Forex Market in India

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 Sr.                                 Particulars                    Page Nos.
1      Executive Summary                                            1
2      Introduction                                                 2-3
3      Foreign Exchange Market – Overview
       - Need for Foreign Exchange                                  4
       - Foreign Exchange in India                                  5
       - About Foreign Exchange Market                              5
       - Participants in Foreign Exchange Markets                   6-9
       - Factors Affecting Exchange Rates                           10
       - Cross Rates                                                11
       - Value Date                                                 12 – 13
       - Factors Affecting Premium / Discount                       14
4      Nature of Currency Risk                                      15 – 17
5      Foreign Exchange Exposure
       - Types of Exposures                                         18 -20
       - Role of Treasury in Foreign Exchange Exposure Management   20
6      An Approach to Managing Currency Risk                        21 – 22
7      Risk Management Strategies
       - Foreign Exchange Policies                                  23
       - Scenario Planning ~ Making Rational Decisions              24
       - Choosing a Currency Risk Management Strategy               25 – 26
8      Hedging Choices                                              27
9      Controlling Currency Risk                                    28
10     Foreign Exchange Derivatives
       - Forwards                                                   29
       - Futures                                                    30
       - Options                                                    31 – 32
       - Swaps                                                      33 - 44
11     Bibliography                                                 45

                          Executive Summary

The Foreign Exchange Market is one in which the currencies are bought &
sold against each other. It is the largest financial market in the world. It
operates virtually around the clock. This market trades enormous amount of
money, which is estimated at several trillion dollars. It is an over the counter
market. The exchange rate represents the number of units of one currency
that exchanges for a unit of another.

There are various reasons for occurrence of foreign exchange such as
tourism, global investment, service & trade, international integration and
political factors etc.

Forex market is the largest & the most liquid market in the world. The world
over, about 85 % of the forex trading arises as a result of transaction between
market makers & speculators, with only 15 % of the transactions being traded
or commerce related.

In today’s market place, the dollars constantly fluctuates against the other
currencies of the world. Several factors, such as decline of global equity
markets & declining world interest rates, have forced investors to pursue new
opportunities. The global increase in trade & foreign investments has lead to
many national economies becoming interconnected with one & other. This
interconnection, & the resulting fluctuations in exchange rates, has created a
huge international market, the Foreign Currency Exchange Market (FOREX),
Is better than stock market because of several reasons.

Foreign Exchange is the simultaneous buying of one currency & selling of
another. No other market equals the volume & scope of the FOREX market’s
daily turnover of more than $ 1.5 trillion.

                         Forex Market in India


Currency risk, also referred to as foreign exchange risk, is the risk from
adverse movements in exchange rates. When a company has assets or
liabilities denominated in a foreign currency, or contracts to receive or pay in a
foreign currency, it has an exposure to that currency.

An adverse movement in the exchange rate can affect a company by :
    Reducing its cash income
    Increasing its cash expenditures
    Reducing its reported profits
    Reducing its reported value of its currency assets
    Increasing the value of its foreign currency liabilities
    Damaging its competitive position in its domestic and foreign markets
       to the advantage of foreign rivals.

Cash flows are at risk from adverse exchange rate movements because :

    Companies that receive income in foreign currency often will wish to
       exchange it into domestic currency.
    Companies with debts in a foreign currency will have to convert
       domestic currency into the foreign currency, i.e. buy currency, to pay
       what they owe.

Currency risk to cash flows arises because of movements in the prices, or
exchange rates, at which foreign currency is converted.

Profits also are at risk if they are earned by foreign subsidiaries. A U.K.
company, for e.g. might earn annual profits of $ 600,000 from a US
subsidiary. If the sterling/dollar exchange rate moves from £ 1= $1.5 to £1
=$2, the value of annual profits will slide from £ 400,000 to £ 300,000. In
much the same way, the value of the assets of foreign subsidiaries,
expressed in the parent company’s domestic currency, is at risk from adverse
exchange rate movements.

Currency Risk arises for organizations involved, directly or indirectly, in
international trade and finance because:

    Exchange rates are volatile, in both the short and long term
    Future movements in exchange rates cannot be predicted accurately
    Companies have exposures to foreign currencies and will suffer losses,
      or loss of business as a result of adverse exchange rate movements

In today’s world no country is self sufficient, so there is a need for exchange
of goods and services amongst the different countries. However, 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, which is a
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.


Let us consider a case where a Japanese company exports electronic goods
to USA and invoices the goods in US Dollars. The American importer will pay
the amount in US dollars, as the same is his home currency. However the
Japanese exporter requires Yen means his home currency for procuring raw
materials and for payment to the labour charges etc. Thus he would need
exchanging US dollars for Yen. If the Japanese exporters invoice his goods in
Yen, then importer in USA will get his dollars converted in Yen and pay the

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 the third country. In that case both the countries,
which are transacting will require converting their respective currencies in the
currency of the third country. For that also the foreign exchange is required.


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 balances payable in any foreign currency
       and any drafts, traveler’s cheques, letters of credit and bills of
       exchange, expressed or drawn in Indian currency but payable in any
       foreign currency,
        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.

For India we can conclude that foreign exchange refers to foreign money,
which includes notes, cheques, bills of exchange, bank balances and deposits
in foreign currencies.


Particularly for foreign exchange market there is no market place called the
foreign exchange market. It is mechanism through which one country’s
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.
The market comprises of all foreign exchange traders who are connected to
each other through out the world. They deal with each other through
telephones, telexes and electronic systems. With the help of Reuters Money
2000-02, it is possible to access any trader in any corner of the world within a
few seconds.


The main players in foreign exchange markets are as follows:
        CUSTOMERS
The customers who are engaged in foreign trade participate in foreign
exchange markets 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

They are most active players in the forex market. Commercial banks dealing
with international transactions 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 the
goods. As every time the foreign exchange bought and sold may not be equal
banks are left with the overbought or oversold position. The balance amount
is sold or bought from the market.

Nowadays, in international foreign exchange markets, the international trade
turnover accounts for a fraction of huge amounts dealt, i.e. bought and sold.
The balance amount is accounted for either by financial transactions or
speculation. Banks have enough financial strength and wide experience to
speculate the market and banks does so. This is popularly known as the
trading in the forex market.

Commercial banks have following objectives for being active in the foreign
exchange markets.
        They render better service by offering competitive rates to their
       customers engaged in international trade;
        They are in a better position to manage risks arising out of exchange
       rate fluctuations;
        Foreign exchange business is a profitable activity and thus such
       banks are in a position to generate more profits for themselves;

        They can manage their integrated treasury in a more efficient

In India Reserve Bank of India has given license to the commercial banks to
deal in foreign exchange under section 6 Foreign Exchange Regulation Act,
1973, which are called the Authorized Dealers (ADs).

In all countries central banks 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. Apart from this central banks deal in
the foreign exchange market for the following purposes:

1) Exchange rate management: It is achieved by the intervention though
sometimes banks have to maintain external rate of
the domestic currency at a level or in a band so fixed.

2) Reserve management: Central bank of the country is mainly concerned
with the investment of countries foreign exchange reserve in a stable
proportions in range of currencies and in a range of assets in each currency.
For this bank has to involve certain amount of switching between currencies.

Forex brokers play a very important role in the foreign exchange markets.
However the extent to which services of forex brokers are utilized depends on
the tradition and practice prevailing at a particular forex market center. In India
as per FEDAI guidelines the A Ds are free to deal directly among themselves
without going through brokers. The forex brokers are not allowed to deal on
their own account all over the world and also in India.

Banks seeking to trade display their bid and offer rates on their respective
pages of Reuters screen, but these prices are indicative only. On inquiry from

brokers they quote firm prices on telephone. In this way, the brokers can
locate the most competitive buying and selling prices, and these prices are
immediately broadcast to a large number of banks by means of hotlines /
loudspeakers in the banks dealing room / contacts many dealing banks
through calling assistants employed by the broking firm. If any bank wants to
respond to these prices thus made available, this is done by counterparty
bank by clinching the deal. Brokers do not disclose counterparty bank's name
until the buying and selling banks have concluded the deal. Once the deal is
struck the broker exchange the names of the bank who has bought and who
has sold. The brokers charge commission for the services rendered. In India
broker's commission bas been fixed by FEDAI.


Today the daily global turnover is guestimated 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 markets is constituted of
financial transactions 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.

The speculators are the major speculators in the forex market.
Banks dealing are the major speculators in the forex markets 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

Corporations    particularly   Multinational   Corporation     and    transnational
corporations having business operations 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. Sometimes they take positions so as to take
advantage of the exchange rate movement in their favor and for undertaking
this activity, they have state of the art dealing rooms. In India, some of the big
corporate are as the exchange control have been loosened, booking, and
canceling forward contracts, and at times the same borders on speculative

Governments borrow or invest in foreign securities and delay coverage of the
exposure on account of such deals.

Individuals like share dealings 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.

Corporate entities take positions in commodities whose prices are expressed
in foreign currency. This also adds to speculative activity.


In a 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 singe reason and
consequently, it becomes difficult to precisely define the factors that affect
exchange rates. How ever, the more important among them are as follows:

          Balance of payments
          Strength of economy
          Fiscal policy
          Interest rates
          Monetary policy
          Political factor
          Exchange control
          Central bank intervention
          Speculation
          Technical factors
          Expectations of the foreign exchange market


We know that US dollar being the currency of intervention only US
dollar/rupee exchange rate is available in the Indian Forex market and
exchange rates of rupee with all other foreign currencies are derived from this

rate through crosses. If we want to remit French from India, exchange rate of
French franc/rupee has to be arrived at. What we have to do is the first buy
US dollar against rupee and by selling US dollar so bought, say in London
market, we buy French franc.

Let us understand by an example…

If exchange rates in Mumbai inter bank market and London market are as
Inter bank market:
Mumbai Market
US $ 1 = Rs. 41.2550-41.2650

London Market
US $ 1 = FRF 6.0500-6.0550

The transaction will proceed like, interbank market takes rupees 41.2650 and
gives US $ 1. This US $ is taken to the London market for conversion in the
FRF. The London market takes US $ 1 and gives FRF 6.0500.

So we can calculate the direct rate between FRF and INR.

FRF 6.0500 = US $1 And US $ 1 = RS. 41.2650 Therefore, FRF 6.0500 = US
$ 1 = RS. 41.2650

So, FRF 1 = RS.41.2650/6.0500          = RS. 6.8206
In this way, banks can calculate exchange rate between any two currencies.


In foreign exchange market, it takes some times to process the transactions
and send the instruction to the correspondent bank/branch abroad. Therefore,
it is customary to quote the rate to do the deal exchange the currencies not on
the same date but generally afterwards.

Value date is the date on which the exchange of currencies actually takes
place. This is irrespective of the date of deal.

Date of deal                               Value Date
Cash/Ready                                   9-1-2003   Friday
9-1-2003 Friday
Tom                                        12-1-2003    Monday
9-1-2003     Friday
Spot                                       13-1-2003    Tuesday
9-1-2003     Friday
Forward                                    14-1-2003 Beyond Spot Date
9-1-2003     Friday

Generally exchange rates are quoted on spot basis i.e. the settlement takes
place on the second working day after the date of transaction. The exchange
rate for settlement on a day beyond spot date is naturally different and is
called ‘forward rate’

Forward rate has two components;
1) Spot rate
2) Forward points

Forward points, also called as forward differentials, reflect the interest
differential between the pair of currencies provided capital flows are freely
allowed. This is not true in case of US $ / Rupee rate as there are exchange
control regulations prohibiting free movement of capital from/into India. In
case of US $ / Rupee it is pure demand and supply which determines forward

If forward price is higher than the spot price the currency is said to be at
‘premium’. And if forward price is lower than spot price the Currency is said to
be at ‘discount’.

Forward rates are quoted by indicating spot rate and premium/discount.
In direct rate.
Forward rate = spot rate + Premium / - Discount

In foreign exchange market forward transaction are necessary for following
            One can hedge or cover an existing future financial, commercial
       or trade related exchange risk.
            These types of deals, in combinations of spot deals, are used for
       money market operations through ‘ swap transactions’.
            Taking a view of the market, these can be used for speculation.

When a currency is costlier in future (forward) as compared to spot, the
currency is said to be at premium vis-à-vis another currency.

When a currency is cheaper in future (forward) as compared to spot, the
currency is said to be at discount vis-à-vis another currency.


Forward differentials are relatively but are not constant and therefore, vary
from time to time. The following factors affect forward differentials:

1) Supply and demand for the currency for a settlement date.
If for a currency for a particular settlement date, there are more buyers than
sellers the forward differential will go up. Similarly, if a Currency for a

particular settlement date, there are more sellers and buyers the forward
differential will go down. This is all the more true when there is restriction of
capital flows.

2) Market expectations.
Market expectations about the development in interest differentials and
exchange rates of the currencies on account of various factors.

3) Interest rate differentials
Interest rate differentials between the currencies exchanged. In fact, this is the
only factor, which affects the forward differentials provided capital flows are
free from restrictions.

The exchange rates quoted by Authorized Dealers in India, for transactions
with merchants are known as ‘Merchant Rates’. The rates quoted by banks for
dealing in inter bank market are known as ‘Inter bank rates’.

There are four types of merchant rates are used in India..
    TT (Buying) Rate
    TT (Selling) Rate
    Bill (Buying) Rate
    Bill (Selling) Rate.


Currency risk or exchange rate risk arises in buying, selling, investing and
borrowing. Therefore, it is essential to recognize the nature of currency risk
and how they arise in business.


A company selling goods or services abroad faces currency risk,
regardless of whether its sales are priced in its domestic currency or in a
foreign currency.
For e.g. suppose that a UK Company sells goods to foreign buyers.

Sales priced in sterling: If sterling strengthens, prices to foreign buyers
in their domestic currency will rise. Demand will fall to an extent that will
depend on the strength, or elasticity, of demand for the product. Falling
sales will reduce total profits.
Sales priced in a foreign currency: If exports are priced in a currency
that falls in value against sterling, the company’s sterling earnings will fall.
Profit margins also will fall. The company either must accept the lower
profits margins or raise prices. Higher prices could result in lower sales
demand and lower profits.

A company buying goods from abroad might be invoiced in its domestic
currency, but is more likely to be invoiced in a foreign currency.
For e.g. suppose that a US company buys a range of goods from foreign
Purchases invoiced in dollars: If the dollars weakens, foreign suppliers are
likely to raise their dollar prices so that profits in their own currency can be
maintained. Costs of purchases therefore will rise.
Purchases invoiced in a foreign currency: If the dollar weakens, it will cost
the company more in dollars to buy the foreign currency to pay for the
goods. Costs of purchases will rise.

The profits of a parent company’s foreign subsidiary, as reported in the
parent company’s domestic currency, will fall if the subsidiary’s domestic
currency weakens in the value against the parent company’s domestic
currency. As a result multinational companies with foreign subsidiaries
have constant exposure to currency risk.

 The value of a foreign investment will fall if the currency in which it is
 denominated weakens against the investor’s domestic currency.

 Exchange rate movements, as well as interest rates, affect the cost of
 borrowing in a foreign currency. The cost of a foreign currency loan will
 rise or fall if the borrower’s domestic currency weakens or strengthens
 against the currency in which the loan is denominated.
 Currency risk would be reduced if either
         The volatility in exchange rate movements were lessened and
          exchange rates fairly stable, or
         Future exchange rate movements could be predicted with
          reasonable accuracy.

Currency Risk depends on the regularity and size of exchange rate
movements. An exposure to currency risk is greater when the exchange rate
could change by a larger percentage amount, i.e. when exchange rate
volatility is high. Changes that might occur in the future can be estimated
from changes that have occurred in the past.
Currency risk is lower when exchange rates are fairly stable.

Various attempts have been made to establish a system of stable exchange
rates between major currencies such as

1) The Gold Standard:
The exchange rates between major currencies were fixed in relation to the

2) The Bretton Woods Agreements:
Under this system,

         Each member country set a parity value for its currency against
           the dollar and gold, and undertook to use central bank intervention
           to maintain the exchange rate within 1% of its parity
         The dollar’s value against gold was fixed at $35 an ounce, and the
           US government undertook to buy and sell gold in exchange for
           dollars at this fixed rate.

 3) The Exchange Rate Mechanism (ERM):
 Currencies in the ERM had fixed central rates against each other and
 against the ECU, a composite European currency, but a variation margin
 around the central rate was permitted before central government
 intervention was required.

 However, exchange rate stability cannot be maintained in the long term
 when the economy of one or more of the countries is weak. A Government
 can raise interest rates to sustain the value of its currency, but only for a
 limited period without further damaging the economy.

 Thus several attempts were made to maintain exchange rate stability, but all
 had a temporary success.
 Therefore it can be concluded that Currency risk in an inevitable feature of
 international trade and finance. However, individual companies can take
 measures to avoid or reduce their own exposures to risk, i.e. to Hedge their
 exposures, provided they know what exposures they face and how large
 they could be.


Foreign exchange risk is related to the variability of the domestic currency
values of assets, liabilities or operating income due to unanticipated changes
in exchange rates, whereas foreign exchange exposure is what is at risk.

Foreign currency exposures and the attendant risk arise whenever a business
has an income or expenditure or an asset or liability in a currency other than
that of the balance-sheet currency. Indeed exposures can arise even for
companies with no income, expenditure, asset or liability in a currency
different from the balance-sheet currency. When there is a condition prevalent
where the exchange rates become extremely volatile the exchange rate
movements destabilize the cash flows of a business significantly. Such
destabilization of cash flows that affects the profitability of the business is the
risk from foreign currency exposures.


Financial economists distinguish between three types of currency exposures -
transaction exposures, translation exposures, and economic exposures. All
three affect the bottom- line of the business.

Suppose that a company is exporting deutsche mark and while costing the
transaction had reckoned on getting say Rs 24 per mark. By the time the
exchange transaction materializes i.e. the export is affected and the mark sold
for rupees, the exchange rate moved to say Rs 20 per mark. The profitability
of the export transaction can be completely wiped out by the movement in the
exchange rate. Such transaction exposures arise whenever a business has
foreign currency denominated receipt and payment. The risk is an adverse
movement of the exchange rate from the time the transaction is budgeted till
the time the exposure is extinguished by sale or purchase of the foreign
currency against the domestic currency.


Translation exposure arises from the need to "translate" foreign currency
assets or liabilities into the home currency for the purpose of finalizing the
accounts for any given period. A typical example of translation exposure is the
treatment of foreign currency borrowings. Consider that a company has

borrowed dollars to finance the import of capital goods worth Rs 10000. When
the import materialized the exchange rate was say Rs 30 per dollar. The
imported fixed asset was therefore capitalized in the books of the company for
Rs 300000. In the ordinary course and assuming no change in the exchange
rate the company would have provided depreciation on the asset valued at Rs
300000 for finalizing its accounts for the year in which the asset was

If at the time of finalization of the accounts the exchange rate has moved to
say Rs 35 per dollar, the dollar loan has to be translated involving translation
loss of Rs50000. The book value of the asset thus becomes 350000 and
consequently higher depreciation has to be provided thus reducing the net


An economic exposure is more a managerial concept than a accounting
concept. A company can have an economic exposure to say Yen: Rupee
rates even if it does not have any transaction or translation exposure in the
Japanese currency. This would be the case for example, when the company's
competitors are using Japanese imports. If the Yen weekends the company
loses its competitiveness (vice-versa is also possible).
The company's competitor uses the cheap imports and can have competitive
edge over the company in terms of his cost cutting. Therefore the company's
exposed to Japanese Yen in an indirect way.

In simple words, economic exposure to an exchange rate is the risk that a
change in the rate affects the company's competitive position in the market
and hence, indirectly the bottom-line. Broadly speaking, economic exposure
affects the profitability over a longer time span than transaction and even
translation exposure. Under the Indian exchange control, while translation and
transaction exposures can be hedged, economic exposure cannot be hedged.

The Role of Treasury in Foreign Exchange Exposure Management:

The days of corporate treasuries being aggressive profit centers are long
gone although there are a few that still survive. These days Corporate are far
more conservative with foreign exchange risk management and have
reasonably well defined guidelines for the management of Forex risk. At a
minimum Corporate should have a foreign exchange policy which spells out
exactly what should be done with the foreign exchange risks they face. Quite
often this policy is developed in tandem with an exposure measurement
process. For Corporate with minimal risk exposure measurement may be a
very simple process of forecasting what the cash receipts or payments are
likely to be for a given period.


Management is generally risk averse and often will take measures that reduce
or eliminate exposures that could have a harmful effect on its business. A risk
Avoidance measure is known as hedging the risk or the exposure.

It is important to recognize that currency exposures could create potential
losses, and every company ought to establish
    Whether it has any currency exposures and in what currencies?
    If so, what kind of risk are involved and how do they arise?
    Are they significant and should they be hedged?

Even if they are not hedged, management should ensure that they are
regularly monitored to ensure that the risk does not increase to the point
where potential losses could be significant.

Managing Financial Risk: Monitoring Exposures

                           Is the Company exposed
                                to currency risk?

                           If yes what kind of risks
                             are they exposed to?
                           (Transition or economic)

                          How do the risk arise?

                          How large are they and in
                            which Currencies?

                             Are they significant?

                            Should they be managed

                          If not managed, is there a
                          continued monitoring
                          system to ensure that
                          exposures do not become a
                          serious risk to the company?

Some of the foreign exchange risk management issues that may come up in
the day-to-day Foreign Exchange transactions.

    Unexpected changes in currency exchange rate
    Lost payments
    Delayed confirmation of payments and receivables
    Discrepancies between bank drafts received and the contract

The basic objective of Risk Management is to :
       Minimize Costs
       Maximize Revenue
       Stabilize Margins in the Future


A good foreign exchange policy is critical to the sound risk management of
any corporate treasury. Without a policy decisions are made ad-hoc and
generally without any consistency and accountability. Its important for treasury
personnel to know what benchmarks they are aiming for and its important for
senior management or the board to be confident that the risks of the business
are being managed consistently and in accordance with overall corporate


The recognition of the financial risks associated with foreign exchange mean
some decisions need to be made. The key to any good management is a
rational approach to decision making. The most desirable method of
management is the pre-planning of responses to movements in what are
generally volatile markets so that emotions are dispensed with and previous
careful planning is relied upon. This approach helps eliminate the panic factor
as all outcomes have been considered including 'worst case scenarios', which
could result from either action or inaction. However even though the worst
case scenarios are considered and plans ensure that even the 'worst case
scenarios' are acceptable (although not desirable), the pre-planning focuses
on achieving the best result.

Most Business are exposed to currency risk, even a local producer for a local
market often will be threatened by cheap foreign imports, a form of indirect
economic exposure.
The potential costs and benefits of exposures can be assessed quite easily,
provided the exposures have been quantified. This assessment calls for a
simple judgment about the possible change in the relevant exchange rate.
Transaction exposures and translation exposures should be analysed

e. g. A US company owns a Dutch subsidiary that has a net asset value of
€ 20million and earns annual profits of € 3 million. The current exchange rate
is €1=$ 1.08.

Translated into dollars at the current exchange rate, the value of the
company’s net assets is $21.6 million; the annual profits are $3.24 million
(3*1.08).A 5% movement in the exchange rate ,up or down, would result in
the dollar value of the net assets changing by $1,080,000 and reported annual
profits changing by $162,000.


Currency risk is a two-way risk because exchange rate movements can be
either favourable with a resulting gain, or adverse with a resulting loss. A
Company might take a view that currency risk is acceptable whenever it
occurs, and that gains or losses on exchange rate movements should be
tolerated because over the long term they should cancel each other out. This
attitude to currency exposures is considered RISK NEUTRAL.

Risk Neutrality might be a suitable strategy to adopt when the potential cost or
gains are small relative to the size of the company’s business and profits.

For e.g. Suppose a UK company earns annual income of about ₤ 30million
and $ 9 million, and expects annual profits to be about ₤6 million. There is
some currency exposure with the dollar income. If the current exchange rate
is ₤1=$ 1.5,the dollar income would yield ₤ 600,000 at the current rate, and a
fall in the value of the dollar by 20% would cost the company ₤120,000 in lost
annual income. In relation to total profits of ₤6 million, the currency risk might
seem tolerable. But if the total profits of the company were only ₤500,000,then
the currency exposures might cause greater concerns.

If the potentials losses and gains from the exchange rate movements are high
in proportion to the expected trading profits, a company should be less
inclined to take a risk-neutral attitude, and ought to consider ways of
managing the risk.

Risk Management involves
    Avoiding risk whenever possible where significant losses might occur

    Controlling risk if it cannot be avoided altogether to minimize the size of
       potential losses
    Tolerating the risk, or even adding to exposures when exchange rate
       movements are more likely to be favourable than adverse.

Taking measures to avoid or minimize the risk from exposures is called

Management of currency risk implies that the company is not risk neutral. A
company is risk averse if measures are taken to minimize the exposures, and
risk seeking if measures are taken to increase exposures to profit from
favourable exchange rate movements.

The aim of hedging is to reduce or eliminate the risk from adverse exchange
rate movements. A consequence of hedging is either

    Having to incur additional expenditure to hedge the exposure, or
    Forgoing the opportunity to make a profit if there is a favourable
       movement in exchange rates.

Hedging therefore has a cost, or a potential cost. Companies accept the costs
of hedging as the price to pay for reducing the risk of losses.


                                  Quantify exposures

                               Assess potential gains or
                                losses from exchange
                                   rate movements

                    NO                                      YES

       Adopt risk neutral
        attitude. Tolerate                                 Future exchange
      exposures when they                                  rate movements
              occur                                           likely to be
                                                            favourable or
                                              Could be either                Most
                                              favourable or                  likely
                                              unfavourable                   Favour
             Seek measures to avoid
                 or control risk
                                                                    Accept currency
                                                                    exposures. Perhaps seek
                                                                    to increase exposures

Controlling Currency risk:

There are several ways in which a company might seek to control its currency
    Transaction exposures can be avoided by refusing to buy or sell except
         in domestic currency.
    Translation exposures can be avoided by refusing to establish foreign
    The threat that foreign competition might benefit from exchange rate
         movements (indirect economic exposure) and be able to be countered
         by measures to improve productivity, reduce output costs and because
         more cost competitive.
Measures to hedge currency exposures have evolved over recent decades,
and companies including banks, can choose which hedging methods to use.
These include the foreign exchange derivatives such as forwards, futures
options and swaps.


The main foreign exchange linked derivatives are currency forwards, currency
futures, currency options and currency swaps and combination of the above.
For borrowers, access to the currency derivatives ensures that they have
access to the lowest cost capital markets around the world. The integration of
international capital markets through foreign exchange derivatives markets
encourages a competitive cost of capital. In addition to this integration role,
foreign exchange derivatives serve a very real purpose. Foreign exchange
fluctuations affect the competitive positions of companies, the cost of
borrowing abroad, and the returns on global investment portfolios. Precise
commercial and financial objectives can be managed through such


A Forward contract is an agreement between two parties- a buyer and a
seller- to purchase or sell something (say foreign currency) at a later date at a
price (say in terms of domestic currency) agreed upon today.

FX Value Forward
A foreign exchange contract where the settlement of currencies takes place
on any date beyond spot is called FX values Forward or value Outright. This
product is useful to obtain cover on future foreign currency receivables and

Time Option Forward Exchange Contract
Where the foreign currencies have to be settled during a specified period in
the future, the FX Contract is called a Time Option Forward Exchange
Contract. The start and end date for exercising the option (for settlement of
currencies) is always specified while entering into the contract. The product is
useful to cover forward receivables and payables where the exact date of
such transactions is not fixed or known.

A Future contract is evolved out of a forward contract and posses many of the
same characteristics. In essence, they are like liquid forward contracts. Unlike
forward contracts however, futures contracts trade on organized exchanges
called futures markets. The contract has standardized amount and is subject
to daily settlement procedure.

Currency Futures
A currency future is the price of a particular currency for settlement in a
specified future date. A currency future contract is an agreement to buy or
sell, on the future exchange, a standard quantity of foreign currency at a
future date at the agreed price. The counterpart to futures contracts is the
future exchange, which ensures that all contracts will be honored. This
effectively eliminates the credit risk to a very large extent.

Currency futures are traded on futures exchanges and the most popular
exchanges are the ones where the contracts are fungible or transferable
freely. The Singapore International Monetary Exchange (SIMEX) and the
International Monetary Market, Chicago (IMM) are the most popular futures
exchanges. There are smaller futures exchanges in London, Sydney, Tokyo,
Frankfurt, Paris, Brussels, Zurich, Milan, New York and Philadelphia.


Option is a contract wherein the buyer of the option has the right but no
obligation to buy or sell a specific quantity of a particular asset, at a specified
price at or before a specific date in the future. An option may increase,
decrease or remain unchanged in value depending on the price around which
the particular commodity is trading. Options may represent the right to buy or
sell commodities, equities, currencies or even futures on other securities. An
option on a future would allow the owner the right to buy or sell the future
agreement at specific price within a specific time frame i.e. a derivative on a

Options trade in organized markets, much like the stock market, However, a
large amount of option trading is conducted privately between two parties who
find that contracting with each other preferable to exchange. Options
Exchange as the counter party helps to minimize the counter party credit risk.
Adequate collateral is ensured by a market-adjusted margin.

Currency Options
Currency options is a contract wherein the buyer of the option has the right to
buy or sell a fixed amount of one currency versus another at a fixed rate on a
date in future but has no corresponding obligation. The rate, currencies,
amount and date are predetermined, at the time of entering contract.

Currency options are useful tools to limit losses and for unlimited access to
unlimited profit potential in volatile market. Writing currency options is a
profitable business in calm market. Option contracts are ideal while carrying
out ongoing transactions where outcome is uncertain. Option provides the
best tools to hedge balance-sheet translation exposures. Example 1 will show
hedging FX risk through option. Example 2 will show a comparison of a
Foreign Currency Forward / Future Hedge and Option Hedge.

Currency options and futures are among the oldest forms of options and
futures products. Traded currency options are divided into two types- options
on cash and options on futures. Cash Currency Option is the right to buy or

sell a fixed quantity of one currency in exchange for a specific quantity of
another currency in a ratio by a specific exchange rate at or before a specific
future date. Futures Currency Option is the right to buy or sell a traded
currency futures contract at a specific futures price at or before a specific date
in the future.

Using these products many banks make markets in more complicated foreign
exchange linked derivatives such as currency swaps and long dated swaps
and combinations of the above. Access to currency options and futures
ensures that borrowers have access to the lowest cost capital markets around
the world. Foreign exchange fluctuations affect the competitive positions of
companies, the cost of borrowing abroad and the returns on global investment
portfolios. Precise commercial and financial objectives can be managed
through products in foreign exchange markets.


In the late 1970's, the first currency swap was engineered to circumvent the
currency control imposed in the UK. A tax was levied on overseas

investments to discourage capital outflows. Therefore, a British company
could not transfer funds overseas in order to expand its foreign operations
without paying sizeable penalty. Moreover, this British company had to take
an additional currency risks arising from servicing a sterling debt with foreign
currency cash flows. To overcome such a predicament, back-to-back loans
were used to exchange debts in different currencies. For example, a British
company wanting to raise capital in the France would raise the capital in the
UK and exchange its obligations with a French company, which was in a
reciprocal position. Though this type of arrangement was providing relief from
existing protections, one could imagine, the task of locating companies with
matching needs was quite difficult in as much as the cost of such transactions
was high. In addition, back-to-back loans required drafting multiple loan
agreements to state respective loan obligations with clarity. However these
types of arrangements lead to development of more sophisticated swap
market of today.

A Swap is a contract between two parties, referred to as counter parties, to
exchange two streams of payments for agreed period of time. The payments,
commonly called legs or sides, are calculated based on the underlying
notional using applicable rates. Swaps contracts also include other provisional
specified by the counter parties. Swaps are not debt instrument to raise
capital, but a tool used for financial management. Swaps are arranged in
many different currencies and different periods of time. US$ swaps are most
common followed by Japanese yen, sterling and Deutsche marks. The length
of past swaps transacted has ranged from 2 to 25 years.

The problem of locating potential counter parties was solved through dealers
and brokers. A swap dealer takes on one side of the transaction as counter
party. Dealers work for investment, commercial or merchant banks. "By

positioning the swap", dealers earn bid-ask spread for the service. In other
words, the swap dealer earns the difference between the amount received
from a party and the amount paid to the other party. In an ideal situation, the
dealer would offset his risks by matching one step with another to streamline
his payments. If the dealer is a counter party paying fixed rate payments and
receiving floating rate payments, he would prefer to be a counter party
receiving fixed payments and paying floating rate payments in another swap.
A perfectly netted position as just described is not necessary. Dealers have
the flexibility to cover their exposure by matching multiple parties and by using
other tools such as futures to cover an exposed position until the book is

Swap brokers, unlike a dealer do not take on a swap position themselves but
simply locate counter parties with matching needs. Therefore, brokers are free
of any risks involved with the transactions. After the counter parties are
located, the brokers negotiate on behalf of the counter parties to keep the
anonymity of the parties involved. By doing so, if the swap transaction falls
through, counter parties are free of any risks associated with releasing their
financial information. Brokers receive commissions for their services.

Swap Market Participants

Since swaps are privately negotiated products, there is no restriction on who
can use the market. However, parties with low credit quality have difficulty
entering the market. This is due to fact that they cannot be matched with
counter parties who are willing to take on their risks. In the U.S. many parties
require their counter parties to have minimum assets of $10 million. This
requirement has become a standardized representation of           "eligible swap

The following list includes a sample of swaps market participants:

 Multinational companies
Shell, IBM, Honda, Uni lever, Procter & Gamble, Pepsi Co.

 Banks
Banks participate in the swap market either as an intermediary for two or
more parties or as counterparty for their own financial management.

 Sovereign and public sector institutions
Japan, Republic of Italy, Electricity de France, Sallie Mae (U.S. Student Loan
Marketing Association).

 Super Nationals
World Bank, European Investment Bank, Asian Development Bank.

 Money Managers
Insurance companies, Pension funds.

Foreign Exchange Swap
A basic foreign exchange swap is the simultaneous purchase and sale of one
currency for another, where the two contracts have different dates (different
positions of same or different amount on different dates) .

Cash-Management Swap
It is used to realize efficient cash management or to adjust the maturity dates
of existing forward contracts.

Handling Surplus and Deficit Cash Positions

The international scope of business conducted by financial and non-non
financial organization will often require the management of cash flows in more

than one currency. From time to time, an entity will find itself with surplus cash
balance in one currency and deficit balances in another currency.

Netting of Foreign Exchange Exposures

Organization will often face situations where there are offsetting foreign
currency inflows and outflows. The ideal situation in the most cases would
occur if the amounts were equal and cash flows materialized on the same
day. That seldom happens, however, and mismatches in timings and amounts
predominate. If the issue is timing, the problem is a cash management issue
similar to topic discussed above. The company may invest the temporary
surplus or borrow to fund the temporary deficit. Alternatively, it may do a cash-
management swap. If the problem is not just timing of cash flows, but also
different amounts of incoming and outgoing cash, then cash manager may
view the difference as one exposure and handle it using forward contracts,
currency options, or spot contracts.

Swapping Forward Contracts Forward at Historical Rates

Corporations often face considerable uncertainty in timing and/or amount
when forecasting currency cash flows. Forward contracts that were dealt to
hedge such flows may mature on a date that does not match the actual cash
flow. In such cases, the maturity of the original forward contract creates cash
flows for which there is no immediate offset.

Once again, the cash manager can borrow to fund the deficit, invest the
surplus, or execute a cash-management swap. Another method to deal with
this type of situation is to swap contracts at historical rates. This method
involves dealing a swap in which the spot sale is dealt at a rate equaling the
original forward contract rate. The new forward contract consists of the
maturing forward rate adjusted by the current points and a working capital
interest factor. Historical-rate rollovers have the same basic economic as
market-rate saps. They also eliminate the need for any cash settlements on
the original maturity date and avoid the accounting problems frequently

associated with the FX gain/loss account. On small forward contracts, the
actual dollar amount of the net settlement may be small, and cost of settling
may be excessive given the amount involved. In other cases, an entity may
not have the cash to settle on the swap but still want the swap done.

As a general comment, usage of historical-rate swaps varies from market to
market, but this type of swap is not a heavily traded transaction. One of the
major reasons is its susceptibility to abuse.

Investment Swaps

Investment swaps are investments in a foreign currency asset, which have no
foreign exchange risk. In most cases, the risk is eliminated by the execution of
a foreign exchange swap. The most common investment swap is not liquid,
although a semi liquid swap can be dealt. The appeal of the investment swap
to the investor is higher yield. Credit risk is usually comparable to other bank
paper. See example 5.

Negotiable Investment Swaps

The underlying foreign currency investment vehicle in most swaps is a bank
term deposit that is nonnegotiable. Because the underlying deposit is illiquid,
the swap is also illiquid. However, a swap could be done using a negotiable
investment such as treasure bills, banker’s acceptances, or commercial
paper. In this case the investment could be liquidated, although not as simple
as if underlying currency of investment is home currency. To liquidate the
swap, the investor would sell the negotiable investment of underlying foreign
currency and unwind the outstanding forward contract by doing a foreign
exchange swap.

Borrowing in Foreign Currencies

Borrowers in today’s markets have a variety of ways of raising money. Some
borrow in foreign currency because they have revenues in that currency which
was used to service debt. Others borrow in another currency because they
believe that the currency being borrowed will weaken, thereby reducing the
overall cost of borrowing. Other borrowers in foreign currencies have no
offsetting revenues and do not want to incur any foreign exchange risk. They
will fully hedge their foreign borrowings by means of a foreign exchange swap
transaction in much the same way investor’s hedge their foreign fixed income

Swaps Using Currency Options

In managing foreign currency exposure in foreign currency investment, three
principal alternatives are available:

1. The first alternative is simply to leave the exposure unhedged for the time
being. However, doing nothing has considerable risk, which may be beyond
the risk that the investor wants to assume.
2. A second alternative is to use forward contracts. Doing so, however will
might generate a return similar to investment made in home currency.
3. The third alternative is currency options.

Currency Swaps

Each entity has a different access and different long term needs in the
international markets. Companies receive more favorable credit ratings in
their country of domicile than in the country in which they need to raise
capital. Investors are likely to demand a lower return from a domestic
company, which they are more familiar with than from a foreign company. In
some cases a company may be unable to raise capital in a certain currency.

Currency swaps are also used to lower the risk of currency exposure or to
change returns on investment into another, more favorable currency.
Therefore, currency swaps are used to exchange assets or capital in one
currency for another for the purpose of financial management.
A currency swap transaction involves an exchange of a major currency
against the U.S. dollar. In order to swap two other non-U.S. currencies, a
dealer may need to arrange two separate swaps. Although, any currency can
be used in swaps, many counter parties are unable to exchange their
currencies due to a lack of demand. Since currency swap transaction involves
the exchange of two or more types of       currencies, the actual exchange of
principals takes place at the commencement and the termination of the swaps
in addition to exchange of interest payments on agreed intervals. The
exchange of principal and interest is necessary because counter parties may
need to utilize the respective exchanged currencies.

The uses of currency swaps are summarized below:
    Lowering funding cost
    Entering restricted capital markets
    Reducing currency risk
    Supply-demand imbalances in the markets

As for interest rate swaps, many variants of the plain vanilla currency swaps
were created to meet some of the common financial management needs.

    Amortizing currency swaps
The notional principals of these swaps are scheduled to decrease over the life
of the swaps. Therefore, principals are exchanged accordingly.

    Accreting currency swaps
The notional principals of these swaps increase periodically. Principals are
exchanged as scheduled.

    Floating- for -floating rate currency swaps
As indicated by the name, this swap involves the exchange of a floating
interest rate payment schedule in one currency against another floating
interest rate payment schedule in another currency.

Swap Documentation
Swap agreements are usually initiated over the phone. The phone
agreements are confirmed, usually within 24 hrs., by a telex, fax or letter. The

agreement is not final until proper documentation covering all the relative
issues are exchanged and signed by counter parties.

New York based International Swap and Derivatives Association (ISDA),
British Banker’s Association (BBA) and Australian Banker’s Association
standardized the documentation of swap. BBA's code BBAs Interest Rate
Swap (BBAIRS) focuses primarily on the documentation of inter bank swaps
and the Australian Banker's Association's code focuses on documenting
Australian interest rates swaps.

In, 1987, ISDA introduced two standards forms of agreements. The Interest
Rate Swap Agreement is an agreement for US dollar denominated swaps.
This master swap agreement is based on the 1986 Revised Version of the
Code of Standard Wording, Assumptions and Provisions for Swaps. The other
master swap agreement is called the Interest Rate and Currency Exchange
Agreements. This agreement is used for currency swap and interest rate
swaps in any currency. Any new swap is a supplement to these masters’
swaps agreements.

The standardization of swap agreements eliminated many impediments to the
swap market. The decrease in the number of hours spent on drafting
agreements lowered legal expenses as well as expedited the transaction
process. The standardization allowed dealers to match potential counter
parties with more ease and allowed existing counter parties to reverse swaps
with fewer complications.

The documentation covers the following issues:
           Payments
           Representations
           Agreements

           Events of Default and Termination Event
           Transfer
           Tax matter
           Credit Support Documentation
           Exiting Swap Agreement

Following are risks associated with swaps:
           Interest rate risk
           Exchange rate risk
           Default risk
           Sovereign risk
           Mismatch risk (for dealers only)

In 1987, a set of principal were arranged by the central banking authorities of
the Group of Ten plus Luxembourg known as the Basle Supervisor's
Committee to standardize capital requirements across nations. According to
this set of requirements, called the Basle Accord, dealers of swaps and other
off-balance sheet instruments are imposed risk-adjusted capital requirements.

Examples from Indian Market

1) SBI-HUDCO enter into yen swap deal

 STATE Bank of India has entered into a long-term rupee- Japanese yen
swap with Housing and Urban Development Corporation (HUDCO).

According to a press release, HUDCO has swapped its foreign currency
liability of ¥ 2.89 billions for equivalent rupee resources with SBI for a tenor of
10 years. Under the arrangement, HUDCO will deposit its yen with SBI on the
day of transaction and SBI in return will pay the equivalent rupee resources to

According to officials, the swap will be done at the prevailing exchange rate
on the day of the transaction. According to officials, HUDCO will use the
rupee resources for lending to their projects in India. The overseas branches
of SBI in Japan to fund their own assets will use yen. As per the swap
agreement, SBI would provide the long-term hedge to HUDCO for a period of
10 years to cover the exchange risk of the foreign liability.

As a result of this, the swap will neutralize both the exchange rate risk and
interest rate risk of HUDCO on yen loan by converting the yen flows into risk
neutral fixed interest rate rupee flows for the company. At the end of 10 years,
HUDCO will take back the yen by giving the rupee equivalent to SBI.

Earlier SBI had struck a rupee-dollar swap of sizable transaction with ICICI. At
present, the bank is considering similar deals with companies, which do not
have international presence to manage the foreign currency risk effectively,
said an official.

The bank is actively involved in developing the derivative market in India by
facilitating the use of hedging instruments such as currency swaps. This has
been possible after the permission was granted by the Reserve Bank of India
to enable the corporate to obtain suitable hedge for their exposures arising
out of their foreign currency loans.

2) Nalco contains loss on yen loan via swap deal

National Aluminum Co (Nalco) has hedged its ¥ 20-billion loan by swapping
50 per cent of the principal into US dollars when the yen was at 144.15
against the dollar.

Last week the yen tumbled to 147 to a dollar. The yen bullet loan is due for
redemption on September 1998. By covering its exposure, Nalco has
insulated itself against possible foreign exchange fluctuations.

The benefits arising from sharp depreciation of the yen against the US dollar
was   partially   nullified   by   the   simultaneous   depreciation   of   rupee.
``Depreciation of ¥ 1 to Rs 1.30 to neutralizes the effect on the loan,
In other words, there will be no impact on the bottom line of Nalco as far as
the fluctuation is within this range mentioned above.

Further, Nalco has parked about ¥ 10 billion and $16 million in the exchange
earners foreign currency (EEFC) account abroad. The EEFC corpus would
more than mitigate the Forex risk and its impact on the loan.

An Attempt………..
To understand the nature of currency risk, how it is measured and the
implications for the business and to examine a broad policy towards currency
risk management and in particular whether a business should seek to limit or
hedge its exposure.










  1) Inter Finance – By Apte

  2) Tresury & Forex Management – ICFAI

  3) FEDAI – Newsletter


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