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NMIMS FOREX EXPOSURE MANAGEMENT

P R O J E C T R E P O R T

FOREX EXPOSURE MANAGEMENT

Pr oj ec t Gu id e : Pr of . A.
Bh L.
at ia

By
S. SH RE EK AN T
MF M-II IB , RO LL N-O 14 2
NA RS EE M ON JE E IN ST IT UT E OF M AN AG EM EN T ST UD IE S,
VI LE P AR LE , MU MB AI
AC AD EM IC Y EA R 20-2
0100 2

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TABLE OF CONTENTS

RUDIMENTS OF FOREIGN EXCHANGE...............................................................................................4


1.1 FOREIGN EXCHANGE-INTRODUCTION.......................................................................................................4
1.2 THE NEED FOR FOREIGN EXCHANGE.......................................................................................................5
1.3 CAN THE TRANSACTION BETWEEN TWO COUNTRIES BE SETTLED IN A 3RD COUNTRY?........................................5
1.4 FOREIGN EXCHANGE MARKET...............................................................................................................5
1.5 PARTICIPANT OF FOREIGN EXCHANGE MARKETS.......................................................................................6
1.6 TYPES OF DEALING IN THE LOCAL FOREIGN EXCHANGE MARKETS.................................................................7
1.7 FACTORS THAT CONTRIBUTE TO THE GROWTH OF INDIAN FOREX MARKETS.....................................................8
OVERVIEW OF FOREIGN TRADE........................................................................................................12

ORGANISATIONAL SET UP OF M/S CIBA SPECIALTY CHEMICALS INDIA LTD..................14


1.8 INTRODUCTION..................................................................................................................................14
1.9 BACKGROUND..................................................................................................................................16
FOREX MANAGEMENT POLICY..........................................................................................................17
1.10 PRE-REQUISITES..............................................................................................................................17
1.11 ANALYSIS......................................................................................................................................17
1.12 CONCEPT OF GROSS EXPOSURE AND NET EXPOSURE.............................................................................18
1.13 FRAMING A POLICY ........................................................................................................................18
1.14 PERFORMANCE EVALUATION CRITERIA................................................................................................20
1.15 FOREIGN EXCHANGE RISK MANAGEMENT POLICY OF M/S CSCIL..........................................................20
1.16 RISK MEASUREMENT APPROACH........................................................................................................21
1.17 TYPES OF FOREIGN EXCHANGE RISKS.................................................................................................22
1.18 RECOGNITION OF EXCHANGE RISKS.....................................................................................................23
1.19 FOUR STEPS IN RISK MANAGEMENT...................................................................................................24
1.20 POSSIBLE PERFORMANCE EVALUATION CRITERIA AT M/S CSCIL:.............................................................28
1.21 CONCEPT TRANSFER PRICING............................................................................................................30
1.22 PERIOD OF MEASUREMENT................................................................................................................31
1.23 NET POSITION................................................................................................................................31
1.24 EXHIBIT-1: FOREX RATES & EXPOSURES..........................................................................31
1.25 MATURITY MISMATCH OR GAPS.........................................................................................32
STRUCTURE OF LIMITS.........................................................................................................................35
1.26 OVERALL LIMITS...........................................................................................................................35
1.27 INDIVIDUAL DEALER LIMITS.............................................................................................................35
GUIDELINES FOR RISK MANAGEMENT...........................................................................................37
1.28 HEDGING..................................................................................................................................37
1.29 PASSIVE RISK MANAGEMENT..............................................................................................37
1.30 ACTIVE RISK MANAGEMENT..............................................................................................38
VALUATIONS OF FOREIGN EXCHANGE EXPOSURES.................................................................39

INTERNAL CONTROLS...........................................................................................................................40
1.31 BALANCE OF PAYMENT........................................................................................................41
1.31.1 SOME BASIC CONCEPTS.........................................................................................................41
1.32 COMPONENTS OF BALANCE OF PAYMENTS :..........................................................................................42
1.32.1 Current account..........................................................................................................................42
1.32.2 Trade flows.................................................................................................................................42
1.32.3 Invisibles.....................................................................................................................................42
1.32.4 Deficit & Surplus........................................................................................................................42
1.32.5 Capital Account..........................................................................................................................44
THE MANAGEMENT OF FOREIGN EXCHANGE RISK .................................................................46
1.33 OVERVIEW...............................................................................................................................46
1.34 SHOULD FIRMS MANAGE FOREIGN EXCHANGE RISK-HOW? ........................................47
1.35 ECONOMIC EXPOSURE, PURCHASING POWER PARITY & THE INTERNATIONAL FISHER EFFECT......................49

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1.36 FOREIGN EXCHANGE FORECASTING.....................................................................................................49


1.37 HISTORICAL PERSPECTIVE ON EXCHANGE RATE, GOLD STANDARD..............................................................50
1.37.1 Gold standard ............................................................................................................................50
1.37.2 Definition of Arbitrage ..............................................................................................................51
1.37.3 Bretton Wood’s System ..............................................................................................................51
1.38 FEATURES OF EXCHANGE RATE SYSTEM .............................................................................................51
1.38.1 Collapse of Bretton Woods System (1944 to 1971)...................................................................52
1.39 FLOATING EXCHANGE RATE SYSTEM................................................................................................52
1.40 OBJECTIVES OF LIMITED FLEXIBILITY SYSTEM......................................................................................53
1.41 CRAWLING PEG (GLIDING PARITIES ) ....................................................................................................53
1.42 MIXED SYSTEM.............................................................................................................................53
1.43 EXCHANGE RATE ARRANGEMENTS ....................................................................................................53
1.44 MARKET SIZE ...............................................................................................................................54
1.45 MECHANICS OF EXCHANGE RATE......................................................................................................54
1.46 IDENTIFYING EXPOSURE ...................................................................................................................56
1.47 METHOD FOLLOWED BY US COMPANIES............................................................................................58
1.48 EXPOSURE - TYPES AND DESCRIPTION .............................................................................63
1.49 MANAGING ECONOMIC EXPOSURE ...................................................................................64
1.50 STEPS IN MANAGING ECONOMIC EXPOSURE .................................................................64
1.51 GUIDELINES FOR CORPORATE FORECASTING OF EXCHANGE RATES ..........................................................66
1.52 TOOLS AND TECHNIQUES FOR THE MANAGEMENT OF FOREIGN EXCHANGE RISK ......................................70
FOREIGN EXCHANGE MARKET.........................................................................................................70
1.53 STRUCTURE OF THE FOREX MARKET:..................................................................................................70
1.54 MARKET PLAYERS :.........................................................................................................................71
1.55 MECHANICS OF CURRENCY TRADING: ................................................................................................71
1.56 TYPES OF TRANSACTIONS AND SETTLEMENT DATES :..............................................................................71
1.57 ARBITRAGE BETWEEN BANKS:...........................................................................................................72
1.58 INVERSE QUOTES AND 2-POINT ARBITRAGE............................................................................................72
1.59 OUTRIGHT FORWARD QUOTATIONS.....................................................................................................73
1.60 DISCOUNTS AND PREMIA IN THE FORWARD MARKET..............................................................................73
1.61 ANNUALIZED PREMIUM / DISCOUNT:...................................................................................................74
1.62 MARGIN REQUIREMENT:...................................................................................................................74
1.63 FORWARD CONTRACTS, FUTURES & CURRENCY OPTIONS...........................................74
1.63.1 Forward Contract.......................................................................................................................74
1.63.2 Currency Futures .......................................................................................................................75
1.63.3 Debt instead of forwards or futures ..........................................................................................76
1.63.4 Currency Options ......................................................................................................................77
1.63.5 Swap............................................................................................................................................78
1.63.6 Cross Rates.................................................................................................................................78
1.63.7 Controlling Corporate Treasury Trading Risks ........................................................................79
1.64 MARKET FORECASTS ......................................................................................................................80
1.65 MARKET PARTICIPANTS....................................................................................................................80
1.66 MARKET PARTICIPANTS - 4 CATEGORIES.............................................................................................81
1.67 HEDGE FUNDS................................................................................................................................81
1.68 DEALING ROOMS............................................................................................................................81
1.69 INFORMATION SYSTEMS ...................................................................................................................81
1.70 PAYMENT AND COMMUNICATION SYSTEM............................................................................................82
1.71 RISK APPRAISAL ............................................................................................................................82
1.72 BENCHMARKING .............................................................................................................................83
1.73 HEDGING ......................................................................................................................................84
1.74 STOP LOSS ...................................................................................................................................85
1.75 REPORTING AND REVIEW .................................................................................................................86
1.76 CONCLUSION .................................................................................................................................87
LATEST IN FOREIGN EXCHANGE - TECHNOLOGY ADVANTAGE...........................................88

RESREVE BANK OF INDIA REGULATIONS & DEFINITIONS......................................................92


1.77 SHORT TITLE & COMMENCEMENT......................................................................................................92
1.78 DEFINITIONS .................................................................................................................................92
1.79 SUMMARY OF EXCHANGE RATE REGIME IN INDIA.................................................................................93
1.80 EXCHANGE RATE CALCULATIONS.......................................................................................................93

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1.81 MULTI CURRENCY OPTION...............................................................................................................94


FROM THE ILLUSTRATION - LESSONS TO BE LEARNT..............................................................95

INFORMATION ON EURO .....................................................................................................................96


1.82 EVOLUTION OF EURO MARKET...........................................................................................................96
1.83 WHAT ARE EURO MARKETS ?.............................................................................................................96
FOREX MARKET IN INDIA.....................................................................................................................98

RUDIMENTS OF FOREIGN EXCHANGE

1.1 Foreign Exchange-Introduction

Foreign Exchange, simply stated, means foreign money. Thus, foreign


exchange and near money instruments denominated in foreign currency,
are called foreign exchange. In other words, all claims to foreign currency
payable abroad, whether consisting of funds held abroad in foreign
currency or bill or cheques in foreign currency etc., fall in the category of
foreign exchange.
In India, foreign exchange has been given a statutory definition:

Def: Sec 2(b) of Foreign Exchange Regulation Act, 1973 states:

“Foreign Exchange” means foreign currency and includes:

1. all deposits, credits and balances payable in any foreign currency


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

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2. any instruments payable, at the option of drawee or holder thereof


or any other party thereto, either in Indian currency or in foreign
currency or partly in one and partly in the other.

1.2 The need for Foreign Exchange

An example in this aspect would be apt to understand the need of Foreign


Exchange.

A Japanese company exports electronic goods to USA and invoices the


goods in US Dollars. The American importer will pay the amount in US
dollars, as the same is his home currency. However, the Japanese
exporter requires Yen i.e. his home currency for procuring raw material
locally and making payments for the labour charges incurred for the
purpose etc.

Thus, he would need exchanging US dollars for Yen. If the Japanese


exporter invoices his goods in Yen, then importer in USA will get his dollars
converted in Yen and pay the exporter. And therefore, it can be inferred
that in case goods are bought or sold outside the country, exchange of
currencies becomes necessary.

1.3 Can the transaction between two countries be settled in a 3rd


Country?

Yes, it is also possible that the transactions between two countries might
be settled in the currency of third country.

Ex:
An Indian exporter, exporting goods to Singapore may raise an invoice for
the goods sold in US dollars and as the importer in Singapore has to make
payment in US dollars and as the importer in Singapore has to make
payments in US dollars, he will have to exchange his Singapore dollars into
US dollars. The Indian exporter on receipt of US dollars will exchange them
into Indian Rupees. Thus, as in this case, the transaction may give rise to
exchange of currencies in the exporter’s country as well as the importer’s
country. Such transaction may give rise to conversion of currencies at two
stages.

1.4 Foreign Exchange Market

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Foreign Exchange market is in fact misnomer or misleading in as much as


there is no market place as such which can be called foreign exchange
market. However, it is a facilitating mechanism through which one country’s
currency can be exchanged i., e bought or sold for the currency of another
country. It does not have any geographic location. The foreign exchange
market comprises of all the foreign exchange traders who are connected to
each other throughout the world through telecommunication network. They
deal with each other through telephones, telexes, and electronic systems.
With advent of advanced technology like Reuters Money 2000-2, it is
possible to access any trader in any corner of the world within a few seconds.
In fact now deal can be done through electronic dealing systems that allow
bid and offer rates to be matched automatically through central computers
and thus transaction take place in jiffy.

1.5 Participant of Foreign Exchange Markets

Any one who exchanges the currency of one country for currency of
another country or needs such services is said to participate in foreign
exchange markets. The main players in the foreign exchange markets are:

a. Customers

The customers who are engaged in foreign trade participate in


foreign exchange markets by availing of the services of banks, like
an exporter or importer. Also services may be required for settling
any International obligations i.e., payment of technical know-how
fees or repayment of foreign debt etc.

b. Commercial Banks

Commercial banks dealing with international transactions offer


services for conversion of one currency into another. They are the
most active players in forex market.

c. Central Banks

The central banks, in most of the countries, have been charged


with the responsibility of maintaining the external value of the
currency of the country. If the country is following a fixed exchange
rage system then the central bank has to take necessary steps to
maintain the parity i.e., the rate so fixed. Even under the floating
exchange system the central bank has to ensure orderliness in the
movement of exchange rates. This is achieved by central bank’s
intervention in the forex market. Apart from intervention the Central
bank deal in the foreign exchange markets for the purpose of:

• Exchange rate Management

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Sometimes it is achieved thru the intervention yet where a Central


Bank is required to maintain external rate of the domestic currency
at a level or in a band so fixed, they deal in the market to achieve
the desired objective.

1. Reserve Management

Central Bank is predominantly concerned with investment of


countries foreign exchange reserves in fairly stable proportions in
range of currencies, and in a range of assets in each currency.
These proportions are, inter-alia, influenced by the structure of
official external assets/liabilities. The process of reserve
management inevitably involves a certain amount of switching
between currencies.

d. Exchange Brokers

In India dealing is done in inter bank market through forex brokers.


Similarly, in London, New York and Paris inter bank transactions
are put through forex brokers. However, in India the A Ds are free
to deal directly among themselves without going through brokers.
The forex brokers are not allowed to deal in their own account all
over the world and also in India.

e. Speculators

Major chunk of the foreign exchange dealings in the forex market is


on account of speculators and speculative activities.

Banks do the same in view to make profit on account of favorable


movement in exchange rates, take positions, i.e. if they feel that
rate of a particular currency is likely to go up in short term then they
buy currency and sell it as soon as they are able to make quick
profits.

Corporations-MNCs & TNCs having business operations beyond


their national frontiers and on account of their cash flows being
large and in multi currencies get into foreign exchange exposures.
With a view to take advantage of the exchange rate movements in
their favor they either delay covering exposures or do not cover
until cash flows materialize. Sometimes they take positions so as to
take advantage of the exchange rate movement in their favor and
for undertaking this activity they have state of art dealing rooms.

As the exchange controls have been loosened, in India also some of the
big corporates are booking and canceling forward contracts and at times
the same borders on speculative activity.

1.6 Types of dealing in the local Foreign Exchange Markets

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• Merchant Transaction
When authorized dealers buy/sell foreign exchange from/to
exporter/importers and other customers then it’s called a merchant
transaction. This transaction can be undertaken only on account of
genuine exposure of the customers and speculation is prohibited.
These merchant can book, re-book, cancel forward contracts with
Authorised Dealers with respect to their genuine foreign exchange
exposure. This facility was available to residents only. However, RBI
has loosened the grip further and allowed NRIs/FIIs also to book
forward contract for certain accounts/investments by them in India.

• Inter-Bank Transaction
When one bank deals with another bank i.e. buys/sells foreign
exchange, it is known as inter bank dealing. The banks in India are
allowed to deal freely amongst themselves. Most of the banks are not
market makers and rather they are market users. Thus, there is not
much liquidity and depth in the foreign exchange market in India and
the market notices even the small demand or supply. After Rupee has
joined the freely floating currencies there are days when exchange
rates in inter bank markets have been very volatile and RBI has been
forced to intervene in the market almost on regular basis, particularly
during such periods.

• Overseas Transaction

When a bank in India buys/sells foreign exchange in the overseas


foreign markets then it is called an overseas transaction. The banks in
India can cover its positions arising out of merchant transactions or
inter bank dealings freely in overseas exchange market. RBI has also
permitted banks on a selective basis to initiate positions overseas.

• Transaction between Banks and RBI

After introduction of Modified Liberalized Exchange Rate Management


System (Modified LERMS) and on account of amendment to Section
40 of RBI Act, 1934, RBI is not obliged to sell foreign exchange but
buys foreign exchange offered to it buy A Ds at market related rates.
Therefore, RBI has discontinued, w.e. f Oct 4th 1995, the practice of
announcing its two way exchange rates. However, the RBI has been
invested with the right to intervene in the market as and when
necessary and it intervenes in its wisdom it deems fit. In fact RBI has
been buying foreign exchange when there was excess supply in the
market. RBI has also been intervening in the market through Spot,
Forward & Swaps quite often after the Rupee started floating, so
called, freely.

1.7 Factors that contribute to the growth of Indian Forex Markets

Global Forex market has taken quantum jump and the Indian market has
followed suit.

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Better communication network like telephones, telexes, SWIFT,


Reuters/Telerate system etc., have been made available to the forex
dealers and these have contributed to the speed and efficiency of the
market. Thus, they are able to generate larger turnover.

Rigid and tight exchange controls have been relaxed and the banks are
completely free to deal in the inter bank market as also, to some extent, in
the overseas market.

With opening up of the banking sector to private sector more players have
been added to the market. Also, many more foreign banks have set up
shops in India and those, which were already operating, have established
more branches. This has contributed to higher foreign exchange turnover.

Banks have been allowed to have, albeit to a small extent, an access to the
foreign currency assets and liabilities. With limited integration of Indian and
overseas forex markets, banks have access to the inter bank markets for
conversion of forex funds into Indian rupees and re-conversion of the same
on a continuous basis has given the fillip in the market.

The Liberalised Exchange Rate Management System and freedom given to


the corporates to book, re-book and cancel forward
contracts so long they have the genuine exposure, have also contributed to
the increased inter-bank dealings and consequently increase in the trading
volume in the foreign exchange markets.

• Types of currencies traded in Indian Market

The major currencies being traded in the Indian Forex market are US
dollar, Pound Sterling(GBP), Deutsche Mark(DEM), Japanese Yen(YEN),
French Franc(FRF), Swiss Franc(CHF), Italian Lira(ITL) etc. The market
also trades in exotic currencies like Middle East currencies. The EURO is a
new single currency used by most of the nations of the Western Europe. It
will gradually replace national currencies such as German Mark or the
French Frank etc. Thus, Euro will also play a major role as far trading in
India in concerned.

• Growth of forex market over the years

The forex market is the world's largest financial market, with $1.4-trillion in
transactions daily. The turnover in the Indian forex market has also been
increasing over the years. The average daily gross turnover in the dollar-
rupee segment of the Indian forex market (merchant plus inter-bank) was in
the vicinity of US$ 3 billion during 1998-99. The daily turnover in the
merchant segment of the dollar-rupee segment of foreign exchange market
was US$ 0.7 billion, while turnover in the inter-bank segment was US$ 2.3
billion. The average daily turnover in the spot market was around US$ 1.2
billion and in the forward and swap market, the daily turnover was US$ 1.8
billion during 1998-99.

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• FEDAI's role in the forex market

Foreign Exchange Dealers Association of India (FEDAI) sets the ground


rules for fixation of commissions and other charges, and also involves itself
in matters of mutual interest of the Authorised Dealers. FEDAI also
accredits brokers through whom the banks put through deals.

• Authorised dealers in foreign exchange

RBI may, on an application made to it in this behalf, authorise any person


to deal in foreign exchange or in foreign securities, as an authorised dealer,
money-changer or off-shore banking unit, or in any other manner as it
deems fit.

Generally, authorisations, in the form of licenses, to deal in foreign


exchange, are granted to banks, which are well equipped to undertake
foreign exchange transactions in India. Authorisations have been given to
certain financial institutions to undertake specific types of foreign exchange
transactions incidental to their main business, which are also called
`restricted authorised dealers'.

• Rupee quoted against Dollar

In India, we follow a direct exchange rate quote which gives the home
currency price of a certain amount of the foreign currency quoted, i.e. the
amount of foreign currency is fixed and the amount of home currency
keeps varying with the change in exchange rate. This, however, is not the
only method of quoting the exchange rate; banks in Great Britain quote the
value of the pound Sterling in terms of the foreign currency, which is called
the `indirect exchange rate quote'. The form of quoting Pound sterling,
Euro and Australian Dollar is called indirect quote because GBP has
always been stronger than USD, even Euro started as a stronger currency
than USD and Australian Dollar is the commonwealth currency so it has to
follow the path of GBP.

• Activities that can possibly carry foreign exchange exposure

Foreign exchange exposures arise from many different activities. A traveler


going to visit another country has the risk that if that country's currency
appreciates against their own, their trip will be more expensive.

Similarly, an exporter who sells his/her product in a foreign currency faces


the risk that if the value of the Indian rupee appreciates vis-à-vis dollar, his
revenue in terms of the Indian rupee, nose-dives.

An importer, who buys goods priced in foreign currency, faces the risk that

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the rupee might depreciate against the dollar, thereby making the local-
currency cost of the imports greater than expected.
• Authorised money-changers and the powers they are they vested with

The Reserve Bank of India has empowered certain people, i.e. shops,
emporia, travel agents, etc., to deal in foreign currency, subject to certain
restrictions. They are not allowed to deal in foreign exchange; rather they
are supposed to play the role of facilitators for undertaking the function of
money changing. They are required to provide facilities for encashment of
foreign currency to visitors from abroad, especially foreign tourists.

They can be classified into two categories, i.e., full-fledged money-


changers who can undertake both purchase and sale transactions with the
public, and restricted money-changers who are authorised only to purchase
foreign currency notes, coins and travelers cheques, subject to the
condition that all such collections are surrendered by them in turn to an
authorised dealer in foreign exchange/ full-fledged money-changer.
• Has the Reserve Bank permitted exchange brokers to operate in the
foreign exchange market?

Yes, the Reserve Bank of India has stated that there is no objection to
employment of brokers, but in all cases, their principal as well as the
brokers must comply with the requirement of the exchange control.
Exchange brokers are, however, not authorised to deal in foreign exchange
on their own account, hence, they should not purchase or sell foreign
exchange from/to the public.

• Does a customer, i.e. an importer, exporter or any other person, have


the liberty to enter into a trade contract in whichever currency he or she
desires?

The Reserve Bank of India has not placed any restrictions on any foreign
currency being chosen for trade purposes, but the EXIM policy stipulates that
all export contracts and invoices shall be denominated in permitted
currencies only, i.e. freely convertible foreign currency.

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OVERVIEW OF FOREIGN TRADE


Any business is open to risks from movements in competitors' prices, raw
material prices, competitors' cost of capital, foreign exchange rates and
interest rates, all of which need to be (ideally) managed.

These Risk Management Guidelines are primarily an enunciation of some


good and prudent practices in exposure management. They have to be
understood, and slowly internalised and customised so that they yield
positive benefits to the company over time. It is imperative and advisable
for the Apex Management to both be aware of these practices and approve
them as a policy. Once that is done, it becomes easier for the Exposure
Managers to get along efficiently with their task.

The efforts of globalization of Indian economy have set a new pace to


foreign trade. Further, the advent of economic reforms, liberalisation,
deregulation & the process of opening up the economy to global players
had a far-reaching impact on foreign trade. Capital flows across nations
have registered a quantum leap with the removal of rigid exchange controls
by many nations and the consequent increase in cross-border trade. The
impact of these developments is visibly obvious in the developing nations.

It can be observed that foreign trade constituting exports and imports were
USD 46391 Mio in the year 1990-91 which increased to USD 73872 Mio in
1995-96 and subsequently to 107456 Mio in 1999-00. It is also
encouraging that the exports now finance over 78 percent of imports
compared to only about 60 percent in the latter half of the eighties. India’s
export performance grew by 11.5 PA; almost double that of world exports
which grew by 5.6 percent. Similarly, the quantified export growth was 20
percent in 1996-97, 18 percent in 1997-98 & 21 percent in 1998-99.
Measured by all standards India’s foreign trade definitely entered as fast
track in the new global trajectory. Therefore, the demands on Public Sector
Banks (PSBs) too increased in the area of handling international trade and
related services.

While the expansion in economic activities in various other sectors could be


handled by emerging new financial institutions and non-banking financial
institutions, the requirements of foreign trade, international settlement of
transactions, global funds transfer and other exotic services related to
Foreign Exchange (FX) transactions need to be routed through the
authorised dealers. Therefore, the pressure for service centers more on the
selected authorised branches of PSBs and EXIM bank.

But, on the other hand, the infrastructure to handle foreign trade in Public
Sector Banks is growing at a lesser pace than the pace of growth of foreign
trade, which often creates a vacuum impinging the quality of services. The
attempt of PSBs to cope with growing demand is transparent.

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The opening of specialised FX desk in branches, the proliferation of


dedicated overseas business branches, mechanisation of operations,
introduction of new range of products/services etc. are certainly the
manifestation of PSBs to meet the needs of increasing foreign trade
entrepreneurs.

These large increases in foreign trade by India are having its effects
directly or indirectly on every organisations. The reduction of import duty
tariffs is exposing domestic organisations to the global environment.
Domestic organisations are now restructuring their business to take
advantage of lower imports in order to produce more competitive finished
goods.

Similarly, reduced costs and incentives provided by the Government to


promote exports attracts the domestic organisations to export trade.

This new environment has forced the organisations to participate in foreign


trade, which in turn has led them to face new foreign currency exposure. In
the succeeding sections, we shall see more of M/s CSCIL, its policies for
handling its Foreign Trade Exposures and other related matters of Foreign
Trade, and managing of foreign exchange exposures.

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ORGANISATIONAL SET UP OF M/S CIBA SPECIALTY


CHEMICALS INDIA LTD
1.8 Introduction

M/s CSCIL was incorporated in the year 1975 on the 1st of July with an
authorised Share Capital of 10000000 Equity Shares of Rs.100/- each
amounting to Rs.10 Crore. Issued, Subscribed and Paid-up share capital
amounted to Rest. 5 Cores made up of 500000 equity shares of Rs.100/-
each with 51% foreign stake. The Parent Company of Ciba Specialty
Chemicals Inc. is based in Basle, Switzerland. It is a multi-segment; multi
product range is now diversified into the following areas:

1. Plastic Additives
2. Coating Effects
3. Water & Paper Treatment
4. Textile Effects
5. Home & Personal Care

With respect to the exposures in Foreign Currency, the Company has


exposures in respect of:

1. Imported Raw Materials & Capital Goods


2. Exports
3. Royalty Payments
4. Technical Know-how Fees
5. Commission in respect of Exports
6. Dividend Remittance
7. Income from Research & Development Services rendered

The figures for last 5 years in relation to imports & exports have been
tabulated below and also presented graphically. It is observed that M/s
CSCIL is a net importer and, therefore, its policy is based on imports. Exports
are, therefore, considered as an internal hedge, subject to mismatches of
maturity dates. It is important to note here that any adverse impact of rupee
depreciation or devaluation will have a favourable impact on exports and vice
versa.

Now, moving onto a sound risk management policy vis-à-vis the policy of M/s
CSCIL the following graph will make an attempt to understand how each of
the above mentioned exposures are managed.

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IMPORTS OF CSCIL IN THE LAST 5 YEARS

Year 95-96 96-97 97-98 98-99 99-00


Rs.Crores 15.23 20.48 36.76 62.40 83.96

CSCIL IMPORT- LAST 5 YEARS

60
Year
CRORES

40
RS.

95-96

99-00
20 96-97

98-99
97-98
96-97
0 97-98
95-96
Year

1 2
98-99
YEAR 99-00

EXPORTS OF CSCIL IN THE LAST 5 YEARS

Year 95-96 96-97 97-98 98-99 99-00


Rs.Crores 22.97 63.52 89.13 64.49 164.95

CSCIL EXPORTS- LAST 5 YEARS

22.97
63.52 95-96
164.95 96-97
97-98
98-99
99-00
89.13
64.49

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1.9 Background

Liberalisation of Indian Economy coupled with lowering of import tariffs on


one hand and thrust on exports on other hand has resulted into significantly
higher transactions denominated in foreign currency for many Corporates.
Up to 1992, for a long time, Indian Rupee was continuously but steadily
depreciating against major foreign currencies. Forex Management was
relatively easier, as steady decline of Indian Rupee was more or less
matched by the forward cover premiums.

The year 1992 saw Indian Rupee being officially devalued by more than
10% in 8 days time. This was followed by huge inflow of foreign currency
in the country. The huge inflows were not only due to increase in exports,
but also due to Foreign Direct Investments (FDI) and Portfolio investments
by Foreign Institutional investors. As a result, the USD vis-à-vis Rupee rate
was rock steady at about Rs.31.40 - 45 for more than 30 months.
However, during this period also, USD suffered a setback of more than
20% between May 1994 to August 1994 against European currencies and
Yen. Indian Rupee is linked to other currencies through USD. Therefore, it
also depreciated by 20% against European currencies and Yen.

Thus, during a period of unprecedented steady Rupee against USD faced


substantial volatility. Also Corporates having exposure to other foreign
currencies had to face the same.

In the recent past alone, Indian Rupee first depreciated against USD by
more than 20% and then recovered by about 7%. USD has appreciated by
a range of 10 - 15% against European currencies and Yen.

All this brings about the importance of active Forex management by


Corporates. This paper attempts to explain all the important parameters of
active Forex management. It is broadly divided into five major sections viz:

• Forex Management Policy


• Treasury Performance Evaluation Criteria
• Policy and Performance evaluation of derivative products
• Managing External Commercial borrowings
• Concept of Transfer Pricing

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FOREX MANAGEMENT POLICY


1.10 Pre-requisites

It is said that whatever gets measured gets managed better.

The first step in this direction is having a clear forex management policy. A
detailed and well laid down policy should determine authority and
responsibility of various people involved in the process. Ideally, Corporate
Finance should be responsible for Forex Management, as finance people
are more aware of forex risk and closer to bankers who offer forex hedging
products as well as settle all forex transactions. The process is followed
sequentially as shown below:

DEPT/ACTIVITY DEPT/ACTIVITY EXPOSURE RESULT


1 Purchase Dept/ Finance Dept/Forex Forward Contract Execution 
Import Order Policy (Norms) cover Full/Part of Order
2 Sales Dept/ Exporter Finance Dept/Forex Keep part or full Sales 
Order Policy (Norms) exposure open Realisation

It is absolutely essential that the import and export order should clearly
state the currency, shipment schedule, payment terms etc. It’s
recommended that the exposure should be recognised with only on
receipt of a complete import or export order.

The following cash flows/ transactions are considered for the purpose of
exposure management.

Variable / Cash Flows Transaction Type


Contracted Foreign Currency Cash Flows Both Capital and Revenue in nature
Foreign Interest Rates, whether Floating or Fixed All Interest Payments/ Receipts
Cash Flows from Hedge Transactions All Open hedge transactions
Projected/ Contingent Cash Flows Both Capital and Revenue in nature

• Cash Flows above $100,000/- in value will be brought to the notice of the
Exposure Manager, as soon as they are projected.
• It is the responsibility of the Exposure Manager to ensure that he receives
the requisite information on exposures from various sections of the
company in time.

1.11 Analysis

These exposures will be analysed and the following aspects will be studied:

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 Foreign Currency Cash Flows/ Schedules


 Variability of Cash flows - how certain are the amounts and/ or
value dates
 Inflow-Outflow Mismatches / Gaps
 Time Mismatches / Gaps
 Currency Portfolio Mix
 Floating / Fixed Interest Rate ratio

1.12 Concept of Gross Exposure and Net Exposure

Some managements look at imports and exports separately and,


therefore, treat the exposures separately. Some are more particular
where some imports are made towards export order & therefore, net forex
inflow against forex outflow.

There are certain limitations of looking at Net Exposures:

• The period of inflow and outflow may not match;


• The currency of inflow and outflow may be different;
• Cancellation or postponement of an import or export order may
result into substantial change in risk profile.

This is the reason why exposure of imports and exports should be


managed separately.

1.13 Framing a Policy

Forex policy will reflect the management philosophy to the risk. It should
clearly state the risk the management is willing to take and the delegation
of authority, to various people.

The policies have been discussed followed by many Corporates and


recommendations of leading forex consultants. Practically, all of them
recommend a range between 25% to 75% for forward covers.

It means that the values covered should never be below 25% of the
exposure & not beyond 75% of the exposures.

A slightly different but more practical approach to this is shown below:

a) Operational or Treasury Department Level:

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COVER COVER
(MINIMUM) (MAXIMUM)
1 For professionally managed 35% 65%
and/or some what aggressive
Organisation

2 For Organisations who do not 45% 55%


have proper set up or those
who are risk averse

b) Top management level


(Owner/Managing Director/ Head of Finance)

COVER COVER
(MINIMUM) (MAXIMUM)
1 For professionally managed 25% - 35% 65%-75%
and/or somewhat aggressive
Organisation
2 For organisation who do not 25%-45% 55%-75%
have a proper set up or those
who are risk averse

Top Mangement’s decision should always be based upon input and


recommendations of either the operations level management or Banks or
Consultants. It should always be recorded in writing.

We will observe that the arithmetic mean of minimum cover and maximum
cover is 50%. This is same as the probability of getting head or tail when
we toss a coin. Here there is a question. Is there any logic in keeping the
mean at 50%?

The answer is Yes. We will see this in our next section.

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1.14 Performance Evaluation Criteria

Very few organisations have an elaborate forex policy. Even among those,
very few have performance evaluation criteria. Why?

• One major problem is that of a having reasonable and rational


performance evaluation criteria.

• The second problem could be the efforts required to evaluate the


performance. A major factor could also be the fear of a bad performance.
This issue is attacked first as it helps prepare ground for our
recommendations towards the end of this section.

Consider following factors:

1. Forex business exceeds USD 1000 billion every day. There are many
large players trying to outperform each other.

2. Forex market has rarely responded to basic fundamental factors in short


to medium terms. Short to medium term refers to a period of
1 week to 6 months. Most of the corporate exposures will be for this
period.

3. When USD started depreciating against Yen and European currencies in


1994-95, even intervention by 12 central banks of most powerful nations
in the world could not arrest the dollar fall.

4. Like any other market, forex is a zero sum game. Rewards normally
depend upon the risk one is taking.

In view of the above, it’s recommended that any performance, which is


even slightly above average, should be acceptable. Its advised not to set
very ambitious performance criteria, as this may result into total failure of
the system or taking up of undue risk by the Treasury Manager.

1.15 Foreign Exchange Risk Management Policy of M/s CSCIL


Importance:

Any institution exposed to risk on account of foreign exchange exposure


should maintain written policies and procedures that clearly outline its risk
management strategy. These policies will help the institution in managing
the impact of exchange rate/ interest rate fluctuations on its profit and loss
account and its balance sheet. The foreign exchange policy is also based
on and in consistency with the organization’s broader business strategies,
capitalization and loss bearing capacity, management expertise and
corporate philosophy on risk taking in this area. This policy seeks to
establish a sound and appropriate risk management process.

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The primary components of the risk management process are:

• A comprehensive risk management approach


• A details structure of limits
• Guidelines and other parameters used to govern risk management
• A strong management information system for controlling,
monitoring and reporting risk.

In the light of the above, we shall study, in detail the primary components
of risk management process at CSCIL.

The Board of Directors has approved the Foreign exchange risk


management guidelines. The senior management is responsible for
ensuring that procedures exist is followed strictly for conducting
transactions on a day-to-day basis. Also, the reporting and measurement
in terms of exposure for risk management is adhered to.

Responsibility for daily currency risk management activities is


concentrated in a central Treasury Function. The Corporate Treasurer is
responsible for defining and managing the net currency exposure and
gaps or maturity mismatches of the company from the exposures and
gaps of the various individual units of the company. Responsibility for
reporting risk exposures to senior management is with a unit independent
of the treasury function to ensure that control and policy compliance
objectives are met.

1.16 Risk Measurement Approach

A sound risk measurement should identify

⇒ the various types of foreign exchange risks that the institution is


exposed to (which has been listed in the earlier pages)

⇒ the point of recognition of these risks

⇒ the period of measurement.

Using these, the Corporate Treasurer defines the net position and
gaps/maturity of the company.

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1.17 Types of Foreign Exchange Risks

A foreign exchange risk can be defined as the net effect of rate


fluctuations on the Profit & Loss Account (P&L) and on the Balance Sheet
position.

In this context a foreign exchange risk impacting the P&L Account would
arise on account of:

1 Imports of raw materials/exports of goods


2 Availment of buyers/suppliers credits
3 Sundry remittances of royalty/traveling expenses etc
4 Principal amount of foreign exchange loan repayment
5 Interest payments on outstanding foreign exchange loans
6 Translation of financial statements of offshore
branches/subsidiaries incorporated overseas
7 Depreciation on fixed assets financed through foreign
exchange loans

A foreign exchange risk impacting the Balance Sheet (B/S) would be:

∗ Imports of fixed assets financed though foreign exchange loans


∗ Approvals for foreign exchange loans (loans pending draw-down)

Also important to note is the risk on account of interest rate fluctuations in the
case of loans/borrowings/lendings etc. These also need to be addressed by
an institution as they can be optimally managed with the use of derivatives
such as Interest Rate Swaps, Forward Rate Agreements etc.

Volumes of foreign exchange exposures at CSCIL as at 31/03/01 are listed


below:

Nature of Exposures Amount PA


(Rest in Mio)
Imports 1719
Exports 1631
Royalty 3
Technical Know How Fees 0
Indent Commission 2.3
Dividend @ 50% p.a. 24
Income from Research and 0
Development

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Imports
Nature of Exposure
Exports

Royalty

Technical Know
How Fees

Indent
Commission

Dividend @50%
p.a.
1.18 Recognition of Exchange risks
Income from
There are theoretically a number of alternatives when a companyResearch
should and
recognise the existence of a foreign exchange exposure. Development

I. At the time of Budgeting


II. At the time of raising import orders/receiving export
orders/approvals of foreign exchange loans
III. At the time of shipment of goods/draw down of loans
IV. On due date of payment

In order to be proactive in managing foreign exchange exposures, recognise


a foreign exchange risk from the time of budgeting as this would be the
earliest point in time where an exposure can be recognised. However, the
variations in the estimation of budgets may have a serious impact on the
profitability of a company and, therefore, M/s CSCIL recognises its exports
and covers the same only on raising of import order in the case of imports
and on receipt of a confirmed export order in the case of exports or on
approval for foreign exchange loans.

Secondly, the company should also factor in that all budgeted items will not
necessarily fructify. As regards its other exposures, the same are recognised
as and when they arise/on due dates. It is important to note here that certain
foreign exchange remittances may not really involve risk to to the remitter.

For example, M/s CSCIL remits dividends, royalty and technical know-how
fees to its parent company, M/s CSC Inc., Basle, in Switzerland based on
certain factors like dividend is paid at the rate declared on equity of the
company and equivalent USD or CHF (Swiss Francs) is remitted. Similar is
the case of technical know how fees and royalty remittances as the same are
paid as a percentage on sales.

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However, these payments needs to be managed as it would yield better


results or higher remittances to the Parent Company with a limited liability on
M/s CSCIL.

1.19 Four Steps in Risk Management

1. Understand the nature of various risks.


2. Define a risk management policy for the organization and
quantifying maximum risk that organization is willing to take if quantifiable.
3. Measure the risks if quantifiable and enumerate otherwise.
4. Build internal control mechanism to control and monitor all the
risks.

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Step 1 – Understanding Risks

Risks can be classified into five categories:


1. Price or Market Risk
2. Counter party or Credit Risk
3. Dealing Risk
4. Settlement Risk
5. Operating Risks

1. Price Risks or Market Risk


This is the risk of loss due to change in market prices. Price risk can increase
further due to Market Liquidity Risk, which arises when large positions in
individual instruments or exposures reach more than a certain percentage of
the market, instrument or issue. Such a large position could be potentially
illiquid and not be capable of being replaced or hedged out at the current
market value and as a result may be assumed to carry extra risk.
2. Counter party Risk or Credit Risk
This is the risk of loss due to a default of the Counterpart in honouring its
commitment in a transaction (Credit Risk). If the Counterparty is situated in
another country, this also involves Country Risk, which is the risk of the
Counter party not honouring its commitment because of the restrictions
imposed by the government though counter party itself is capable to do so.
3. Dealing Risk
Dealing Risk is the sum total of all unsettled transactions due for all dates in
future. If the Counter party goes bankrupt on any day, all unsettled
transactions would have to be redone in the market at the current rates. The
loss would be the difference between the original contract rate and the
current rates. Dealing risk is therefore limited to only the movement in the
prices and is measured as a percentage of the total exposure.
4. Settlement Risk
Settlement risk is the risk of Counterparty defaulting on the day of the
settlement. The risk in this case would be 100% of the exposure if the
corporate gives value before receiving value from the Counterparty. In
addition the transaction would have to be redone at the current market rates.

5. Operating Risks

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Operational risk is the risk that the organization may be exposed to financial
loss either through human error, misjudgment, negligence and malfeasance,
or through uncertainty, misunderstanding and confusion as to responsibility
and authority.
Further operating risks could be classified as under:
• Legal
• Regulatory
• Errors & Omissions
• Frauds
• Custodial
• Systems
Legal
Legal risk is the risk that the organisation will suffer financial loss either
because contracts or individual provisions thereof are unenforceable or
inadequately documented, or because the precise relationship with the
counter party is unclear.
Regulatory
Regulatory risk is the risk of doing a transaction, which is not as per the
prevailing rules and laws of the country.
Errors & Omissions
Errors and omissions are not uncommon in financial operations. These may
relate to price, amount, value date, currency, and buy/sell side or settlement
instructions.
Frauds
Some examples of frauds are:
• Front running
• Circular trading
• Undisclosed Personal trading
• Insider trading
• Routing deals to select brokers

Custodial
Custodial risk is the loss of prime documents due to theft, fire, water, termites
etc. This risk is enhanced when the documents are in transit.

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Systems
Systems risk is due to significant deficiencies in the design or operation of
supporting systems; or inability of systems to develop quickly enough to meet
rapidly evolving user requirements; or establishment of a great many diverse,
incompatible system configurations, which cannot be effectively linked by the
automated transmission of data and which require considerable manual
intervention.

Step 2 - Define Risk Policy


Decide the basic risk policy that the organisation wants to have. This may
vary from taking no risk (cover all) to taking high risks (open all). Most
organisations would fall somewhere in between the two extremes. Risk and
reward go hand in hand.
Cost Center Vs. Profit Center
A cost center approach looks at exposure management as insurance against
adverse movements. One is not looking for optimisation of cost or realisation
but meeting certain budgeted or targeted rates. In a profit center approach,
the business is taking deliberate risks to make money out of price
movements.
Step 3- Risk Measurement
There are a number of different measures of price or market risk which are
mainly based on historical and current market values Examples are Value at
Risk (VAR), Revaluation, Modeling, Simulation, Stress Testing, Back Testing,
etc.
Step 4- Risk Control
Control of Price Risk
Position limits are established to control the level of price or market risk taken
by the organization.
Diversification is used to reduce systematic risk in a given portfolio.
Control of Credit Risk
Credit limits are established for each counter party for both Dealing Risk and
Settlement Risk separately depending upon the risk perception of the counter
party.

Control of Operating Risk


Establishment of an effective and efficient internal control structure over the
trading and settlement activities, as well as implementing a timely and
accurate Management Information System (MIS).

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Tools to control operating risks


• Comprehensive Systems and Operations Manuals
• Proper Organizations structure and adequate personnel
• Separation of trading function from settlement, accounting and risk control
functions.
• Strict enforcement of authority and limits
• Written confirmation of all verbal dealings
• Voice recording
• Legally binding agreements with counter parties ensuring proposed
transactions are not ultra vires.
• Contingency Planning
• Internal Audits
• Daily reconciliations
• Ethical standards and codes of conduct
• Dealing discipline

1.20 Possible performance evaluation criteria at M/s CSCIL:

1. Spot rate on settlement date

Actual rate of remittance is compared against spot rate on settlement


date. As a result, performance of uncovered transactions is “Average” or
“0” in mathematical terms. Thus, only performance of covered
transactions gets reflected in this type of evaluation. Moreover,
throughout the exposure period, there is no target for the Treasury
Manager.

2. Forward rate on date of exposure

In this method, “Forward Rate” quoted for the expected date of settlement
is taken as standard for evaluation of performance. Since this rate is
known from day one, there is certainly a target for the Treasury Manager.
However, in this case, performance of covered transactions will be “0” or
average. Thus, only performance of uncovered transactions gets judged.
Therefore, this method is also not desirable.

Both the above methods suffer from one major limitation. They have no
reference to the forex policy of the organisation. To elaborate, in case of
1st method, if the rupee is not expected to depreciate to the extent of
premium, the Treasury Manager would like to keep all the import
transactions uncovered and cover all the export transactions.

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Similarly, when he expects rupee to depreciate beyond the premium


levels, he would like to cover all the import transactions and keep open all
the export transactions. What one must find out is whether the policy
permits taking such steps? Can a policy afford to be so flexible? If not,
then a Treasury Manager has no authority to take such extreme positions.
And when he cannot take position as per his views, can he be made
responsible for that position?

To take a concrete example, if we are following:

Method 1: Treasury Manager will incur loss on covered transaction for


imports (and uncovered export transactions), if rupee is
steady vs. premium. Since the policy requires certain
minimum cover, Treasury Manager will attribute the losses to
the policy.

Method 2: Similarly, if we are following this method and say Rupee


depreciates beyond premium, the Treasury Manager will incur
loss on uncovered import and covered exports. Again he will
attribute it to policy. In short, f the Treasury Manager cannot
take a decision to keep uncovered 100% transactions or cover
100% transactions; he cannot be expected to perform as per
either Method 1 or Method 2. Therefore, a more practical
method is recommended.

Method 3: 50% at forward rate on date of exposure and 50% at


settlement date rate, for each transaction. This method has
following advantages:

I) For 50% of the amount of each transaction, there is a clear target,


while for remaining 50%, the Treasury Manager will have to be
really alert, watchful and use his knowledge and experience of
market.

II) In method 1, performance of uncovered items does not get


evaluated, while in method 2, performance of covered item does
not get evaluated. However, in method 3, performance of both
covered and uncovered transactions gets evaluated (though only to
the extent of 50%).

III) Normally any policy will allow taking cover up to 50% and keeping
50% open. Therefore, Treasury Manager will have full authority to
reach a position, which is in line with performance measurement
criteria. Therefore, he cannot attribute anything to rigid forex
policy.

In view of the above, I am of the opinion that method III is most balanced
and acceptable way of performance evaluation.

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An imaginary but realistic situations have been taken and the


performance is calculated under various methods. The results of the
same are given in the annexure. I am sure that the example clearly
brings out limitation of the first two methods and advantages of method III.

1.21 Concept Transfer Pricing

Some company’s follow the concept of transfers pricing for forex


transactions viz. imports and exports. In this concept, the operating
divisions and Finance agree on a budget rate of exchange at the
beginning of a period, generally a financial year. During the whole year,
the transactions are passed on to the divisions at the agreed transfer
price rate. The difference between actual rate and transfer price is borne
by Finance Department. According to advocates of this concept, it helps
operating divisions to meet the budgeted targets, as they are assured of a
certain rate for forex. However, there is a major practical difficulty in this
concept.

Suppose for 1997-98, we have agreed on a transfer price @ 1 USD =


Rs.37/-. Let us assume that some divisions are importing finished goods
costing USD 10 per kg. The product is sold in the market at Rs.400/- per
kg. Now, suppose the USD/Rupee rate goes to Rs.41/- by June 1997. If
the division still continues to import the material (as it can get USD at
Rs.37/- being agreed rate with Finance), the division will make a profit of
Rs.30/- per kg. Finance losses will be Rs.40/- per kg. The Company as a
whole will lose Rs.10/- per kg. Is this situation acceptable? The reality is
that operating or business divisions must accept that there could be
changes in cost of inputs or sales realisation due to changes in exchange
rate. As a matter of fact, can some one guarantee purchase or sale price
even for local materials? Just because there is an added element of
exchange rate fluctuation, business divisions cannot pass it on entirely to
finance.

The best way to handle this kind of situation is to have a continuous


communication between Finance and business divisions. Depending on
level of forex business, Finance Division should send weekly or fortnightly
information about spot and forward rates for major currencies to business
divisions. Based on this, business divisions should take their decisions
and inform the exposure to Finance as early as possible. In exceptional
cases, if there is any large import or export order with a very small
margin, business division may insist on 100% cover specifically. Such
requests should be accepted by Finance. However, in such cases, there
should be no performance evaluation of such transactions, as the forward
cover was business decision and not a finance decision.

In summary, it’s recommended that:

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I) there should be well laid down forex policy, separately for imports
and exports. The policy should be reviewed every year.

II) There has to be performance measurement criteria, giving


weightage to both forward rate on date of exposure and spot rate
on settlement date.

III) Transfer pricing concept should be avoided as far as possible.


However, specific covers for large transactions may be taken as a
business decision.

1.22 Period of Measurement

An institution would also need to define the time period over which
exposure must be managed. For example, exposure up to 1 year or till the
financial year-end. However, as recommended that an exposure should be
recognised at the time of budgeting. The period of measurement should
coincide with the budgeting period. In case of CSCIL, the FOREX risks are
measured to a period of 1 year.

1.23 Net Position

Using these above criteria the Corporate Treasurer defines the new
position if the Company. For this purpose, the company distinguishes
between the USD/INR and the cross currency exposure for every item
independently as the local market in India determines the USD/NSR rate
only and the cover on any other currency is possible through its cross with
USD/INR. This differentiation is important as it enables the company to
match or offset exposures effectively and the hedging strategy for the
crosses would be different as compared to that of the USD/INR.

The General Manager Finance to the Managing Director reports the net
position on a weekly basis. Statistically, it’s shown in the exhibit below:

1.24 EXHIBIT-1: FOREX RATES & EXPOSURES

23-Oct-2001 0915 hrs

25-Oct-01

1 3
Currency Inter Spot 1 month month 2 month 3 month month 6 month

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% TT TT %
Bank TT buy TT Sell TT buy TT Sell premia TT buy TT Sell buy Sell premia TT Buy

47. 47.7 48. 47. 48. 48. 48. 48 48 49.


U.S. Dollar 99 9 19 99 39 0.05 22 62 .44 .84 0.05 15
0. 42.2 43. 42. 43. 42. 43. 42 43 43.
Euro 89 6 33 41 49 0.04 58 66 .76 .84 0.05 32
2. 21.6 22. 21. 22. 21. 22. 21 22 22.
Deutsche Mark 19 1 16 69 24 0.04 77 32 .86 .42 0.05 15
122. 38.7 39. 39. 39. 39. 40. 39 40 40.
Jap. Yen (100) 52 8 55 07 85 0.09 36 15 .66 .45 0.09 58
1. 28.7 29. 28. 29. 29. 29. 29 29 29.
Swiss Franc 66 3 45 87 39 0.02 01 54 .16 .69 0.05 63
1. 67.7 69. 67. 69. 68. 69. 68 69 69.
Pound Sterling 43 4 03 96 25 0.04 21 50 .45 .75 0.04 22
45. 1.0 1. 1. 1. 1. 1. 1 1 1.
Belgian Franc 23 5 07 05 08 0.04 06 08 .06 .09 0.05 07
7. 6.4 6. 6. 6. 6. 6. 6 6 6.
French Franc 36 4 61 47 63 0.04 49 66 .52 .68 0.05 60
Italian Lira 2,171. 2.1 2. 2. 2. 2. 2. 2 2 2.
(100) 19 8 24 19 25 0.04 20 25 .21 .26 0.05 24
2. 19.1 19. 19. 19. 19. 19. 19 19 19.
Dutch Guilder 47 8 66 25 74 0.04 32 81 .40 .89 0.05 66
1. 30.1 30. 30. 30. 30. 30. 30 31 30.
Canadian Dollar 58 3 65 24 77 0.05 37 90 .50 .02 0.05 91
Austrian 15. 3.0 3. 3. 3. 3. 3. 3 3 3.
Schilling 43 7 15 08 16 0.04 09 17 .11 .19 0.05 15
8. 5.7 5. 5. 5. 5. 5. 5 5 5.
Danish Kroner 34 0 81 72 83 0.04 74 85 .76 .87 0.04 83
Singapore 1. 26.0 26. 26. 26. 26. 26. 26 26 26.
Dollar 83 6 48 20 63 0.06 36 78 .51 .93 0.07 98
10. 4.4 4. 4. 4. 4. 4. 4 4 4.
Swedish Kroner 67 6 54 47 55 0.04 49 57 .51 .59 0.05 57
Australian 0. 24.1 24. 24. 24. 24. 24. 24 25 24.
dollar 51 3 81 20 89 0.04 29 97 .37 .06 0.04 64

1.25 MATURITY MISMATCH OR GAPS

By using the above criteria, the Corporate Treasurer defines the gaps of
the Company in USD/INR and the crosses. A gap reflects a mismatch
between the maturity dates and inflows and outflows thereby creating an
interest rate differential risk. For e.g., an import payment for USD 100,000
may be due on the 1st of the month and an export payment for the same
amount would be receivable of the 15th of the same month. In this case,
though the company does not have any net foreign exchange position, it
has a maturity mismatch.

This gap can be closed out by doing a “Swap” where the Institution buys
USD 100,000 for value 1st and sells USD 100,000 for the value 15th through
the money market or through Foreign Exchange forward markets.

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We shall see now how the exposures are reported to the General Manager
Finance in case of exports and imports.

Exhibit No.2 represents the reporting system of exports. When a confirmed


export order is received the same is entered in Exhibit No.2 and the
relevant data is completed from information available from the export order.

Like wise when an import order is issued in favour of some supplier, the
same is entered in Exhibit No.3. The specimen of these formats is listed
below. Exhibit 2 & 3 are sorted on due dates to find out Maturity
Mismatches or Gaps and the same are covered separately.

FOREX
EXPOSURE

EXHIBIT- 2: EXPORT OPEN ORDER-(AS ON DD\MM\YY)

PYMN
T TYPEPO NO PO DATE SHIPMENT BANK STATUS FC C/X FC AMT BUG SET BUDGTD BUDGTD
TERM DATE RATE AMT

21B 121120.12.98 21.02.99 BNP EX/1111 USD C 4414021.03.99 36.24 1599633


21B 121221.12.98 22.02.99 BNP EX/1112 USD X 6375021.03.99 36.46 2324325
21B 121322.12.98 23.02.99 BNP EX/1113 USD X 4318321.03.99 36.22 1564088
21B 121423.12.98 24.02.99 BNP EX/1114 USD C 4200021.03.99 36.92 1550640
21B 121524.12.98 25.02.99 BNP EX/1115 USD C 8400021.03.99 37.14 3119760

EXHIBIT-3 : IMPORT OPEN ORDER(AS ON DD\MM\YY)

PYMT TYPEPO NO PO DATE SHIPMENT BANK STATUS FC C/X FC AMT BUG SET BUDGTD BUDGTD
TERM DATE RATE AMT

21B I-1211 20.12.98 21.02.99 BNP DR/UR CHF X 2478021.03.99 22.33 553337
60B I-1212 21.12.98 22.02.99 BNP DR/UR CHF X 165000021.03.99 26.32 43428000
90B I-1213 22.12.98 23.02.99 ANZ DR/UR CHF H 15450321.03.99 26.49 4092784
90B I-1214 23.12.98 24.02.99 ANZ DR/UR CHF H 304021.03.99 27.65 84056
90B I-1215 24.12.98 25.02.99 ANZ DR/UR CHF X 1189521.03.99 27.71 329610

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NOTE:

Pymnt terms: Payment term of the order


Type: B-Basle, O-Others, G-group Companies
PO No: Purchase Order No
PO Date: Purchase Order Number
PO Recd: Date of which the order reaches the Treasury
Shipment: Shipment Date
Bank: Thru which Order was settled
Status: DR-document received, UR-under retirement
FC: Foreign Currency
C/X: C-covered, E-Exposed, H-Hedged
FC: Invoice in Foreign Currency Amt
BUD SETT DT: Forecasted Settlement Sate
BUD RATE: The forward rate for that duration as quoted in the
PO recd date
BUD AMT: (FC Amt X Budgeted Rate)
ACUTAL RATE: Actual Rate
ACUTAL AMT: (FC Amt X Actual Rate)
PERFORMANCE : Difference between Budgeted & Actual

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STRUCTURE OF LIMITS
The Foreign Exchange Policy should clearly outline the limits of all foreign
exchange positions and gaps of the country. These limits on risk taking
must be decided bearing in mind the risk profile of the company and the
quantum of capital the company is willing to put a risk on account of
movements of exchange rates. The foreign exchange policy as approved
by the Board of Directors should define the following limits:

1.26 Overall Limits

1. Total open position limit for the company either as a percentage of


net position or as a fixed limit based on capital adequacy.

2. Total open gap position limit for the Company.

The policy should not only define the personnel authorised to engage in
foreign exchange business but also outline who will be authorised to deal in
what type of foreign exchange products .

For example the dealers may only be allowed to engage in outright


purchases or sales of foreign exchange but all foreign exchange option
transactions are done by the Corporate Treasurer and Interest Rate or
Currency Swaps may be done subject to senior management approval.

The overall limits in the case of M/s Ciba Specialty Chemicals India Limited
are fixed at 80% to 120% of total exposure. The Direct Hedge PLUS Internal
Hedge should at no point of time of time exceed 120% of total exposure.

Hence a cascading structure of limits for all type of foreign exchange


products is to be outlined for:

• Senior Management (Managing Director/Vice President)

• Corporate Treasurer

• Dealers

1.27 Individual Dealer Limits

• Type of foreign exchange products that can be dealt.

• Position and gap limit of each authorised dealer. Each dealer can
have a different limit based on his experience and expertise.

• Deal size limit. Each dealer should have a limit on the size of any
individual deal. Different dealers may have different deal size limits.

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The policy also defines the hierarchy for approval of temporary


increases/changes in limits. The Board of Directors approves an Increase in
the total open position or open gap position of the company. Similarly, the
policy also outlines the reporting and approval hierarchy for all types of limit
excesses by the dealers or Corporate Treasurer based on the quantum of
excess.

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GUIDELINES FOR RISK MANAGEMENT


One of the following strategies may be adopted for the management of
currency exposures:

1.28 HEDGING

The company may cover all exposures for forward maturities as they arise,
i.e. when import orders are placed or export orders are received or foreign
currency loans are availed of. The company should as far as possible
match offsetting exposures prior to taking cover. However, when the
company matches offsetting exposures, this may result in a gap or a
maturity mismatch. Hence the company would need to close out these
gaps by doing Swaps.

The company may also follow a policy of keeping a certain pre-defined


percentage of their exposures covered. For example, the company may
cover only 50% of net import exposures in USD/INR, whereas net
USD/FCY could continue to be covered 100%. This strategy could, in some
circumstances, save the company the cost of USD/INR discounts.

CSCIL has its import exposures in CHF and export exposures in USD.
However, in imports, it covers only USD / Rest and covers CHF/USD either
subsequently or on spot depending on circumstances/market rates.

1.29 PASSIVE RISK MANAGEMENT

The company can choose to cover selectively and progressively based on


its view of individual currency movements. Hence, the company may leave
some portions of their foreign exchange exposure or gaps open with the
aim of capitalising on certain anticipated market movements.

However, the company could stand to lose should the market not move in
the anticipated direction. This would result in increased cost of imports or
lower realisation of exports. In order that this negative effect is contained
the company should define “Stop-Loss” limits for all open positions. The
stop-loss limit should be defined based on the quantum of money the
company is willing to risk on its open position. Conversely, “Take-Profit”
limits should also be defined to enable the company to crystallise gains on
profitable open positions.

Secondly, the company should decide the extent of total foreign exchange
exposures and gaps that the Central Treasury may keep open either as a
percentage of its total exposure, or as a fixed limit, for e.g., USD 5 million.

CSCIL has not yet defined its “stop-loss” or “take-profit” limits and its policy
is purely based on the overall limits. However in the long run it proposes to
fix such limits on the budgeted rate on the day the exposure arises.

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1.30 ACTIVE RISK MANAGEMENT

In addition to the above mentioned risk management strategies, the


company may also decide to trade in the currencies in which it has
underlying exposures and hence an existing need to manage exchange
risk. This activity should then be viewed as an additional product line or
profit center.

However, this activity should be carried out after adequate internal


approval (Board –approved). Risk Management Policy is obtained and with
an appropriate degree of internal control. This includes:

• Persons authorised to create risk positions and the spot position


limit and gap limit of each trader so authorised.

• Stop-Loss Limits for all open positions, either as a percentage


variance of the exchange rate, or as a quantum of money at risk per
trader per day/month.

• Total open position limits and gap limits for the company at any
given point in time, or total money at risk limit across these activities.

It should also be noted that, due to Exchange Control restrictions “Active


Risk Management” is curtailed to the extent possible within documentation
constraints and against underlying open exposure.

The objective of the Corporate Treasurer is managing forex exposure and


minimising losses due to fluctuations at CSCIL. Even though realised
Gains/Losses are accounted as a separate profit center the objective is not
profit making, but to cover risks. Therefore, CSCIL is in no way in favor of
Active Risk Management.

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VALUATIONS OF FOREIGN EXCHANGE EXPOSURES


The company makes an analysis of the performance of its foreign
exchange portfolio in order to value at current market rates the cost of its
imports, exports, loans, etc., and thus measure the impact of
exchange/interest movements on its Balance Sheet and Profit & Loss
Account on a monthly basis.

In order to achieve this, the company also assigns a budget rate or target
rate to its exposures as and when they arise. This rate can be the forward
value of the exposure on the day the exposure is recognised, which is
calculated by adding the premium amount to the spot value of that
currency.

The performance or the portfolio is then to be measured against these


budgeted rates by comparing the market rates prevailing at which the
exposure can be covered against the budgeted rate.

In the case of passive & active risk management, there may be trading
positions where the budgeted rate would be the rate at which the position
was initiated as this would also be valued at prevailing market rates (also
known as Market-to-Market).

Accounting for the effects of changes in foreign exchange rates may be


done in accordance with the Accounting Standards 11(revised) issued by
the Institute of Chartered Accountants of India.

Exchange Gains or Losses at M/s CSCIL are classified under the


following account heads:

1. Realised Gains/Losses - Inter Company


2. Realised Gains/Losses - Third Party
3. Realised Gains/Losses - Forward Covers
4. Realised Gains/Losses - Cancellations

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INTERNAL CONTROLS
The Institution needs to monitor open positions and stop loss limits on a
continuous basis and evaluate periodically the performance of the foreign
exchange portfolio.

The Central Treasury reports, on a weekly basis, the open positions and
open gaps to Senior Management as represented in Exhibit 1 . This is
counter checked by an Independent Settlements Departments. The
Settlements Department monitors positions of the dealers and any
excesses of any limits are to be reported directly to the senior
management.

The foreign exchange portfolio is marked to market at least once a week


and a valuation report (cross checked by Settlements) is sent by the
Corporate Treasurer to Management . The Board of Directors also reviews
the portfolio performance periodically.

Internal Audits addresses the functioning of the Central Treasury,


adherence to policy & operational risks.

ORGANOGRAM of M/s Ciba Specialty Chemicals India Limited

EFFECTIVE COMMUNICATION INCREASES PRODUCTIVITY

Case Study : Ciba Specialty Chemicals (I) Ltd.


O R G A N O G R A M
M . D
& D I R E C T O R - F I N A N C E

D I R E C T O R S

G . M . G . M . G . M
( T R E A S U R Y ) ( T A X A T I O N ) ( C O N T R O L & A / C 'S )

S R . M A N A G E RS R . M A N A G E R
F R O N T O F F I CB EA C K O F F I C E ( S T A T ) ( M I S )
D E A L E R S S U P P S E R V I C E

S R . M A N A G E R
( S T A T ) M A N A G E R

M A N A G E R
E X E C U T IV E S

E X E C U T IV E S S T A F F

S T A F F

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1.31 BALANCE OF PAYMENT

1.31.1 SOME BASIC CONCEPTS

The fundamental reason why foreign trade benefits an economy is the


so-called principle of comparative advantage. If different countries
concentrate on providing products and services in which they have
comparative advantages arising out of differences in resources, costs or
technology, then international trade can be beneficial to all the countries.
Remember, we are referring to relative, and not absolute, efficiency of
producing goods and services’ in other words, even if a country is the
most efficient producer of all the goods and services it needs it will still
benefit by engaging in international trade, as the relative efficiencies
would surely differ in practice.

1. Balance of Payments of a country is systematic records of all receipts


and payments between residents of the country with non-residents of
the country over a period of time, say one year. These receipts and
payments could be of account on account of import and export of
goods and the difference on this account is known as ‘balance of
trade.’

2. If receipt and payments on account of import and export of services like


tourism, banking, insurance etc are also added to that of goods then
the difference on this account is known as ‘balance on current account.’

3.The 3rd component of balance of payment is grants, aids, foreign


investment etc falls under Capital Account.

Thus, receipt and payments on account of all the three components make
the “Balance of Payments” of the country.

Incidentally the BOP of a country is always balanced. If the receipt under


the 3 components i., e goods, services and capital account are less than
the payments then the BOP of the country is said to be negative or
adverse. Since BOP is always balanced the balancing is done thru
Foreign Exchange Reserve of the country.

The principle of comparative advantage is easy to understand. The


classic textbook example is that of a person who happens to be both the
best lawyer as well as the best stenographer in the city.

Let us assume that as a lawyer he can earn Rest. 5000/- Per Hour while
he can hire a stenographer[who may not be as good as himself] at say
Rest. 50/- Per Hour. It obviously makes economic sense for the lawyer to
hire a stenographer and devote all his time to working as a lawyer as his
comparative advantage, given the earnings and expenses, obviously lies
in working as a lawyer. It is a known factor that international trade benefits
an economy, the question of external receipts and payments has to be
considered. It is customary to classify a country’s external receipts and

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payments under two broad headings- Current Account and Capital


Account. The third category falling under BOP is the Reserve Account.

1.32 Components of Balance Of Payments:

1.32.1 Current account

The Current Account in turn, is split under two heads -

1. Trade flows &


2. Invisibles

Of the two trade flows comprising exports and imports of goods is easier to
understand. The difference between the two is commonly referred to as the
surplus or deficit trade balance. It is customary to report imports on CIF
basis and exports on FOB basis for calculating the trade balance.

1.32.2 Trade flows

Strong economic growth of economy in 1995-96 resulted in widening of


the trade deficit to USD 8.9 bn. However, high interest rates and an
overall liquidity squeeze in the corporate sector through second half of
1996 saw growth taper off rapidly. This was reflected in non-pol
[petroleum, oil, lubricants] imports decline by 4 percent during April
November 1996 as against an increase of 36 percent last year’s, whereas
imports till November were up by 4.66 percent, exports showed slightly
higher growth at 7.81 percent, resulting in narrowing of the trade deficit.
It is expected that the trade for 1996-97 would be between 7.5 to 8 bn.
Conventionally, trade in physical goods is distinguished from trade-in
services. Invisibles comprise current international payments for items
other than merchandise exports or imports. Some of the more important
items under the head [invisibles] comprising travel, transportation and
insurance, interest, indenting
commission, export commissions, research income, dividend payments
and other miscellaneous income and expenditure.

1.32.3 Invisibles

Invisibles have maintained a rising trend in recent years, on account of


steady increase in private transfer receipts. It is expected that this trend
would continue as a moderate rate at the rate of [20] percent in 1996-97.
Trade flows and invisibles together comprise the current account of a
country and the difference give the current account surplus deficit.

1.32.4 Deficit & Surplus

Meaning of Deficit and Surplus in BOP

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1. BOP is a double entry accounting record and hence must balance


except for errors and omissions.

2. As such deficit or surplus refer to subsets of accounts included in


BOP. These are imbalances or economic disequilibria.

3. Need to optimally group various accounts within BOP statement so


as to give proper signals to the authorities to correct disequilibrium.

4. Division of entire BOP into set of accounts


a. Above the line (if the net balance is positive, then there is BOP
surplus and if negative, there is a BOP deficit).
b. Below the line (this net balance should be equal in magnitude but
opposite in sign of the balance above the line).

5. The items below the line are "compensatory" in nature. They


"finance or settle" the imbalance above the line.

6. The transactions above the line are "autonomous transactions".


This means a transaction undertaken for its own sake, in response to
given configuration of price, exchange rate, interest rate, etc. and usually
to realize profit / reduce cost. It does not take into account situation
elsewhere in the BOP.

7. An accommodating transaction (below the line) is undertaken with


a view to settle the imbalance arising out of other transactions. For e.g.
financing the deficits arising out of autonomous transactions.

8. BOP deficit or surplus is understood to mean deficit or surplus on


all autonomous transactions taken together.
Difficulties in deciding what is autonomous and what is accommodating.

9. Exports and imports of goods / services, private sector capital


flows, migrant workers remittances, unilateral gift are all clear cases of
autonomous transactions.

10. Sale or purchase of foreign exchange to engineer certain


movements in exchange rate is clearly an accommodating transaction.

11. Government borrowing from World Bank may be used to finance


the deficit on other transactions or to finance a public sector project or a
combination. In the first case, it is an accommodating transaction in the
second case an autonomous while in the third, it is a mixture.

12. Some degree of ambiguity is inevitable. As such, several concepts


of "balance " have evolved:

• Trade Balance: This is the balance on the merchandise trade


account.

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• Balance on goods and services: This is the balance between


exports and imports of goods and services (in the current account,
excludes private transfers and investment income).
• Current Account Balance: This is the net balance on the entire
current account.
• Balance on current account and long-term capital (also known as
basic balance): Indicates long-term trends in the BOP. The idea is
short term capital flows are volatile but long term capital flows are of a
more permanent nature and are indicative of the under laying
strengths and weaknesses of the economy.

13. Errors and omissions


While changes in reserve assets are accurately measured and recorded,
some other items are subject to errors arising out of data inadequacy,
errors in reporting, discrepancy in valuation and timing. These are group
together under this heading.

Relevance of BOP Statistics and Decision Making

14. Impact on the exchange rates in the short term. BOP reflects
excess demand over supply or otherwise for the currency.

15. Data for successive months can give an indication of trends - their
accentuation or reversal.

16. Signal of policy shift by the monetary authorities either unilaterally


or with the trading partners.

17. A country facing current account deficit may resort to raise interest
rates to attract short-term capital inflows to arrest depreciation of the
currency.

18. Continuing current account deficit may lead to tax incentives.

19. Who bears exchange risk?


a. If invoice is in exporter's currency, the importer bears the risk and vice
versa.
b. More often, US Dollar, both bear the risk.
c. Currency risk hedging possible with forward markets

1.32.5 Capital Account

Transfers on capital account include external borrowings or payments of


external borrowings, external investments or disinvestments. The balance

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of current account and capital account together will result in the country’s
reserves of foreign exchange going up or down correspondingly.

A current account deficit may be combined with a higher capital account


surplus and therefore reflect as an addition to the country’s reserves of
foreign exchange.

The current account deficit or surplus of a country can also be looked at in


another way. In macro economic and national accounting term the current
account is a mirror image of the difference between domestic savings and
domestic investments. If domestic savings exceed the domestic
investments then a surplus on current account will result. On the other
hand if the domestic savings are insufficient to finance the domestic
investments a deficit on current account would result and would need to
be financed either through a draw down of reserves or by external
borrowings.

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The Management of Foreign Exchange Risk


1.33 OVERVIEW

(a) Goals

Exchange risk is the effect that unanticipated exchange rate changes have
on the value of the firm. This chapter explores the impact of currency
fluctuations on cash flows, on assets and liabilities, and on the real
business of the firm. Three questions must be asked.

First, what exchange risk does the firm face, and what methods are
available to measure currency exposure?

Second, based on the nature of the exposure and the firm's ability to
forecast currencies, what hedging or exchange risk management strategy
should the firm employ?

And finally, which of the various tools and techniques of the foreign
exchange market should be employed: debt and assets; forwards and
futures; and options. The chapter concludes by suggesting a framework
that can be used to match the instrument to the problem.

(b) What is exchange risk?

Exchange risk is simple in concept: a potential gain or loss that occurs as a


result of an exchange rate change.

For example, if an individual owns a share in Hitachi, the Japanese


company, he or she will lose if the value of the yen drops.

Yet from this simple question several more arise. First, whose gain or loss?
Clearly not just those of a subsidiary, for they may be offset by positions
taken elsewhere in the firm. And not just gains or losses on current
transactions, for the firm's value consists of anticipated future cash flows as
well as currently contracted ones. What counts, modern finance tells us, is
shareholder value; yet the impact of any given currency change on
shareholder value is difficult to assess, so proxies have to be used. The
academic evidence linking exchange rate changes to stock prices is weak.

Moreover the shareholder who has a diversified portfolio may find that the
negative effect of exchange rate changes on one firm is offset by gains in
other firms; in other words, that exchange risk is diversifiable. If it is, than
perhaps it's a non-risk.

Finally, risk is not risk if it is anticipated. In most currencies there are


futures or forward exchange contracts whose prices give firms an indication
of where the market expects currencies to go. And these contracts offer the

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ability to lock in the anticipated change. So perhaps a better concept of


exchange risk is unanticipated exchange rate changes.

These and other issues justify a closer look at this area of international
financial management.

1.34 SHOULD FIRMS MANAGE FOREIGN EXCHANGE RISK-HOW?

Many firms refrain from active management of their foreign exchange


exposure, even though they understand that exchange rate fluctuations
can affect their earnings and value. They make this decision for a number
of reasons.

First, management does not understand it. They consider any use of risk
management tools, such as forwards, futures and options, as speculative.
Or they argue that such financial manipulations lie outside the firm's field of
expertise. Saying like "we are in the business of manufacturing slot
machines, and we should not be gambling on currencies." Perhaps they
are right to fear abuses of hedging techniques, but refusing to use forwards
and other instruments may expose the firm to substantial speculative risks.

Second, they claim that exposure cannot be measured. They are right-
currency exposure is complex and can seldom be gauged with precision.
But as in many business situations, imprecision should not be taken as an
excuse for indecision.

Third, they say that the firm is hedged. All transactions such as imports or
exports are covered, and foreign subsidiaries finance in local currencies.
This ignores the fact that the bulk of the firm's value comes from
transactions not yet completed, so that transactions hedging is a very
incomplete strategy.

Fourth, they say that the firm does not have any exchange risk because it
does all its business in dollars (or yen, or whatever the home currency is).
But a moment's thought will make it evident that even if you invoice
Japanese customers in dollars, when the Yen drops your prices will have to
adjust or you'll be undercut by local competitors. So revenues are
influenced by currency changes.

Finally, they assert that the balance sheet is hedged on an accounting


basis-especially when the "functional currency" is held to be the dollar.

But is there any economic justification for a "do nothing" strategy?

Modern principles of the theory of finance suggest prima facie that the
management of corporate foreign exchange exposure may neither be an
important nor a legitimate concern.
It has been argued, in the tradition of the Modigliani-Miller Theorem, that
the firm cannot improve shareholder value by financial manipulations:
specifically, investors themselves can hedge corporate exchange exposure

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by taking out forward contracts in accordance with their ownership in a firm.


Managers do not serve them by second-guessing what risks shareholders
want to hedge.

One counter-argument is that transaction costs are typically greater for


individual investors than firms. Yet there are deeper reasons why foreign
exchange risk should be managed at the firm level. The assessment of
exposure to exchange rate fluctuations requires detailed estimates of the
susceptibility of net cash flows to unexpected exchange rate changes.
Operating managers can make such estimates with much more precision
than shareholders who typically lack the detailed knowledge of competition,
markets, and the relevant technologies. Furthermore, in all but the most
perfect financial markets, the firm has considerable advantages over
investors in obtaining relatively inexpensive debt at home and abroad,
taking maximum advantage of interest subsidies and minimizing the effect
of taxes and political risk.

Another line of reasoning suggests that foreign exchange risk management


does not matter because of certain equilibrium conditions in international
markets for both financial and real assets. These conditions include the
relationship between prices of
goods in different markets, better known as Purchasing Power Parity
(PPP), and between interest rates and exchange rates, usually referred to
as the International Fisher Effect.

However, deviations from PPP and IFE can persist for considerable periods
of time, especially at the level of the individual firm. The resulting variability
of net cash flow is of significance as it can subject the firm to the costs of
financial distress, or even default.

Modern research in finance supports the reasoning that earnings


fluctuations that threaten the firm's continued viability absorb management
and creditors' time, entail out-of-pocket costs such as legal fees, and create
a variety of operating and investment problems, including under investment
in R&D. The same argument supports the importance of corporate
exchange risk management against the claim that in equity markets it is
only systematic risk that matters.

To the extent that foreign exchange risk represents unsystematic risk, it


can, of course, be diversified away provided again, that investors have the
same quality of information about the firm as management-a condition not
likely to prevail in practice.

This reasoning is buttressed by the likely effect that exchange risk has on
taxes paid by the firm. It is generally agreed that leverage shields the firm
from taxes, because interest is tax deductible whereas dividends are not.
But the extent to which a firm can increase leverage is limited by the risk
and costs of bankruptcy.

A riskier firm, perhaps one that does not hedge exchange risk, cannot
borrow as much. It follows that anything that reduces the probability of

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bankruptcy allows the firm to take on greater leverage, and so pay less
taxes for a given operating cash flow. If foreign exchange hedging reduces
taxes, shareholders benefit from hedging.

However, there is one task that the firm cannot perform for shareholders: to
the extent that individuals face unique exchange risk as a result of their
different expenditure patterns, they must themselves devise appropriate
hedging strategies. Corporate management of foreign exchange risk in the
traditional sense is only able to protect expected nominal returns in the
reference currency.

1.35 Economic Exposure, Purchasing Power Parity & The International


Fisher Effect

Exchange rates, interest rates and inflation rates are linked to one another
through a classical set of relationships, which have import for the nature of
corporate foreign exchange, risk. These relationships are:

(1) the Purchasing Power Parity Theory, which describes the linkage
between relative inflation rates and exchange rates;

(2) the International Fisher effect, which ties interest rate differences to
exchange rate expectations; &

(3) the unbiased forward rate theory, which relates the forward
exchange_rate-to-exchange_rate expectations. These relationships,
along with two other key "parity" linkages.

1.36 Foreign Exchange Forecasting

Forecasting foreign exchange rate is important for forex management as it


reduces the uncertainties associated with commitments to accept or to
make payments in foreign currencies with short-term and long-term
investment decisions, with financing decisions and with income earned in
foreign currencies. It is also important for a forex manager to understand
the intricacies and the limitations of forecasting foreign exchange rates as it
helps them to utilize the alternate avenues to manage exchange rate risk.
Though it is difficult to forecast the exact time of change or change on a
particular day, the available forecasts are accurate enough to forecast
direction and magnitude of change in longer term.

Hence, exchange rate forecast are very useful in planning long-term


investments. The exchange rate forecasts help to:

1. Analyze attractiveness of foreign borrowings


2. Plan investments in foreign countries
3. Plan long term export-import strategy
4. Manage exchange rate risks and plan hedging strategies

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1.37 Historical perspective on exchange rate, Gold standard

• Exchange Rate : Is the value of one currency in terms of another.


• Exchange Rate Regime : Refers to mechanism, procedure and
institutional framework for determining exchange rates at a point of
time and changes in the same over a period of time including the
factors, which induce the changes.
• Two extremes of exchange rate regimes
1. Perfectly rigid or fixed exchange rates.
2. Perfectly flexible or floating.
3. Between the two extremes, a number of hybrids with varying
degrees of flexibility.

1.37.1 Gold standard

• Oldest system till world war 1

• Gold specie standard : Actual currency in circulation consisted of


gold coins with fixed gold content.

• Gold bullions standard : The basis of money remains a fixed rate of


gold. Currency is paper and authorities standing ready to convert
unlimited amount of paper currency into gold and vice versa at fixed
conversion ratio.

• Gold exchange standard : Authorities standing ready to convert, at


a fixed rate, the paper currency issued by them into another paper
currency of different country operating on gold specie or gold bullion
standard.

• Monetary authorities must obey three golden rules

1. They must fix rate of conversion of paper money issued by


them into gold.
2. They must ensure free flow of gold between countries on gold
standard.
3. Money supply in country must be tied to the amount of gold
held by monetary authorities in reserve.

• Pros and cons of gold standard regimes

1. Stable and predictable exchange rates


2. Built in anti-inflationary bias – no reckless expansion of money
supply
3. Imposes very rigid discipline
4. Politically difficult to administer
5. Limping gold standard

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6. If authorities suspend the free convertibility of paper currency


into gold, it is called limping gold standard.
7. Britain restored gold standard at end of world war-I but finally
abandoned in 1931, when faced with prospect of massive gold
outflow

Interwar instability and Bretton Woods, Change over from fixed exchange
rates to fluctuating exchange rates.

1.37.2 Definition of Arbitrage

A transaction in which one buys something for a given sum of money and
after going through one or more buy / sell transactions, ends up with a
larger sum of money than what was spent at the beginning, thus realizing
an arbitrage profit without exposure to any risk.

Interwar period :
• Break down of gold standard.
• Stock market crash in late 20’s pushing USA into recession.
• Fall in imports by USA and consequent trade deficits by European
countries, which had to be financed by export of gold.
• Fall in domestic money supply and hence deflation.
• Fall in currency values and finally UK decides to quit gold standard.
25 other countries follow suit.

1.37.3 Bretton Wood’s System

• 1944: Near end of Word War II, allied powers, UK and USA took up
the task of thorough overall of international monetary system.
• Exchange rate regime put in place can be characterized as gold
exchange standard (in 1968 it became limping gold exchange
standard).
• Birth of International Monetary Fund (IMF) and World Bank

1.38 Features of Exchange Rate System

• US Government commitment to convert dollars freely into gold at


US dollars 35 per Oz.

• Other members countries of IMF agreed to fix the parities of their


currencies vis-à-vis the dollar with variation within 1% on either side of
central permissible parity.

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• Should the exchange rate hit either of the limits, monetary


authorities of the country obliged to “defend” its own currency through
buy / sell of dollars to any extent required to keep the exchange rate
within the limits.

• Member countries of IMF allowed to borrow from IMF to carry out


interventions.

• Thus, Bretton Woods introduced “adjustable” rate system in place


of “fixed rate (equal to gold standard)” system.

• Parity of currency against the dollar could be changed in case of


“fundamental disequilibrium”.

• Fundamental disequilibrium : when at a given exchange rate, the


country repeatedly faces BOP disequilibrium and has to constantly
intervene and either buy or sell dollars.

• Changes up to +/- 10 % could be made without the consent of IMF


while larger changes with IMF’s approval.

• US Government undertook obligation not to change value of


dollar.

1.38.1 Collapse of Bretton Woods System (1944 to 1971)

• Triffin Paradox : Bretton Woods System depended on dollar


performing its role as key currency. Countries other than US had to
accumulate dollars to make payments. Hence, US had to run BOP
deficits.
• 1944 to 1960 US deficits were moderate. War ravaged Europe and
Japan economies were being rebuilt.
• 1960s saw rising BOP deficits of USA. Result : Loss of faith in
ability of the US to convert dollars into gold.
• US gold stock inadequate to honor convertibility commitments.
• Abortive attempt to salvage the system by means of series of parity
realignments dollar devaluation in terms of gold and widening bands
around central parities.
• US finally abdicated its role as anchor of world monetary system
and era of floating exchange rates starts.

1.39 Floating Exchange Rate System

• Original proponent was Milton Friedman (1953).


• Relative price of currency determined by demand and supply and
authorities make no attempt to hold exchange rate.
• In freely floating exchange rate situation, no effort is made by the
authorities to influence current value and future evolution of exchange
rate. This is theoretical.

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• In practice interventions (managed or dirty floats) so as to


smoothen out short terms fluctuations or force the rate towards a
particular target value.

1.40 Objectives of Limited Flexibility System

• To introduce flexibility into fixed rate system.


• To effect changes in gradual and plant banner rather than abrupt
or unpredictable manner (seen in floating rate system).

1.41 Crawling peg (gliding parities)

• Replaces the abrupt parity changes with gradual modification with


permissible variations around parity in a narrow band (usually) +/-1 %.
• Change in parity in a year is subject to sub ceiling say not more
than 8.33% of variation per month.
• Parity changes carried out based on set of indicators like current
account deficit, relative inflation rates and moving average of past spot
rates.
• Brazil and Portugal have adopted in past.

1.42 Mixed System

• Some transactions are subject to fixed rate while others are subject
to market determined floating rates.
• Belgium (1955 to 1990) operated current account transactions at
fixed rate and capital flows at floating rate.
• Motive is to control capital flows.
• Commercial market meant for current account transactions allowed
to be operated by “authorized dealers”.
• Financial market meant for capital transactions open to all
participants.

1.43 Exchange Rate Arrangements

• Exchange rate of any currency settled in many ways:

1. Administered by Central Bank


2. Market forces
3. Combinations between the two exchanges

• IMF classifies exchange arrangements under 3 heads

1. Pegged to a single currency (dollar or Euro) or currency basket like


SDR.

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2. Flexibility limited against single currency (Danish Krone against


Euro).
3. Managed or independently floating.

1.44 Market Size

1. Daily Foreign Exchange Transaction Volume > US $2 trillion.


2. World Merchandised Exports in 1997 = US $ 5.3 trillion.
3. World Trade of Services (1997) = US $ 1.3 trillion.
4. Conclusion : Over 90% transactions are financial or speculative.
5. With introduction of Euro, intra-European trading will die.
6. Trade with emerging markets will boom. East Asia melt down is
expected to be temporary phase and on the whole this trade will
compensate for loss of intra-European trade.
7. US dollars remains most traded currency in market and involved in
87% of world transactions.
8. Geographical spread from Tokyo to West Coast of USA.

1.45 Mechanics Of Exchange Rate

The Purchasing Power Parity (PPP) theory can be stated in different ways,
but the most common representation links the changes in exchange rates
to those in relative price indices in two countries.

Rate of change of exchange rate = Difference in inflation rates

The relationship is derived from the basic idea that, in the absence of trade
restrictions changes in the exchange rate mirror changes in the relative
price levels in the two countries. At the same time, under conditions of free
trade, prices of similar commodities cannot differ between two countries,
because arbitragers will take advantage of such situations until price
differences are eliminated. This "Law of One Price" leads logically to the
idea that what is true of one commodity should be true of the economy as a
whole--the price level in two countries should be linked through the
exchange rate--and hence to the notion that exchange rate changes are
tied to inflation rate differences.

The International Fisher Effect (IFE) states that the interest rate differential
will exist only if the exchange rate is expected to change in such a way that
the advantage of the higher interest rate is offset by the loss on the foreign
exchange transactions.

This International Fisher Effect can be written as follows:

The expected rate of change of the exchange rate = The interest rate
differential

In practical terms the IFE implies that while an investor in a low-interest


country can convert his funds into the currency of the high-interest country

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and get paid a higher rate, his gain (the interest rate differential) will be
offset by his expected loss because of foreign exchange rate changes.

The Unbiased Forward Rate Theory asserts that the forward exchange rate
is the best, and an unbiased, estimate of the expected future spot
exchange rate. The theory is grounded in the efficient markets theory, and
is widely assumed and widely disputed as a precise explanation.

The "expected" rate is only an average but the theory of efficient markets
tells us that it is an unbiased expectation--that there is an equal probability
of the actual rate being above or below the expected value.

The unbiased forward rate theory can be stated simply:

The expected exchange rate = The forward exchange rate

Now, we can summarize the impact of unexpected exchange rate changes


on the internationally involved firm by drawing on these parity conditions.
Given sufficient time, competitive forces and arbitrage will neutralize the
impact of exchange rate changes on the returns to assets; due to the
relationship between rates of devaluation and inflation differentials, these
factors will also neutralize the impact of the changes on the value of the
firm .

This is simply the principle of Purchasing Power Parity and the Law of One
Price operating at the level of the firm. On the liability side, the cost of debt
tends to adjust as debt is repriced at the end of the contractual period,
reflecting (revised) expected exchange rate changes. And returns on equity
will also reflect required rates of return; in a competitive market these will
be influenced by expected exchange rate changes.

Finally, the unbiased forward rate theory suggests that locking in the
forward exchange rate offers the same expected return as remaining
exposed to the ups and downs of the currency -- on average, it can be
expected to err as much above as below the forward rate.

In the long run, it would seem that a firm operating in this setting will not
experience net exchange losses or gains. However, because of contractual,
or, more importantly, strategic commitments, these equilibrium conditions
rarely hold in the short and medium term.

Therefore, the essence of foreign exchange exposure, and, significantly, its


management, is made relevant by these "temporary deviations."

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1.46 Identifying Exposure

The first step in management of corporate foreign exchange risk is to


acknowledge that such risk does exist and that managing it is in the interest
of the firm and its shareholders. The next step, however, is much more
difficult: the identification of the nature and magnitude of foreign exchange
exposure. In other words, identifying what is at risk, and in what way.

The focus here is on the exposure of non financial corporations, or rather


the value of their assets. This reminder is necessary because most
commonly accepted notions of foreign exchange risk hedging deal with
assets, i.e., they are pertinent to (simple) financial institutions where the
bulk of the assets consists of (paper) assets that have with contractually
fixed returns, i.e., fixed income claims, not equities.

Clearly, such time your assets in the currency in which they are
denominated" applies in general to banks and similar firms.

Non-financial business firms, on the other hand, have, as a rule, only a


relatively small proportion of their total assets in the form of receivables
and other financial claims. Their core assets consist of inventories,
equipment, special purpose buildings and other tangible assets, often
closely related to technological capabilities that give them earnings power
and thus value. Unfortunately, real assets (as compared to paper assets)
are not labeled with currency signs that make foreign exchange exposure
analysis easy.

Most importantly, the location of an asset in a country is an all too fallible


indicator of their foreign exchange exposure.

The task of gauging the impact of exchange rate changes on an enterprise


begins with measuring its exposure, that is, the amount, or value, at risk.
This issue has been clouded by the fact that financial results for an
enterprise tend to be compiled by methods based on the principles of
accrual accounting. Unfortunately, this approach yields data that frequently
differ from those relevant for business decision-making, namely future
cash flows and their associated risk profiles. As a result, considerable
efforts are expended -- both by decision makers as well as students of
exchange risk -- to reconcile the differences between the point-in-time
effects of exchange rate changes on an enterprise in terms of accounting
data, referred to as accounting or translation exposure, and the ongoing
cash flow effects which are referred to as economic exposure. Both
concepts have their grounding in the fundamental concept of transactions
exposure.

The relationship between the three concepts is illustrated in the Exhibit 2.


Some basic concepts are mentioned here to make the present chapter
self-contained.

(a) Exposure in a simple transaction

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The typical illustration of transaction exposure involves an export or import


contract giving rise to a foreign currency receivable or payable. On the
surface, when the exchange rate changes, the value of this export or
import transaction will be affected in terms of the domestic currency.

However, when analyzed carefully, it becomes apparent that the exchange


risk results from a financial investment (the foreign currency receivable) or
a foreign currency liability (the loan from a supplier) that is purely incidental
to the underlying exports or import transaction; it could have arisen in and
of itself through independent foreign borrowing and lending. Thus, what are
involved here are simply foreign currency assets and liabilities, whose
value is contractually fixed in nominal terms.

While this traditional analysis of transactions exposure is correct in a


narrow, formal sense, it is really relevant for financial institutions, only. With
returns from financial assets and liabilities being fixed in nominal terms,
they can be shielded from losses
with relative ease through cash payments in advance (with appropriate
discounts), through the factoring of receivables, or via the use of forward
exchange contracts, unless unexpected exchange rate changes have a
systematic effect on credit risk.
However, the essential assets of non financial firms have non contractual
returns, i.e. revenue and cost streams from the production and sale of their
goods and services which can respond to exchange rate changes in very
different ways.

(b) Accounting Exposure

The concept of accounting exposure arises from the need to translate


accounts that are denominated in foreign currencies into the home
currency of the reporting entity.

Most commonly the problem arises when an enterprise has foreign


affiliates keeping books in the respective local currency. For purposes of
consolidation these accounts must somehow be translated into the
reporting currency of the parent company. In doing this, a decision must be
made as to the exchange rate that is to be used for the translation of the
various accounts. While income statements of foreign affiliates are typically
translated at a periodic average rate, balance sheets pose a more serious
challenge.

To a certain extent this difficulty is revealed by the struggle of the


accounting profession to agree on appropriate translation rules and the

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treatment of the resulting gains and losses. A comparative historical


analysis of translation rules may best illustrate the issues at hand.

1.47 Method Followed By US Companies

Over time, U.S. companies have followed essentially four types of


translation methods. These four methods differ with respect to the
presumed impact of exchange rate changes on the value of individual
categories of assets and liabilities. Accordingly, each method can be
identified by the way in which it separates assets and liabilities into those
that are "exposed" and are, therefore, translated at the current rate, i.e., the
rate prevailing on the date of the balance sheet, and those whose value is
deemed to remain unchanged, and which are, therefore, translated at the
historical rate.

Method 1. The current/non current method of translation divides assets


and liabilities into current and non-current categories, using
maturity as the distinguishing criterion; only the former are
presumed to change in value when the local currency
appreciates or depreciates vis-à-vis the home currency.

Method 2. Supporting this method is the economic rationale that foreign


exchange rates are essentially fixed but subject to occasional
adjustments that tend to correct themselves in time. This
assumption reflected reality to some extent.
However, with subsequent changes in the international financial
environment, this translation method has become outmoded;
only in a few countries is it still being used.

Method 3. Under the monetary/non-monetary method all items explicitly


defined in terms of monetary units are translated at the current
exchange rate, regardless of their maturity. Non-monetary items
in the balance sheet, such as tangible assets, are translated at
the historical exchange rate. The underlying assumption here is
that the local currency value of such assets increases
(decreases) immediately after a devaluation (revaluation) to a
degree that compensates fully for the exchange rate change.
This is equivalent of what is known in economics as the Law of
One Price, with instantaneous adjustment.

Method 4. A similar but more sophisticated translation approach supports


the so-called Temporal Method. Here, the exchange rate used
to translate balance sheet items depends on the valuation
method used for a particular item in the balance sheet. Thus, if
an item is carried on the balance sheet of the affiliate at its
current value, it is to be translated using the current exchange
rate.

Alternatively, items carried at historical cost are to be translated at the


historical exchange rate. As a result, this method synchronizes the time

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dimension of valuation with the method of translation. As long as foreign


affiliates compile balance sheets under traditional historical cost principles,
the temporal method gives essentially the same results as the
monetary/non-monetary method. However, when "current value
accounting" is used, that is, when accounts are adjusted for inflation, then
the temporal method calls for the use of the current exchange rate
throughout the balance sheet.

Critique of the Accounting Model of Exposure

Even with the increased flexibility users of accounting information must be


aware that there are three system sources of error that can mislead those
responsible for exchange risk management:

1. Accounting data do not capture all commitments of the firm that give rise
to exchange risk.

2. Because of the historical cost principle, accounting values of assets and


liabilities do not reflect the respective contribution to total expected net
cash flow of the firm.

3. Translation rules do not distinguish between expected and unexpected


exchange rate changes.

Regarding the 1st method, it must be recognized that normally,


commitments entered into by the firm in terms of foreign exchange, a
purchase or a sales contract, for example, will not be booked until the
merchandise has been shipped. At best, such obligations are shown as
contingent liabilities.

More importantly, accounting data reveals very little about the ability of the
firm to change costs, prices and markets quickly. Alternatively, the firm
may be committed by strategic decisions such as investment in plant and
facilities. Such "commitments" are important criteria in determining the
existence and magnitude of exchange risk.

The 2nd method surfaced in our discussion of the temporal method:


whenever asset values differ from market values, translation--however
sophisticated--will not redress this original shortcoming. Thus, many of the
perceived problems had their roots not so much in translation, but in the
fact that in an environment of inflation and exchange rate changes, the lack
of current value accounting frustrates the best translation efforts.

Finally, translation rules do not take account of the fact that exchange rate
changes have two components:

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1. expected changes that are already reflected in the prices of assets


and the costs of liabilities (relative interest rates); &

1. the real goods and services, the basic rationale for corporate
foreign exchange exposure management is to shield net cash flows,
and thus the value of the enterprise, from unanticipated exchange rate
changes.

This thumbnail sketch of the economic foreign exchange exposure concept


has a number of significant implications, some of which seem to be at
variance with frequently used ideas in the popular literature and apparent
practices in business firms.

Specifically, there are implications regarding:

1. the question of whether exchange risk originates from monetary or


non-monetary transactions,

2. a revaluation of traditional perspectives such as "transactions risk,"


&

3. the role of forecasting exchange rates in the context of corporate


foreign exchange risk management.

Contractual versus Non-contractual Returns

An assessment of the nature of the firm's assets and liabilities and their
respective cash flows shows that some are contractual, i.e. fixed in nominal,
monetary terms. Such returns, earnings from fixed interest securities and
receivables, for example, and the negative returns on various liabilities are
relatively easy to analyze with respect to exchange rate changes: when they
are denominated in terms of foreign currency, their terminal value changes
directly in proportion to the exchange rate change. Thus, with respect to
financial items, the firm is concerned only about net assets or liabilities
denominated in foreign currency, to the extent that maturities (actually,
"durations" of asset classes) are matched.

What is much more difficult, however, is to gauge the impact of an exchange


rate change on assets with non-contractual returns. While conventional
discussions of exchange risk focus almost exclusively on financial assets, for
trading and manufacturing firms at least, such assets are relatively less
important than others. Indeed, equipment, real estate, buildings and
inventories make the decisive contribution to the total cash flow of those
firms. (Indeed companies frequently sell financial assets to banks, factors, or
"captive" finance companies in order to leave banking to bankers and instead
focus on the management of core assets!) And returns on such assets are
affected in quite complex ways by changes in exchange rates. The most

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essential consideration is how the prices and costs of the firm will react in
response to an unexpected exchange rate change.

For example, if prices and costs react immediately and fully to offset
exchange rate changes, the firm's cash flows are not exposed to exchange
risk since they will not be affected in terms of the base currency.

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Currency of denomination versus currency of determination

One of the central concepts of modern international corporate finance is the


distinction between the currency in which cash flows are denominated and
the currency that determines the size of the cash flows. In the example in the
previous section, it does not matter whether, as a matter of business
practice, the firm may contract, be invoiced in, and pay for each individual
shipment in its own local currency. If foreign exporters do not provide price
concessions, the cash outflow of the importer behaves just like a foreign
currency cash flow; even though payments are made in local currency, they
occur in greater amounts. As a result, the cash flow, even while denominated
in local currency, is determined by the relative value of the foreign currency.
The functional currency concept introduced in FAS 52 is similar to the
"currency of determination" -- but not exactly. The currency of determination
refers to revenue and operating expense flows, respectively; the functional
currency concept pertains to an entity as a whole, and is, therefore, less
precise.

To complicate things further, the currency of recording, that is, the currency
in which the accounting records are kept, is yet another matter. For example,
any debt contracted by the firm in foreign currency will always be recorded in
the currency of the country where the corporate entity is located. However,
the value of its legal obligation is established in the currency in which the
contract is denominated.

It is possible, therefore, that a firm selling in export markets may record


assets and liabilities in its local currency and invoice periodic shipments in a
foreign currency and yet, if prices in the market are dominated by
transactions in a third country, the cash flows received may behave as if they
were in that third currency. To illustrate: a Brazilian firm selling coffee to West
Germany may keep its records in cruzeiros, invoice in German marks, and
have DM-denominated receivables, and physically collect DM cash flow, only
to find that its revenue stream behaves as if it were in U.S. dollars! This
occurs because DM-prices for each consecutive shipment are adjusted to
reflect world market prices, which, in turn, tend to be determined in U.S.
dollars. The significance of this distinction is that the currency of
denomination is (relatively) readily subject to management discretion,
through the choice of invoicing currency. Prices and cash flows, however, are
determined by competitive conditions, which are beyond the immediate
control of the firm.

Yet an additional dimension of exchange risk involves the element of time. In


the very short run, virtually all local currency prices for real goods and
services (although not necessarily for financial assets) remain unchanged
after an unexpected exchange rate change. However, over a longer period of
time, prices and costs move inversely to spot rate changes; the tendency is
for Purchasing Power Parity and the Law of One Price to hold.

In reality, this price adjustment process takes place over a great variety of
time patterns. These patterns depend not only on the products involved, but

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also on market structure, the nature of competition, general business


conditions, government policies such as price controls, and a number of
other factors. Considerable work has been done on the phenomenon of
"pass-through" of price changes caused by (unexpected) exchange rate
changes. And yet, because all the factors that determine the extent and
speed of pass-through are very firm-specific and can be analyzed only on a
case-by-case basis at the level of the operating entity of the firm (or strategic
business unit), generalizations remain difficult to make. Exhibit 6 summarizes
the firm-specific effects of exchange rate changes on operating cash flows.

Conceptually, though, it is important to determine the time frame within which


the firm cannot react to (unexpected) rate changes by:

(1) raising prices


(2) changing markets for inputs and outputs and/or
(3) adjusting production and sales volumes.

Sometimes, at least one of these reactions is possible within a relatively short


time; at other times the firm is "locked-in" through contractual or strategic
commitments extending considerably into the future. Indeed, those firms that
are free to react instantaneously and fully to adverse (unexpected) rate
changes are not subject to exchange risk.

A further implication of the time-frame element is that exchange risk stems


from the firm's position when its cash flows are, for a significant period,
exposed to (unexpected) exchange rate changes, rather than the risk
resulting from any specific international involvement. Thus, companies
engaged purely in domestic transactions but who have dominant foreign
competitors may feel the effect of exchange rate changes in their cash flows
as much or even more than some firms that is actively engaged in exports,
imports, or foreign direct investment.

1.48 EXPOSURE - TYPES AND DESCRIPTION

WHAT IS ECONOMIC EXPOSURE?

Economic exposure is tied to the currency of determination of revenues


and costs.

M/s PDVSA, the Venezuelan state-owned oil company, recently set up an


oil refinery near Rotterdam, The Netherlands, for shipment to Germany and
other continental European countries. The firm planned to invoice its clients
in ECU, the official currency unit of the European Community.

How the treasurer will source long term financing ?

In the past all long-term finance has been provided by the parent company,
but working capital required to pay local salaries and expenses has been
financed in Dutch guilders. The treasurer is not sure whether the short-term
debt should be hedged, or what currency to issue long term debt in. This is

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an example of a situation where the definition of exposure has a direct


impact on the firm's hedging decisions.

Economic exposure is tied to the currency of determination of revenues


and costs. Since the world market price of oil is dollars, this is the effective
currency in which PDVSA's future sales to Germany are made. If the ECU
rises against the dollar, PDVSA must adjust its ECU price down to match
those of competitors like Aramco. If the dollar rises against the ECU,
PDVSA can and should raise prices to keep the dollar price the same,
since competitors would do likewise. Clearly the currency of determination
is influenced by the currency in which competitors denominate prices.

WHAT IS TRANSALATION EXPOSURE?

Translation exposure has to do with the location of the assets.


In this case it would be a totally misleading measure of the effect of
exchange rate changes on the value of the unit. After all, the oil comes
from Venezuela and is shipped to Germany: its temporary resting place, be
it a refinery in Rotterdam or a tanker en route to Germany, has no import.
Both provide value added, but neither determine the currency of revenues.
So financing should definitely not be done in Dutch guilders.

WHAT IS TRANSACTION EXPOSURE?

Transactions exposure has to do with the currency of denomination of


assets like accounts receivable or payable.
Ex : Once sales to Germany have been made and invoicing in ECU has
taken place, PDVSA-Netherlands has contractual, ECU-denominated
assets that should be financed or hedged with ECU. For future sales,
however, PDVSA-Netherlands does not have exposure to the ECU. This is
because the currency of determination is the U.S. dollar.

1.49 MANAGING ECONOMIC EXPOSURE

(a) Economic Effects of Unanticipated Exchange Rate Changes on Cash


Flows

From this analytical framework, some practical implications emerge for the
assessment of economic exposure. First of all, the firm must project its cost
and revenue streams over a planning horizon that represents the period of
time during which the firm is "locked-in," or constrained from reacting to
(unexpected) exchange rate changes. It must then assess the impact of a
deviation of the actual exchange rate from the rate used in the projection of
costs and revenues.

1.50 STEPS IN MANAGING ECONOMIC EXPOSURE

1. Estimation of planning horizon as determined by reaction period.

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2. Determination of expected future spot rate.

3. Estimation of expected revenue and cost streams, given the expected


spot rate.

4. Estimation of effect on revenue and expense streams for unexpected


exchange rate changes.

5. Choice of appropriate currency for debt denomination.

6. Estimation of necessary amount of foreign currency debt.

7. Determination of average interest period of debt.

8. Selection between direct or indirect debt denominations.

9. Decision on trade-off between arbitrage gains vs. exchange risk


stemming from exposure in markets where rates are distorted by controls.

10. Decision about "residual" risk: consider adjusting business strategy.

Subsequently, the effects on the various cash flows of the firm must be
netted over product lines and markets to account for diversification effects
where gains and losses could cancel out, wholly or in part. The remaining
net loss or gain is the subject of economic exposure management.

For a multiunit, multi-product,multi-national corporation the net exposure


may not be very large at all because of the many offsetting effects. And by
contrast, enterprises that have invested in the development of one or two
major foreign markets are typically subject to considerable fluctuations of
their net cash flows, regardless of whether they invoice in their own or in
the foreign currency.
For practical purposes, three questions capture the extent of a company's
foreign exchange exposure.

1. How quickly can the firm adjust prices to offset the impact of an
unexpected exchange rate change on profit margins?

2. How quickly can the firm change sources for inputs and markets for
outputs? Or, alternatively, how diversified are a company's factor and
product markets?

3. To what extent do volume changes, associated with unexpected


exchange rate changes, have an impact on the value of assets?

Normally, the executives within business firms who can supply the best
estimates on these issues tend to be those directly involved with
purchasing, marketing, and production. Finance managers who focus
exclusively on credit and foreign exchange markets may easily miss the
essence of corporate foreign exchange risk.

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Financial versus operating strategies for Hedging

When operating (cash) inflows and (contractual) outflows from liabilities


are affected by exchange rate changes, the general principle of prudent
exchange risk management is:

Any effect on cash inflows and outflows should cancel out as much as
possible. This can be achieved by maneuvering assets, liabilities or both.
When should operations -- the asset side -- be used?

We have seen that exchange rate changes can have tremendous effects
on operating cash flows. Does it not therefore make sense to adjust
operations to hedge against these effects? Many companies, such as
Japanese auto producers, are now seeking flexibility in production
location, in part to be able to respond to large and persistent exchange
rate changes that make production much cheaper in one location than
another. Among the operating policies is the shifting of markets for output,
sources of supply, product-lines, and production facilities as a defensive
reaction to adverse exchange rate changes.

Put differently, deviations from purchasing power parity provide profit


opportunities for the operations-flexible firm. This philosophy is epitomized
in the following quotation.

It has often been joked at Philips that in order to take advantage of


currency movements, it would be a good idea to put our factories aboard
a supertanker, which could put down anchor wherever exchange rates
enable the company to function most efficiently. In the present currency
markets...[this] would certainly not be a suitable means of transport for
taking advantage of exchange rate movements. An aeroplane would be
more in line with the requirements of the present era.

The problem is that Philips' production could not fit into either craft. It is
obvious that such measures will be very costly, especially if undertaken
over a short span of time. it follows that operating policies are not the
tools of choice for exchange risk management. Hence operating policies,
which have been designed to reduce or eliminate exposure, will only be
undertaken as a last resort, when less expensive options have been
exhausted.

It is not surprising, therefore, that exposure management focuses not on


the asset side, but primarily on the liability side of the firm's balance
sheet. Whether and how these steps should be implemented depends
first, on the extent to which the firm wishes to rely on currency forecasting
to make hedging decisions, and second, on the range of hedging tools
available and their suitability to the task.

1.51 Guidelines for Corporate Forecasting of Exchange Rates

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Academics and practitioners have sought the determinants of exchange


rate changes ever since there were currencies. Many students have
learned about the balance of trade and how the more a country exports,
the more demand there is for its currency, and so the stronger is its
exchange rate. In practice, the story is a lot more complex. Research in the
foreign exchange markets have come a long way since the days when
international trade was thought to be the dominant factor determining the
level of the exchange rate.

Monetary variables, capital flows, rational expectations and portfolio


balance are all now understood to factor into the determination of
currencies in a floating exchange rate system.

Many models have been developed to explain and to forecast exchange


rates. No model has yet proved to be the definitive one, perhaps because
the structure of the world’s economies and financial markets are
undergoing such rapid evolution.

Corporations nevertheless avidly seek ways to predict currencies, in order


to decide when and when not to hedge. The models they use are typically
one or more of the following kinds:

1. political event analysis


2. fundamental
3. technical

Exchange rates react quickly to news. Rates are far more volatile than
changes in underlying economic variables; they are moved by changing
expectations, and hence are difficult to forecast. In a broad sense they are
"efficient," but tests of efficiency face inherent obstacles in testing the
precise nature of this efficiency directly.

The central "efficient market" model is the unbiased forward rate theory
introduced earlier. It says that the forward rate equals the expected future
level of the spot rate. Because the forward rate is a contractual price, it
offers opportunities for speculative profits for those who correctly assess
the future spot price relative to the current forward rate.

Specifically, risk neutral players will seek to make a profit their forecast
differs from the forward rate, so if there are enough such participants
the forward rate will always be bid up or down until it equals the expected
future spot. Because expectations of future spot rates are formed on the
basis of presently available information (historical data) and an
interpretation of its implication for the future, they tend to be subject to
frequent and rapid revision.

The actual future spot rate may therefore deviate markedly from the
expectation embodied in the present forward rate for that maturity. The
actual exchange rate may deviate from the expected by some random
error.

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Another way of looking at these errors to consider them as speculative


profits or losses: what you would gain or lose of you consistently bet
against the forward rate. Can they be consistently positive or negative? A
priori reasoning suggests that this should not be the case. Otherwise one
would have to explain why consistent losers do not quit the market, or why
consistent winners are not imitated by others or do not increase their
volume of activity, thus causing adjustment of the forward rate in the
direction of their expectation. Barring such explanation, one would expect
that the forecast error is sometimes positive, sometimes negative,
alternating in a random fashion, driven by unexpected events in the
economic and political environment.

Forecasting exchange rate changes, however, is important for planning


purposes. To the extent that all significant managerial tasks are concerned
with the future, anticipated exchange rate changes are a major input into
virtually all decisions of enterprises involved in and affected by international
transactions.

However, the task of forecasting foreign exchange rates for planning and
decision-making purposes, with the purpose of determining the most likely
exchange rate, is quite different from attempting to beat the market in order
to derive speculative profits.

Expected exchange rate changes are revealed by market prices when


rates are free to reach their competitive levels. Organized futures or
forward markets provide inexpensive information regarding future
exchange rates, using the best available data and judgment.

Thus, whenever profit-seeking, well-informed traders can take positions,


forward rates, prices of future contracts, and interest differentials for
instruments of similar riskiness (but denominated in different currencies),
provide good indicators of expected exchange rates. In this fashion, an
input for corporate planning and decision-making is readily available in all
currencies where there are no effective exchange controls.

The advantage of such market-based rates over "in-house" forecasts is


that they are both less expensive and more likely to be accurate. Those
who tend to have the best information and track record determine market
rates; incompetent market participants lose money and are eliminated.

The nature of this market-based expected exchange rate should not lead to
confusing notions about the accuracy of prediction. In speculative markets,
all decisions are made on the basis of interpretation of past data; however,
new information surfaces constantly. Therefore, market-based forecasts
rarely will come true. The actual price of a currency will either be below or
above the rate expected by the market. If the market knew which would be
more likely, any predictive bias quickly would be corrected. Any predictable,
economically meaningful bias would be corrected by the transactions of
profit-seeking transactors.

Example: Hedging with a Forward Contract

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Janet Fredericks, Foreign Exchange Manager at M/s Murray Chemical,


was informed that Murray was selling 25,000 tones of Naphtha to Canada
for a total price of C$11,500,000, to be paid upon delivery in two months'
time. To protect her company, she arranged to sell 11.5 million Canadian
dollars forward to the Royal Bank of Montreal. The two-month forward
contract price was US$0.8785 per Canadian dollar.

Two months and two days later, Fredericks received US$10,102,750 from
RBM and paid RBM C$11,500,000, the amount received from Murray's
customer.

The importance of market-based forecasts for a determination of the


foreign exchange exposure of the firm is that of a benchmark against which
the economic consequences of deviations must be measured. This can be
put in the form of a concrete question: How will the expected net cash flow
of the firm behave if the future spot exchange rate is not equal to the rate
predicted by the market when commitments are made? The nature of this
kind of forecast is completely different from trying to outguess the foreign
exchange markets.

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1.52 Tools And Techniques For The Management Of Foreign Exchange


Risk

In this section we consider the relative merits of several different tools for
hedging exchange risk, including forwards, futures, debt, swaps and
options. We will use the following criteria for contrasting the tools.

First, there are different tools that serve effectively the same purpose. Most
currency management instruments enable the firm to take a long or a short
position to hedge an opposite short or long position. Thus one can hedge a
DM payment using a forward exchange contract, or debt in DM, or futures
or perhaps a currency swap. In equilibrium the cost of all will be the same,
according to the fundamental relationships of the international money
market as illustrated in Exhibit 1. They differ in details like default risk or
transactions costs, or if there is some fundamental market imperfection.
Indeed in an efficient market one would expect the anticipated cost of
hedging to be zero. This follows from the unbiased forward rate theory.

Second, tools differ in that they hedge different risks. In particular,


symmetric hedging tools like futures cannot easily hedge contingent cash
flows: options may be better suited to the latter.

Tools and techniques: Foreign Exchange Forwards

Foreign exchange is, of course, the exchange of one currency for another.
Trading or "dealing" in each pair of currencies consists of two parts, the
spot market, where payment (delivery) is made right away (in practice this
means usually the second business day), and the forward market.

FOREIGN EXCHANGE MARKET


1.53 Structure of the Forex Market:

• Retail market in which travelers and tourists exchange one currency for
another in the form of currency notes or travelers cheques. The spread
between buying and selling is large.
• Wholesale market or inter-bank market where in the participants is
commercial banks, corporates and central banks.

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1.54 Market Players:

• The primary price makers (professional dealers) who make a two-way


market to each other and to the clients, comprise of commercial banks,
investment dealers and large corporates.
• Among the primary price makers there is a kind of tie ring a few giant
multinational banks deal in large currencies in large amounts and often
deal directly with each other without brokers thus, influencing the market.
The next tier may comprise of large banks that deal in restricted number
of currencies and use brokers. The last tier may comprise of small local
institutions and deal in very small number of major currencies against the
home currency.
• Foreign currency brokers act as middleman and provide information to
market making banks about prices at which there are firm buyers and
sellers in a pair of currencies.
• Brokers also play the role of "showing" the market anonymously the
prices from the price makers.
• Central banks intervene in the market from time to time and attempt to
move the exchange rates in the targeted direction.
• Over 90% of the transaction is accounted for by inter-bank transactions.

1.55 Mechanics of Currency Trading:

• ISO has developed three letter codes for all the currencies (USD, INR,
JPY, CHF, DEM, GBP, FRF, etc.)
• Inter-bank dealing for a typical SPOT transaction could be something like
Bank A: Bank A calling. Your price on Mark - Dollar please.
Bank B: Forty, Forty-Eight.
Bank A: Ten Dollars Mine at Forty-Eight.
• Bank B is offering rate of 1.4540 / 1.4548
• Bank B is willing to pay DM 1.4540 for every USD it buys.
• It will charge DM 1.4548 for every USD it sells.
• The spread is 8 points. The difference between bid and offered rates.
• DM 1.45 is the "big figure" and hence only last two figures are quoted
namely 40 and 48.
• Bank A wants to buy Dollars against the DM and he conveys this in the
third line, which means that "I buy 10 million Dollars at your offer price of
DM 1.4548 per Dollar".
• Bank B is then said to have been "hit" on its offer side.
• If Bank A wanted to sell USD 5 million, he would have said "Five Dollars
yours at Forty".

1.56 Types of Transactions and Settlement Dates:

• Settlement of a transaction takes place by transfers of deposits between


the two parties. The day on which these transfers are effected is called
"Settlement Date or Value Date".

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• The dealing locations need not necessarily be the settlement locations.


• Depending upon the time elapsed between transaction date and the
settlement date; the foreign exchange transaction can be categorized in
to SPOT or Forward. Yet another category is called swap, which is a
combination of SPOT and Forward transaction.
• In a SPOT transaction the settlement or value date is usually two
business days ahead for European currencies or Yen traded against the
Dollar. The two-day gap is necessary for confirming and clearing the deal
through the communication network such as SWIFT.
• Value Dates for Forward Transaction: This is arrived at by adding one
calendar month to the Value Date for a SPOT transaction between the
two currencies. Should this be a holiday, the next working day is
considered.
• Forward maturities are normally for whole month however; banks often
quote "broken date" or "odd date" contract (73 days).
• A swap transaction is a combination of SPOT and Forward in the opposite
direction. Thus a bank will buy DM SPOT against USD and
simultaneously enter into a Forward transaction with the same counter
party to sell DM against USD, keeping the amount of one of the
currencies fixed.
• It is a temporary exchange of one currency for another with an obligation
to reverse it at a specific future date.

1.57 Arbitrage between Banks:

• Not all banks have identical quotation for a given pair of currencies at a
given point of time. Suppose banks A and B are quoting for Dollar against
Pound 1.4550 / 60 and 1.4538 / 48, it can give rise to arbitrage
opportunity as follows:

 Buy Pounds at $1.4548 from B.


 Sell Pounds at $1.4550 to A.
 Earn Net Profit of $0.0002 per Pound till bank B raises its offer
rates and/or bank A lowers its bid rates.

• Thus the two quotes must overlap by at least 1 point to prevent arbitrage.
Say that bank B increases its' rates to $1.4545 / 55, the arbitrage
opportunity vanishes. However, bank A will find that it is "being hit" on its
bid side much more often whereas bank B will find that it is confronted
largely with buyers of Pound and very few sellers.
• From time to time banks deliberately move its quotations to discourage
one type of transaction and encourage the opposite, if this is not done,
bank A would have built a large net short position in Pound and may now
want to encourage sellers of Pound and discourage buyers. Bank B
would be in the opposite position.

1.58 Inverse quotes and 2-point arbitrage

• Suppose a Zurich bank offers a SPOT quotation:

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CHF / Dollar = 1.4955 / 62


• At the same time, a New York bank offers the following quote:
USD / CHF = 0.6695 / 99
• Buying One Million Swiss Franks from Zurich bank means $ 1000000 /
1.4955 = US$ 668700 to acquire Swiss Franks.
• Sell One Million Swiss Franks in New York and earn US$ 669500 in New
York.
• Couple of phone calls and risk less profit of $ 800, clearly indicating that
the two bank quotations are out of line. This arbitrage transaction is
called "two point arbitrage" and foreign exchange markets very quickly
eliminate such opportunities if and when they arise.
• (USD / CHF) ask is the rate that applies when bank sells Swiss Franks in
exchange for Dollars.
• To avoid arbitrage, the following must hold:
Implied (USD / CHF) bid = 1/(CHF / USD) ask
Implied (USD / CHF) ask = 1/(CHF / USD) bid

1.59 Outright Forward Quotations

• Quotations for such transactions are given in the same manner as


SPOT quotations.

Thus a quote like:


FRF / USD 3 month Forward: 4.4570 / 95 means Bank will give FRF
4.4570 to buy a USD, delivery 3 months from the corresponding SPOT
value date.

1.60 Discounts and Premia in the Forward Market

• Consider the following pair of quotations:


DM / USD SPOT: 1.5677 / 85
DM / USD 1 month Forward: 1.5575 / 85

• Dollar is cheaper for delivery after 1-month compare to SPOT. The


Dollar is said to be at a Forward discount against DM or DM at a
Forward premium in relation to Dollar.

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1.61 Annualized Premium / Discount:

• Annualized percentage discount / premium is calculated as:


[Forward(DEM/USD)mid - SPOT(DEM/USD)mid ] * 12 * 100
SPOT(DEM/USD)mid
• In the above example, the discount will work out to
= (1.5580 - 1.5681) * 12 * 100 / 1.5681
= - 7.73%

1.62 Margin Requirement:

• Forward contract between 2 banks involves telephonic agreement


on price, amount and period.
• When bank enters into Forward deal with corporate, it has to
protect against default in commitment.
• Done through either allocate credit limit or cash deposit.

1.63 FORWARD CONTRACTS, FUTURES & CURRENCY OPTIONS

1.63.1 Forward Contract

The rate in the forward market is a price for foreign currency set at the time
the transaction is agreed to but with the actual exchange, or delivery,
taking place at a specified time in the future. While the amount of the
transaction, the value date, the payments procedure, and the exchange
rate are all determined in advance, no exchange of money takes place until
the actual settlement date. This commitment to exchange currencies at a
previously agreed exchange rate is usually referred to as a Forward
Contract.

Forward contracts are the most common means of hedging transactions in


foreign currencies. The trouble with forward contracts, however, is that they
require future performance, and sometimes one party is unable to perform
on the contract. When that happens, the hedge disappears, sometimes at
great cost to the hedger. This default risk also means that many companies
do not have access to the forward market in sufficient quantity to fully
hedge their exchange exposure. For such situations, futures may be more
suitable.

Example
Suppose XYZ Ltd needs US $ 3,00,000 on 1st May 2000 for repayment of
loan installment and interest. As on 1st December 1999, it appears to the
company that the US $ may be dearer as compared to the exchange rate
prevailing on that date, say US $ 1 = Rest. 43.50. Accordingly, XYZ Ltd
may enter into a forward contract with a banker for US $ 3,00,000. The
forward rate may be higher or lower than the spot rate prevailing on the

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date of the forward contract. Let us assume forward rate as on 1st


December 1999 was US$ 1 = Rest. 44 as against the spot rate of Rest.
43.50. As on the future date, i.e., 1st May 2000, the banker will pay XYZ
Ltd $ 3,00,000 at Rest. 44 irrespective of the spot rate as on that date. Let
us assume that the Spot rate as on that date be US $ 1 = Rest. 44.80
In the given example XYZ Ltd gained Rest. 2,40,000 by entering into the
forward contract.

Payment to be made as per forward contract


Rs.132, 00,000
(US $ 3,00,000 * Rs.44.00)

Amount payable had the forward contract not


been in place
Rs.134, 40,000
(US $ 3,00,000 * Rs.44.80)

Gain arising out of the forward exchange


Rs.240, 000
contract

1.63.2 Currency Futures

Outside of the interbank forward market, the best-developed market for


hedging exchange rate risk is the currency futures market.

In principle, currency futures are similar to foreign exchange forwards in


that they are contracts for delivery of a certain amount of a foreign
currency at some future date and at a known price. In practice, they differ
from forward contracts in important ways.

1. One difference between forwards and futures is standardization.


Forwards are for any amount, as long as it's big enough to be worth the
dealer's time, while futures are for standard amounts, each contract
being far smaller that the average forward transaction.

2. Futures are also standardized in terms of delivery date. The normal


currency futures delivery dates are March, June, September and
December, while forwards are private agreements that can specify any
delivery date that the parties choose. Both of these features allow the
futures contract to be tradable.

3. Another difference is that forwards are traded by phone and telex and
are completely independent of location or time. Futures, on the other
hand, are traded in organized exchanges such the LIFFE in London,
SIMEX in Singapore and the IMM in Chicago.

4. But the most important feature of the futures contract is not its
standardization or trading organization but in the time pattern of the

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cash flows between parties to the transaction. In a forward contract,


whether it involves full delivery of the two currencies or just
compensation of the net value, the transfer of funds takes place once:
at maturity. With futures, cash changes hands every day during the life
of the contract, or at least every day that has seen a change in the
price of the contract. This daily cash compensation feature largely
eliminates default risk.

Thus, forwards and futures serve similar purposes, and tend to have
identical rates, but differ in their applicability. Most big companies use
forwards; futures tend to be used whenever credit risk may be a problem.

1.63.3 Debt instead of forwards or futures

Debt -- borrowing in the currency to which the firm is exposed or investing


in interest-bearing assets to offset a foreign currency payment -- is a
widely used hedging tool that serves much the same purpose as forward
contracts.

An example :

Elizabeth sold Canadian dollars forwards. Alternatively she could have


used the Eurocurrency market to achieve the same objective. She would
borrow Canadian dollars, which she would then change into francs in the
spot market, and hold them in a US dollar deposit for two months. When
payment in Canadian dollars was received from the customer, she would
use the proceeds to pay down the Canadian dollar debt. Such a
transaction is termed a money market hedge.

The cost of this money market hedge is the difference between the
Canadian dollar interest rate paid and the US dollar interest rate earned.

According to the interest rate parity theorem, the interest differential


equals the forward exchange premium, the percentage by which the
forward rate differs from the spot exchange rate. So the cost of the money
market hedge should be the same as the forward or futures market
hedge, unless the firm has some advantage in one market or the other.

The money market hedge suits many companies because they have to
borrow anyway, so it simply is a matter of denominating the company's
debt in the currency to which it is exposed that is logical. But if a money
market hedge is to be done for its own sake, as in the example, the firm
ends up borrowing from one bank and lending to another, thus losing on
the spread.

This is costly, so the forward hedge would probably be more


advantageous except where the firm had to borrow for ongoing purposes
anyway.

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1.63.4 Currency Options

Many companies, banks and governments have extensive experience in


the use of forward exchange contracts. With a forward contract one can
lock in an exchange rate for the future.

There are a number of circumstances, however, where it may be


desirable to have more flexibility than a forward provides. For example a
computer manufacturer in California may have sales priced in U.S. dollars
as well as in German marks in Europe. Depending on the relative strength
of the two currencies, revenues may be realized in either German marks
or dollars.

In such a situation the use of forward or futures would be inappropriate:


there's no point in hedging something you might not have. What is called
for is a foreign exchange option: the right, but not the obligation, to
exchange currency at a predetermined rate.

Defn. : A foreign exchange option is a contract for future delivery of a


currency in exchange for another, where the holder of the option
has the right to buy (or sell) the currency at an agreed price, the
strike or exercise price, but is not required to do so. The right to
buy is a call; the right to sell, a put. For such a right he pays a
price called the option premium. The option seller receives the
premium and is obliged to make (or take) delivery at the agreed-
upon price if the buyer exercises his option. In some options, the
instrument being delivered is the currency itself; in others, a
futures contract on the currency. American options permit the
holder to exercise at any time before the expiration date;
European options, only on the expiration date.

Example

Steve of Jackson Agro just agreed to purchase 15 million worth of


potatoes from his supplier in County Cork, Ireland. Payment of the five
million punt was to be made in 245 days' time. The dollar had recently
plummeted against all the EMS currencies and Steve wanted to avoid any
further rise in the cost of imports. He viewed the dollar as being extremely
instable in the current environment of economic tensions. Having decided
to hedge the payment, he had obtained dollar/punt quotes of $2.25 spot,
$2.19 for 245 days forward delivery. His view, however, was that the
dollar was bound to rise in the next few months, so he was strongly
considering purchasing a call option instead of buying the punt forward. At
a strike price of $2.21, the best quote he had been able to obtain was
from the Ballad Bank of Dublin, who would charge a premium of 0.85% of
the principal.

Steve decided to buy the call option. In effect, he reasoned, I'm paying for
downside protection while not limiting the possible savings I could reap if
the dollar does recover to a more realistic level. In a highly volatile market
where crazy currency values can be reached, options make more sense

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than taking your chances in the market, and you're not locked into a rock-
bottom forward rate.

This simple example illustrates the lopsided character of Options.

1.63.5 Swap

• A SWAP transaction between currencies A & B consists of a SPOT


purchase (sale) of A coupled with a Forward sale (purchase) of A, both
against B. The amount of one of the two currencies is identical in
SPOT and Forward
• The banks quote and do outright Forward deals with non-bank
customers. The Forward deals are done in inter-bank market in the
form of SWAP
• Assume that a bank buys Pounds one month Forward against
Dollars from a customer. It has thus created long position in Pounds
and short in Dollars.

If it wants to square it up, it will do as follows:

A Swap in which it buys Pounds Spot and sells one month Forward, thus
creating an offsetting short Pound position one month Forward.

Coupled with a Spot sell of Pounds to offset the long Pound position in
Spot created in the above Swap.

The reason for this is that it is very difficult to find counter parties with
matching opposite news to cover the original position by an opposite
outright Forward.

How to derive Outright Forward from swap quotation?

• Suppose DEM / USD SPOT is 1.6265 / 75 and 1-month swap is


15/8 (15/8 is in "points") point = 10-4
• To arrive at implied Forward, 15 points to be added to or
subtracted from SPOT bid rate and 8 points to be added / subtracted
from SPOT ask.
• How to determine whether to add or subtract? The answer guided
by two principles
o The bank must always profit. Rate at which it sells a currency must
be > buys same currency.
o Bid and ask spread widens as we go farther and farther into future.

In the above example if we add swap points, we will have 1-month


Forward rate as 1.6280 / 83. This is in conformity with first principle
but violets second.

1.63.6 Cross Rates

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In case the price of one currency is not quoted angst the other currency
the parity between them is obtained by using an intermediary currency.
The rate thus obtained is called a cross rate and the principle applied for
obtaining the cross rate is called the chain rule.

Ex:
Say in the Indian market the US dollar is quoted is at USD 1 =
35.8675/8725

In case the DM is quoted in New York as 1 USD = DM 1.5900/5910


1 DM = Rs.22.5582, If 1.5910DM= 1 USD and 1 USD = Rs.35.8675 then
the answer for 1DM would be = Rs.22.5540

Similarly, if the cross rate currency for any currency is known then it is
possible to arrive at the rate of the desired currency.

1.63.7 Controlling Corporate Treasury Trading Risks

In a corporation, there is no such thing as being perfectly hedged. Not


every transaction can be matched, for international trade and production
is a complex and uncertain business. As we have seen, even identifying
the correct currency of exposure, the currency of determination, is tricky.
Flexibility is called for, and management must necessarily give some
discretion, perhaps even a lot of discretion, to the corporate treasury
department or whichever unit is charged with managing foreign exchange
risks. Some companies, feeling professionals best handle that foreign
exchange, hire ex-bank dealers; other groom engineers or accountants.
Yet however talented and honorable are these individuals, it has become
evident that some limits must be imposed on the trading activities of the
corporate treasury, for losses can get out of hand even in the best of
companies.

In 1992 a Wall Street Journal reporter found that Dell Computer


Corporation, a star of the retail PC industry, had been trading currency
options with a face value that exceeded Dell's annual international sales,
and that currency losses may have been covered up. Complex options
trading were in part responsible for losses at the treasury of Allied-Lyons,
the British foods group. The $150 million lost almost brought the company
to its knees, and the publicity precipitated a management shakeout.

In 1993 the oil giant Royal Dutch-Shell revealed that currency trading
losses of as much as a billion dollars had been uncovered in its Japanese
subsidiary.

Clearly, performance measurement standards, accountability and limits of


some form must be part of a treasury foreign currency-hedging program.
Space does not permit a detailed examination of trading control methods,
but some broad principles can be stated.

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First, management must elucidate the goals of exchange risk


management, preferably in operational terms rather than in platitudes
such as "we hedge all foreign exchange risks."

Second, the risks of in-house trading (for that's often what it is) must be
recognized. These include losses on open positions from exchange rate
changes, counter party credit risks, and operations risks.

Third, for all net positions taken, the firm must have an independent
method of valuing, marking-to-market, the instruments traded. This
marking to market need not be included in external reports, if the
positions offset other exposures that are not marked to market, but is
necessary to avert hiding of losses. Wherever possible, marking to market
should be based on external, objective prices traded in the market.

Fourth, position limits should be made explicit rather than treated as "a
problem we would rather not discuss." Instead of hamstringing treasury
with a complex set of rules, limits can take the form of prohibiting
positions that could incur a loss (or gain) beyond a certain amount, based
on sensitivity analysis. As in all these things, any attempt to cover up
losses should reap severe penalties.

Finally, counter party risks resulting from over-the-counter forward or


swap contracts should be evaluated in precisely the same manner as is
done when the firm extends credit to, say, suppliers or customers.

1.64 Market Forecasts

After determining its Exposures, the company has to form an idea of


where the market is headed.

The company will focus on forecasts for the next 6 months, as forecasts
for periods beyond 6 months can be unreliable.

The focus of the Apex Management is to be aware of the Direction or the


Big Trend in rates

• the underlying assumptions behind the forecasts

• the Probability that can be assigned to the forecast coming true

• the possible extent of the move

The Risk Appraisal exercise and Benchmarking decisions will be based on


such forecasts

1.65 Market Participants

• OTC Nature - Trades effected on phone, fax or electronically.


• Major banks act as "market makers".

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• Two way quotes - rate at which willing to buy and sell one currency
for another (bid and offered rates). 9 digit dollars.
• Cross currency rates done by utilizing the dollar.

1.66 Market Participants - 4 Categories

• Non-bank entities that wish to exchange currencies to meet or


hedge contractual commitments (for import or export contracts).
• Banks, which exchange currencies to meet requirements of their
clients.
• Speculators buying or selling currencies. These speculators
comprise of large commercial banks, MNCs and hedge funds.
• Arbitragers - limited role due to communication systems.

1.67 Hedge Funds

• Investment vehicles for wealthy individuals. Popular in US and


privately placed. Total capital is US $ 300 billion.
• "Short" sell say (overpriced) silver and simultaneously (under
priced) gold. The term overpriced and under priced refer to relative ruling
prices in comparison to past. The objective is to make profit when prices
revert to historical relationship.
• Hedge funds typically operate on 10% margin and leverage fund
corpus 10 times. Hence, far greater degree of risk and reward.
• Unlike MFs, no supervision or regulation and lack of disclosure.
• Fund manager fees are typically 15 to 20% of profits.

1.68 Dealing Rooms

• Banks in major money markets investing heavily in computer and


communication infrastructure for efficient functioning of trading room.
• Integrated dealing rooms, which handle not only foreign exchange
but also derivatives like swaps, futures and options.
• MNCs too are in the market not only for covering their own
exposures but actively speculating on currency movements and making
treasury management as profit center.

1.69 Information Systems

• Reuter monetary service introduced in 1973 - bid and offered


quotations now far greater coverage and sophistications.
• Other real time financial data providers are Bloomberges.
• Deals are allowed to be struck and settlement instructions given
through system.

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• Reuters 3000 provides dealing system + electronic broker by


matching the quoted rates of subscribing banks.
• Rapid growth of cheap and electronic broking facilitates instant
deal confirmations and has replaced traditional voice brokers.
• 24 hours open dealing rooms to take care of all time zones.
• Internet further revolutionizing the system.

1.70 Payment and Communication System

• Once deal is "done", the dealers simultaneously specify where they


want currencies to be delivered.
• No paper-based system can meet the needs.
• Electronic or automated interbank fund transfer system like
CHIPS(clearing house interbank payment system) in New York.

1.71 Risk Appraisal

This exercise is aimed at determining where the company's exposures


stand vis-à-vis market forecasts.

The following Risks will be considered.

1. Risk to the Exposure or Value at Risk (VAR)

Given a particular view or forecast, VAR tries to determine by how much


the company’s underlying cash flows are affected. The VAR is the answer
to the question, “If the Rate actually moves to xx.xxxx, how much Profit/
Loss does the company make?”

2. Forecast Risk

What is the likelihood of the rate actually moving to xx.xxxx and what is
the likelihood of a forecast going wrong. It is imperative to know this
before deciding on a Benchmark and devising a hedging strategy.

3. Market and Transaction Risk

This will take into consideration the risks attached with each particular
market and the likelihood of a transaction not going through smoothly. For
instance, The Rupee is given to sudden swings in sentiment, whereas the
Deutschemark is generally more predictable.
The monetary and time costs of hedging with a nationalised bank are
generally higher than with a private/ foreign bank.

4. Systems Risk

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The risks that arise through gaps or weaknesses in the Exposure


Management system. For example:

Reporting Gap where there are delays/ errors in reporting exposures


to the Exposure Management cell
Implementation where there is a gap between the decision to hedge
Gap and the implementation of such hedge decision.

The company will endeavor to reduce the non-market risk or Systems


Risk over time.

1.72 Benchmarking

This exercise aims to state where the company would like its exposures
to reach.

1. The company will set a Benchmark for its Exposure


Management practices.
2. The Benchmarks will be set for 6 months periods.
3. The Benchmark will reflect and incorporate the following:
The Objective of Exposure Management, or in other words, "Should
Exposure Management be conducted on a Profit Center or Cost Center
basis?"

The Forecasts discussed and agreed upon earlier. Mathematically, the


Benchmark should be the Probabilistic Expectation of the rate in question.
The Forecast risk, Market and Transaction risk, and Systems
risk as determined earlier.

Room for error in keeping with the Stop Loss Policy to be decided

4. The Benchmark will be realistic and achievable.

Suggestions:
Companies whose exposures are of long-term Capital nature
can look to manage them on a Profit Center basis, since the
exposures are not open to day-to-day business risks.
Companies whose exposures are of short-term Revenue
nature should manage them on a Cost Center basis, since
the exposures impact the P&L Account directly.

A small note on the Profit/ Cost center concept:

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Profit Center Under this concept, the Exposure Manager is required to


generate a NET profit on the exposure over time. This is an
aggressive stance implying a high degree of risk appetite on
the part of Apex Management. A company with a strong
position in its daily bread and butter business can afford to
take some financial risks and can opt for this concept.
The Benchmarks under a Profit-Center concept would take
the form of “The total cost of a foreign currency loan should be
reduced by at least 25 bp over a one year period, from the
forecasted rate of x.x % p.a.”.
Cost Center Under this concept, the Exposure Manager would be required
to ensure that the cash flows of the company are not
adversely affected beyond a certain point. This is a defensive
strategy, implying a lower risk appetite. A company whose
cash flows are volatile, or whose underlying business is not on
a very sound footing would be advised to adopt this concept.
The Benchmarks under a Cost-Center concept would take the
form of “Foreign Exchange fluctuations should add no more
than x% to the cost of Imported Raw Material over and above
the budgeted cost.”

1.73 Hedging
This is the most visible and glamourised part of the Exposure
Management function. However, the Trader is like the Driver in a car rally,
who needs to follow the general directions of the Navigator.
a. Hedging strategies will be designed to meet the Exposure
Management objectives, as represented by the Benchmarks

b. The Exposure Management Cell will be accorded full operational


freedom to carry out the hedging function on a day to day basis
c. Hedges will be undertaken only after appropriate Stop-Loss and
Take-Profit levels have been predetermined
d. The company will use all hedging techniques available to it, as per
need and requirement. In this regard, it will pass a Board
Resolution authorising the use of the following:
 Rupee-Foreign Currency Forward Contracts
 Cross Currency Forward Contracts
 Forward-to-Forward Contracts
 FRAs
 Currency Swaps
 Interest Rate Swaps

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 Currency Options
 Interest Rate Options
 Others, as may be required

Suggestion:
Indian companies with sizeable US Dollar denominated exposures are
extremely vulnerable to sudden drastic moves in the USD-INR rate. They
can, to an extent, insulate themselves from such shocks by undertaking
hedges in currencies other than Rupee-Dollar.
For instance, a Dollar payable can be hedged by selling a currency (say
Sterling Pound) in order to buy Dollars, instead of selling the Rupee. The
choice of currency would, of course, depend on the trend and forecast for
the currency(s) at that point of time.
It is easier and safer to generate profits from a Cross-Currency Forward
Contract and a Rest 1 Lac profit thereon is equivalent to saving a 10
paise depreciation in the Rupee (on USD 1 million)

1.74 Stop Loss


Exposure Management should not be undertaken without having a Stop-
Loss policy in place. A Stop-Loss policy is based on the following two
fundamental principles:

1. To err is human
2. A stitch in time saves nine
It is appropriate to recount here some words from a speech of Dr Alan
Greenspan, Chairman of the US Federal Reserve, delivered in December
1997, on the Asian financial crisis. He says,

“There is a significant bias in political systems of all varieties to


substitute hope (read, wishful thinking) for possibly difficult pre-emptive
policy moves. There is often denial and delay in instituting proper
adjustments……Reality eventually replaces hope and the cost of the
delay is a more abrupt and disruptive adjustment than would have been
required if action had been more preemptive.”

Whether an Exposure is hedged or not, it is assumed that the decision to


hedge/ not to hedge is backed by a View or Forecast, whether implicit or
explicit. As such, Stop Loss is nothing but a commitment to reverse a
decision when the view is proven to be wrong.

Suggestions:
Stop Losses should be activated when

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• Critical levels in the rate being monitored are reached, which


clearly tell that the view held has been proven wrong.
• The factors/ assumptions behind a view either change or are
proven wrong.
• The Exposure Manager should be accorded flexibility to set
appropriate Stop-Losses for each trade.
• The Exposure Manager should, however, make sure he has set
a stop-loss for positions he enters into, on an a priori basis.

While Benchmarks will be based upon the Big Trend and will incorporate
a certain amount of room for error, the Exposure Manager should be
careful to not violate the Benchmark on the wrong side.

1.75 Reporting and Review


There needs to be continuous monitoring whether the Exposures are
headed where they are intended to reach. As such, the Exposure
Management activities need to be reported and reviewed.

Reporting
The Exposure Manager will prepare the following Reports on a regular
basis:

Report Name What it shows Periodicity


MTM Report The Mark-to-Market Profit/ Loss status
Daily, closing
on Open Forward Contracts
Exposure NAV The All-in-all exchange/ interest rate
Report achieved on each Exposure, and Fortnightly
profitability vis-à-vis the Benchmark
VAR Report Expected changes in overall Exposure
due to forecasted exchange/ interest Monthly
rate movements

Review
A monthly Review meeting will consider the following:

Points to be
Issue On the basis of
reviewed
Exposure Exposure NAV Report Is the
Performance Benchmark

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being met/
bettered?

What are the


chances of
the
Benchmark
being violated
on the wrong
side?

Reasons for
the
Benchmark
being violated
on the wrong
side

Market Reviews of market developments Is the Big


Situation Trend still in
place? Or has
Forecasts of market movements it changed?

Does the
Benchmark
Benchmarking The above two
need to be
changed?
Is the strategy
working well?
Hedging Or does it
MTM and Exposure NAV Reports
Strategy need to be
fine-tuned/
overhauled?
Operational
Operational
Exposure Manager's experiences problems to
issues
be solved

1.76 Conclusion
Exposure Management is an essential part of business and should be
viewed with Objectivity. It is neither a license to print money nor is it a
cause for getting trapped in a Fear Psychosis, and should be viewed with
the same clarity of vision as, say, Production or Marketing is viewed.
Having said that, it should be remembered that
o All that has been stated above cannot start happening straightaway

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o Installing Hedging, Reporting and Review systems that work takes


time and effort
o There will be a Learning Curve to be overcome when setting
Benchmarks
o There will be initial losses, which should be viewed as what they
are - initial losses.
There has to be a long-term commitment to Exposure Management,
because it is today an activity, which no company can afford to ignore.

LATEST IN FOREIGN EXCHANGE - TECHNOLOGY


ADVANTAGE

K mailer on : Finance Published : 31-10-2001 ISSN 0972-3900

International Finance
Online Foreign Exchange - Promises Galore (Update)-- Asian markets
have been slow to adapt to online foreign exchange (fx) trading despite the
creation of many private networks. The promises envisaged prior to the launch
still elude the online segment...

Dealing Online (Advance) -- Atriax has been the latest addition to sites that
facilitate foreign exchange (fx) dealings online. However, despite the growing
number of sites, experts are still skeptical about the liquidity they can provide in
comparison to physical markets....

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Asian markets have been slow to adapt to online foreign exchange (fx) trading despite the creation
of many private networks. The promises envisaged prior to the launch still elude the online
segment
A year ago, corporate treasurers in Asia were upbeat about the introduction of online fx trading. In
fact many big banks have expressed their desire to start online fx trade. Experts opined that 25 to
30% of fx transactions would be done online. These expectations came about when people had a
fascination for anything related to the Internet. Players in fx market felt that online trading would
remove the chaos prevalent in the markets. Online trade was expected to provide liquidity to
players trading in global currencies and also fetch them the best price.

Dreams - unrealised
CFOWeb.com, one of the first Internet forex services set up in 1999, received a dismal response.
According to rough estimates only 2% of the trade in Asia is being done online. The major reason
for this, according to Peter Wong, convenor of the Association of Corporate Treasurers, is that
many of them are still not comfortable with online trade. They prefer to trade through dealers who
can help them in making decisions.

The results of CFO Asia poll, conducted for top 10 corporate treasuries at major companies in
Asia, shows disappointing results. None of them adopted online trade and only three of them
propose to adopt it over the next few years. This is far from what was predicted. Vendors on their
part are not disappointed. They feel that it is too early to expect huge numbers. For instance,
managing director of Cognotec Asia Pacific, an Internet fx technology provider, feels that
treasurers in Japan have just started and those in Singapore and Honk Kong are yet to start.

The low response, it is alleged is because of banks' resistance to trade on the Internet. Banks
resist transparency with a fear that it might reduce their spreads and hence, their trading profits. If
banks do not adapt to online trade, then their competitors would. Fxall and Atriax have emerged
to take a share of $3 trillion per day fx market. The former has Bank of America, Credit Suisse
First Boston, Goldman Sachs, HSBC, JP Morgan Stanley Dean Witter and UBS Warburg as its
partners. The later has Chase Manhatan,Citibank and Deustche Bank as partners. Apart from
these mega portals many small ones are emerging. Matchbook FX, Gain Capital, and Currenex
are some of them.

Private portals
Despite the growing number of facilitators for online trade, corporates are slow in taking advantage
of them. The basic drawback, from corporates' perspective, of private portals is that they lack
Straight Through Processing (STP). STP means complete automation from transaction to
settlement. This would enhance the speed of processing at a lesser cost and lesser number of
errors. Though Atriax and FXall provide STP, the challenge is to integrate these with corporates'
banks end systems.

Integrating corporates' systems with those of banks would take more time and involve higher costs.
Also the present systems coroprates use are time tested and suffice their needs. Hence, they
consider it is an unnecessary investment at this juncture.

Speed is slow
Online trade requires better connectivity that would enable faster processing of transactions.
However, connectivity in Asia is inconsistent and the processing pace is phenomenally slow.
Private networks have leased lines and hence enhance the speed. Also, security controls provided
by these networks are unmatchable.However these services are more expensive than traditional
channels.
Another cause of concern has been legal issues, which take a long time to be solved. For instance,
when banks give a draft contract to their clients, the initial reaction of clients is that it is biased
towards ISPs. On the other hand, banks restrict their liability in case systems crash mid way
through a transaction. Clients do not like this. Such issues have to be solved as and when they
arise as they are not always predictable.

To conclude...
Despite these hurdles, efforts are on to make online fx trade a success. It, however, goes beyond
saying that banks should take a first step so others follow.

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Atriax has been the latest addition to sites that facilitate foreign exchange (fx) dealings online.
However, despite the growing number of sites, experts are still skeptical about the liquidity they
can provide in comparison to physical markets
Atriax, Currenex, FXall and FX connect are sites that have been launched to facilitate clients'
buying foreign exchange (fx). Availability of options will enable clients to compare functionality
offered by them, the products they offer and pricing mechanisms. Such comparison will help
customers to select the right site. Despite the convenience they offer, customers have been slow
to adapt this route. Also these sites are yet to provide their ability to provide liquidity.

These sites need to adopt existing models in the interbank market and focus on attracting
customers from physical markets.

Reuters and EBS - old war horses


Interbank market started electronic broking in early 1990s, through Reuters and Electronic
Broking Services (EBS). This system uses the matching concept. Under the system, offers and
bids are taken from the clients and a counter party expecting the same rates is found. Bank to
client (b-to-c) platforms, on the other hand, offer a new kind of mechanism known as request for
quote. Under this mechanism, parties to trade decide on the price, before executing the
transaction. This reduces the parties' vulnerability to risk and hence makes it a preferable channel
in comparison to other Internet sites.

b-to-c platforms are basically private networks. However, they are quicker and offer better security
than other channels. Hence, they are more expensive. This should not be a handicap as they have
the ability to cater to interbank (b-to-b) trading models. Also they offer flexibility to customers in
terms of choosing between quote to order and matching mechanisms. In addition, they claim to
introduce new pricing mechanisms in the future. Atriax facilitates any customer who wants to trade
inclusive of b-to-b.

Slow progress
b-to-c platforms are targeting buy side users (people who buy fx products). These people,
however, are not interested in trading complex fx instruments. A majority of them are still not
comfortable with electronic trading. Interbank markets will benefit from b-to-c channels, which are
considered to be a one -stop shop for a diverse range of products. Atriax and FX all launched by
consortium of banks would benefit the most as they can corner a bigger share of b-to-b market.

b-to-c platforms are now gearing up to the challenges of straight through processing (STP) that is
essential for interbank markets. Also these private networks enable customers to have automatic
download of deals. Since counter parties trade together, credit checks would become less labour
intensive.

Banks oppose opening of markets


It is logical for b-to-c platforms to focus on interbank trade till buy side customers adapt to it.
However, experts opine that these two markets will remain separated. Buy side customers had a
bitter experience in the past while working on interbank fx platforms. Banks resisted opening up the
markets. The same would continue if buy side segment and inter bank markets remain separated.

B-to-C platforms claim to provide transparency about the pricing they offer. This might be
misleading as customers can make a comparison between prices banks are offering but still they
cannot know the interbank pricing. This would mean that big banks would still command prices in
the market. These b-to-c platforms offer an ideal situation for banks for the following reasons:
• When b-to-c and b-to-b markets remain separated, banks need not declare their tightest
prices, in a b-to-c environment where anybody can trade with anybody
• As long as markets are separate banks would be protected from the threat of disinter
mediation and the possibility of developing buy-side to buy-side credit relationships
• In request for quote markets big banks have an undue advantage of winning clients of
small banks
The cumulative affect of all this will hinder the efficiency of markets. b-to-c platforms designed to
remove intermediation will not be able to achieve this and banks will continue to get their margins
by acting as intermediaries.

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RESREVE BANK OF INDIA REGULATIONS &


DEFINITIONS
1.77 Short title & commencement

1. These Regulations may be called the Foreign Exchange Management


(Foreign exchange derivative contracts) Regulations, 2000.

2. They shall come in force on the 1st day of June 2000.

1.78 Definitions

In these Regulations, unless the context requires otherwise, -

(i) `Act' means the Foreign Exchange Management Act,1999 (42 of


1999);

(ii) `authorised dealer' means a person authorised as authorised dealer


under sub- section (1) of section 10 of the Act;

(iii) `Cash delivery ' means delivery of foreign exchange on the day of
transaction ;

(iv) `Forward contract' means a transaction involving delivery, other than


Cash or Tom or Spot delivery, of foreign exchange;

(v) `Foreign exchange derivative contract' means a financial


transaction or an arrangement in whatever form and by whatever
name called, whose value is derived from price movement in one or
more underlying assets, and includes,

(a) a transaction which involves at least one foreign


currency other than currency of Nepal or Bhutan, or

(b) a transaction which involves at least one interest rate


applicable to a foreign currency not being a currency of
Nepal or Bhutan , or

(c) a forward contract, but does not include foreign exchange


transaction for Cash or Tom or Spot deliveries;

(vi) `Registered Foreign Institutional Investor (FII) ' means a foreign


institutional investor registered with Securities and Exchange board
of India;

(vii) `Schedule' means a schedule annexed to these RegulationS;

(viii) `Spot delivery' means delivery of foreign exchange on the second


working day after the day of transaction;

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(ix) `Tom delivery' means delivery of foreign exchange on a working


day next to the day of transaction;

(x) The words and expressions used but not defined in these
Regulations shall have the same meanings respectively assigned to
them in the Act.

1.79 Summary of Exchange Rate Regime in India

• Foreign exchange for all permitted imports, payment of dividend, interest


on approved ECBs is freely available.
• For other current account purposes like travel, study abroad, hiring
foreign personnel, specific exchange control guidelines.
• All receipts from exports / remittances / income must be sold to AD at
prevailing rate. A part of the earnings can be kept in the form of foreign
currency for specified time period and this balance can be used for
specified purpose.
• Capital account transactions are subject to exchange controls. These
include borrowing abroad, acquisition of assets abroad, JV contribution,
etc.
• Corporates can maintain foreign currency accounts abroad subject to
approval by RBI.

1.80 Exchange Rate Calculations

• Cash or ready delivery means delivery on the same date.


• Value next day means delivery on the next business day.
• SPOT means two business days ahead.
• For Forward contracts, the delivery date is either fixed in which case the
tenor is computed from the SPOT value date or it may be option Forward
in which case the delivery may be during a specified week or fortnight.
• Rates quoted by banks to non-banking customers are called Merchant
Rates.
• TT Rate denotes rate applicable for clean inward or outward remittance
i.e. the bank undertake from the currency transfer and does not perform
any other function such as handling documents.
• When there is delay between bank paying the customer and bank itself
getting paid (bank discounting export bill), the bank may charge margin
from the TT buying rate. The margins are subject to ceiling specified by
FEDAI.
• Similarly on the selling side when bank has to handle documents, apart
from effecting payment, margins are added to TT selling rate.

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1.81 Multi Currency Option

• This enables the borrower to change the borrowed currency on any


interest refixation day based on short-term view on likely movements in
the exchange rates.
• The loan document may provide for this option. It would prescribe
the primary currency (usually Dollar) and alternate currencies.
• Switch from primary to alternate currency is allowed on any roll
over day. Conversion done at SPOT rate ruling on the roll over day.
• If interest linked to LIBOR, the new interest is based on LIBOR
applicable to the alternate currency.
• On the next roll over day, borrower has option to continue in
alternate currency, switch back to primary currency or switch to another
alternate currency.
• Liability of the borrower is calculated in primary currency.

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FROM THE ILLUSTRATION - Lessons to be Learnt


 If borrower's view on the likely movement in exchange rate goes wrong,
he can incur substantial repayment liability.

 Borrower has to constantly monitor the exchange market and cover the
exchange risk at appropriate point during the roll over by purchasing
Swiss Franks in the forward market.

 Multi currency option does not require him to take a long term view on the
currency borrowed but can limit the risk by taking a series of short term
views.

 Lending bank has no difficulty in allowing multi currency option since it


funds the loan through short-term borrowing.

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INFORMATION ON EURO
1.82 Evolution of Euro market

a. Russians (Ironical) originated - sale of gold and other commodities and


buying grain. Parking of funds in Euro instead of US.
b. Restrictions imposed by US authorities on domestic banks and capital
markets - ceiling on deposit interest, CRR, Deposit Insurance.
c. Dollar being vehicle currency, many European corporations have cash
flows in Dollars and hence surpluses / deficits.

1.83 What are Euro markets?

a. It is mainly an inter-bank market trading in time deposits and debt


instruments. A Euro currency deposit is a deposit in the relevant
currency with a bank outside the home country of that currency. For
e.g. US Dollar Deposit in London Bank is a Euro Dollar Deposit or a
DM Deposit in Parris is Euro Mark Deposit.
b. Similarly a Euro Dollar Loan is a Dollar Loan made by bank outside
the US to a customer / another bank.
c. The prefix Euro is now outdated since such deposits / loans are often
traded outside Europe, like Singapore and Hong Kong.

Instruments

• Certificates of Deposit (CD) - Short-Term Instrument


• Euro Commercial Paper (ECP) - Short-Term Instrument
• Medium to Long-Term Floating Rate Loans
• Floating Rate Notes

Why such instruments are so attractive?

• Euro banks are free from regulatory provisions like CRR, Deposit
Insurance, etc.
• This results in reduced cost of funds.
• Lesser restrictions on "rating" and disclosure requirements
applicable for domestic issues and registrations with security
exchange authorities.

Interest Rates

a. In the Euro currency market, Inter-bank borrowing and lending rates


are benchmarked by LIBOR.
b. LIBOR is index of rate charged by one first class bank in London to
another first class bank for a short-term loan. It is not necessarily rate
charged by a particular bank but it is an indicator of demand supply
condition in the inter-bank deposit market in London.
c. Three and Six months LIBORs are normally available. A Euro currency
deposits range in maturity from overnight to one year.

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d. LIBOR varies according to the currency and the term.

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FOREX MARKET IN INDIA


 India - founder member of IMF
 Fixed Exchange Rate System - Intervention currency was Pound.
 Post 1971, RBI continued to maintain parity with Pound and crossed
currency rates determined through parity with Pound.
 September 1975 - Trade substantially diversified in terms of currencies.
Hence, Rupee linked to a secret basket. Pound continued to intervention
currency.
 July 1991 major devaluation of Rupee, intervention currency changed to
dollar and cash compensatory support for exports discontinued.
 March 1992: LERMS - Duel Exchange Rate System 60:40.
 March 1993: Single market determined rate.
 Spot and forward rates determined by demand and supply.
 Direct Rate: Exchange rate for a foreign currency expressed in terms of
units of local currency equal to one unit of foreign currency for e.g. US $
1.00 = INR 47.05.
 Indirect Rates US $ 2.3529 = INR 100.00.
 Buying Rate and selling rate are also referred as bid and offered rates.
 Spot Rate = Rate used for immediate transaction for a particular time.
 Tomorrow value (TOM) for next working day.
 Forward Rate = Rate quoted for transaction over a period of time in case
of transactions that takes place at a future date.

Local Exchange Market is two tier

1. Non-bank customers who buy / sell currency from authorized dealers.


2. Interbank market.

 RBI can influence the market rates through:

1. Verbal (media statements).


2. Tightening exchange control to curb speculation.
3. Tightening money supply or change of interest rates.
4. Actual sale or purchase of dollars.

Global Financial Market

• Emergence of global markets since mid 70's. Massive cross border


capital flows.
• Euro currencies market: Borrower / investor from country A could raise /
place funds from / with financial institutions located in country B,
denominated in the currency of country C.
• This market performed useful function of recycling "Petro-Dollars" beyond
1973 oil shock. It is no more a "Euro" market but a part of "offshore
market".
• Liberalization and removal of restrictions in developed and developing
countries has accelerated geographical integration of financial markets.

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• Early 80's: Process of disinter mediation where in highly rated issuers


began approaching investors directly rather than going through bank loan
route.
• Intense competition amongst commercial banks, lower spreads in
domestic operations and hence need for additional products and markets.
• Need for external financial assistance from developing countries due to
disequilibrium in BOP.
• Extent of linkage (cost of funding) between domestic and offshore
markets depends on extent of regulation in the domestic and offshore
markets.

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NMIMS FOREX EXPOSURE MANAGEMENT

Bibliography & List of References

I. Primary Sources of Data


(Interview conducted with the following personnel from the
Company):

Mr. Suresh Bagul, M/s Ciba Specialty Chemicals India


Limited

Mr. Mahesh Kalmane, M/s Ciba Specialty Chemicals India


Limited

II. Secondary Sources of Data


A. The Internet

Economic Times Website


The Business Standard Website
Reserve Bank of India Website
ICAI Website
Giddy's Web Portal (ian.giddy@nyu.edu)
The Managementor.Com website

B. Print Media

Annual Report 2000-2001: M/s Ciba Specialty Chemicals India Ltd.


Annual Report 1999-2000: M/s Ciba Specialty Chemicals India Ltd.
Annual Report 1998-1999: M/s Ciba Specialty Chemicals India Ltd.
Annual Report 1997-1998: M/s Ciba Specialty Chemicals India Ltd.
Annual Report 1996-1997: M/s Ciba Specialty Chemicals India Ltd.

International Financial Management-P.G.APTE


The Economic Times
Business Standard
RBI Circulars
The Management of Foreign Exchange Risk
- Ian H. Giddy & Gunter Dufey, New York
University and University of Michigan)
Foreign Exchange Handbook
-H.P. Bharadwaj
Multinational Financial Management
- Alan C. Shapiro
Options, Futures & other Derivatives
- John C. Hull

"Translation Methods and Operational Foreign


Exchange Risk Management,"
- Alder, Michael

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