A Project Report On

Undertaken at

VADILAL ENTERPRISES LTD.

In partial fulfillment of Summer Training (1st year MBA)

Submitted to AES PG Institute of Business Management Gujarat University Ahmedabad

Submitted by Urvija Shah (48)

PREFACE
In every field of education imparted to the student, working on project plays an immense role in bringing out and exhibiting the qualities which are helpful in implementing students knowledge in the practical life.

When it comes to the practical knowledge in Financial field, there are number of areas to be specialized in. one can go for core finance like working capital management, Investment decisions, capital structure decisions, credit policies etc, and one can look forward to equity and forex markets as well. Both are important part of the Finance.

But amongst all these fields tremendous opportunities are residing in the Foreign Exchange field. As in India, the FOREX system is main fundamental thing for any kind of International business.

Getting the deep and practical knowledge of this field can be of great help to the students who are interested in finance. This kind of training and projects can help the students to use their theoretical knowledge on the practical aspects of the field.

July 20, 2006 Ahmedabad

Urvija Shah

ACKNOWLEDGEMENT
Study of business management is all about gaining knowledge from the experience one gets from the corporate world. When students get into the corporate world to gain the knowledge, he is a novice. They need and opportunity and of-course help of his/her senior to explore the aspects of business management.

I was given this opportunity by one of the best Foreign Exchange Exposure management companies: VADILAL Enterprises Ltd. I am obliged to VADILAL Enterprises Ltd. for providing me an opportunity to undergo training in their esteemed organization.

I wish to express my heartfelt gratitude to Mr. ASPY Bharucha, President, and Mr. Victor Saldanha, Consultant Advisor, FOREX, VADILAL Enterprises Ltd for their immense help in making my training and project fruitful. I would also like to thank all the employees of FOREX division for their needed help.

I also thank Dr. Mayank Joshipura for his kind help in the subject and I am thankful to all other faculty members at AES PGIBM for their kind support.

Finally, not to miss anyone, I thank all the people who have directly or indirectly helped me a lot throughout the training period and in completion of my project successfully.

Urvija shah______________

EXECUTIVE SUMMARY
The main plot for my project was to study Indian Foreign Exchange market. To find out the risk involved in the Foreign Exchange market and to learn about the tools for managing FOREX tools.

Chapter 1 contains some basic information on the Foreign Exchange. i.e. what exactly Foreign Exchange and what does it include as well as provide.

Chapter 2 contains information about FOREX markets (Indian as well as global) and its general workings (how it operates) and participants of the market. Getting this knowledge can help in detailed information in the next chapters. It also contains basic information of modified Liberalized Exchange Rate Management System

Chapter 3 is built around the FOREX Market rates. The initial part is packed with the direct rate and indirect rate and how they are defined, then the cross rate and the methods for calculating the same. Finally, the forward rate, importance of the same for the importer and exporter and its calculations.

FOREX market is not a market where anyone who has money can come and participate; it has its own guidelines. In chapter 4 these guidelines which are necessary for FOREX market and which has been given by RBI are covered. Also the guidelines given by FEDAI are included.

Every business opportunity is combined with the risk. Chapter 5 gives us the basic knowledge about all kind of risk which has been involved in the FOREX market activities.

Now once we find out the risk in market, it is very much necessary to know, to understand or say to learn how to manage that risk; so chapter 6 contains detail about Risk Management procedure and tools/products in FOREX markets.

RESEARCH METHODOLOGY
Objective: Main objective: To study Foreign Exchange markets To learn FOREX Risk management Sub objectives: Finding out risk involved in foreign exchange transaction of an organization. Finding out various tools and techniques for managing foreign exchange risk. Develop appropriate strategy for effective management of foreign exchange risk. To evaluate the effect of the advices or study outcomes in real time application in Vadilals client industry. Scope: The project looks into the actual workings of VADILAL Enterprises Ltd. In this Forex System study I tried to cover every objective of the project, mentioned above and various aspects of the Forex Risk Management. Scope of my project study is restricted to managing Transaction Exposure part of Forex risk by using most effective hedging tools. Data collection: Primary data collected from Vadilal Enterprises Ltd. regarding their processes and secondary data from relevant literature along with the websites are the main sources of information. The primary information is collected through discussions with the personnel of Vadilal Enterprises Ltd. and from the documents provided by them.

Limitations: Time constraints Resource constraints Confidentiality of business operations Restricted study of a particular type of industry engaged in manufacturing and exports Industrial Application:

With extinction of geographical boundaries and increase in foreign trade each and every firm is facing more foreign exchange exposure and thus foreign exchange risk they have ever faced. Though there are many tools available for managing foreign exchange exposure nothing comes without cost. So a business house has to find out a proper mix of hedging tools which offers them maximum risk cover at minimum cost and maximum flexibility. I have tried to make a humble attempt to handle this one of the most important issue of foreign exchange risk management. To fulfill my objective I have conducted a study of foreign exchange risk management at Harsha Engineering Ltd

TABLE OF CONTENTS
Introduction to VADILAL Enterprises Limited 1. Introduction 1.1 1.2 1.3 2. What is Foreign Exchange? What does FX involve? What does FX provide? 1 2 2 3 4 6 8

Foreign Exchange market 2.1 2.2 2.3 Market participants Indian FX market Modified LERMS

3.

Exchange Rates 3.1 Type of rates and its working 3.1.1 Direct rate 3.1.2 Indirect rate 3.1.3 Cross rate 3.1.4 Forward rate Factors affecting exchange rates 9 10 10 11 13 21

3.2

4.

Guidelines 4.1 4.2 RBI FEDAI 25 27 28 30 34 54 55 57

5. 6. 7. 8.

Export Finance Types of risk involved in FX market Tools of Risk management Development of appropriate strategy for Risk Management 8.1 8.2 Strategy development Field Report at Harsha Engineers Ltd.

Annexure: Reports provided by Vadilal Enterprises Limited Bibliography Glossary

INTRODUCTION TO VADILAL ENTERPRISES LIMITED

VADILAL ENTERPRISES LIMITED www.vadilalmarkets.com FOREX ADVISORY & FFMC DIVISION VADILAL FOREX & FFMC Division provides customers who are engaged in Export / Import and trading in commodities a personal link with markets.

With the opening up of the Indian economy and financial markets several changes have hit the market in recent past. Our country is now counted among the developed countries in matters of current account transactions scenario, treasury and financial markets, international trade and commerce activities. Volatility world FOREX markets has increased

manifold. Foreign exchange valuation of the country depends upon several factors in that fluctuation in exchange rate is now linked with Currency Risk.

Foreign Exchange Management, Commodity Market Advisory, is gaining importance now a days on account of its complexity, as also requires expert comments, advise, guidance, and also utmost importance in view of the fact that the whole of FOREX and Commodity markets becoming very closely integrated. Treasury Management concept has been accepted by large organizations. Forex Advisory as a tool is also accepted widely by Exporters, Importers and Commodity Traders, because of timely and appropriate advice in relation to movements of the currency, commodity and money markets.

VADILALFOREX offers different area of services to suit most Exporters and Importers, those engaged in trading / imports of Metals [Base and Minor] and Precious Metals Gold / Silver. The FOREX Division offers the area of service in relation to: FOREX Advisory and FOREX EXPOSURE MANAGEMENT to Importers and Exporters. A thorough service connected with Banking, ECD-RBI, FEDAI rules and guidelines, etc. LME-METAL Advisory service of most base metal quotes at LME, COMEX, NYMEX, Shanghai, markets, and complete guide and informative service on forward, futures and relative data. BULLION Informative service of Gold, Silver, and Precious metals on International trading, quotes, rates, forwards, futures, etc., on various international markets, inclusive of COMEX/NYMEX; Vadilals business motto TO UPDATE YOUR NEEDS AND REQUIREMENTS & BRING GLOBAL MAREKT CLOSER TO YOU

PERSONNEL: A team of experienced, competent, qualified and, professional staff consisting of ex-bankers with Treasury Management experience both in India and abroad, Analysts, qualified Chartered Financial Analysts (CFA), MBAs; Post Graduates, etc. The Team is totally dedicated and committed to provide exclusive guidance and advice to all its customers in relation to the area of activities listed above.

INFRASTRUCTURE: TELERATE Money line service.

FOREX ADVISORY AND EXPOSURE MANAGEMENT service segments Access to website vadilalmarkets.com on a continuous process of up-gradation of quotes of crosses, Indian Rupees, news, comments, etc. FOREX (daily four reports)* at different time zones to carry all related information on INRupee, Cross currencies, forward positions and relative information on Money and Stock Markets. All 4 reports are provided on e-mail, and on web-site, and also includes important one at 10.30 morning on fax to attract direct attention; Weekly, Monthly reports; [conversion rates, bank reference rates, Customs rates, FEDAI rates, etc.,* Periodic Forex up-dates, EXIM up-dates, etc. Exposure Management (on confirmed arrangement) taken well care of exposure by experienced staff having banking knowledge and expertise; Arrangement on Import Bill discounting, for exports - Forfeiting and Factoring, and ECB arrangement at the concessional service cost. * All the reports are attached as annexure ADDITIONAL SERVICE:

On-line service (real time value information) to ascertain level of the currencies, forward differences, etc., between 9.30 am till closing of NY markets.

Response to any query on FOREX related matter linked with Banking, RBI, FEDAI rules, etc., In-house session on FOREX and Risk Management in relation to banking, RBI and FEDAI directives and EXIM related matters, Workshops Seminars on periodic basis on Foreign Exchange and Risk Management and EXIM related matters.

FFMC = FULL FLEDGED MONEY CHANGER

RBI authorized FFMC agent to release

foreign

exchange

entitlements; in relation to Business Travels, and BTQ : Basic Travel Quota (general permission) Authorized to sell financial products of AMEXCO American Express Banking Travel Related Service.

SERVICE OFFERED with Value Added, High-Tech Sophistication, and personalized

professionalism

What is Foreign Exchange?

Countries of the world have been exchanging goods & services amongst themselves from time immemorial. The world has come a long way from the days of barter trade. With the inventions of money, the rigors & problems of barter trade have disappeared. Barter trade has made way to exchange of goods & services for money instead of exchange for other goods & services.

As every sovereign nation has a distinct national currency, international trade has involved exchange of currencies. It is said that although the business of changing money is as old as money itself, the foreign exchange markets where currencies of different countries are exchanged, started taking shape only in late nineteenth century. The exchange of currencies has brought about the concept of exchange rates.

Like any other commodity, the price of one unit of foreign currency can be stated in terms of domestic currency; in fact a unit of one currency can be stated in terms of any other currency. Rate of exchange means the price of one currency in terms of other currency. To state differently, the exchange rate is said to be the rate at which a number of units of one currency can be exchanged for a number of units of another currency. Simply defined, exchange rate is nothing but value of one currency expressed in terms of another currency. For example, the price of US Dollar (USD) of Japanese Yen (JPY) or Pound Sterling (GBP) can be expressed in terms of Indian Rupees (INR). Thus, if we say USD 1 = INR 47.00. It means the exchange of US Dollar & Indian Rupees is 1:47.00. Similarly, GBP 1= INR 77 meaning that the exchange rate of Sterling Pounds & Indian Rupee is 1:77.

Different countries have adopted different exchange rate system at different times.

What Does FX Involve? A foreign exchange deal involves: Exchange of two currencies As an agreed exchange rate For a specified settlement date Settlement instructions for receipt and payment, and Confidence that the terms of the trade will be adhered to i.e. limits What Does FX provide? Foreign exchange provides us: The method or mechanism to conduct and settle the proceeds of international trade The means to obtain / provide technology, expertise and the sharing of information The means to minimize the risks of currency fluctuations primarily through the use of various tools and financial instruments, and Trading opportunities to generate incremental income.

For any currency the main foreign exchange market is the country's financial centre - viz. for genuine, trade related corporate business. This is the centre where the country's central bankers and monetary authorities determine and implement their monetary policies, its investment strategies and above all its intervention polices to ensure stability in its currency markets. This is the centre where the country's business leaders transact their trade related financial deals and where the rest of the world comes to as a last resort to cover its requirements. However, for major world currencies, the world is a 24 hour market that stretches from Wellington to Los Angeles. In this global marketplace there are certain major trading centers called "money centers" and these are Tokyo, Hong Kong, Singapore, Bahrain, London, Frankfurt, Zurich, New York and Los Angeles. The FX Market is a facilitating mechanism through which currencies are exchanged. It comprises FX traders connected across the world through an advanced telecommunication network

MARKET PARTICIPANTS (I) Corporate Customers Institutional and Individual Customers, Exporters, Importers, Foreign Currency Borrowers and Lenders, Investors and Fund Managers all form corporate customers. These players can be major participants in markets where there are exchange controls and restricted currency trading. (II) Banks Banks are the most active market participants. They essentially perform the task of market makers. With their ability to take on foreign exchange positions, they can quote prices for their own account. They have the communication network, branches, support from exchange brokers, access to overseas markets and limits with overseas banks which enable them to be market makers. In India, RBI license to engage in FX transactions is required and those that are granted this license are called Authorized Dealers. The authorized dealers collectively constitute the Interbank Foreign Exchange (FOREX) market in India. (III) Central Banks Central Banks world-wide are entrusted the responsibility of determining and monitoring the external value of the currency of the country. The main role of the Central Bankers is to avoid volatility, instability and wild fluctuations in the FX markets. To this end, Central Bankers, from time to time, are key players in FX markets. (IV) Exchange Brokers Exchange brokers provide an important service to FX markets all over. They are instrumental in bringing buyers and sellers together by providing rates, market information and their network across various centers. Forex

brokers generally deal with banks. In India, they are not allowed to deal on their own account. (V) Overseas FX Markets FX markets world-wide have an astronomical turnover which is estimated to run into hundreds of billions of dollars. Of the total volume of FX trade, genuine corporate demand is estimated to constitute only around 5% of the total volume. The FX market is largely supported by a very advanced communication network which not only provides uninterrupted information on world currencies, economies, politics and the like, it also is characterized by a very large number of participants. This is what gives the market the depth and the clout it has. Some of the most popular communication systems available in the market today are Reuters Information Service, Telerate, Reuters Technical Analysis, Reuters TV, Knight Ridder, Reuters Dealing System etc. (VI) Speculators Speculators are in the market mainly to generate trading income. The growth in volumes, better communications, pressures to constantly generate profits and a general improvement in competence have all contributed to see the emergence of the speculators as a force to reckon with. Banks and corporate, at different times, can be speculators as well.

INDIAN FX MARKETS Foreign Exchange business in India is regulated closely by the RBI. With Exchange Control Regulations, the RBI ensures that involvement in the Foreign Exchange business is restricted to certain sections of the business community only. The main market participants here are: 1. Corporate: Importers, Exporters and Customers for genuine trades or merchant transactions. 2. Banks: One authorized dealer dealing with another to generate profit or cover its open exposure. 3. Overseas Traders: Banks in India are permitted to buy and sell currencies abroad in cover of customer requirements. They have very recently been permitted to initiate positions abroad too. Overseas banks call banks in India to cover their Indian Rupee requirements. 4. Authorized Dealers v/s RBI: This occurs only when the RBI intervenes in the market and not in the normal course. RBI restrictions in terms of participation in foreign currencies can be summarized as under. Corporate: Individuals as per the Exchange Control Manual (Retail) Importers, Exporters and Borrowers of Foreign Currencies (Wholesale) Money Changers (RMC's and FFMC's) licensed by the RBI to buy/sell Banks/Others: Foreign Currency Notes and Travelers Cheque from individuals (Retail) Banks licensed by the RBI, to carry out foreign exchange business on a Commercial wholesale level, called Authorized Dealers. Brokers are permitted to bring together buyers and sellers but cannot Brokers: trade for their own account. This means they have to strike the deal with the buyers and sellers simultaneously.

The Indian FX Market has seen a remarkable growth in the last few years. The reasons for are:

Relaxation of controls by RBI and permitting banks to deal freely in the Inter-bank market - this essentially is the process of economic reforms.

Better communication and availability of information - Reuters, Telerate, Knight Ridder, RTA, Dealing System, Swift etc.

A virtual explosion in volumes in global FX market and Indian markets follows suit.

General improvement in competence, freehand to trade and generate incremental income and

The likelihood of full convertibility of rupee in the near future.

MODIFIED LIBERALISED EXCHANGE RATE MANAGEMENT SYSTEM In the process of liberalization it was decided by RBI to make the Rupee fully floating with effect from March 1, 1993. The new arrangement is called Modified LERMS. Its salient features are as under: Effective March 1, 1993, all foreign exchange transactions, receipts and payments, both under current and capital accounts of balance of payments are being put through by authorized dealers at market determined exchange rates. Foreign exchange receipts and payments, however, continued to be governed by Exchange Control Regulations. Foreign exchange receipts are to be surrendered to the authorized dealers except in cases where the residents have been permitted by RBI to retain them either with the banks in India or abroad. Authorized dealers are free to retain the entire foreign exchange surrendered to them for being sold for permissible transactions and are not required to surrender to the Reserve Bank any portion of such receipts. Reserve Bank of India, under Section 40 of RBI Act, 1934, was obliged to buy and sell foreign exchange to the authorized dealers. Reserve Bank is now required to sell any authorized person at its offices/branches US Dollars for meeting foreign exchange payments at its exchange rates based on the market rate only for such purposes as are approved by the Central Government. The RBI buys spot US Dollars from authorized dealers at its exchange rate. Reserve Bank does not ordinarily buy spot Pound Sterling, Deutsche Mark and Japanese Yen. It does not buy forward any currency. The exchange rate at which the RBI buys and sells foreign exchange is in the 5% band of the market rate. Also, the RBI announces the reference rate at 12:00 hours which is the rate at which transactions with IMF/IBRD etc. are undertaken.

EXCHANGE RATE ARITHMETIC & MARKET CONVENTION The FX market is characterized by professional and competitive participants who always quote a two way price i.e. buying rate and selling rate. Bid rate: The buying rate Ask or Offer rate: The selling rate Spread: The difference between the Selling rate and the buying rate Market participants expect to make a profit by trading in the FOREX market and this is reflected in the spread. How wide or narrow the spread is, is a function of the competitiveness and the volatility in the markets. TYPES OF RATES There are mainly four types of rates: 1. 2. 3. 4. Direct rate Indirect rate Cross rate Forward rate

1. Direct rate: Direct rate is an example of the value of foreign currency in domestic currency terms. For example, 1 USD = INR 46.40 100 JPY = INR 40.46 1 GBP = INR 78.00 1EUR = INR 58.00

2. Indirect rate: Indirect rate is an expression of the value of domestic currency in foreign currency terms. Indirect rates are also known as reciprocal rates. For example, 100 INR = USD 2.1368 100 INR = JPY 250.63 100 INR = GBP 1.298 100 INR = EUR 1.8265

The direct rate for one country becomes reciprocal for the corresponding country.

In international markets though, practice is to quotes rates for a unit of

USD in terms of the other currency, such as 1 USD = CHF 1.2285 1 USD = JPY 107.50 1 USD = INR 46.23 There is an exception to this rule though in the case of just 4 currencies GBP, EUR, AUD & NZD Market practice is to quote the value of these currencies in terms of USD. For example, 1 GBP = USD 1.8285 1 AUD = USD 0.7610 1EUR = USD 1.2585 1NZD = USD 0.7135 1 USD = CAD 1.2600 1 USD = SAR 3.7500

3. Cross rate: Cross rate is an expression of the value of one foreign currency versus another foreign currency neither of which is a domestic currency. For example, USD / CHF = 1.2900 EUR / USD = 1.1700 etc. These would all be cross currencies for us in India as neither of the currency in the set is Indian Rupee. However in international markets cross rates refer to those where neither of the currency is the USD. To calculate the cross currency rate care should be taken to determine the following: The terms i.e. the base currency and the foreign currency The rates to be used i.e. bid or offer rate The method of conversion i.e. divide or multiply Suppose we have following rates on a given day in the local market: USD/INR CHF/INR = = 46.80 36.30 GBP/INR EUR/INR = = 77.00 54.75 USD / JPY = 117.35

To work out the cross rates versus USD for say CHF we would have to: (I) Determine the terms i.e. we need to find out say USD/CHF. So CHF is the base (or domestic) currency and USD is the foreign currency. This is popularly called CHF terms. (II) Next the rates to be used i.e. USD/INR and CHF/INR. This is particularly important where we have bid/offer rates. Care should be taken to use the correct bid rate for one and the offer rate for the other to derive at the cross rate.

(III)

Finally, the conversion method. i.e. divide the USD/INR rate by the CHF/INR

Expressed in the formula this is: CHF 36.30 So, USD 1 USD/CHF = = INR 46.80 = USD 1 = 1.2892

46.80 36.30

= 1.2892

Now suppose we have USD/INR 46.80 46.85 (bid/offer) and the CHF/INR 36.27-36.32 (bid/offer). To work out the cross bid/ offer rates for USD/CHF, the rates to be used are: For, USD/CHF bid rate use 46.80 (bid of USD/INR) and 36.32 (offer of CHF/INR) So, 46.80 36.32 = 1.2885 For, USD/CHF offer rate use 46.85 (offer of USD/INR) and 36.27 (bid of CHF/INR) So, 46.85 36.27 = 1.2917 It is important to remember the market convention when it comes to quoting of exchange rates. Some currencies are quoted to 2 decimal points such as USD/JPY and the erstwhile USD/ITL, some to 5 decimal points such as USD/KWD, USD/BHD, while most of the others are quoted to 4 decimal points. As a rule of thumb, most currencies with a low absolute value to the USD are quoted to 2 decimal points; those with a high absolute value are quoted to 5 decimal points and the rest to four decimal points. Settlement Date FX Contracts have to be settled and currencies exchanged. Normal market practice is to settle FX Contracts on a T+2 basis, i.e. 2 working days after transaction date. This is called Value Spot. All market quotes are for Value Spot.

4. FORWARD POINTS: Forward point is the adjustment made to the spot rate to derive a forward exchange rate. As we know market rates are quoted for value spot. But where an exchange has to be made for a forward date, an adjustment has to be made to the spot rate. This adjustment depends on whether a currency is at a premium, discount or par in relation to the corresponding currency in the exchange.

Forward points reflect, in the long term, the interest rate differential between the currencies for the different settlement / value dates.

The factors that determine the forward points are: Demand and supply of the currency for the particular settlement date. Market expectations over the given period both in the FX and interest rates. Interest differentials between the currencies, for the period involved.

In the case of direct quotes, premium is positive forward points while discount is negative forward points and par reflects no forward points. FORWARD FOREIGN EXCHANGE RATES

Forward FX rate is the rate at which exchange of currencies take place for the agreed forward date. A forward rate has two components: 1. 2. Spot rate Forward Points

Where there are no restrictions on capital flows, the only factor determining forward points is the interest rate differential between the currencies involved. How do Forward Points arise? Suppose market rates are as follows: Spot USD / CAD = 1.3500

1 year USD interest rates = 1 year CAD interest rates = 1 year forward USD/CAD =

1.25% and 3.00% 1.3500

To take advantage of this interest rate differential one would Borrow USD on spot @ 1.25% Convert the USD to CAD @ 1.3500 Lend CAD for 1 year @ 3.00% and Reconvert CAD back to USD on maturity @ 1.3500 The cash flow from these transactions would be as under:

USD + Borrow USD on spot @ 1.25% Spot FX @ 1.3500 Lend CAD on Spot for 1 year @ 3.00% Interest Flows P I on maturity FX on maturity @ 1.3500 NET 1030.00 17.50 0 0 12.50 1012.50 1000.00 1000.00 +

CAD -

1350.00 40.50 1390.50 1390.50 0

The example suggests one who borrows USD 1000.00, coverts to CAD, lends the CAD and converts back to USD on maturity makes a profit of USD 17.50.

The market, in such a situation, provides what is called an arbitrage opportunity, i.e. an opportunity to take advantage of various markets, currencies or products to generate risk free profit. This cannot last long because every speculator would do the same while no one would want to lend USD or sell CAD. Alternatively, every lender of USD would demand a rate higher than 1.25% and no borrower of CAD would pay 3.00%. There would be a series of corrections or amendments till equilibrium is reached.

The change could be in any of the following areas: USD interest rates moving higher CAD interest rates moving lower Forward rate moving towards it being (P + I of DC) (P + I of FC)

More accurately, there is fundamental flaw in this example i.e. the assumptions that the Forward FX rate is the same as Spot rate.

The forward rate has to reflect the interest differentials and a true forward FX rate for USD / CAD would take into account the total CAD inflow and total USD outflow.

Therefore the FX rate USD/CAD 1 year forward would be USD 1012.50 USD 1 = = = CAD 1390.50 1390.50 1020.50 1.3733

We now have the following: Spot USD/CAD = 1.3500 1.3733 Forward rate spot rate 1.3733 1.3500 +0.0233

Forward USD/CAD = Forward points = = =

In our example, USD is at forward premium to the CAD (as forward USD/CAD is higher then Spot USD/CAD) and the CAD at a discount to the USD. Because always FR > SR it means DCIR > FCIR and foreign currency is at premium and domestic/base currency is at discount.

Since USD/CAD @ 1.3500 is a direct quote, we add the premium to the spot rate to give us the Forward FX rate.

CALCULATION OF FORWARD POINTS

The formula for calculation of forward points is:

Forward points = (spot rate interest differential period 100) Basis

Where, interest differential is Domestic Currency Interest Rate Foreign Currency Interest Rate. This formula, called the Interest Rate Differential Method, is used widely in Indian markets. The formula takes into account interest rate differentials as opposed to total inflows and outflows. Besides, the formula has an assumption i.e. the basis for the two currencies are the same. This, we have seen, is not always the case, a classic example being USD versus Indian Rupees. US Dollars having a 360 day basis and the Indian Rupees having a 365 day basis. The forward point worked out using this formula is not accurate.

If we apply the formula in our earlier example we would have: Forward points = 1.3500 1.75 100 = 0.0236 Which is quite different from that we worked out earlier i.e. 0.0233

The more accurate formula id one which takes total inflows and outflows into account called the Round Robin Method. Where,

Forward rate = {(Domestic Currency P + I) (Foreign Currency P + I)}

Where, P represents the Spot Values of the respective currencies and I is the interest amount over the period.

While calculating the interest for the currencies care should be taken while using the basis and the actual number of days involved.

Forward Rate = Spot Rate + Forward Points, and Forward Points = Forward Rate Spot Rate

As in Spot rates, forward rates too are quoted for buying and selling i.e. Bid / Offer rates. Both of these rates are quoted in points of the spot / forward rates. However, in the case of Forward Rates the forward points reflect the premium or discount, as the case may be. As we know premium is added to the spot rate and discount is deducted from the spot rate. In the case of premium, the bid rate is lower than the offer rate. Whereas, the way market quotes rates, bid rate appears to be higher than the offer arte in the case of discount. CROSS FORWARD FX RATES The principle is exactly the same as the spot cross rates but care should be taken while adjusting for forward points. For example,

Spot USD/INR Spot CHF/INR So, Spot USD/CHF

= = =

46.80/46.85 36.27/36.32 1.2900/1.2905

3 months USD/INR Forward Points 3 months CHF/INR Forward Points So, 3 months Forward USD/INR Rate 3 months Forward CHF/INR Rate 3 months Forward USD/CHF Rate

= = = = =

5/7 25/30 46.85/46.92 36.52/36.62 1.2794/1.2848

From these rates we can also work out 3 months USD / CHF forward points

Forward Rate Spot Rate = Forward Points 1.2794 1.2900 = -0.0106, and 1.2848 1.2905 = -0.0057 Based on this market quote 3 months USD / CHF would be 106/57

Forward Rates
Where settlement is sought for any date other than Spot, the applicable rate is not the Spot Rate. An adjustment arises due to differences in interest rates in the currencies involved. The forward value of a currency may be higher (premium), lower (discount) or the same (par) as the Spot Value

The forward value is a function of the Interest Rate Differential in the currencies. Therefore, to calculate the forward rate, it is necessary to know the prevailing interest rates for the duration.

Interest Differential (or Annualized Premium) is INR Interest Rate (DCIR) minus FC Interest Rate (FCIR)

The formula for Forward Rate is: SR + {(SR x ID x Duration) 365} Say Spot USD/INR = 43.50, 3 months Annualized Interest Rates for USD 3.30% and INR 4.50% ID = DCIR FCIR = 4.50% - 3.30% = 1.20% FR = 43.50 + {(43.50 x 1.20% x 3) 12} Then FR = 43.50 + 0.1305 = 43.6305

Likewise forward rates can be calculated for any duration, from 1 day to 6 months and beyond. All one needs to know is the interest rates in the currencies or the Interest Differential, but there exists a vibrant forward market where rates are available for month-ends of successive calendar months

There may be instances when a requirement is not for a month-end. An exporter has a receivable or an importer a payable for say 11th August 2005. Forward rates available are for 29th July and 31st August of 43.60 and 43.65. To calculate the rate for 11th August one merely needs to extrapolate the rate So {(43.65 43.60) 33} x 13 = 0.0197

You need to add this adjustment to the earlier date rate, i.e., of 29th July 43.60 + 0.0197 = 43.6197, the rate for 11/08 This is market practice for calculating what is called broken date forward rates by the extrapolation method Prior to Spot Often a corporate needs to settle a contract immediately, i.e. even before Spot Value For example, say today is 1st June so Spot Value is 3rd June and an exporter receives proceeds today. He has not covered the exposure as yet and needs to convert today. The bank would calculate the 2 day adjustment from 3rd to 1st June The calculation is the same as for any other forward using the same formula. However since the adjustment is for a date prior to Spot the adjustment has to be reversed Premium has to be deducted from the Spot Rate and Discount added to the Spot Rate. This is what is known as Cash-Spot. Similar would be the treatment when an adjustment is to be made to 2nd June, i.e. a 1 day adjustment. The settlement for 2nd June is popularly known as Tom-Spot As in Cash Spot, for Tom-Spot too, the Premium is deducted from and Discount added to the Spot.

Rates for an Exporter An exporter needs to sell FC to the bank. The bank will quote its Bid (Buying) Rate, the lower rate. Where an exporter wants to sell forward, the bank would quote the forward bid rate. To an exporter the bank quotes its buying rate for Value Cash where proceeds come in and the same has not been covered as yet Rates for an Importer An importer needs to buy FC from the bank to pay for the import. The bank will quote its Offer (Selling) Rate, the higher rate. Where an importer wants to buy forward, the bank would quote the forward offer rate. To an importer the bank quotes its selling rate for Value Cash where immediate payment has to be made and the same has not been covered as yet.

FACTORS AFFECTING EXCHANGE RATES The Bretton Woods conference in July 1944 resulted into a new monetary order. The main objectives of this were to establish an international monetary system with stable exchange rates, to eliminate exchange controls, and to bring about convertibility of all currencies. This required the central banks of various countries to declare their parity to gold or to the US Dollar. In turn, USA agreed to exchange US Dollar for gold at 35 dollars per ounce. The Central banks were expected to keep the rate fluctuations within 1%. However, due to chronic US balance of payments deficits there was a general loss of confidence in the US Dollar. This culminated in the demise of the Bretton Woods System in 1971. At the monetary conference held on December 17 and 18, 1971, a new arrangement, popularly known as Smithsonian Agreement was at. Under the system intervention points range was widened to 2.25%. However, as the USA had done away with the convertibility of Dollars into Gold, the arrangement under Smithsonian Agreement could not continue for long and ultimately in 1973 many countries started floating their currencies. This development gave rise to fluctuating exchange rates. Although in a free market it is the demand and supply of the currency which should determine the exchange rates there are many more factors responsible for these fluctuations. The volatility of exchange rates cannot be traced to a single reason and consequently it becomes difficult to precisely define the factors that affect the exchange rates. However, the important among them are: (I) Balance of payments Balance of payments position of a country is a definite indicator of the demand and supply of foreign exchange. If a country has a favorable balance of payments position it implies that there is more supply of foreign exchange and therefore foreign currencies will tend to be cheaper vis--vis domestic currency. However, if balance of payments position is unfavorable, it indicates that there is more demand for foreign exchange and this will result in the price of foreign exchange vis--vis domestic currency firming up.

(II) Strength of the economy The relative strength of the economy also has an effect on the demand and supply of foreign currencies. If an economy is growing at a faster rate it is generally, in the long-run, expected to have a better performance on balance of trade. However, in the short run increasing economic activity in the country may necessitate higher imports and exports may take sometime to increase. The economic growth is indicated by various parameters like relative rate of growth in industrial production and capacity utilization, rate of increase in Gross National Product and fall in employment rate, etc. (III) Fiscal policy The fiscal policy followed by government has an impact on the economy of the country which in turn affects the exchange rates. If the government follows an expansionary policy by having low interest rates, it will fuel the engine of economic growth and will lead to better trade performance. However, a word of caution is necessary here. If the government is following an expansionary policy by resorting to high budget deficit and monetizing the deficit, this will lead to high inflation in the economy. This will prove to be counter productive as far as growth in exports is concerned. (IV) Interest rate High interest rates make the speculative capital move between countries and this affects the exchange rates. The capital is attracted, provided there are no controls towards currencies yielding high interest rates. If interest rates of domestic currency are raised this will result in more demand for domestic currency and more supply of the foreign currency, thus making the latter cheaper vis--vis the former. (V) Monetary policy The central banks of various countries have a control on the monetary policy to be pursued although it is generally in consonance with the fiscal policies of the government. Monetary policy is a very effective tool for controlling money

supply, and is used particularly for keeping a tab on the inflationary pressures in the economy. The main objective of the monetary policy of any economy is to maintain the money supply in the economy at a level which will ensure price stability, full employment and growth in the economy. Pursued by the central bank, it also gives a hint about the future interest rates. If the money supply in an economy is more it will lead to inflation and the central bank will raise interest rates, sell government securities through open market operations, raise cash reserve requirement thus giving a signal for tight money supply policy. On the other hand, to spur the growth in the economy the central bank may lower interest rates, buy government securities in the market, and lower the cash reserve requirements thus heralding an era of easy monetary policy. This will be a sign for low interest rates in future. It will be clear from the above that monetary policy influences interest rates, inflation, employment, etc. and consequently, affects the exchange rates. (VI) Political factors If a change is expected in the government on account of elections or if there is change in the incumbency in the government, the exchange rates may be affected. Market thrives on stability and any perception of political instability is sufficient to move exchange rates significantly. However, whether the currency of the country concerned will become stronger or weaker will depend upon expected policies to be pursued by the new government which is likely to take over. But there are some currencies, like the US Dollar, Swiss Franc etc. in which people have confidence and at times of any international crisis foreign funds move into these currencies. These are known as safe havencurrencies. War also affects the exchange rates of the currencies of the country involved. Sometimes it affects the currencies of other countries too. (VII) Exchange control Exchange control is generally aimed at disallowing free movement of capital flows and it therefore affects exchange rates. Sometimes countries exercise control through exchange rate mechanism by keeping the price of their currency at an artificial level. If a country wants to give a boost to exports, it

will keep the value of its currency low vis--vis the foreign currency. This will help exporters in realizing more units of the local currency for the same units of foreign currency received by them as export earnings. However, reverse would be the case if the government decides to follow a liberal import policy. (VIII) Central Bank intervention Buying or selling of foreign exchange in the market by the central bank with a view to increase the supply or demand, thereby affecting the exchange rates is known as intervention. If a central bank is of the opinion that local currency is becoming stronger thereby affecting the exports, it will buy foreign currency and sell local currency. It will increase the demand for foreign currency and the rates of foreign currency vis--vis local currency will go up. However, if the rate of exchange is kept artificially at low levels, it tends to accelerate inflation. Therefore, the central bank has to take into consideration many factors before intervening in the market. (IX) Speculation In FOREX markets, a dealer taking speculative positions is common. If a few big speculative operators are buying/selling a particular currency in a big way, others may follow suit and that currency may strengthen/weaken in the short run. This is popularly known as the bandwagon effectand this can affect exchange rates significantly, particularly in the near term. (X) Technical factors Technical factors particularly in the short run can influence exchange rates. If, for example, regulations by the central bank make it necessary to limit the size of open position and if banks have a big short position, they may, in order to cover such a position, buy foreign exchange. This will result in higher short-term demand which is not genuine. Similarly, reserve requirement of the central bank may also create a technical position thus influencing the exchange rates.

RBI (RESERVE BANK of INDIA) Guidelines

1. Category Exporter Importer Foreign Currency Borrower 2. Currency Blanket Permission. The currency which has no blanket permission has to go through RBI reference or say RBI reference is necessary for those currencies for doing any kind of trading. The currencies with blanket permission are USD, EUR, GBP, CHF, JPY, AUD and CAD. These currencies are used for payment of Imports; accept of Exports and for borrowing. 3. Trade Amount (expect for borrower) 4. Duration On the date or above the starting period and before the end date 5. Speculation No speculation is allowed as per RBI 6. Trading Exporter he has receivables so if foreign currency goes up he has profit and if FC goes down than it is risk for him. An exporters risk starts on receipt of an export order or an Export L/C. Risk ends when payment is due; On shipment (DP Basis) or end of credit period (DA Basis) Importer he has payment to make so if foreign currency goes down he has profit and if FC goes up than it is risk for him. An importers risk starts on placing an import order or opening of Import L/C and it ends when payment is due, either on receipt of documents (DP Basis) or end of credit period (DA Basis) RBI permits importers and exporters to hedge their exposures (partial or full) at any time from the commencement to the termination of the FX risk

 Banks are authorized to provide cover against confirmed orders or L/C. They may also quote rates against past performance RBI also permits exporters/importers to hedge their exposures against cross currencies. Trading in cross currencies requires a thorough understanding of currency markets and a pro-active participation in the market

F E D A I - FOREIGN EXCHANGE DEALERS ASSOCIATION OF INDIA Foreign Exchange business in India was confined to few foreign banks only till the period 1959. The said group banks were known as Exchange Banks. They had formed an Association, which was known as the "Exchange Banks' Association". It was mainly covering the areas of activities within Bombay (now Mumbai), Calcutta (now Kolkata), Madras (now Chennai), Delhi and Amristsar. On introduction of the exchange control in India during 1939, the said Association was functioning within rules framed by RBI. The rules and regulations - introduced and practiced were also covered by RBI approval. On account of expansion in the foreign trade, and business, RBI allowed schedule commercial banks also to undertake foreign exchange transactions. Those banks which were allowed and permitted by RBI to deal in foreign exchange transactions were known as AD - Authorised Dealers. The FEDAI - Foreign Exchange Dealers' Association of India was formed with approval of RBI during August 1958. It was under ECM-RBI directives under reference ECS/198/86-58-Gen dated 16th August, 1958, authorized the banks to handle foreign exchange business. All Public sector banks, foreign banks, private sector and co-operative banks and certain Financial institutions are the members of FEDAI. FEDAI is a non-profit making Association and relative expenses are shared by all its member banks. FEDAI acts as a facilitating body and in consultation with Reserve Bank of India, frames rules / regulations for AD in India for conduct of the foreign exchange business related transactions. FEDAI is the Association of the member Banks. Naturally, the guidelines and rules prepared were of interest of the member Banks. However, on account of liberalization and reforms introduced during 1991 to boost the foreign trade to and fro India, it becomes imperative by FEDAI to review Rules and Guidelines. FEDAI has also taken due care of the interest of both Importers and Exporters while revising rules and guidelines.

To promote exports the RBI has directed commercial banks to offer export finance at subsidized rates. But export finance is of course subject to the bank sanctioning such a facility. Exporters must approach their bankers in advance, to get the limit approved Banks provide finance, both before and after shipment, to facilitate exports. Export finance is given for the purpose of procuring raw materials, process, production, packing and shipment of goods for exports The subsidy that is available is conditional on actual exports Pre-Shipment Finance Finance that is given for procuring raw materials, production, packing and shipment is classified as Pre-Shipment Finance or Packing Credit Banks normally provide packing credit only against confirmed Letters of Credit which have to be lodged with the bank. For prime clients, banks offer Packing Credit against export orders, as well. Pre-shipment finance has to be liquidated by submission of documents evidencing exports Post-Shipment Finance When an exporter-borrower submits export documents to liquidate Packing Credit, banks either purchase or negotiate or discount these documents. This is referred to as Post-Shipment finance This finance has to be liquidated from export proceeds received from abroad, through banking channels

Export Finance Export finance can be availed of either in rupees (EPC) or in the foreign currency (PCFC) of invoicing PCFC is cost-effective as borrowing cost in FC is generally lower than those in rupees but this is subject to availability of foreign currency with the commercial bank Availing export finance in foreign currency liquidates the FX Risk On the other hand when packing credit is taken in rupees, the exporter still needs to convert the foreign currency when the proceeds come in. The FX Risk therefore remains open The RBI subsidizes the rate of interest on export finance Export Finance Rates The lending rates for export finance is linked to market rates; PLR in the case of Rupees and LIBOR for foreign currencies (PCFC). Since RBI subsidizes the rate, rupee finance can be obtained at subPLR. No subsidy is available when export finance is availed in foreign currency But given current market scenario it is possible to reduce the borrowing cost to below rupees when availing PCFC

An example would clarify the point better Rupee PLR 10.00% less 2.50% RBI subsidy. So net cost in Rupees 7.50%. USD 3m LIBOR 4.35% plus bank margin 0.75% (max. as per RBI directive but almost 1%), plus 3m cover cost 0.70%. So net cost in USD 5.80%. Similar would be the cost if export finance is availed in the other major currencies

FOREIGN EXCHANGE RISK

FX Risk pertains to the risk of adverse movement in exchange rates:

On Exports On Imports On Foreign Currency Borrowings, Installments Payments and

Repayments The FX risk arises primarily due to:

Developments in overseas markets Central Bank Intervention Activities of major market players Political Turmoil Economic Developments Lack of depth or liquidity in the market Non - availability of enough hedging tools Development in other markets such as - domestic and overseas stock markets, turmoil in other currencies, commodities markets, oil prices etc.

The RBI recognizing the financial risks associated with international trade, has laid down several Directives and Rules in the Exchange Control Manual. We are primarily concerned with the directives, rules and guidelines associated with the management of Foreign Exchange and Interest Rate Risks. Imports The RBI permits cover of the FX risks on imports as soon as the import L/C is opened or as soon as a confirmed order is placed. When the documents under the L/C are received - the L/C opening bank is due to make payment to the exporter. This is done by debit to the importer's domestic account meaning the FX risk terminates. The bank debits the importer's rupee account and pays the exporter (or his bank) in foreign currency. An importer has the

time from opening of the L/C to date of receipt of the documents to manage the foreign currency exposure. A 10 day grace period is normally permitted by the RBI to the customers to pay for imports. Exports The FX risk on exports can be covered immediately on receipt of an export order (or L/C). The RBI also stipulates that FX realizations should be converted into rupees immediately on negotiation of documents. This implies that the FX exposure on exports can be managed only between the times an order is received to the date of shipment. Commercial banks are allowed to grant 10 days grace for receipts of export proceeds beyond which concessional rate finance is not extended

Category EXPORTER IMPORTER

Risk FC FC

Commencement/Start of Risk Receipt of Export order or L/C Opening of Import L/C or placing of import order Utilization or draw-down of loan

Termination /End of Risk Shipment Receipt of documents Final repayment

FC FC BORROWER Example

An exporter in India contracts to sell to a firm in London machinery at a price of GBP 10,000. Before agreeing to this price, the exporter calculates his cost of production adds a reasonable amount of profit and satisfies that the proceeds of GBP 10,000 would cover this amount. He bases his calculations on the exchange rate prevailing as on the date of his quotation. For example, if the exchange rate on the date is Rs. 70 per sterling pound, he expects to receive Rs. 7, 00,000 on executing the contract.

The exchange rate is not stable: it is changing every day. By the time the exporter executes his contract and his bill is realized, which may be after a lapse of 3 months or 6 months, the rate of exchange might have turned

adverse for him. For example, if the rate prevailing on the date the bill is realized or purchased by his banker is Rs. 65, he would receive only Rs. 6, 50,000 as against his estimate of Rs. 7, 00,000. Thus he may have to bear a shortfall of Rs. 50,000. True, the rate may turn favorable to him and bring him unexpected profits. But the fact remains that the amount that he would receive on execution of the contract remains uncertain.

This uncertainty about the rate that would prevail on a future date is known as the exchange risk. For the exporter, the exchange risk is that the foreign currency in which the transaction is designated may depreciate in future and may bring less than the expected realization in local currency terms.

The importer too faces exchange risk when the transaction is designated in a foreign currency. The risk is that the foreign currency may appreciate in value and he may be compelled to pay in local currency an amount higher than that was originally contemplated. Importers generally make arrangements for loans for payment for the imports. If the foreign currency appreciates subsequent to the arrangement of the loan, the importer may find that the resources are not sufficient to meet the importer bill putting him in a difficult situation.

FOREX Risk Management

Foreign Exchange dealing is a business that one gets involved in, primarily to obtain protection against adverse rate movements on their core international business. But, as we have seen earlier, it provides plenty of trading opportunities as well. Foreign Exchange dealing is essentially a risk reward business where profit potential is substantial but it is extremely risky too. It is in this context that it is absolutely vital that controls are in place which would enable the department to maintain a check on losses and shocks.

FX business has the certain peculiarities that make it a very risky business. These would include:

1. FX deals are across country boarders and therefore, often foreign currency prices are subject to controls and restrictions imposed by foreign authorities. Needless to say, these controls and restrictions are invariably dictated by their own domestic factors and economy. 2. FX deals involve two currencies and therefore, rates ate influenced by domestic as well as international factors. 3. The FX market is a 24 hour global market and overseas developments can affect rates significantly. 4. The FX market has great depth and numerous players shifting vast sums of money. FX rates therefore can move considerably, especially when speculation against a currency rises. 5. FX markets are characterized by advanced technology,

communications and speed. Decision making has to be instantaneous.

With the growth in the Indian FX markets a lot of the features and characteristics of the global FX markets are present in our very midst. Indian banks get involved in FX market with a view to generate trading income.

With the RBI guidelines loosening its controls, granting greater operational and trading freedom, more and more corporate are getting involved in FX markets with a view to generating trading income.

With time, as the Indian Rupee gets fully convertible and as the Indian FX markets get fully integrated with global markets the risks will be more pronounced in our own exchange market.

It is, therefore, imperative to get the right controls in place prior to any involvement in FX markets.

RISK MANAGEMENT TOOLS

FORWARD CONTRACT

CURRENCY OPTIONS

CURRENCY FUTURES

1. Forward exchange contract

Forward Exchange Contract is a device which can afford adequate protection to an importer or an exporter against exchange risk.

Under a forward exchange contract a banker and a customer or another banker enter into a contract to buy or sell a fixed amount of foreign currency on a specified future date at a predetermined rate of exchange.

Our exporter, for instance, instead of groping in the dark or making a wild guess about what the future rate would be, enters into a contract with his banker immediately. He agrees to sell foreign exchange of specified amount and currency at a specified future date. The banker on his part agrees to buy this at a specified rate of exchange. The exporter is thus assured of his price in local currency. For example, the exporter may into a forward contract with the bank for 3 months delivery at Rs. 49.50. This rate, as on the date of contract, is known as 3 month forward rate. When the exporter submits his bill under the contract, the banker would purchase it at the rate of Rs. 49.50 irrespective of the spot rate then prevailing.

Fixed and Option Forward Contract

The forward contract under which the delivery of foreign exchange should take place on a specified future date is known as Fixed Forward Contract. For instance, if on 5th march a customer enters into 3 months forward contract with his bank to sell GBP 10, 000, it means the customer would be presenting a bill or any other instrument on 7th June to the bank for GBP 10,000. he cannot deliver foreign exchange prior to or later than the determined date.

Forward contract is a device through which the customer tries to cover the exchange risk. The purpose will be defeated if he is unable to deliver foreign exchange exactly on the due date.

With a view to eliminating the difficulty in fixing the exact date for delivery of foreign exchange, the customer may be given a choice of delivering the foreign exchange during a given period of days.

An arrangement whereby the customer can sell or but from the bank foreign exchange on any day during a given period of time at a predetermined rate of exchange is known as Time Option Forward contract.

The rate at which the deal takes place is the option forward rate. For example, on 15th September a customer enters into two months forward sale contract with the bank with option over November. It means the customer can sell foreign exchange to the bank on any day between 1st November and 30th November. The period from 1st to 30th November is known as the Option Period

Booking of forward contracts The steps involved in booking and utilization of a forward contract may be summarized as under: Step 1: The transaction of booking of forward contract is initiated with the customer enquiring of his bank the rate at which the required foreign currency is available. Before quoting a rate the bank should get details about (i) the currency, (ii) the period of forward cover, including the particulars of option, and (iii) the nature and tenor of the instrument. Step 2: The branch may not be fed with forward rates of all currencies by the Dealing Room. Even for major currencies forwards rates for standard delivery period may only be available at the branch. If the rate for the currency and/or delivery period is not available, the branch should contact the Dealing Room over phone or telex and obtain rate. Step 3: If the rate quoted by the bank is acceptable to the customer, he is required to submit an application to the bank along with documentary evidence to support the application, such as the sale contract. Step 4: After verification of the application and the documentary evidences submitted, the bank prepares a Forward Exchange Contract.

2. Currency Options DEFINITION An option is a unique financial instrument or contract that confers upon the holder or the buyer thereof, the right but not an obligation to buy or sell an underlying asset, at a specified price, on or up to a specified date. In short, the option buyer can simply let the right lapse by not exercising it. On the other hand, if the option buyer chooses to exercise the right, the seller of the option has an obligation to perform the contract according to the terms agreed. Participants in the Options Market There are four types of participants in options markets depending on the position they take: 1. Buyer of call 2. seller of call 3. buyer of put 4. seller of put People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions.

Here is the important distinction between buyers and sellers: Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights if they choose. Call writers and put writers (sellers), however, are obligated to buy or sell. This means that a seller may be required to make good on a promise to buy or sell. OPTIONS TERMINOLOGY

Call Option: A call option gives the option buyer the right to buy one currency X against another Y at a stated price on or before a stated date. Put Option: A put option gives the option buyer the right to sell one currency X against another currency Y at a stated price on or before a stated date. In foreign exchange transactions one currency is bought by selling another currency. Thus if we consider the EUR/USD currency pair, a call option on the euro is no different from a put option on the dollar. Similarly, a put option on the euro is nothing but a call option on the dollar. Strike Price: This is the price specified in the option contract at which the option buyer can buy or sell currency X against currency Y or for instance the euro against the dollar. Maturity Date: The date on which the option expires. American Option: A call or put option that can be exercised by the buyer on any business day up to and including the maturity date. European Option: A call or put option that can be exercised only on the maturity date.

Premium (Option Price or Option Value):

The upfront fee that option writer or seller charges the buyer for giving the latter the right inherent in the option. If the option lapses unexercised, the buyer loses this amount. This premium can be split into 2 parts: intrinsic value and time value. Premium = Intrinsic value + Time value. Intrinsic value is the amount an option would be worth was it to be exercised immediately. For instance, if an American call option on EUR has a strike price of $0.85 and the current spot EUR/USD rate is say $0.88, the intrinsic value is $0.03 per euro. European options can be exercised only at maturity. Even so, they can have intrinsic value. European call options will have intrinsic value if the forward rate applicable for the maturity date exceeds the strike price. An option with an intrinsic value is called an in-the-money option. An American/European option is said to be at-the-money if the strike price equals the spot price/maturity forward price. Lastly,

American/European call options are said to be out-of-the-money if strike price exceeds the spot price/maturity forward price.

American/European put options are said to be out-of-the-money if the strike price is less than the spot price/maturity forward price. An option can have time value only if it has some time remaining to expiry. Time value depends on the chances of the option gaining in value before expiry. At-the-money and out-of-the-money options have no intrinsic value and can have only time value. The time value of a currency option thus depends upon a number of factors such as the spot price, strike price, time to maturity, volatility of the market price, domestic interest rate and the foreign interest rate.

Two primary factors affect the time value:

1. The length of time remaining until expiration. 2. The volatility of the underlying futures price.

Other factors such as underlying futures price, strike price and general interest levels in the economy will also influence the option premiums.

Usually decreases with length of time until expiration, but does increase as price volatility of the underlying futures contract increases. All else remaining equal, the more time an option has until expiration, the higher its premium because it has more time to increase in value. But the options time value will erode much rapidly as the option approaches expiration. An option value at the expiration will be equal to its intrinsic value the amount by which it is in the money. This is why options are sometimes described as decaying assets.

In-the-Money (ITM) options have intrinsic value where as Out-of theMoney (OTM) options have no intrinsic value. They only have time value left in the premiums.

What is meant by ITM and OTM? Let us know about these.

An option whose strike price is roughly the same as the underlying futures price is said to be At-the-Money, while an option that would result in a loss if exercised is said to be Out-of the-Money. An option that would result in a profit if exercised is said to be In-the-Money.

A call option is said to be: In-the-Money (ITM), if Strike price is less than Futures price At-the-Money (ATM) If Strike price equal to Futures price. Out-of-the-Money (OTM) If Strike price greater than Futures price.

Comparison of Forward Contract and Currency Options

Importer An Importer has the risk of FC appreciating. To hedge this risk he can either buy FC forward or buy a Call Option. If on the expiry date, FC has appreciated, he would exercise the option. If FC has depreciated, he would let the contract lapse An example of Strategy for Importers An Importer has a payable after 3 months and has the risk of FC appreciating To cover this risk he has two choices Buy currency forward Buy a Call Option for the forward date Suppose Current USD/INR Spot Rate is 45.98-46.00 and 3 months Premium is 13-15. If he decides to cover the forward his cost is 46.00 + 0.15 = 46.15 If he decides to buy a Call at a Strike Price of 46.15 and if he has to pay Option Premium of say 25 paisa, his all-in cost would then come to 46.40 Where an importer covers the forward his risk is protected as the cover rate is fixed Market rate on the forward date could be 46.15, higher or lower He would have to settle the contract irrespective of what the market rate is. If market rate is lower than the cover rate the importer has an opportunity cost. Unfortunately a forward contract does not provide any flexibility in such a case But a Call Option could provide the answer Let us understand one thing an option contract provides protection against the unexpected. And the unexpected for an importer is a fall in FC value Given the volatility that we have seen in currency markets, it is impossible to forecast rates with any degree of certainty

 On a positive note, volatility in markets offer opportunities which can be exploited to reduce cost of hedging When an importer buys a Call, he gets protection against appreciation in FC. But what if FC falls? Moreover all of us want to reduce costs. So how can we go about tackling these dual tasks, of a falling FC and cost reduction? Let us take three scenarios: Foreign Currency rises, remains same and falls Suppose FC rises above 46.15 before the expiry date. Though the Call Option becomes In-the-Money no action need to be taken because risk is FC may continue to rise further or remain above the Strike Price till expiry. Call Options provide protection in this very situation If FC remains same at 46.15 then no point in doing anything. But what if FC depreciates to below the strike price? If USD/INR drops to say 45.50 before expiry. Cover the forward and leave the Option open till expiry. This would help recover all of the premium and more. Later, on expiry, to exercise or lapse the Option would depend on the market rate prevailing then But if the market moves up before expiry but after doing the forward you get an opportunity to reduce cost If USD/INR moves to above 46.15 (say 46.50) liquidating the option before expiry results in a profit (cost reduction)

Exporter An Exporter has the risk of FC depreciating. He can either Sell FC forward or buy a Put Option to cover this risk. If on the expiry date, FC has depreciated, he would exercise the option. However if FC has appreciated, he would let the contract lapse An example of Strategy for Exporters An exporter has a receivable say after 3 months and has the risk of FC depreciating To cover this risk he has two choices Sell currency forward Buy a Put Option for the forward date If he decides to cover the forward rate is 45.98 + 0.13 = 46.11 If he buys a Put at 46.11 and if he has to pay Option Premium of 25 paisa, his all-in rate would then come to 46.36 Where an exporter covers the forward his risk is protected as the cover rate is fixed Market rate on the forward date could be 46.11, higher or lower He would have to settle the contract irrespective of what the market rate is. If market rate is higher than the cover rate the exporter has an opportunity cost. Unfortunately a forward contract does not provide any flexibility in such a case But a Put Option could provide the answer The unexpected in this case is a rise in FC value When an exporter buys a Put, he gets protection against depreciation in FC. But what if FC rises? Moreover every exporter wants to maximize his return. So how can we go about tackling these dual tasks, of a rising FC and ensuring maximum return? Let us take three scenarios: FC falls, remains same and rises Suppose FC falls below 46.11 before the expiry date.

 Though the Put Option becomes In-the-Money no action need to be taken because risk is FC may continue to fall further or remain below the Strike Price till expiry. Put Options provide protection in this very situation. If FC remains stable at 46.11 then no point in doing anything. But what if FC goes above the strike price? If USD/INR rises to say 46.50 before expiry. Cover the forward and leave the Option open till expiry. This would help recover at least some of the premium Later, on expiry, to exercise or lapse the Option would depend on the market rate prevailing then But if the market goes down before expiry but after doing the forward you get an opportunity to earn out of the option If USD/INR moves below 46.11 (say 45.85) liquidating the option before expiry would be beneficial

INDIAN Options market

What are available in India are OTC Options contracts only. There is no exchange where Rupee options are quoted. The market for rupee options is thin and prices tend to vary widely. Some of the more aggressive banks market exotic options which do not involve any premium payout. These have knock-in or knock-out rates which increase the exposure in the event of it going wrong. This increases risks substantially going against the very essence of options being a No-Risk product

Look at Options as Insurance, simply because an Option Contract is designed to provide protection. As in any insurance policy, whose aim is to obtain protection, an option too, is meant to provide protection to the buyer And protection at no cost, as a concept, is inherently flawed. A plain vanilla option is one that provides protection at a price. Such a contract has no hidden conditions and no risk. Once you buy a plain vanilla option you obtain protection from any and all future risks. Besides you have unlimited profit potential. For such a product (facility) there is a price to be paid, i.e. the Premium. Surely one needs to weigh the risk versus the cost of protection. As in any insurance plan, consider the risk that you want protected against cost of obtaining protection. If it makes sense, go ahead and get the protection have unlimited profit potential. When the risk is high, as we have seen in currency markets, we need to take steps to protect our margins. And option premium, we believe, is a small price to pay in these volatile markets. While a mix of options and forwards could provide a good hedge, trading strategies are possible in options as well. Indian corporate are skeptical of Options, the way they exist at the moment, particularly the so called zero cost ones. Banks appear to be charging exorbitantly high premium, Market is thin and getting comparative prices is difficult. Banks do not quote two-way prices making their quotes biased and unprofessional.

Types of options

Mainly three types of options are in use: a. Purchased Plain Vanilla Option Contracts b. Range Forward (Zero cost) Option c. Exotic Option I. A Purchased Plain Vanilla Option Contract A Purchased Foreign Currency Option Contract is a transaction which gives the buyer (corporate) of the option contract the right but not the obligation to settle the contact at a predetermined price (strike price) for a predetermined maturity and amount. A CALL option gives the buyer the right but not the obligation to buy the base currency and a PUT option give the buyer the right but not the obligation to sell the base currency. The authorized dealer (writer/seller of the option contract) charges an up front premium for the transaction.

Risks Premium paid has built in margins of Bank dealers and is not transparent European Options cannot be exercised before maturity

Inputs: Exposure type Business Unit Name Underlying Transaction Details Currency Amount Bank Details Purchased Plain Vanilla Option Contract

Outputs: Best negotiated Option Premium paid Bank advice Deal Slip Confirmation letter to Bank

Process chart - Purchased Plain Vanilla Option Contracts

Work out CALL/PUT option strike price, Amount, maturity and Option Type for the identified Currency pair.

Consult REUTERS/Bloomberg for the given structure

Calculate premium amount payable using Option Premium Calculator

Obtain quotes for premium for required structure from at least TWO BANKS and verify with own calculations

Select authorized Bank where the premium offered is lower

Call the FX Desk of the selected Bank, ask Dealers name

Mention purchase of CALL/PUT option with structure details and negotiate premium percentage %

Confirm deal

Give the underlying contract details. Confirm American / European option, CALL/PUT, currency Pair, maturity, strike price. Premium to be paid in INR

II. Range Forward (zero cost) Option Contracts A range forward deal involves the simultaneous purchase and sale of call and put options, for the same principal amount and period, but at different strike prices. Here the corporate gives up some of the profit potential in return for a reduced premium liability. A zero cost range forwards is a particular type of range forward where the strike prices for the call and put options are chosen in such a manner that there is no premium payable i.e. the premium payable for the options bought are exactly offset by the premium to be received on account of the options sold.

Risks Valuation of option contract is difficult. Premium paid has built in margins of Bank dealers and is not transparent European options cannot be exercised before maturity

Inputs: Premium to be paid on purchased option Premium to be received on sold option Range of prices for exercising strike price

Range Forward (Zero Cost) Options Contract

Outputs: Spot price risk hedged for short maturity Payment of premium to Bank (if any) Limited FX Desk profit over and above premium paid (if any), when strike price is not exercised

Example Transaction

Underlying exposure: Imports in Japanese Yen (purchase order amount = 29,250,000) 1 month Forward USD / JPY = 117.00

corporate FX desk buys USD 2,50,000 ATM European Call option on Japanese Yen for 1 month at strike price of USD / JPY = 117.00, and pays a premium of 2% (234 pips).

corporate also writes (sells) a USD 2,50,000 OTM Put option on the Japanese Yen for the identical maturity to the counter party at a strike price of 120.00 and receives a premium of 1.5% (180 pips) from the counter party.

(Assumptions Spot USD / INR = 47)

Net premium paid to the counter party

= 234 180 = 54 / 100pips (47 / 117) 250000 = INR 54, 234 /-

USD / JPY = 110

USD / JPY USD / JPY USD / JPY = 117 118 = 120 = 125 Counter partys profit profile

Corporate profit profile

Corporate will exercise its strike price at 117.00 if the USD / JPY exchange rate is below 117 on maturity. Counter party will exercise its strike price at 120.00 if the USD / JPY exchange rate is above 120 on maturity.

Spot rate on Option Expiry Date USD / JPY > 117 < 120

Has the hedge worked? Corporate will let the Option expire. Transaction is settled at the spot rate. FX Desks P/L = spot rate (117 + 0.54) profit Corporate will exercise strike price. Transaction is settled at the strike price. FX Desks P/L = (0.054) loss Corporate will let the Option expire. Transaction is settled at the spot rate. FX Desks P/L = 120 (117 + 0.54) profit

USD / JPY < 117

USD / JPY > 120

III. Exotic Options Knock-out and knock-in options: These are together known as Barrier Options and have a conditionality clause built into them. For instance, knock-out options cease to exist when the spot rate moves in a certain direction and touches a specified trigger level while knock-in options come into existence only when the spot rate touches a specified trigger level. The main advantage of these options is their smaller up-front premia compared to plain vanilla options. The trigger level can be above or below the present spot rate. Options that get knocked out when the spot rate touches a higher trigger level are called Up-and-Out options while those that get knocked out when the spot rate hits a lower trigger level are called Down-and-Out options. Knock-in options are also either Up-and-In options or Down-and-In options. A simple call or put - option is nothing but a knock-out option plus a knock-in option with the same strike and same trigger level. If these options are used for risk management, you would normally buy options which get knocked-out when spot rate has moved and is expected to move in your favor or knocked in when the spot rate has moved against you and is threatening your risk limit. That is, a call option will get knocked out when the spot rate falls to a lower trigger level or gets knocked in when the spot rate rises to a higher trigger level.

If you expect a temporary adverse price movement followed by a major trend reversal in your favor, you could do the opposite, that is, buy a call option that gets knocked in when the spot rate falls to lower trigger level. In such cases, you will still have to guard against an earlier-than-expected trend reversal through good-till-cancelled stop-loss orders. There are many zero-cost exotic combinations of simple options and knockouts or knock-ins. One such version is called Smart Forward. Essentially, this is an out-of-the-money synthetic forward contract which you can walk away from if the maturity spot is more favorable provided a pre-specified trigger level has not been traded at any time during the life of the option. For example, for a 3-month euro liability with spot at 0.87 and ATM strike of 0.8740, if you specify your cap or risk limit as say 0.90, the bank may tell you that the trigger for the zero-cost smart forward is say 0.85. What this means is that if the spot rate trades at 0.85 any time during the life of the option, you will be obliged to buy euros at 0.90 irrespective of the maturity spot. On the other hand, if the spot rate has never hit the trigger level, the smart forward is like a simple out-of-the-money option. Besides, the more out-of-the-money the strike price is, the further is the trigger from the current spot rate. A few words of caution would not be out of place at this juncture. The names given to this and other similar hedges are so alluring as to make you feel smart, enhanced and so on. So be it but beware of the risks and dont let these exotic names lead you up the garden path. How would it look, if in the above case the maturity spot of the euro is say 0.80 and you have to buy at 0.90? In a lighter vein, one slip and a smart forward might look like a dumb backward!

3. Currency Futures

Futures are similar to a FX Forward The major difference being Futures are traded on an Exchange while Forwards are OTC contracts No Rupee Futures contract exists at the moment Cross currency futures are actively traded in the major exchanges of the world Prices on these exchanges are very competitive and the exchanges are very professional Using futures is advisable only if one is prepared to participate proactively Trades can be put through the members of the exchange only

OBJECTIVES OF THE FIRM IN FOREX RISK MANAGEMENT

A firm might participate in the foreign exchange markets to achieve one or more of the following objectives: A. Hedge against the risk of currency exchange loss: Hedging has advantages similar to those of insurance: to mitigate the risk of losses from unexpected adverse changes in the exchange rates. B. Speculative Gains: At times, hedging might only be a smoke screen and the real intent of the firm might be to profit by trading in foreign exchange markets. The profit objective might not be the stated objective. Often, large cash-rich multinationals may take active positions in the foreign exchange markets for profit motive. C. Smoothing earnings: Hedging helps in minimizing the impact of changes in currency rates and thereby increases the certainty of cash flows and operating incomes. D. Competitive advantage: Forex risk management provides a competitive advantage in maintaining profit margins and market share. Consider the case of a firm that has exported software worth $10,000 receivable in three months, and the firms operating cost is Rupees 360,000. Suppose a 3-month forward sale contract is available at Rupees 45.00/$ so that the firm could be assured of a profit margin of Rupees 90,000 (i.e. $10,000 x Rupees 45.00 Rupees 360,000). If the firm does not hedge the Forex risk, and the USD declines to Rupees 43.00, the firm could lose Rupees 20,000 reducing its profit margin to Rupees 70,000. If the firm tries to increase the price of its product to make up for the lost profit, its products might become uncompetitive and the firm could lose sales and its market share. Foreign Exchange Risk management in the organization is subject of very due diligence. Organizations should have designed and implement the strategies or solution on their customize requirements rather than following or

accepting readymade solutions or models available in the market.

While

developing strategies for risk management should decide the motives behind in prior like

Does organizations motive is to safeguard against unexpected change in exchange rates and streamline the earnings? Does Organization want to earn profit on favorable rates and also want to hedge the risk appropriately? Does organization want to speculate on exchange rates and allows treasury to play role of profit center?

So by keeping in mind above questions organization can in general develop the hedging program. Here I have tried to explain the strategies of the organizations, which have different exposure according to their business operations. We have tried to develop a five step hedging procedure, which can be followed by every organization.

Strategy Development
Step 1: Exchange Forecasting The First step involves reviewing the likelihood of exchange movements. The treasury staff or FOREX department, if any, estimates possible ranges for dollar (or whichever is the foreign currency) strength or weakness over a year planning horizon. In doing so, the major factors expected to influence exchange rates, such as the U.S. trade deficit, capital flows, the U.S. Budget deficit, and government policies regarding exchange rates etc. are taken into consideration.

Step 2: Assessing strategic Plan Impact Once the expected future exchange rate ranges are estimated, cash flows and earnings are projected and compared under the alternative exchange

scenarios, such as strong dollar and weak dollar. These projections should made for a year on a cumulative basis and also on month to month basis because it provide more useful information concerning the magnitude of exchange exposure associated with the companys plan. Step 3: Deciding whether to hedge In deciding whether to hedge exchange exposure, Organization should focused on the objective of maximizing cash flows and on the potential effect of exchange rate movements on the firms ability to meet its strategic objectives. This focus is ultimately intended to maximize shareholder wealth. Step 4: Selecting the Hedging Instruments The objective of this step is to select the most cost - effective hedging tool that can accommodate the companys risk preferences. Firm should choose the most effective tool from various hedging tools, such as forward currency contracts, foreign currency borrowing, Currency futures and options etc. Step 5: Constructing a Hedging program Having selected hedging instrument as the key hedging vehicle, the company still had to formulate an implementation strategy regarding the term of hedge, the contract rates, and the percentage of income to be covered. After simulating the outcomes of alternative implementation strategies under various exchange rate scenarios organization should decide various tools and terms and exposure to be hedged. Various computer based models can also been used now a days to design effective hedging program.

Field Report at Harsha Engineers Ltd.

As a practical part of my project I have taken real time exposure at Harsha Engineers Ltd. a customer of VADILAL. As per above designed program I had tried to study risk management strategies used by HEL in its main field i.e. exports.

Vadilal provides HEL daily reports with daily briefing about currency movements, present scenario and also advice them for their exposures. It also provides HEL weekly, monthly and special reports which are very useful in understanding the market and to forecast currency movements. ABOUT COMPANY

HARSHA ENGINEERS LTD is Indias leading Bearing Cage manufacturing company with a formidable international presence. HARSHA has been established on 1st September, 1972. Its a deemed Ltd. Company with Net Sales of Rs. 200 crores as on 31.03.2006 located at Changodar (Three Division and Corporate office), Moraiya (EOU) and Odhav, at close proximity in metro city Ahmedabad. The complete product range of HARSHA is as below:

1. 2. 3. 4. 5. 6. 7.

Steel Tapered Roller Bearing Cages Steel Pre Riveted Ball Bearing Cages Brass Spherical Cages Brass Cylindrical Bearing Cages Brass Angular Contact Bearing Cages Steel Cylindrical Bearing Cages Special Application Cages

The Prime Customers of HARSHA are:

HARSHA is proud of the fact that it is been a single source of supply to many of these companies for over a decade and more and every major bearing manufacturer feature in its client list. Indigenous 1. 2. 3. 4. 5. 6. 7. 8. Export 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. British Timken Timken Europe Timken Brazil Timken Romania Timken Italy Timken USA Timken Canadian FAG Germany SKF Altoona SKF Hanover SKF Uitenhage (South Africa) Timken Ltd., Jamshedpur Tisco, Khadakpur SKF Bearing (I) Ltd., Pune & Banglore ABC Ltd., Bharuch & Lonawala FAG Precision Bearings (I) Ltd., Vadodara HMT Ltd., Hyderabad NEI Ltd., Jaipur NRB, Jalna

As HEL is a manufacturing company and mainly in exports, it has risk of foreign currency depreciating. It has exports i.e. receivables in mainly USD, EUR and JPY. Now a days market is very much volatile so it is required that HEL choose the right tool to manage the risk involved.

Policy at HEL HEL believes not to trade in an aggressive manner. The main objective is to hedge against the risk of currency exchange loss. As per their policy they always keep 60% exposure open and covers only 40% with the use of risk management tools Risk Management tools used by HEL 1. Forwards 2. Zero cost options 3. Interest Rate Swap Steps undertaken at HEL for Risk management

1. 2. 3.

Study the exposure details Decide that whether to go for hedging or to keep the exposure open Decide how much to hedge on the basis of expected volatility in the market

4. 5.

Call for the structures from the banks for the hedging tool Take the advice from Vadilal Enterprises Ltd. On the structures provided by the banks

6.

Exercise the tool.

Role of Vadilal Enterprises Ltd. at HEL At HEL the major Foreign Exchange Risk Management decisions are taken on the basis of advice given by expert personnel from Vadilal. Personnel at HEL make their forecasting with the help of daily as well as special reports provided by Vadilal. Vadilal conducts seminar and workshops at HARSHA to make their employees aware about the pros and cons of various risk management tools and also the recent development and currency movements.

Conclusion As per discussion with Mr. Harshendra Punjawat, finance manager at HEL it can be concluded that Forex department at HEL is very much satisfied with all the services provided by VADILAL. Their all Foreign exchange risk management decisions are based on the advice provided form VADIALAL. HEL has very big exposure in exports but still it is not taking advantage from various risk management tools. It uses only three risk management tools i.e. forward contract, zero cost options and IRS. Vadilal should convince them on benefits of taking other risk management tools. HEL is covering only 40% of their amount and remaining 60% they always keep open. Vadilal should convince them to cover more than 40% amount if there is an expectation of foreign currency depreciations.

BIBLIOGRAPHY
Books

Eun, Cheol and Bruce Resnik, International Financial Management. TMH Publication, 2004.

A.V.Rajwade, Foreign exchange International finances Risk management. Academic of business studies.

C. Jeevanandam, foreign exchange & Risk Management. Sultan Chand & Sons, 2004.

D.C.Patwari, Options & Futures, Indian Perspective. Jaico Publishing House, 2005. Magazines & News Papers

Indian Economic review, January 2006, Forex The Economic times Business Standard Business Line Websites

www.vadilalmarkets.com www.fxstreet.com www.rbi.gov.in www.debtonnet.com www.wto.org

GLOSSARY A
Arbitrage The simultaneous purchase of one commodity against the sale of another in order to profit from fluctuations in the usual price relationships. Variations include the simultaneous purchase and sale of different delivery months of the same commodity; of the same delivery month, but different grades of the same commodity; and of different commodities.

B
Basis The differential that exists at any time between the cash, or spot, price of a given commodity and the price of the nearest futures contract for the same or a related commodity. Basis may reflect different time periods, product forms, qualities, or locations. Cash minus futures equals basis. Position is implemented and liquidated.

Black-Scholes Model options pricing formula initially derived by Fisher Black and Myron Scholes for securities options and later refined by Mr. Black for options on futures.

C
Commodity As defined by the Commodity Futures Trading Commission, specifically enumerated agricultural commodities, all other goods and articles, except onions, and all services, rights, and interests in which contracts for future delivery are presently, or in the future may be, dealt.

D
Derivative Financial instrument derived from a cash market commodity, futures contract, or other financial instrument. Derivatives can be traded on regulated exchange markets or over-the-counter. For example, futures contracts are derivatives of physical commodities; options on futures are derivatives of futures contracts.

Discount Where a currency is cheaper for a forward value date, it is said to be at a discount. In case of a direct quote, discount is deducted from the spot rate for both buying and selling.

F
Forward Contract A supply contract between a buyer and seller, whereby the buyer is obligated to take delivery and the seller is obligated to provide delivery of a fixed amount of a commodity at a predetermined price on a specified future date. Payment in full is due at the time of, or following, delivery. This differs from a futures contract where settlement is made daily, resulting in partial payment over the life of the contract.

H
Hedge The initiation of a position in a futures or options market that is intended as a temporary substitute for the sale or purchase of the actual commodity. The sale of futures contracts in anticipation of future sales of cash commodities as a protection against possible price declines, or the purchase of futures contracts in anticipation of future purchases of cash commodities as a protection against the possibility of increasing costs.

L
Liquidity A market is said to be "liquid" when it has a high level of trading activity and open interest.

M
Marked-to-Market Daily cash flow system used by U.S. futures exchanges to maintain a minimum level of margin equity for a given futures or options contract position by calculating the gain or loss in each contract position resulting from changes in the price of the futures or options contracts at the end of each trading day.

P
Par Where a currency value is same for a forward value date as spot it is said to be at par. No adjustments need to be made to the spot rate where the currencies are at par to derive the forward rate as the forward rate is the same as the spot rate.

Position The net total of a trader's open contracts, either long or short, in a particular underlying commodity.

Premium (Option) 1) The price or cost of an option determined competitively by buyers and sellers in open outcry trading on the exchange trading floor. 2) An upward adjustment in price allowed for delivery of a commodity of higher grade against a futures contract.

S
Speculator A trader who hopes to profit from the specific directional price move of a futures or options contract, or commodity.

Spot Term which describes one-time open market case (CHANGE TO CASH) transaction, where a commodity is purchased "on the spot" at current market rates. Spot transactions are in contrast to term sales, which specify a steady supply of product over a period of time.

Spread (Options) The purchase and sale of options which vary in terms of type (call or put), strike prices, expiration dates, or both. May also refer to an options contract purchase (sale) and the simultaneous sale (purchase) of a futures contract for the same underlying commodity.

Strike Price The price at which the underlying futures contract is bought or sold in the event an option is exercised. Also called an exercise price.