CHAPTER 1

1.1 INTRODUCTION

FOREX MARKET
The foreign exchange market is the market where the currency of one country is exchanged
for that of another country and where the rate of exchange is determined. The genesis of
Foreign Exchange (FE) market can be traced to the need for foreign currencies arising from:

International trade;

Foreign investment; and

Lending to and borrowing from foreigners.

In order to maintain an equilibrium in the FE market, demand for foreign currency (or the
supply of home currency) should equal supply of foreign currency (or the demand for home
currency). In operational terms, the demand for an supply of home currency should be equal.
In the event of a disequilibrium venues/steps in the bring out the desired balance by:

Variation in the exchange rate; or

Changes in official reserves; or

Both.

1.2 OBJECTIVE OF STUDY

Participants in the FE market
Major participants in the FE market are:

Large commercial banks (through their campsites or dealers) operating either at retail
level for individual exporters and corporations, or at wholesale level in the interbank
market;

Central banks of various countries that intervene in order to maintain or to influence the
exchange rate of their currencies within a certain range, and also to execute the orders of
government;

Individual brokers or corporations. Bank dealers often use brokers to stay anonymous
since the identity of banks can influence short-term quotes.

Exchange markets primarily function through telephone and telex. Currencies with limited
convertibility play a minor role in the FE market. And, only a small number of countries have
established full convertibility of their currencies for all transactions.
Foreign exchange rates are quoted either for immediate delivery (spot rate) or for delivery on
a future date (forward rate). In practice, delivery in spot market is made two days later.
A FE quotation is the price of a currency expressed in the units of another currency. The
quotation can be either direct or indirect. It is direct when quoted as so many units of local
currency per unit of foreign currency. For example, Rs. 35 = US$ 1, is direct quotation for
US dollars in India. Similarly, a quotation in the USA will be $ 0.22 = Ffr1 whereas in
France, it would be Ffr 3.3 = DM 1, etc.
On the other hand, an indirect quotation is the one where exchange rate is given in terms of
variable units of foreign currency as equivalent to a fixed number of units of home currency.
For example, in India, US$ 2.857 = Rs. 100 is an indirect quotation. This type of quotation is
made in the UK. For example, in London a quotation may be made a $ 1.55 = 1.
Since 1 August 1993, all quotations in India use the direct method of quotation. Some
currencies are quote as so many rupees against one unit while others as so many rupees
against 100 units.

1.3 METHODS OF RESEARCH

This information is been collected from Secondary source such as e-data.

CHAPTER 2
2. LITERATURE REVIEW
Financial risk or exposure: can be defined as sensitivity to any outcome which could
alter the valuation of assets or liabilities on an entitys balance sheet.
Given the interlink ages in any economic system, business entities are exposed to risks
arising from diverse parts of the national and international economies.
Ideally, however, an economic entity should only be exposed to those risk that are intrinsic
to its core businesses since its returns accrue from these core activities.
Risk Management...
Thus it is necessary to manage the total risk to which a corporate/institution is exposed, in
order to eliminate unwanted risk.
Managing away unwanted risk involves setting up hedge positions, which essentially
offset the cash flows arising from the unwanted exposure, thus neutralizing the potential of
the latter to affect the balance sheet.
Exchange rate risk (ERR): is inherent in the business of all multinational enterprises as they
are to make or receive payments in foreign currencies. This risk means eventual lossed
incurred by these enterprises due to adverse movements of exchange rates between the dates
of contract and payment However, ERR does not imply that it will result into losses only.
Gains may also accrue if the movement of rates is favorable. Thus the appreciation of dollar
in 1985, for example, was beneficial for those enterprises that exported to the USA and billed
in US dollars. Conversely, the American companies exporting outside and billion in other
currencies suffered losses. Similarly, the depreciation of US dollar in 1995 caused losses to
the non-USA companies whose exports were billed in US dollars and proved profitable for
the USA companies exporting and billing in non-US dollar currencies.
In view of the substantial and significant stake in foreign countries, foreign exchange risk has
become an integral part of the management must be aware of the various techniques of
dealing with ERR. Covering the foreign exchange risk is also known as hedging the risk. If a
company in its wisdom does not want to hedge, it tantamounts to have the view that the

future movements of exchange rates will be in its favour. On the contrary, the conservative
enterprises may adopt the policy of hedging everything.
Hedging decision: companies are constantly confronted with the decision of whether to
hedge future payables and receivables in foreign currencies. Whether a firm hedges may be
determined by its forecasts of foreign currency values.
Short-term financing decision: When large corporations borrow, they have access to several
different currencies. The currency they borrow will ideally (1) exhibit a low interest rate and
(2) weaken in value over the financing period.
Short-term investment decision: Corporations sometimes have a substantial amount of
excess cash available for a short term. Large deposits can be established in several currencies.
The ideal currency for deposits would (1) exhibit a high interest rate and (2) strengthen in
value over the investment period.
Capital budgeting decision: When a Company attempts to determine whether to establish a
subsidiary in a given country, a capital budgeting analysis is conducted. Forecasts of the
future cash flows used within the capital budgeting process will be dependent on future
currency values. This dependency can be due to (1) future inflows or outflows denominated
in foreign currencies that will require conversion to the home currency and / or (2) the
influence of future exchange rates on demand for the corporations products. There are
several additional ways by which exchange rates can affect the estimated cash flows, but the
main point here is that accurate forecasts of currency values will improve the estimates of the
cash flows, and therefore enhance the company decision-making abilities.
Long-term financing decision: Corporations that issue bonds to secure long-term funds may
consider denominating the bonds in foreign currencies. As with short-term financing,
corporations would prefer the currency borrowed to depreciate over time against the currency
they are receiving from sales. To estimate the cost of issuing bonds denominated in a foreign
currency, forecasts of exchange rates are required.
Earnings assessment: When earnings of a company are reported, subsidiary earnings are
consolidated and translated into the currency representing the parent firms home country. For
example, consider a comapny with its home office in the United State and subsidiaries in
Switzerland and Great Britain. The Swiss subsidiarys earnings in Swiss francs must be

measured by translation to US dollars. The British subsidiarys earnings in pounds must also
be measured by translation to US dollars. Translation does not suggest that the earnings are
physical converted to US dollars. It is simply a recording process to periodically report
consolidated earnings in a single currency. Using the scenario just described, appreciation of
the Swiss franc will boost the Swiss subsidiarys earnings when reported in (translated to )US
dollars.
Why Exchange Rate Risk is Relevant
Volatile foreign earnings can also cause more volatile growth and downsizing cycles within a
firm, which is more costly than slow stable growth. Hedging can reduce the firms volatility
of cash flows because the firms payments and receipts are not forced to

fluctuate in

accordance with currency movements. This can reduce the possibility of bankruptcy, which
allows the firm easier access to credit from creditors or suppliers, and may allow the firm to
borrow at lower interest rates (because the perceived risk is lower). Hedging may also allow
the firm to more accurately forecast future payments and receipts, which can enhance its cash
budgeting decisions.
Exchange rates cannot be forecasted with perfect accuracy, but the firms can at least measure
its exposure to exchange rate fluctuations. If the firm is highly exposed to exchange rate
fluctuations, it can consider techniques to reduce its exposure in the following chapter. Before
choosing these techniques, the firm should first measure its degree of exposure.
Exposure to exchange rate fluctuations comes in three forms :

Transaction exposure

Economic exposure

Translation exposure.

Transaction Exposure
The value of a firms cash inflows received in various currencies will be affected by
respective exchange rates of these currencies when converted into the currency desired.
Similarly, the value of a firms cash outflows in various currencies will be dependent on the
respective exchange rates of these currencies. The degree to which the value of future cash

transitions can be affected by exchange rate fluctuations in referred to as transactions can be

affected by exchange rate fluctuations is referred to as transaction exposure.
Two steps are involved in measuring transaction exposure: (1) determining the projected net
amount of inflows or outflows in each foreign currency, and (2) determining the overall risk
of exposure to those currencies.
Transaction exposure based on currency correlations
Measurement of Currency Correlations: The Correlations among currency movement can
be measured by their correlation coefficients, which indicate the degree to which two
currencies move in relation to each other. thus, MNCs could use such information when
deciding their degree of transaction exposure. The extreme case is perfect positive
correlation, which is represented by a correlation coefficient equal to 1.00. Correlations can
also be negative, reflection an inverse relationship between individual movements, the
extreme case being - 1.00.
Economic Exposure
The degree to which a firms present value of future cash flows can be influenced by
exchange rate fluctuations is referred to as economic exposure to exchange rates. Transaction
exposure is a subset of economic exposure. However, the influence of exchange rate
fluctuations on a firms cash flows is not always due to transaction of currencies.
Economic Exposure to Exchange Rate Fluctuations
Variables That Influence the
Firmss

Local

Currency

Inflows

Local sales (relative to foreign

Impact of Local

Impact of Local

Currency

Currency

Appreciation on

Depreciation on

Variables

Variables

Decrease

Increase

Decrease

Increase

Decrease

Increase

competition in local markets)

Firms exports denominated in
local currency
Firms exports denominated in
foreign currency

Interest received from foreign

Decrease

Increase

investments
Variables That Influence the Firms Local Currency Outflows
Firms

imported

supplies

No Change

No Change

Decrease

Increase

Decrease

Increase

denominated in local currency

Firms

imported

denominated

supplies

in

foreign

currency
Interest owed on foreign funds
borrowed

The economic exposure refers to the change in expected cash flows as a result of an
unexpected change in exchange rates. For example, an American exporter who operates in
French market can increase his market share merely by reducing the French Company which
is a potential competitor to the American firm can profit indirectly from currency losses of
the American company. Thus it can be se en that though the French company is not directly
exporting but business competition can be generated on account of the strength of the
currency of competitors, which can be termed as economic exposure. Economic risks cannot
be managed as they are not reported in accounts, are difficult to quantify and perhaps
unhedgable.
Translation Exposure
The exposure of the MNCs consolidated financial statements to exchange rate fluctuations is
known as translation exposure. For example, if the assets or liabilities of the MNCs
subsidiaries are translated at something other than historical exchange rates, the balance sheet
will be affected by fluctuations in currency values over time. In addition, subsidiary earnings
translated into the reporting currency on the consolidated income statement are subject to
changing exchange rates.
Determinates of Translation Exposure
Translation exposure is dependent on

The degree of foreign involvement by foreign subsidiaries

The locations of foreign subsidiaries

The accounting methods used.

Degree of Foreign Involvement:

The greater the percentage of an MNCs business

conducted by its foreign subsidiaries, the larger will be the percentage of a give financial
statement item that is susceptible to translation exposure.
Locations of Foreign Subsidiaries: The locations of the subsidiaries can also influence the
degree of translation exposure, since the financial statement items of each subsidiary are
typically measured by the countrys home currency.
Accounting Methods: Degree of accounting exposure can be greatly affected by the
accounting procedures it uses to translate when consolidating financial statement data.
Transaction exposure: exists when the future cash transactions of a firm are affected by
exchange rate fluctuations. For example, a US firm that purchases German goods may need
marks to buy the goods. While it may know exactly how many marks it will need, it doesnt
know how many dollars will be needed to be exchanged for those marks. This uncertainly
occurs because the exchange rate between marks and dollars fluctuates over time. Also
consider a US - based MNC that will be receiving a foreign currency. Its future receivebles
are exposed since it is uncertain of the dollars it will obtain when exchanging the foreign
currency received.
If transaction exposure does exist, the firm faces three major tasks. First it must identify the
degree of transaction exposure. Second, it must decide whether to hedge this exposure.
Finally, if it decides to hedge part or all of the exposure it must choose among the various
hedging techniques available.
Identifying Net Transaction Exposure
Before the MNC makes any decision related to hedging, it should identify the individual net
reansaction exposure on a currency-by-currency basis. The term net here refers to the
consolidation of all expected inflows and outflows for a particular time and currency. The
management at each subsidiary plays a vital role in the process of reporting its expected

inflows and outflows. Then a centralized group consolidates subsidiary reports in order to
identify for the MNC as a whole, the expected net positions in each foreign currency during
several upcoming periods. The MNC can identify its exposure by reviewing this
consolidation of subsidiary positions.
Is Hedging Worthwhile?
If a firm decides to hedge its periodic future payables denominated in a foreign currency. The
forward contract is a common heeding device against this foreign currency position. If the
spot rate in the future exceeds todays forward rate, then the company will save money by
hedging its net payables (as opposed to no hedge). If the spot rate in the future is less than
todays forward rate, then the company will lose money by hedgings its net payables. A
forward rate that serves as an unbiased forecast of the future spot rate will underestimate and
overestimate the future sport rate with equal frequency. In this case periodic hedging with the
forward rate will be more costly in some periods and less costly in other periods. On the
average, it will not reduce the company cost. Thus it could be argued that hedging is not
worth while.
If the company choose to hedge only in those situations in which they expect the currency to
move in a direction that will make hedging feasible. That is they may hedge future payables
that they foresee appreciation in the currency denominating the payables. In addition they my
hedge future receivables if they forsee depreciation in the currency denominating the
receivables.
In general, decisions on whether to hedge, how much to hedge, and how to hedge will vary
with the company managements degree of risk aversion, and its forecasts of exchange rates.
companies that are more conservative tend to hedge more of their exposure.
Most company do not perceive their foreign exchange management as a profit center. The
main responsibility is to (1) measure the potential exposure to exchange rate movements,
which is necessary to assess the risk (2) determine whether the exposure should be hedged,
and (3) determine how the exposure should be hedged, if at all. Thus is normally
inappropriate for the foreign exchange management group to set a profit goal, as it may even
use some hedges that will likely result in slightly worse outcomes than no hedges at all, just
to avoid the possibility of a major adverse movement in exchange rates.

Techniques to Eliminate Transaction Exposure

If the company decides to hedge part or all of its transaction exposure, it may select from the
following hedging techniques :

Future hedge

Forward hedge

Money market hedge

Currency option hedge.

Futures Hedge
Currency futures can be used by firms that desire to hedge transaction exposure. A futures
contract hedge is very similar to that of a forward contract except that forward contracts are
common for large transactions, whereas futures contracts may be more appropriate for firms
that prefer to hedge in smaller amount.
A firm that buys a currency futures contract is entitled to receive a specified amount in a
specified currency for a stated price on a specified date. To hedge payment on future payables
in a foreign currency, the firm may desire to purchase a currency futures contract representing
the currency it will need in the near future. By holding this contract, it locks in the amount of
its home currency needed to make payment on the payables,.
While currency futures can reduce the firms transaction exposure, they sometimes backfire
on the firm. If the firm is hedging payables the locked in futures price for the currency could
end up being higher than the future spot rate of the currency (if the currency depreciates over
time). If the firm expected the currencys value to depreciate by the time it would need to
make payment, it would not purchase a currency futures contract.
A firm that sells a currency futures contract is entitled to sell a specified amount in a specified
currency for a stated price on a specified data. To hedge the home currency value of future
receivable in a foreign currency, the firm may desire to sell a currency future receivable in a
foreign currency, the firm may desire to sell a currency futures contract representing the

currency it will be receiving. This way the firm knows how much of its home currency it will
receive after converting the foreign currency, it insulates the value of its future receivables
from the fluctuations in the foreign currencys spot rate over time.
Forward Hedge
Forward contracts are commonly used by large corporations that desire to hedge. To use the
forward contract hedge, the MNC purchases that currency denominating the payables
forward. For example, if a US - based MNC must pay a Swiss supplier 1,000,000 francs in 30
day, it can re quest from a bank a forward contract to accommodate this future payment. The
bank agrees to provide the Swiss francs to the MNC in 30 days in exchange for US dollars.
The MNC hedges its position by locking in the rates it will pay for Swiss francs in 30 days.
Thus, it now knows the number of dollars it will need to exchange for francs.
If the US - based MNC expects receivable in Swiss francs in 30 days, it would like to lock in
the rate at which it can sell these francs for dollars. In this case, a request for a forward sale of
Swiss francs is appropriate. Many MNCs commonly implement the forward hedging
technique. For example, Du Pont Company often has the equivalent of $ 300 million to $ 500
million in forward contracts at any one time, to cover open currency positions.
Money Market Hedge
A money market hedge involves taking a money market position to cover a future payables or
receivable position.
Currency Option Hedge
Firms recognize that hedging techniques such as the forward hedge and money market hedge
can backfire when a payables currency depreciates or a receivable currency appreciates over
the hedged period. In these situations, an unhedged strategy would likely outperform the
forward hedge or money market hedge. The ideal type of hedge would insulate the firm
against adverse exchange rate movements but allow the firm to benefit from favourable
exchange rate movement. Currency options exhibit these attributes. However, a firm must
assess whether the advantages of a currency option hedge are worth the price (premium) paid
for it.