Tools for FX risk management (Hedging)

A Dissertation Report submitted in partial fulfillment for the award of

Post Graduate Diploma in Management

By Praveen Pardeshi (10085)

Kohinoor Business School & Center for Management Research, Khandala

March 2012

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Acknowledgements

I extend my sincere gratitude to our Director - KBSCMR Dr. Bigyan Prakash Verma for giving me opportunity to work on this report. This really helped me to explore and learn new things. I would also like to thank our Dean Prof. Atul Raman who supported me during the development of the report. I am greatly indebted to my mentor Prof. Mr. Milind Dalvi and Prof.G M Jayaseelan who consistently endeavored to give me valuable insights and guidance during the development of report.

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TABLE OF CONTENTS

Chapter No. 1 Objectives & Abstract 1.1 1.2 2 Objective of the project Abstract

Topic

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5 6

Indian currency market 2.1 2.2 Interbank spot market Currency Derivatives market 8 10

Factors affecting exchange rate 3.1 Political factors 3.2 Economic factors 3.3 Central bank intervention Implications of fluctuations in exchange rate 4.1 Impact on exporters and importers 4.2 Impact on the economy Tools for FX risk management (Hedging) 5.1 5.2 5.3 Internal tools External tools Opting for advisory services 12 13 15

17 18

20 25 29 30

Bibliography

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Chapter 1

Objective & Abstract

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1.1 Objectives

The primary objectives of this report are to:

1. To study the prevailing currency market in India. 2. Overview of the forex market. 3. Fundamentals that effects the exchange rate of a particular currency. 4. Difficulties faced by exporters due to currency appreciation & depreciation. 5. Tools for fx risk management i.e. currency hedging.

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1.2 Abstract

The crisis that rocked financial markets in 2008 spurred global investors to examine the strategies they often use to manage, and in some cases, mitigate investment and currency market fluctuations, as well as the impact such market swings have on investment objectives. Derivatives are the financial products which are used to hedge the currency exposure against the future price fluctuation. Say, the exporters want to protect themselves against fluctuations in the exchange rate for rupee. From the time of invoicing to the time of receiving the payment exporter would face exchange rate uncertainty. Through the use of simple derivative products, it was possible for the exporter to partially or fully transfer exchange rate risks by locking-in his exposures. Derivatives markets can broadly be classified as commodity derivatives market and financial derivatives markets. As the name suggest, commodity derivatives markets trade contracts are those for which the underlying asset is a commodity. It can be an agricultural commodity like wheat, soybeans, rapeseed, cotton, etc. or precious metals like gold, silver, etc. or energy products like crude oil, natural gas, coal, electricity etc. Financial derivatives markets trade contracts have a financial asset or variable as the underlying. The more popular financial derivatives are those which have equity, interest rates and exchange rates as the underlying. The most commonly used derivatives contracts are forwards, futures and options. At present when the market is so volatile there is a huge risk for traders specially importers & exporters as they have an exposure in foreign currency. Since exchange rate movements are huge their exposure is ought to make them suffer losses. Hence it is very important for them to cover their exposure from such risk and accordingly hedge their positions.

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Chapter 2

Indian Currency Markets

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2.1 Interbank spot market

During 2003-04 the average monthly turnover in the Indian foreign exchange market touched about 175 billion US dollars. Compare this with the monthly trading volume of about 120 billion US dollars for all cash, derivatives and debt instruments put together in the country, and the sheer size of the foreign exchange market becomes evident. Since then, the foreign exchange market activity has more than doubled with the average monthly turnover reaching 359 billion USD in 2005-2006, over ten times the daily turnover of the Bombay Stock Exchange. As in the rest of the world, in India too, foreign exchange constitutes the largest financial market by far. Liberalization has radically changed Indias foreign exchange sector. Indeed the liberalization process itself was sparked by a severe Balance of Payments and foreign exchange crisis. Since 1991, the rigid, four-decade old, fixed exchange rate system replete with severe import and foreign exchange controls and a thriving black market is being replaced with a less regulated, market driven arrangement. While the rupee is still far from being fully floating (many studies indicate that the effective pegging is no less marked after the reforms than before), the nature of intervention and range of independence tolerated have both undergone significant changes. With an overabundance of foreign exchange reserves, imports are no longer viewed with fear and skepticism. The Reserve Bank of India and its allies now intervene occasionally in the foreign exchange markets not always to support the rupee but often to avoid an appreciation in its value. There has been a considerable improvement in the forex market turnover in the recent years, particularly during the post-reform period. The total turnover, i.e., merchant and interbank taken together, in the forex market increased by 6-fold between the period 1987-88 to 1999-00. The average monthly turnover increased from about US $ 17 billion in 1987-88 to US $ 50 billion in 1993-94 and further to US $ 109 billion in 1998-99. Reflecting restrictions on rebooking of cancelled forward contracts for imports and splitting of forward and spot legs of a commitment, the monthly turnover declined to US $ 95 billion in 1999-00. The inter-bank turnover constitutes the predominant part of total turnover. The proportion of inter-bank turnover in total turnover increased from 82 per cent in 1987-88 to 91 per cent by 1991-92 but declined to less than four-fifths by 1999-00. As regards the classification by way of spot and forward transactions, available data for the recent period indicate that the merchant segment is dominated by spot transactions, while the inter-bank segment is dominated by forward transactions. During 1999-00, spot transactions accounted for about 55 per cent of total merchant turnover, while the forward transactions formed 40 per cent of total inter-bank turnover.

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In the Indian forex market, which is essentially transactions driven, interbank transactions in the spot segment mostly facilitate market making. At times, however, inter-bank transactions also reflect the "day trading" pattern. With restrictions on overnight overbought and oversold positions, day trading allows one to benefit from the intra-day exchange rate movements without violating the close of the day position limits. During normal market conditions, the ratio between inter-bank and merchant transactions should be somewhat stable. In the face of disorderly conditions, tendency for day trading may increase and, as a result, the ratio may increase. Whenever the Indian rupee was under pressure, the ratio of inter-bank spot transactions to merchant transactions tended to exceed the average, suggesting that day trading activities increase during volatile market conditions.

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2.2 Currency Derivatives

In the forward/swap segment of the market, importers and corporates generally tend to rush for cover when the spot market turns disorderly and prefer to keep their positions open during stable market conditions. This creates occasional large mismatches in the forward segment of the market. If merchant sale in the forward segment is used as a proxy for forward demand by importers and merchant purchase in the forward segment is used as a proxy for supplies by exporters in the forward market, then the ratios of monthly forward demand to monthly imports and monthly forward supply to monthly exports could explain the sensitivity of exporters and importers to forward market in India. The ratio of demand for forward cover to imports remained below one during stable market conditions, but got close to one or exceeded one whenever the spot exchange rate came under pressure. Two-way movement in the exchange rate is essential to increase the sensitivity of exporters and corporates to the forward market. Initiation of longer maturity contracts up to one year represents a healthy development in the forex market. According to the BIS Survey on Global Foreign Exchange markets, the maturity breakdown of outright forward transactions in different markets shows that while for the global market as a whole the share of one year contracts was about 4 per cent, in India it was close to 3 per cent. Forward contracts up to seven days, however, represented 51 per cent of total outright forward transactions in the world as against 22 per cent in India. This could be on account of the restrictions in the Indian market that without an underlying transaction, an agent cannot enter into a forward contract. The Reserve Bank's presence in the market essentially reflects its policy of ensuring orderly market conditions. Reflecting its stance, net intervention sales of the Reserve Bank generally coincided with conditions of excess demand in the market, while net intervention purchases coincided with surplus market conditions and contributed to reserve build-up.

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Chapter 3

Factors affecting exchange rate

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3.1 Political factors

All exchange rates are susceptible to political instability and anticipations about the new government. For example, political or financial instability in Russia is also a flag for the euro to US dollar exchange because of the substantial amount of German investments directed to Russia. Political scenario of the country ultimately decides the strength of the country. Stable efficient government at the centre will encourage positive development in the country, creating successful-investors confidence and a good image in the international market. An economy with a strong, positive image will obviously have a strong domestic currency. This is the reason why speculations rise considerably during the parliament elections, with various predictions of the future government and its policies. In 1998, the Indian rupee depreciated against the dollar due to the American sanctions after India conducted the Pokharan nuclear test. Value of a currency is thus not a simple result of its demand and supply, but a complex mix of multiple factors influencing the demand and supply. Its a tight rope walk for any country to maintain a strong, stable currency, with policies taking care of conflicting demands like inflation and export promotion, welcoming foreign investments and avoiding an appreciation of the domestic currency, all at the same time. Growing global tension will result in instability in the forex market. Irregular inflow or outflow of currencies may result in significant fluctuations in exchange rates. The stability of a foreign currency is closely related to the political situation of that place. In general, the more stable the country is, the more stable its currency will be. We will illustrate how political factors influence exchange rates with some actual examples. At the end of 1987, the US Dollar was suffering from continuous depreciation. In order to stabilize the US Dollar, the G7 Finance Ministers and central bank governors released a joint statement on 23 December 1987 announcing plans for a large-scale intervention in the forex market. On 4 January 1988, the group started to dump Japanese Yen and Deutsche Mark in huge volumes while buying US Dollars. This resulted in a rebound of the US Dollar and maintained its exchange rate at a stable level. For our second example, if you have been observing the Euro, you would have noticed that for three consecutive months during the Kosovo War, the Euro fell by about 10% against the US Dollar. One of the reasons was the downward pressure on the Euro caused by the Kosovo War.

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3.2 Economic factors

Currency changes affect you, whether you are actively trading in the foreign exchange market, planning your next vacation, shopping online for goods from another countryor just buying food and staples imported from abroad. Like any commodity, the value of a currency rises and falls in response to the forces of supply and demand. Everyone needs to spend, and consumer spending directly affects the money supply (and vice versa). The supply and demand of a countrys money is reflected in its foreign exchange rate. When a countrys economy falters, consumer spending declines and trading sentiment for its currency turns sour, leading to a decline in that countrys currency against other currencies with stronger economies. On the other hand, a booming economy will lift the value of its currency, if there is no government intervention to restrain it. Consumer spending is influenced by a number of factors: the price of goods and services (inflation), employment, interest rates, government initiatives, and so on. Here are some economic factors you can follow to identify economic trends and their effect on currencies. 1. Interest Rates "Benchmark" interest rates from central banks influence the retail rates financial institutions charge customers to borrow money. For instance, if the economy is under-performing, central banks may lower interest rates to make it cheaper to borrow; this often boosts consumer spending, which may help expand the economy. To slow the rate of inflation in an overheated economy, central banks raise the benchmark so borrowing is more expensive. Interest rates are of particular concern to investors seeking a balance between yield returns and safety of funds. When interest rates go up, so do yields for assets denominated in that currency; this leads to increased demand by investors and causes an increase in the value of the currency in question. If interest rates go down, this may lead to a flight from that currency to another. 2. Employment Outlook Employment levels have an immediate impact on economic growth. As unemployment increases, consumer spending falls because jobless workers have less money to spend on nonessentials. Those still employed worry for the future and also tend to reduce spending and save more of their income. An increase in unemployment signals a slowdown in the economy and possible devaluation of a country's currency because of declining confidence and lower demand. If demand continues to decline, the currency supply builds and further exchange rate depreciation is likely. One of the most anticipated employment reports is the U.S. Non-Farm Payroll (NFP), a reliable indicator of U.S. employment issued the first Friday of every month.

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3. Economic Growth Expectations To meet the needs of a growing population, an economy must expand. However, if growth occurs too rapidly, price increases will outpace wage advances so that even if workers earn more on average, their actual buying power decreases. Most countries target economic growth at a rate of about 2% per year. With higher growth comes higher inflation, and in this situation central banks typically raise interest rates to increase the cost of borrowing in an attempt to slow spending within the economy. A change in interest rates may signal a change in currency rates. Deflation is the opposite of inflation; it occurs during times of recession and is a sign of economic stagnation. Central banks often lower interest rates to boost consumer spending in hopes of reversing this trend. 4. Trade Balance A country's balance of trade is the total value of its exports, minus the total value of its imports. If this number is positive, the country is said to have a favorable balance of trade. If the difference is negative, the country has a trade gap, or trade deficit. Trade balance impacts supply and demand for a currency. When a country has a trade surplus, demand for its currency increases because foreign buyers must exchange more of their home currency in order to buy its goods. A trade deficit, on the other hand, increases the supply of a countrys currency and could lead to devaluation if supply greatly exceeds demand.

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3.3 Central bank intervention

With interest rates in several major economies already very low (and set to stay that way for the time being), central bank and government officials are now resorting to other, less commonly used measures to directly intervene in the market and influence economic growth. For example, quantitative easing is being used to increase the money supply within an economy. It involves the purchase of government bonds and other assets from financial institutions to provide the banking system with additional liquidity. Quantitative easing is considered a last resort when the more typical responselowering interest ratesfails to boost the economy. It comes with some risk: increasing the supply of a currency could result in a devaluation of the currency. Some governments attempt to influence the value of their currency. For example, China has sought to keep its currency undervalued to make Chinese exports more competitive. They can do this by buying US dollar assets which increases the value of the US dollar to Chinese Yuan. The most common reason for central bank intervention over the last decade or so would be because of a sharp or sudden decline in the value of a currency. It can however turn problematic for a nation to use market intervention whenever the currency value does decline steeply in the foreign exchange market and it will lead to several disadvantages to the nation. Export-dependent countries could spiral into recession if they become too reliant on market intervention. Global trading partners exchange rates will rise as well, while the prices of their exports increase within the global market place. A decline in value of a nations currency can also lead to an increase in inflation as prices of imported services and goods are will go up. Subsequently, interest rates will be augmented by the central bank but will unfortunately disturb the economic growth and asset markets, and possibly developing into a decline of the currencys value. Nations with large budget deficits rely on foreign inflows of capital. A decline in the value of a currency can cause major financial difficulty to countries with high budget deficits. Financing the deficits will be extremely delayed and will jeopardize the economic growth of a nation. In order to maintain the value of the currency, there will need to be an elevation of interest rates.

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Chapter 4

Implications of fluctuations in exchange rate.

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4.1 Impact on exporters and importers

Until the 70s and 80s India aimed at to be self-reliant by concentrating more on imports and allowing very little exports to cover import costs. However, this could not last long because the oil price rise in the 1970s and 80s created a big gap in Indias balance of payment. Balance of payment (BOP) of any country is the balance resulting from the flow of payments/receipts between an individual country and all other countries as a result of import/exports happening between an individual country, in our case India and rest of the world. This gap widened during Iraqs attempt to take over Kuwait. Thereafter, exports also contributed to FX reserve along with Foreign Direct Investment into the Indian economy and reduced the BOP gap Indian rupee appreciation against dollar impacted heavily to the following: 1. Exporters 2. Importers 3. Foreign investors Exports from India are of handicrafts, gems, jewelry, textiles, ready-made garments, industrial machinery, leather products, chemicals and related products. Since the 1990s, India is the worlds largest processor of diamonds. The mentioned export items contribute substantially to foreign receipts. During the periods when the dollar was moving high against the rupee, exporters stood to gain, when $1 = Rs. 48, was getting them Rs. 4800 for every $100. Since the beginning of the year 2007, rupee appreciated by about 10%. With its value of rupee Rs. 39.35 = $1 as on 16 Nov 2007, for every $100, exporters would get only Rs. 3935. This difference is towing away the profit margins of exporters and BPO service providers alike. Imports to India are of petroleum products, capital goods, chemicals, dyes, plastics, pharmaceuticals, iron and steel, uncut precious stones, fertilizers, pulp paper etc. With the same scenario as given for export, if we analyze - an importer is paying Rs. 3935 now instead of Rs. 4800 paid during yester years for every $100. This gain on FX is likely to create savings in cost, which could be passed on to consumers, thereby contributing to control inflation. On one hand the rupee appreciation will affect exporters, BPOs, etc., on the other, rupee depreciation will affect importers.

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4.2 Impact on economy

Rupee appreciation makes imports cheaper and exports more expensive. According to intelligence reports by the Associated Chambers of Commerce and Industry of India, sectors like petroleum and petroleum products, drugs and pharmaceuticals and engineering goods which have import inputs of as much as 77 percent, 19 percent and 21 percent, respectively will gain if the rupee appreciates. They would have to pay less for the imported raw materials which would increase their profit margins. Likewise, a depreciating rupee makes exports cheaper and imports expensive. So, it is good news for industries such as IT, textiles, hotels and tourism which generate income mainly from exporting their products or services. Rupee depreciation makes Indian goods and services cheaper for overseas buyers, thus leading to increases in demand and higher revenue generation. The foreign tourists would find it cost effective to come to India, therefore increasing the business of hotel, tours and travel companies. Indias IT sector is dependent on foreign clients, especially the United States, for more than 70 percent of its revenue. When an IT company gets a project from a client, it pre-decides on the length of the contract and the cost of the project. The contracts with U.S. clients are usually quoted in U.S. dollar terms. So, the fluctuation in the exchange rate can bring about a considerable difference in the performance of a company. Some companies undertake a range of measures like hedging exchange risks using forwards and futures contracts. This helps in mitigating some of the losses due to exchange rate fluctuations, but none-the-less the impact is substantial. The exchange rate is a significant tool that can be used to examine many key industries; with fluctuations potentially having a serious impact on the economy, industries, companies, and foreign investors. Rupee appreciation is generally helpful for industries which rely closely on imported inputs while depreciation of the rupee is welcome news for industries which are exporting a majority of their products. Foreign investment into India is also contributing well to dollar depreciation against dollar. With the recent liberalized norms on foreign investment policy like Foreign investment of up to 51% equity limit in high priority industries; foreigners & NRIs are allowed to repatriate their profits and capital with exception for Indian nationals who were allowed to do so only under special circumstances; allowing free usage of export earnings to exporters, made foreign investment in India very attractive. It is this favorable atmosphere which made FX reserve surplus in US dollar and helped rupee to appreciate Conclusively, appreciation and depreciation of rupee cannot certainly be taken as beneficial to the Indian economy in general. On one hand the rupee appreciation will affect exporters, BPOs, etc., on the other, rupee depreciation will affect importers. So now it depends on what the future has to reveal for, how effectively the central bank can balance the FX rates with little impact to the relative areas of FX usage.
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Chapter 5

Tools for FX risk management (Hedging)

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5.1 Internal tools

In view of the substantial and significant stake in foreign countries, foreign exchange risk has become an integral part of the management activities of any multinational enterprise. Therefore, the management must be aware of the various techniques of dealing with ERR. Covering the foreign exchange risk is also known as hedging the risk. If a company in its wisdom does not want to hedge, it tantamount to have the view that the future movements of exchange rates will be in its favor. On the contrary, the conservative enterprises may adopt the policy of hedging everything. Exchange rate risk (ERR) is inherent in the businesses of all multinational enterprises as they are to make or receive payments in foreign currencies. This risk means eventual losses incurred by these enterprises due to adverse movements of exchange rates between the dates of contract and payment. However, ERR does not imply that it will result into losses only. Gains may also accrue if the movement of rates is favorable. Hedging obviously means a certain cost to an enterprise. Suppose the company hedges the exposure and the forward rates move in favour of the company due to a shift in economic factors between the dates of invoice and conversion of currency, the company would suffer or lose on this account. There are two types of techniques to cover exchange rate risk: internal techniques, adopted by the enterprise to limit the exchange risk, and external techniques that require a recourse to forward market, money market and external organizations. EXPOSURES : Multinational enterprises are subject to the following three types of risks/exposures: Transaction Exposure Consolidation Exposure Economic Exposure Transaction Exposure Whenever there is a commitment to pay foreign currency or possibility to receive foreign currency at a future date, any movement in the exchange rate will affect the domestic value of the transaction. The following situations give rise to transaction exposure: Trade transactions with foreign countries when billing is done in foreign currencies like export or imports. Banking and financial transactions done in foreign currencies like lending and borrowing or equity participation, etc.
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Consolidation (or Translation) Exposure This results from direct (joint ventures) or indirect investments (portfolio participation) in foreign countries. When balance sheets are consolidated, the value of assets expressed in the national currency varies as a function of the variation of the currency of the country where investment was made. If, at the time of consolidation, the exchange rate is different from what it was at the time of the investment, there would be a difference of consolidation. The accounting practices in this regard vary from country to country and even within a country from company to company. There is great responsibility on the part of corporate finance manager, who is expected to manage the assets and liabilities with fluctuating foreign exchange rates in such a way that the profits and cash-flow levels stick to budgeted levels as far as possible. Economic Exposure In an open economy, the strength of currencies of competitors due to relative costs and prices in each country which, in turn, have a bearing on exchange rate and the structure of business itself gives rise to economic exposure which may put companies at a competitive disadvantage. Though this is not a direct foreign exchange risk exposure, the underlying economic factors may become a risk factor. Economic Exposure In an open economy, the strength of currencies of competitors due to relative costs and prices in each country which, in turn, have a bearing on exchange rate and the structure of business itself gives rise to economic exposure which may put companies at a competitive disadvantage. Though this is not a direct foreign exchange risk exposure, the underlying economic factors may become a risk factor. Internal Techniques Of Hedging There are several techniques which can be used in this category to reduce the exchange rate risk: Choosing a particular currency for invoice Leads and Lags Indexation clauses in contracts Netting Shifting the manufacturing base Centre of reinvoicing Swaps

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Choice of the Currency of Invoicing In order to avoid the exchange rate risk, many companies try to invoice their exports in the national currency and try to pay their suppliers in the national currency as well. This way an exporter knows exactly how much he is going to receive and how much he is to pay, as an importer. This method is a noble one. However, an enterprise suffers under this method if the national currency appreciates; this is likely to result into a loss of market for the products of the company if there are other competitors. Companies may also have recourse to invoicing in a currency whose fluctuations are less erratic than those of the national currency. For example, in the countries of the European Union, the use of European Currency Unit (ECU) is gaining popularity. Leads and Lags This technique consists of accelerating or delaying receipt or payment in foreign exchange as warranted by the position/expected position of the exchange rate. The principle involved is rather simple. If depreciation of national currency is apprehended, importing enterprises like to clear their dues expeditiously in foreign currencies; exporting enterprises prefer to delay the receipt from their debtors abroad. These actions, however, if generalized all over the country, may weaken the national currency. Therefore, certain countries like France regulate the credits accorded to foreign buyers to avoid market disequilibrium. The converse will hold true if an appreciation of national currency is anticipated; importing enterprises delay their payments to foreigners while the exporting ones will attempt to get paid at the earliest. These actions may have a snowballing effect on national currency appreciating further. Indexation Clauses in Contracts For protecting against the exchange rate risk, sometimes, several clauses of indexation are included by exporters or importers. A contract may contain a clause whereby prices are adjusted in such a manner that fluctuations of exchange rate are absorbed without any visible impact. If the currency of the exporting country appreciates, the price of exports is increased to the same extent or vice-versa. Therefore, the exporter receives almost the same amount in local currency. Thus, exchange rate risk is borne by the foreign buyer. There is another possibility where the contracting parties may decide to share the risk. They may stipulate that part of exchange rate variation, intervening between the date of contract and payment, will be share by the two in accordance with a certain formula, for example, halfhalf or one-third, two-third, etc.

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Netting (Internal Compensation) An enterprise may reduce its exchange risk by making and receiving payments in the same currency. Exposure position in that case is simply on the net balance. Hence an enterprise should try to limit the number of invoicing currencies. The choice of currency alone is not sufficient. Equally important is that the dates of settlement should match. Bilateral Netting may be bilateral or multilateral. It is bilateral when two companies have trade relations and do buying and selling reciprocally. For example, a parent company sells semi-finished products to its foreign subsidiary and then repurchases the finished product from the latter. Multilateral Netting can equally be multilateral. This is taken recourse to when internal transactions are numerous. Volume of transactions will be reduced because each company of the group will pay or be paid only net amount of its debit or credit. Switching the Base of the Manufacture In the case of manufacturing companies, switching the base of manufacture may be useful so that costs and revenues are in the same currency, e.g. Japanese car manufacturers have pened factories in Europe. Reinvoicing Centre A reinvoicing centre of a multinational group does billing in respective national currencies of subsidiary companies and receives the invoices made in foreign currency from each one of them. It would be preferable, if possible, to locate the reinvoicing centre in a country where exchange regulations are least constraining. The centre itself is a subsidiary of the parent company. The principle is simple: the invoices of foreign currencies are made in the name of the reinvoicing centre by the subsidiaries. And, the centre, in turn, will send equivalent sums in national currency. Likewise, payments in foreign currencies to suppliers are made by the centre and it receives equivalent sums in the national currencies from the subsidiaries concerned. Figure indicates how the flow of currencies takes place. Receipts and Payments through Reinvoicing Centre The management of exchange risk is thus centralized at a single place. This helps in reducing the volumes of foreign currency transfers and hedging costs. However, one often encounters the problem where dates of maturity do not match. Besides, the exchange regulations in some countries may not permit reinvoicing.

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Swaps in Foreign Currencies Swap is an agreement reached between two parties which exchange a predetermined sum of foreign currencies with a condition to surrender that sum on a pre-decided date. It always involves two simultaneous operations: one spot and the other on a future date. There are various types of swaps such as cross-credit swaps, back-to-back credit swaps, and export swaps, etc.

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5.2 External tools

Risks under transaction exposure can be minimized using various tools available in the foreign exchange and financial markets. Of these, four are important. Forward exchange contracts Money market hedge Currency Futures Options Forward Exchange Rate Contracts The contract is for the purchase or sale of a specified quantity of a specified currency price is agreed today. Performance is at a future date. This future time can be either a specified date, or any time between two specified dates. Both parties are obliged to perform. Other relevant points are 1. Though spot rates can be obtained for most of the currencies, it may not be possible to enter into forward exchange contracts for all those currencies for which there is a spot market. The reason is insufficiency of demand, or a high volatility in exchange rates. 2. The length of time (depth) up to which one can stretch forward depends upon demand levels. In India, forward rates are available for 6 month periods and can be rolled over. Exotic (minor) currencies such as Argentinean Peso may not have a forward exchange market beyond three months. The longer is the period into future time span, the wider is the bid-ask spread. The size of spread for a given currency increases with maturity. 3. There are three standard periods of time in a forward market, namely, one month, three months and six-months. Rates for such periods can be had instantly alongside spot rates.

4. Forward rates for odd-periods, falling outside the ambit of standard periods, e.g. 72days or 95 days can also be secured, but are specifically tailor-made to suit the needs of customers.
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5. Generally, a forward exchange contract is entered for delivery of underlying foreign currency asset on a given specified future date. But this is not always the case. There can be variations, and banks do provide built-in flexibility to traders, to accommodate them in situations where the delivery date is uncertain. These are known as option forward exchange contracts.

Forward Contracts A forward contract as we know is a contract to either buy or sell foreign currency, on a future date. We also know that both the parties under the contract are obligated to perform. Suppose, you have entered into a forward contract. You could either be a) A buyer of foreign currency (Importer) b) A seller of foreign currency (Exporter)

You could close out this contract either: a) On the due date of settlement of the forward contract. Or, b) On any date prior to the due date of settlement of the forward contract. Closing out can be done either by: a) Honoring the contract b) Rolling over the contract (i.e., extending the contract.) c) Cancelling the contract. Money Market Hedge Money market is a market for short-term instruments. In this market you can borrow or lend for a short period of time. Salient features are: 1. Short period of time ranges from an overnight time period (a day comprising 24 hours from the close of business hours on day 1 till close of business hours on day-2) to generally six to twelve months.

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2. Each time period will have its own interest rates lowest for overnight periods, and increasing gradually with the tenor of the borrowing/lending. 4. Money market rates are always given in nominal annual rates. If a rate of 8% is quoted, it means 8% per annum and will have to be adjusted for the relevant time period. A threemonth tenor would thus carry interest at 2% (8 x 3/12) 5. Interest or deposit rates differ from country to country, and hence currency to currency.

Money market hedge involves: Borrowing in foreign currency (say $) in the case of exports Investing in foreign currency (say ) in the case of imports Steps to be adopted

1. Identify whether Foreign Currency (FC) is asset or liability Importer will have foreign currency liability, Exporter will have foreign currency asset. 2. Create the opposite position either by borrowing or depositing the amount equal to present value of FC liability or FC asset and rates are adjusted for the period of loan or deposit Importer will create FC asset, Exporter will create FC liability. 3. Convert the borrowed funds into required currency Importers have to convert domestic currency into foreign currency at spot rate, Exporters have to convert FC funds borrowed into domestic currency at spot rate. 4. Invest the borrowed funds Importer will deposit the FC overseas, Exporter will deposit in domestic. 5. Settle the payments by withdrawing deposited amounts along with interest Importer will receive maturity proceeds of FC asset and settle FC liability, Exporter will get the asset value from overseas customer, and settle FC liability there itself.

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Currency Futures In the context of international finance, such derivative instruments come in handy as one of the tools to hedge the risks in exchange rate movements. These are known as currency futures or currency options Financial futures contracts include besides stock market indices futures contracts for interest rates, and currencies What are Currency Futures? Financial futures contracts were first introduced by the International Monetary Markets Division of Chicago Mercantile Exchange, in order to meet the needs for managing currency risks, and prompted by a galloping growth in international business. London International Financial Futures and Options Exchange (LIFFE), set up in 1982 had been dealing in currency futures, but have restricted their activity to interest rate futures. A currency futures contract is a derivative financial instrument that acts as a conduct to transfer risks attributable to volatility in prices of currencies. It is a contractual agreement between a buyer and a seller for the purchase and sale of a particular currency at a specific future date, at a predetermined price. A futures contract involves an obligation on both the parties to fulfill the terms of the contract. The fundamental advantage is hedging risks. In a currency futures contract, one of the paid of the currencies is invariably the US $. That is, you can buy or sell a futures contract only with reference to the USD. There are six steps involved in the technique of hedging through futures. These are: i) Estimating target outcome (with reference to spot rate available on a given date) ii) Deciding on whether Futures Contracts should be bought or sold iii) Determining number of contracts (this is necessary, since contract size is standardized) iv) Identifying profit or loss on target outcome v) Closing out futures position and Option Contracts Mechanics of Hedging through Options Hedging through options is a simple four-step process. 1. Deciding on Call or Put options (i.e., whether to buy or sell a currency) 2. Determining number of contracts 3. Selecting an acceptable exercise price, pay premium and conclude the contract. 4. On maturity, i) If market rate is less favourable, exercise your option under the contract, and ii) if market rate is more favourable, ignore the contract and buy or sell in the market.
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5.3 Opting for advisory services

It is a common myth in the market and mostly among small traders that hedging their exposures are mostly done by large firms and also that it is very complicated and there is a lack of knowledge among them. This approach had given opportunity for a new line of business which is known as FX advisory services. More and more firms are entering this line of business. Forex advisory firms basically advise its clients who are generally exporters and importers or we can say who have an exposure in foreign currency. This firms consists of experts team of analyst who tracks the market movements and updates their clients and also advises them on when to take forward cover on their exposure, at what rate, what will be the premium, designing and implementing hedging strategies etc. These firms also conduct treasury audits for their clients and also advise them on trade finance. Import and export companies these days are using such advisory services and doing transactions with their banks. Hence saving on time and using services from market experts.

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BIBLIOGRAPHY

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Bibliography

Websites: www.investopedia.com www.actionforex.com www.wikipedia.com

Articles www.isb.edu/faculty/rajeshchakrabarti/FX_Basu.pdf www.icai.org/resource_file/9900769-772.pdf

Books ICWAI - Group 3 Financial management & International Finance

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