency risk by corporations has come a longway in the last three decades.
Before the break-up of BrettonWoods currency riskwas not a major consideration for corporate
executives, nor did it have to be. Exchange rates were allowed to fluctuate, but only within
reasonably tight bands, while the US dollar itselfwas pegged to that most solid of commodities,
gold. The responsibility for managing currency risk, or rather maintaining currency stability, was
largely that of governments. Needless to say, that burden, that responsibility has now passed
from the public to the private sector.
The way the corporation has dealt with currency risk has changed substantially over time.
Corporations, many of which were reluctant to touch anything but the most vanilla of hedging
structures, have now greatly increased the sophistication of their currency risk management and
hedging strategies, particularly over the last decade. In this regard, two developments have
helped greatly the centralizing of Treasury operations, particularly within large multinationals,
and the focus put on hiring specifically experienced and qualified personnel to manage the dayto-day operations of risk management.
Currency Risk
So, what precisely is currency risk? There is no point in focusing on an issue if one cannot first
define it. Although definitions vary within the academic community, a practical description of
currency risk would be:
The impact that unexpected exchange rate changes have on the value of the corporation
Currency risk is very important to a corporation as it can have a major impact on its cash flows,
assets and liabilities, net profit and ultimately its stock market value. Assuming the corporation
Page 49
has accepted that currency risk needs to be managed specifically and separately, it has three
initial priorities:
1. Define what kinds of currency risk the corporation is exposed to
2. Define a corporate Treasury strategy to deal with these currency risks
3. Define what financial instruments it allows itself to use for this purpose
Currency risk is simple in concept, but complex in reality. At its most basic, it is the possible
gain or loss resulting from an exchange rate move. It can affect the value of a corporation
directly as a result of an unhedged exposure or more indirectly.
Different types of currency risk can also offset each other. For instance, take a US citizen who
owns stock in a German auto manufacturer and exporter to the US. If the Euro falls against the
US dollar, the US dollar value of the Euro-denominated stock falls and therefore on the face of it
the individual sees the US dollar value of their holding decline. However, the German auto
exporter should in fact benefit from a weaker Euro as this makes the companys exports to
the US cheaper, allowing them the choice of either maintaining US prices to maintain margin or
cutting them further to boost market share. Sooner or later, the stock market will realize this and
mark up the stock price of the auto exporter. Thus, the stock owner may lose on the currency
translation, but gain on the higher stock price. This is of course a very simple example and life
unfortunately is rarely that simple. For just as a weaker Euro makes exports from the Euro-zone
cheaper, so it makes imports more expensive. Thus, an exporter may not in fact feel the benefit
of the currency translation through to market share because higher import prices force it to raise
export prices from where they would otherwise would be according to the exchange rate.
The first step in successfully managing currency risk is to acknowledge that such risk actually
exists and that it has to be managed in the general interest of the corporation and the
corporations shareholders. For some, this is of itself a difficult hurdle as there is still major
reluctance within corporate management to undertake what they see as straying from their core,
underlying business into the speculative world of currency markets. The truth however is that the
corporation is a participant in the currency market whether it likes it or not; if it has foreign
currency-denominated exposure, that exposure should be managed. To do anything else is
irresponsible. The general trend within the corporate world has however been in favour of
recognizing the existence of and the need to manage currency risk. That recognition does not of
itself entail speculation. Indeed, at its best, prudent currency hedging can be defined as the
elimination of speculation:
The real speculation is in fact not managing currency risk
The next step, however, is slightly more complex and that is to identify the nature and extent of
the currency risk or exposure. It should be noted that the emphasis here is for the most part on
non-financial corporations, on manufacturers and service providers rather than on banks or other
types of financial institutions. Non-financial corporations generally have only a small amount of
their total assets in the form of receivables and other types of transaction. Most of their assets are
Page 50
made up of inventory, buildings, equipment and other forms of tangible real assets. In order to
measure the effect of exchange rate moves on a corporation, one first has to define the type and
then the amount of risk involved, or the value at risk (VaR). There are three main types of
currency risk that a multinational corporation is exposed to and has to manage.
Types of Currency Risk
1. Transaction risk (receivables, dividends, etc.)
2. Translation risk (balance sheet)
3. Economic risk (present value of future operating cash flows)
Transaction Risk
Transaction currency risk is essentially cash flow risk and relates to any transaction, such as
receivables, payables or dividends. The most common type of transaction risk relates to export or
import contracts. When there is an exchange rate move involving the currencies of such a
contract, this represents a direct transactional currency risk to the corporation. This is the most
basic type of currency risk that a corporation faces.
Translation Risk
Translation risk is slightly more complex and is the result of the consolidation of parent company
and foreign subsidiary financial statements. This consolidation means that exchange rate impact
on the balance sheet of the foreign subsidiaries is transmitted or translated to the parent
companys balance. Translation risk is thus balance sheet currency risk. While most large
multinational corporations actively manage their transaction currency risk, many are less aware
of the potential dangers of translation risk.
The actual translation process in consolidating financial statements is done either at the average
exchange rate of the period or at the exchange rate at the period end, depending on the specific
accounting regulations affecting the parent company. As a direct result, the consolidated results
will vary as either the average or the end-of-period exchange rate varies. Thus, all foreign
currency-denominated profit is exposed to translation currency risk as exchange rates vary. In
addition, the foreign currency value of foreign subsidiaries is also consolidated on the parent
companys balance sheet, and that value will vary accordingly. Translation risk for a foreign
subsidiary is usually measured by the net assets (assets less liabilities) that are exposed to
potential exchange rate moves.
Problems can occur with regard to translation risk if a corporation has subsidiaries whose
accounting books are local currency-denominated. For consolidation purposes, these books must
of course be translated into the currency of the parent company, but at what exchange rate?
Page 51
Income statements are usually translated at the average exchange rate over the period. However,
deciding at what exchange rate to translate the balance sheet is slightly trickier. There are
generally three methods used by major multinational corporations for translating balance sheet
risk, varying in how they separate assets and liabilities between those that need to be translated at
the current exchange rate at the time of consolidation and those that are translated at the
historical exchange rate:
_ The all current (closing rate) method
_ The monetary/non-monetary method
_ The temporal method
As the name might suggest, the all current (closing rate) method translates all foreign currency
exposures at the closing exchange rate of the period concerned. Under this method, translation
risk relates to net assets or shareholder funds. This has become the most popular method of
translating balance exposure of foreign subsidiaries, both in the US and worldwide
On the other hand, the monetary/non-monetary method translates monetary items such as assets,
liabilities and capital at the closing rate and non-monetary items at the historical rate. Finally, the
temporal method breaks balance sheet items down in terms of whether they are firstly stated at
replacement cost, realizable value, market value or expected future value, or secondly stated at
historic cost. For the first group, these are translated at the closing exchange rate of the period
concerned, for the second, at the historical exchange rate.
The US accounting standard FAS 52 and the UKs SSAP 20 apply to translation risk. Under
FAS 52, the translation of foreign currency revenues and costs is made at the average exchange
rate of the period. FAS 52 generally uses the all current method for translation purposes, though
it does have several important provisions, notably regarding the treatment of currency hedging
contracts. Under SSAP 20, the corporation can use either the current or average rate. Generally,
there has been a shift among multinational corporations towards using the average rather than the
closing rate because this is seen as a truer reflection of the translation risk faced by the
corporation during the period. Translation risk is a crucial issue for corporations. Later in this
chapter, we will look at methods of hedging it. For now, it is important to get an idea of how it
can affect the companys overall value.
Example
Take an example of a Euro-based manufacturer, which has bought a factory in Poland. Needless
to say, the cost base in Poland is substantially below that of the parent company, one of several
major reasons why the acquisition was made in the first place. From 1999 to 2001, the Euro was
on a major downtrend, not just against its major currency counterparts but also against most
currencies of the Central and East European area, such as the Polish zloty. Thus we get the
following simple model:
EURUSD = EURPLN
where:
Page 52
EURUSD = The EuroUS dollar exchange rate

EURPLN = The EuroPolish zloty exchange rate
This is an over-simplification to be sure. For one thing, the Polish zloty was pegged to a basket
of Euro (55%) and US dollar (45%) with a crawl and trading bands up until 2000, and thus was
unable to appreciate despite the ongoing decline in the value of the Euro across the board. For
another, it does not take account of EURPLN volatility. That said, general Euro weakness has
clearly been an important factor in the depreciation of the Eurozloty exchange rate. Note
however that as the Eurozloty exchange rate has depreciated for this and other reasons so the
value of the original investment in the Polish factory has increased in Euro terms. Thus:
EURPLN = EURtranslation value of Polish subsidiary
Whatever our Euro-based manufacturer may think of Euro weakness, it is entirely beneficial for
the manufacturers translation value of the Polish factory/subsidiary when the financial
statements are consolidated at the end of the accounting period. The translation benefit to the
balance sheet will depend on the accounting method of translation. Conversely, were the Euro
ever to rally on a sustained basis, this might cause the Eurozloty exchange rate to rally, thus in
turn reducing the translation value of the corporations Polish subsidiary. The consolidation of
financial statements would mean that this not only has an impact on the Euro value of the Polish
subsidiary but also on the balance sheet of the parent, Euro-based manufacturer. The risk of a
sudden balance sheet deterioration of this kind is not negligible where corporations have a broad
range of foreign subsidiaries, with accompanying transactional and translational currency risk.
Economic Risk
The translation of foreign subsidiaries concerns the consolidated group balance sheet. However,
this does not affect the real economic value or exposure of the subsidiary. Economic risk
focuses on how exchange rate moves change the real economic value of the corporation,
focusing on the present value of future operating cash flows and how this changes in line with
exchange rate changes. More specifically, the economic risk of a corporation reflects the effect of
exchange rate changes on items such as export and domestic sales, and the cost of domestic and
imported inputs. As with translation risk, calculating economic risk is complex, but clearly
necessary to be able to assess how exchange rate changes can affect the present value of foreign
subsidiaries. Economic risk is usually applied to the present value of future operating cash flows
of a corporations foreign subsidiaries. However, it can also be applied to the parent companys
operations and how the present value of those change in line with exchange rate changes.
Summarizing this part, transaction risk deals with the effect of exchange rate moves on
transactional exposure such as accounts receivable/payable or dividends. Translation risk focuses
on how exchange rate moves can affect foreign subsidiary valuation and therefore the valuation
of the consolidated group balance sheet. Finally, economic risk deals with the effect of exchange
rate changes to the present value of future operating cash flows, focusing on the currency of
determination of revenues and operating expenses. Here it is important to differentiate between
Page 53
the currency in which cash flows are denominated and the currency that may determine the
nature and size of those cash flows. The two are not necessarily the same. To complicate the
issue further, there is the small matter of the parent companys currency, which is used to
consolidate the financial statements. If a parent company has foreign currency-denominated debt,
this is recorded in the parent companys currency, but the value of its legal obligation remains in
the currency denomination of the debt. In sum, transaction risk is just the tip of the iceberg!
Of necessity, the reality of currency risk is very case-specific. That said, there has been an
attempt by the academic and economic communities to apply the traditional exchange rate
models to the corporate world for the purpose of demonstrating how exchange rates impact a
corporation.
PPP (or the law of one price) suggests that price differentials of the same good in different
countries require an exchange rate adjustment to offset them. The international Fisher effect
suggests that the expected change in the exchange rate is equal to the interest rate differential.
The unbiased forward rate theory suggests that the forward exchange rate is equal to the
expected exchange rate.
Generally, these theories are grounded in the efficient market hypothesis and therefore flawed at
best. Over the long term, these traditional rules of exchange rate theory suggest that
competition and arbitrage should neutralize the effect of exchange rate changes on returns and on
the valuation of the corporation. Equally, locking into the forward rate should, according to the
unbiased forward rate theory, offer the same return as remaining exposed to currency risk, as this
theory suggests that the distribution of probability should be equal on either side of the forward
rate.
The unfortunate thing about such models, however worthy the attempt, is that they do not and
cannot deal with the practical realities of managing currency risk. What academics regard as
temporary deviations from where the model suggests the exchange rate should be can be
sufficient and substantial enough to cause painful and intolerable deterioration to both the P&L
and the balance sheet?
To conclude this part, a corporation should define and seek to quantify the types of currency risk
to which it is exposed in order then to be able to go about creating a strategy for managing that
currency risk.
Core Principles for Managing Currency Risk
1. Determine the types of currency risk to which the corporation is exposed Break these
down into transaction, translation and economic risk, making specific reference to what
currencies are related to each type of currency risk.
Page 54
2. Establish a strategic currency risk management policy Once currency risk types have
been agreed on, corporate Treasury should establish and document a strategic currency risk
`management policy to deal with these types of risks. This policy should include the
corporations general approach to currency risk, whether it wants to hedge or trade that risk and
its core hedging objectives.
3. Create a mission statement for Treasury It is crucial to create a set of values and
principles which embody the specific approach taken by the Treasury towards managing
currency risk, agreed upon by senior management at the time of establishing and documenting
the risk management policy.
4. Detail currency hedging approach Having established the overall currency risk
management policy, the corporation should detail how that policy is to be executed in practice,
including the types of financial instruments that could be used for hedging, the process by which
currency hedging would be executed and monitored and procedures for monitoring and
reviewing existing currency hedges.
5. Centralizing Treasury operations as a single centre of excellence Treasury operations can
be more effectively and efficiently managed if they are centralized. This makes it easier to ensure
all personnel are clear about the Treasurys mission statement and hedging approach. Thus, the
Treasury can be run as a single centre of excellence within the corporation, ensuring the quality
of individual members. Large multinational corporations should consider creating a position of
chief dealer to manage the dealing team, as the demands of a Treasurer often exceed the ability to
manage all positions and exposures on a real-time basis. The currency dealing team must have
the same level of expertise as their counterparty banks.
6. Adopt uniform standards for accounting for currency risk In line with the centralizing of
Treasury operations, uniform accounting procedures with regard to currency risk should be
adopted, creating and ensuring transparency of risk. Create benchmarks for measuring the
performance of currency hedging.
7. Have in-house modelling and forecasting capacity Currency forecasting is as important as
execution. While Treasury may rely on its core banks for forecasting exchange rates relative to
its needs, it should also have its own forecasting ability, linked in with its operational
observations which are frequently more real time than any bank is capable of. Treasury should
also be able to model all its hedging positions using VaR and other sophisticated modelling
systems.
8. Create a risk oversight committee In addition to the safeguard of a chief dealer position
for larger multinational corporations, a risk oversight committee should be established to approve
Page 55
position taking above established thresholds and review the risk management policy on a regular
basis.
Page 56

Forex & Risk

Încărcat de

Informații document

Descriere originală:

Titlu original

Drepturi de autor

Formate disponibile

Partajați acest document

Partajați sau inserați document

Opțiuni de partajare

Vi se pare util acest document?

Este necorespunzător acest conținut?

Drepturi de autor:

Formate disponibile

Forex & Risk

Încărcat de

Drepturi de autor:

Formate disponibile

Overview On FOREX Management

POST GRADUATE DIPLOMA IN MANAGEMENT

Under the Guidance of

Prof Aditi Mahajan

Thakur Institute Of Management Studies And Research

Thakur Institute Of Management Studies And Research

Thakur Institute Of Management Studies And Research

Thakur Institute Of Management Studies And Research

Foreign Exchange Market Overview

Thakur Institute Of Management Studies And Research

Forex Market: A Historical Perspective

Thakur Institute Of Management Studies And Research

Early Stages: 1947-1977

In addition, several initiatives aimed at dismantling controls and providing an enabling

Basic Concepts in Forex Trading

Bid and Ask Rate:

Thakur Institute Of Management Studies And Research

Currency Traded Across Globe & India

Thakur Institute Of Management Studies And Research

Fully automated portfolio solution

Web-based easy-to-use trading

Low cost trading

Diversification and risk management options

Comprehensive online video tutorials and FAQ

Choice of over 70 independent trading strategies and 20 predefined portfolios

No subscription or maintenance fees

USD 500 minimum deposit

Minimum trade size 0.1 lot

Unlimited access to Alpari Academy and Alpari Research

Trade notifications by e-mail for opened/closed trades

Thakur Institute Of Management Studies And Research

Alpari Direct Pro

Factors Affecting Foreign Exchange

Foreign Exchange Management Act, 1999

Participants in foreign exchange market

Thakur Institute Of Management Studies And Research

Corporations particularly multinational corporation and transnational corporation having

Exchange rate System

Foreign Exchange Market Structure

onshore with many countries

Thakur Institute Of Management Studies And Research

Fundamentals in Exchange Rate

Factors Affecting Exchange Rates

Thakur Institute Of Management Studies And Research

Sources of Supply and Demand in the Foreign exchange

Derivative Market Instruments

Thakur Institute Of Management Studies And Research

Corporate Hedging for Foreign Exchange Risk in India

Foreign Exchange Risk Management Framework

Thakur Institute Of Management Studies And Research

Thakur Institute Of Management Studies And Research

Hedging Strategies/ Instruments

Thakur Institute Of Management Studies And Research

Thakur Institute Of Management Studies And Research

Choice of hedging instruments

Thakur Institute Of Management Studies And Research

Determinants of Hedging Decisions

Liquidity and profitability:

Thakur Institute Of Management Studies And Research

An Overview of Corporate Hedging in India

Thakur Institute Of Management Studies And Research

Import/Royalty payable in Yen and