RISK MANAGEMENT IN FOREIGN EXCHANGE

Under the guidance of Prof. SN Ghosh

PREPARED BY Rollno. Name Rishab goel 36 Pradipna lodh Ranu Parmar Chetan Parmar Nishant Singh Section SF-4 Group No. Signature

IIPM IIPM TOWER,SATBARI, CHANDANHAULA,CHATTARPUR-BHATIMINESROAD NEW DELHI

RISK MANAGEMENT IN FOREIGN EXCHANGE

What Does Risk Management Mean? The process of identification, analysis and either acceptance or mitigation of uncertainty in investment decision-making. Essentially, risk management occurs anytime an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment and then takes the appropriate action (or inaction) given their investment objectives and risk tolerance. Inadequate risk management can result in severe consequences for companies as well as individuals. For example, the recession that began in 2008 was largely caused by the loose credit risk management of financial firms.In order to promote orderly development and maintainence of foreign exchange market in India,provisions for derivative has been made in Foreign Exchange Management Reserve Bank of India has issued a circular on Risk Management And Inter-Bank dealings.It covers aspects of forward contracts,hedging of commodities,hedging of capital etc.It also covers inter-bank foreign exchange dealings. What is foreign currency trading? Forex (Foreign Exchange) is the name given to "direct access" foreign currency trading. With an average daily volume of $1.4 trillion, foreign currency trading is 46 times larger than all the futures markets combined and, for that reason, is the world's most liquid market. In the past, foreign currency trading was limited largely to enormous money center banks and other institutional traders. But in just the past few years, technological innovations and the development of online trading platforms, such as that used by T & K Futures, allow small traders to take advantage of the significant benefits foreign currency trading a.k.a. Foreign Exchange, Forex and FX trading.

Cash delivery-Cash delivery means delivery of foreign exchange on the day of transaction Spot delivery-It is a rate which is available by default and is applicable for an execution of a transaction day after tomorrow.This is called as T+2,which means to close the deal today and to execute it after 2 days. Top delivery-Top delivery means delivery of foreign exchange on a working day next to the day of transaction.
Signature of group members

(Mr.Rishab Goel) (Mr.Pradipna lodh) (Mr.Ranu Parmar) (Mr.Yogendar singh ) (Mr.Chetan Parmar) (Mr.Nishant)

Dervative As per Section 2(aa) of Securities Contracts(Regulation)Act,derivativeincludes a security derived from a debt instrument,share loan,wheather secured or unsecured,risk instrument or contract for differences or any other form of security.A contract which derives its value from the prices,or index of prices,of underlying securities.Derivative means an instrument to be settled at a future date,whose value is derived from change in interest rate,foreign exchange rate,credit rating or credit index,price of securities or a combination of more than one of them and includes interest rates swaps,foreign currency options,foreign-currency rupee options or such other instruments as may be specified by the Reserve Bank Of India from time to time.Broadly speaking,Derivative is based on price of some underlying asset.Eg:Stock Exchage index.

Forward Contract Forward contract means a transaction involving delivery,other than cash or top or spot delivery of foreign exchange Foreign exchange derivative contract Foreign exchange derivative contract means a financial transaction or am arrangement in whatever form and by whatever name called ,whose value is derived from price movement in one or more underlying assets.It incudes(a)a atransaction which involves atleast one foreign currency other than currency of Nepal or Bhutan,or(b)a transaction which involves at least one interest rate applicable to a foreign currency not being a currency of Nepal or Bhutan,or(c) a forward contract rate.However it doesnot include foreign exchange transaction for Cash or Top or Spot deliveries. FOREIGN EXCHANGE DERIVATIVES CONTRACTS WHICH A PERSON RESIDENT IN INDIA CAN ENTER INTO Foreign exchange derivatives contracts permissible to person resident in India are specified in schedule 1 to Foreign Exchange Management.The contracts should be with authorized dealer in India and can be (a)forward contract or (b)interest rate swap or currency swap or coupon swap or foreign currency option or forward rate agreement(FRA).A person resident in India can enter into a foreign exchange derivative contract not involving rupee as one of the currencies,

Signature of group members

(Mr.Rishab Goel) (Mr.Pradipna lodh) (Mr.Ranu Parmar) (Mr.Yogendar singh ) (Mr.Chetan Parmar) (Mr.Nishant)

in accordance with provisions to hedge an exposure to risk in respect of a transaction permissible under the FEMA.He can enter into foreign currency-rupee option contract with an authorized dealer to hedge exposure to exchange risk where sale or purchase of foreign currency is permitted. Forward Contract to cover exchange risk-A person resident In India can enter into forward contract to hedge an economic exposure to exchange risk. Booking and cancellation of forward contracts-All forward contracts booked by residents for hedging current account transaction can be canceleld and re-booked freely irrespective of its tenorReporting to RBI is required. Foreign currency rupee options-Foreign currency rupee options are permitted to residents and non-residents. FOREIGN EXCHANGE DERIVATIVES CONTRACTS WHICH A PERSON RESIDENT OUTSIDE INDIA CAN ENTER INTO Foreign Exchange derivatives contracts permissible to person resident outside India are specified in schedule 2 to Foreign Exchange Management.A person resident outside India may enter into a foreign exchange derivative contract with a person resident in India to hedge an exposure to risk in respect of a transaction permissible under FEMA.Reseve Bank may permit a person resident in India to enter into a contract in a commodity exchange or market outside India to hedge price risk in a commodity.A person resident outside India can enter into forward sale contract to hedge currency risk arising out of his proposed foreign direct investment in India.He can also hedge currency risk on the dividend receivable by him from Indian company.Person resident outside India having FDI in India can enter into forward contract with rupee as one of the currencies to hedge currency risk on dividend receivable by them on their investment in India.Forward cover can be taken after dividend is approved by Board of Indian Company.FII,or person resident outside India can enter into a foreign currency-rupee option contract with an authorized dealer in India,under same terms and conditions applicable to forward contracts.A NRI can enter into cross currency forward contracts to convert the balances held in FCNR(B) accounts in one foreign currency to another foreign currency in which FCNR(B) deposits are permitted to be maintained.
Signature of group members

(Mr.Rishab Goel) (Mr.Pradipna lodh) (Mr.Ranu Parmar) (Mr.Yogendar singh ) (Mr.Chetan Parmar) (Mr.Nishant)

Procedure for application for approval for hedging of commodity price risk 1. A person resident in India , engaged in export-import trade ,who seeks to hedge price risk in respect of any commodity including Gold, but excluding oil and petroleum products, may submit an application to the International Banking Division of an authorised dealer giving the following details. i) A brief description of the hedging strategy proposed ; namely : a) description of business activity and nature of risk; b) instruments proposed to be used for hedging ; c) names of commodity exchange and brokers through whom the risk is proposed to be hedged and credit lines proposed to be availed. The name and address of the regulatory authority in the country concerned may also be given ; d) size/average tenure of exposure and/or total turnover in a year , together with expected peak positions thereof and the basis of calculation. ii) copy of the Risk Management Policy approved by the Management covering: a) risk identification, b) risk measurements, c) guidelines and procedures to be followed with respect to revaluation and/or monitoring of positions, d) names and designations of the officials authorised to undertake transactions and limits. iii) Any other relevant information. 2. Authorised dealer after ensuring that the application is supported by documents indicated in paragraph 1, may forward the application with its recommendations to Reserve Bank for consideration. Settlement risk in foreign exchange transactions Financial liberalisation, expanded cross-border capital flows and major advances in trading technology have led to dramatic changes and growth in foreign exchange trading in the last twenty years. While banks have upgraded their operational capacity to settle these trades over time, current settlement practices generally expose each trading bank to the risk that it could pay over the funds it owes on a trade, but not receive the funds it is due to receive from its counterparty. Given the estimated US$ 1 1/4 trillion of foreign exchange trades arranged daily, the resulting large exposures raise significant concerns for individual banks and the international financial system as a whole. Although the probability of a major disruption in the foreign exchange settlement process is low, its potential consequences in a market of this size and complexity are considerable.

Signature of group members

(Mr.Rishab Goel) (Mr.Pradipna lodh) (Mr.Ranu Parmar) (Mr.Yogendar singh ) (Mr.Chetan Parmar) (Mr.Nishant)

The report, which was prepared on behalf of the Committee on Payment and Settlement Systems by its Steering Group on Settlement Risk in Foreign Exchange Transactions, offers a practical approach to dealing with this risk. The report analyses existing arrangements for settling foreign exchange trades and makes recommendations grounded in market realities. It calls upon individual banks and industry groups alike to improve current practices and devise safe mechanisms for addressing settlement risk. For their part, central banks have identified several avenues for cooperating with the private sector and for providing inducements to push this effort forward. I believe the report makes a compelling case that the private sector can, with a relatively modest expenditure of resources, make important progress in containing settlement risk. Banking services for central banks The BIS offers a wide range of financial services specifically designed to assist central banks and other official monetary institutions in the management of their foreign exchange reserves. Some 140 customers, including various international financial institutions, currently make use of these services and on average, over the last few years, some 4% of global foreign exchange reserves have been invested by central banks with the BIS. BIS financial services are provided out of two linked trading rooms: one at its Basel head office and one at its office in Hong Kong SAR. The Bank continually adapts its product range in order to respond more effectively to the evolving needs of central banks. Besides standard services such as sight/notice accounts and fixed-term deposits, the Bank has developed a range of more sophisticated financial products which central banks can actively trade with the BIS to increase the return on their foreign assets. The Bank also transacts foreign exchange and gold on behalf of its customers.In addition, the BIS offers a range of asset management services in sovereign securities or high-grade assets. These may be either a specific portfolio mandate negotiated between the BIS and a central bank or an open-end fund structure - the BIS Investment Pool (BISIP) - allowing customers to invest in a common pool of assets. The two Asian Bond Funds (ABF1 and ABF2) are administered by the BIS under the BISIP umbrella: ABF1 is managed by the BIS and ABF2 by a group of external fund managers.The BIS extends short-term credits to central banks, usually on a collateralised basis. From time to time, the BIS also coordinates emergency short-term lending to countries in financial crisis. In these circumstances, the BIS advances funds on behalf of, and with the backing and guarantee of, a group of supporting central banks.The Bank's Statutes do not allow the Bank to open current accounts in the name of, or make advances to, governments. The BIS does not accept deposits from, or generally provide financial services to, private individuals or corporate entities.
Signature of group members

(Mr.Rishab Goel) (Mr.Pradipna lodh) (Mr.Ranu Parmar) (Mr.Yogendar singh ) (Mr.Chetan Parmar) (Mr.Nishant)

Products and services The BIS has developed a range of banking services specifically designed to assist central banks, monetary authorities and international financial institutions in the management of their foreign exchange and gold reserves. Central bank customers have traditionally looked for security, liquidity and return as the three basic features of their placements at the BIS. To provide security, the Bank has built up a sizeable equity capital and ample reserves. It pursues an investment strategy focused on combining diversification benefits with intensive credit and market risk analysis. To ensure liquidity, the Bank stands ready to repurchase its tradable instruments at little cost to its customers and thus respond quickly and flexibly to their needs. The BIS offers an attractive and competitive return on the funds deposited by central banks and international organisations.

BIS money market instruments

Sight/notice accounts and fixed and floating-rate deposits in most convertible currencies Fixed-term deposits can also be denominated in and index-linked to a basket of currencies such as the SDR Standard and non-standard amounts and maturities BIS tradable instruments Issued in major currencies Available in two forms: Fixed Rate Investments at the BIS (FIXBIS) for any maturities between 1 week and 1 year and Medium-Term Instruments (MTIs) for quarterly maturities from 1 year and up to 10 years MTIs available also with an embedded call feature (Callable MTIs) Foreign exchange and gold services Services offered are: spot deals, swaps, outright forwards, options, FX-linked deposits foreign exchange overnight orders safekeeping and settlements facilities available loco London, Berne or New York purchases and sales of gold: spot, outright, swap or options
Signature of group members

(Mr.Rishab Goel) (Mr.Pradipna lodh) (Mr.Ranu Parmar) (Mr.Yogendar singh ) (Mr.Chetan Parmar)

Asset management services

Fixed income portfolios are: invested in government bonds or high-grade credit securities structured as dedicated portfolio mandates or BIS Investment Pool (open-end funds) offered as either single currency or multi-currency mandates in the major world reserve currencies

Other services Short-term advances to central banks, usually on a collateralised basis Trustee for a number of international government loans Collateral agent functions This information does not constitute an offer by the BIS, nor shall any of the information contained herein be binding upon the BIS. A foreign exchange hedge (FOREX hedge) is a method used by companies to eliminate or hedge foreign exchange risk resulting from transactions in foreign currencies (see Foreign exchange derivative). This is done using either the cash flow or the fair value method. The accounting rules for this are addressed by both the International Financial Reporting Standards (IFRS) and by the US Generally Accepted Accounting Principles (US GAAP). A hedge is a type of derivative, or a financial instrument, that derives its value from an underlying asset. This concept is important and will be discussed later. Hedging is a way for a company to minimize or eliminate foreign exchange risk. Two common hedges are forwards and options. A Forward contract will lock in an exchange rate at which the transaction will occur in the future. An option sets a rate at which the company may choose to exchange currencies. If the current exchange rate is more favorable, then the company will not exercise this option. Corporate Hedging for Foreign Exchange Risk in India 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 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.
Signature of group members

(Mr.Rishab Goel) (Mr.Pradipna lodh) (Mr.Ranu Parmar) (Mr.Yogendar singh ) (Mr.Chetan Parmar) (Mr.Nishant)

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.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). 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.
Signature of group members

(Mr.Rishab Goel) (Mr.Pradipna lodh) (Mr.Ranu Parmar) (Mr.Yogendar singh ) (Mr.Chetan Parmar) (Mr.Nishant)

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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.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, 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. 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.
Signature of group members

(Mr.Rishab Goel) (Mr.Pradipna lodh) (Mr.Ranu Parmar) (Mr.Yogendar singh ) (Mr.Chetan Parmar) (Mr.Nishant)

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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 problems 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 limits for handling foreign exchange exposure. The firm also has to decide whether to manage its 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.
Signature of group members

(Mr.Rishab Goel) (Mr.Pradipna lodh) (Mr.Ranu Parmar) (Mr.Yogendar singh ) (Mr.Chetan Parmar) (Mr.Nishant)

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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 FX Forward Hedges The most direct method of hedging FX risk is a forward contract, which enables the exporter to sell a set amount of foreign currency at a pre-agreed exchange rate with a delivery date from three days to one year into the future. For example, suppose U.S. goods are sold to a Japanese company for 125 million yen on 30-day terms and that the forward rate for 30-day yen is 125 yen to the dollar.
Signature of group members

(Mr.Rishab Goel) (Mr.Pradipna lodh) (Mr.Ranu Parmar) (Mr.Yogendar singh ) (Mr.Chetan Parmar) (Mr.Nishant)

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FX Options Hedges If there is serious doubt about whether a foreign currency sale will actually be completed and collected by any particular date, an FX option may be worth considering. Under an FX option, the exporter or the option holder acquires the right, but not the obligation, to deliver an agreed amount of foreign currency to the lender in exchange for dollars at a specified rate on or before the expiration date of the option. As opposed to a forward contract, an FX option has an explicit fee, which is similar to a premium paid for an insurance policy. If the value of the foreign currency goes down, the exporter is protected from loss. On the other hand, if the value of the foreign currency goes up significantly, the exporter can sell the option back to the lender or simply let it expire by selling the foreign currency on the spot market for more dollars than originally expected, but the fee would be forfeited. While FX options hedges provide a high degree of flexibility, they can be significantly more costly than FX forward hedges.

Foreign currency and exchange risks

Opening foreign currency accounts Although the UK isn't in the eurozone, you can open a euro account here - which could be useful if you conduct a lot of business with European customers. Accounts in other foreign currencies are also available. Foreign currency accounts can be a good option for importers and exporters as they allow you to 'net' receivables and payables in the same currency. These accounts allow the receipt of inward payments, cheques/cash and also allow the issue of international money transfers and drafts. They are offered by most of the UK clearing banks. If we open an account in the currency in which you make the bulk of our transactions you can hedge against exchange rate changes by keeping money in the account until the rate is beneficial to us. This solution suits businesses with:

a large number of dealings in a particular currency a strong cashflow - which means they're unlikely to require immediate access to funds a need to hold currency for future payments

Signature of group members

(Mr.Rishab Goel) (Mr.Pradipna lodh) (Mr.Ranu Parmar) (Mr.Yogendar singh ) (Mr.Chetan Parmar) (Mr.Nishant)

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Advantages

Ease of access. Potential interest earned on your deposits. The ability to discuss transactions in English with your own bank. Avoiding the unnecessary cost of exchanging currency.

Disadvantages There may be charges for setting up and running the account. You should check the charges carefully.

If you need to convert funds in your foreign currency account into sterling for UK use, for example in order to ease cashflow, you will face a loss if the pound is strong against that currency. You may also have to wait a long time for the exchange rate to move in your favour - and it may never do so.

Opening an account with a bank overseas A common alternative to opening a foreign currency account operated by a UK bank is to open a bank account in the country with which we're trading. This option suits businesses that make or receive lots of payments - especially small payments in a foreign currency. However, each national banking system is different so it is important to carefully check the banking rules in your chosen country as well as the terms, conditions and services being offered to ensure it is the best option for our business. Advantages

Because our money will be held in the local currency you can wait for the exchange rate to become more favourable before converting it - as long as we don't need the funds immediately. A bank in the country with which we're trading will also be fully conversant with the rules and regulations regarding transactions in that country, and our customers might prefer to deal with a bank in their own country and in their own language.

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Disadvantages

We may be required to formally register your business in the country in which we wish to open a bank account. We may also be required to deposit a proportion of your capital into that bank account. Banking rules are not harmonised so each country's banking system operates under different conditions. As with UK banks, a bank's terms and conditions can also vary according to the type of account opened. We should check that the bank and account offer the services we require and that you understand the terms, conditions and charges. We may experience communication difficulties that can't be remedied face to face - which wouldn't be the case with a foreign currency account in the UK. Depending on the country in question, there may be complex rules governing who is entitled to open and operate a bank account. Procedures to stop money laundering may mean that setting up such an account is a longwinded process requiring many stages of legal and administrative clearance. For example, we may be asked to provide references and clear credit checks before we can open an account. Overseas banks may not offer the same level of redress and protection as UK banks. For example, the cheque guarantee system does not exist in many European countries.

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