Foreign Exchange Risk Management Using Derivatives

FOREIGN EXCHANGE RISK MANAGEMENT

USING DERIVATIVES

A PROJECT REPORT

SUBMITTED TO
GURU NANAK DEV UNIVERSITY, AMRITSAR
IN THE PARTIAL FULFILLMENT OF REQUIREMENTS FOR THE DEGREE OF

MASTER OF BUSINESS ADMINISTRATION

(2008-2010)

Supervised By:- Submitted By:-

Dr. A.S. Sidhu Sahil Arora

Professor MBA (IV Sem.)
CBM Department Roll No. 880505
GNDU, AMRITSAR

DEPARTMENT OF COMMERCE AND BUSINESS MANAGEMENT

GURU NANAK DEV UNIVERSITY
AMRITSAR
 Foreign Exchange Risk Management Using Derivatives

STUDENT DECLARATION

This is to certify that the project entitled “Foreign Exchange Risk Management Using
Derivatives” completed during the session 2008-2010 for MBA degree is a bonafide piece of
research work and all sources used to complete this project are duly acknowledged in case the
project report, or any part of it is found to be copied or quoted without reference I shall be solely
held accountable for the repercussions arising therefrom.

Dated:- Signature of Student

 Foreign Exchange Risk Management Using Derivatives

GUIDE CERTIFICATE

Certified that the project titled “Foreign Exchange Risk Management- Using Derivatives”
presented by Sahil arora (Roll No. 880505) represents his original work, which was carried out
by him at GURU NANAK DEV UNIVERSITY ,AMRITSAR under my guidance and
supervision during the period from…………………2009 to ………………..2010

Name of guide: Dr. A.S.Sidhu

Signature of guide: …………………………………..

Date: …………………………………………………
 Foreign Exchange Risk Management Using Derivatives

PREFACE

Almost all corporate treasurers have found foreign currency exposure management the most
difficult, onerous, indeed terrifying challenge, but perhaps also the most exciting, and
occasionally even a rewarding activity. The sheer discipline of having to watch almost every
aspect of world news every day is itself demanding, yet fascinating. This is essential whether you
are trading foreign currencies for profit on a daily basis as a few large companies do, or you are
deciding whether and when to establish or change a three-month, 12 month or five year hedged
position.

An interest in the area of risk management coupled with the intriguing complexity of the foreign
exchange markets throughout the world prompted me to undertake this work as a final project.
 Foreign Exchange Risk Management Using Derivatives

ACKNOWLEDGEMENT

I would like to take this opportunity express my sincere gratitude to Dr. A.S.Sidhu for his
constant mentorship and enduring encouragement throughout the course of this project. His
inputs have been invaluable in the completion of this project.

I have tried my best to present this information as clearly as possible using basic terms that I
hope will be understandable by the widest spectrum of researchers, analyst, students for further
studies.

Sahil Arora
 Foreign Exchange Risk Management Using Derivatives

Executive Summary

The term risk management is applied in a number of diverse disciplines. Risk Management is a
process of determining and quantifying risks and then developing strategies to mitigate or
manage the risks. In this project we have tried to delve into the Management of Risk arising
through dealing in foreign exchange as faced by many Indian corporates, which need to indulge
into foreign trade for success of their business. As we usher into a new era of liberalization and
globalization this subject would become more and more important for Indian Corporates.

We start with an introduction of the field of risk management, the generic process and
procedures to be followed for any kind of risk management activities. We also discuss the
alternatives available to mitigate or manage risk and basics of formulating a policy on risk
management. A basic introduction into the field of foreign exchange management is also
provided, which deals with the functioning of the foreign exchange systems and foreign
exchange markets across the world, the basic characteristics of the market and the major players
have also been enumerated.

Further, the project provides a detailed description of types of foreign exchange risks faced by
corporates and present the reasons of why a formal risk management plan is needed to contain
and mitigate such risks. Various ways in which a corporate may be exposed to fluctuations in the
foreign currency market have been described and explained.
Each type of exposure, viz. transaction exposure, translation exposure and operating exposure
has been exemplified. We also discuss various techniques to quantify transaction exposure,
translation exposure and operating exposure like the scenario analysis, stress testing and Value at
Risk procedures.

Next, we provide a detailed description of various foreign exchange hedging instruments

available to corporates. In specific the derivative products on foreign exchange like forwards,
options, swaps and other instruments have been defined and explained with their uses and
 Foreign Exchange Risk Management Using Derivatives

drawbacks. The need to manage foreign exchange risk has been reinforced with a detailed
comparison of unhedged and hedged foreign exchange exposures.

Strategies to deal with various kinds of exposures have been described and explained in the next
chapter. The chapter describes all kind of internal and external hedging techniques in use
throughout the world. It also describes the need for corporates to formulate a clear risk
management policy and various organizational issues which may emerge during the process of
foreign exchange risk management activities.

The specifics to the Indian Foreign exchange markets are discussed in the next chapter. This
chapter provides details on the evolution of the foreign exchange market in India, important
characteristics of the Indian markets, its segment, participants, products and regulatory
mechanism. It also lists the guidelines given by RBI for foreign exchange risk management for
corporates.

A case study on the policies and procedures of risk management at Tata International Limited,
the trade house for the renowned Tata Group has been discussed, enumerating the various
techniques of risk management undertaken by the company and its usefulness.

Finally, some recommendations for the corporates to effectively utilize the hedging techniques
available have been provided with emphasis on techniques, which would provide better risk
management alternatives considering the current market scenario have been discussed.
 Foreign Exchange Risk Management Using Derivatives

Table of Contents

Chapter 1 Introduction.................................................................1
1.1 Introduction to Risk Management.............................................................................1
1.1.1 What is Risk Management?................................................................................2
1.1.2 Risk Management Process..................................................................................2
1.1.3 Steps in a Risk Management Process.................................................................4
1.1.4 Limitations..........................................................................................................4
1.2 Introduction to Foreign exchange..............................................................................5
1.2.1 Foreign Exchange Market...................................................................................5
1.2.3 Fluctuations in exchange rates............................................................................6
1.3 Review of Literature………………………………………………………………...8
1.4 Research Methodology Adopted…………………………………………………..10

Chapter 2 Foreign Exchange ExposureError! Bookmark not

defined.11
2.1 Introduction..............................................................................................................11
2.2 Types of Exposure...................................................................................................12
2.2.1 Transaction Exposure.......................................................................................12
2.2.2 Operating exposure...........................................................................................13
2.2.3 Translation exposure.......................................Error! Bookmark not defined.3
2.3 Quantification exposure and risk.........................Error! Bookmark not defined.14
2.3.1 Scenario Analysis Based on Exchange Rate Forecasts....................................15
2.3.2 Stress Testing....................................................................................................16
2.3.3 Value at Risk (VaR)......................................Error! Bookmark not defined.17
2.3.4 Assessing Operating Exposure.........................................................................19

Chapter 3 Foreign Exchange Hedging Instruments.................27

3.1 Spot Contract...........................................................................................................27
3.2 Forward Contract.....................................................................................................27
3.3 Option dated forward contract.............................Error! Bookmark not defined.28
 Foreign Exchange Risk Management Using Derivatives

3.4 Foreign Currency Options.......................................................................................28

3.5 Zero cost range forwards.........................................................................................28
3.6 Participating Forwards.............................................................................................28
3.7 Currency Swaps.......................................................................................................29

Chapter 4 Hedging strategies......................................................30

4.1 Objectives of A Hedging Policy..........................Error! Bookmark not defined.30
4.2 Internal Hedging Techniques.................................Error! Bookmark not defined.0
4.2.1 Invoicing.......................................................Error! Bookmark not defined.31
4.2.2 Leading and Lagging......................................Error! Bookmark not defined.2
4.2.3 Netting and Offsetting......................................................................................34
4.2.4 Price Variation..................................................................................................37
4.3 External Hedging.....................................................................................................38
4.3.1 Using The Forward Markets For Hedging........................................................38
4.3.2 Hedging With Money Market.......................Error! Bookmark not defined.39
4.3.3 Hedging With Currency Options..................Error! Bookmark not defined.42
4.3.4 Comparison Of Options With Forward Hedging And Open PositionError! Bookmark
not defined.42
4.4 Organizational Issues...............................................Error! Bookmark not defined.

Chapter 5 Foreign Exchange Derivatives in IndiaError! Bookmark

not defined.49
5.1 Evolution of Foreign Exchange Market In India.....................................................49
5.2 Introduction to Foreign Exchange market in IndiaError! Bookmark not defined.50
5.3 Foreign Exchange Market Segments.......................................................................51
5.4 Regulating/Managing Institutions...........................................................................52
5.4.1 RBI....................................................................................................................52
5.4.2 CCIL.................................................................................................................53
5.4.3 FEDAI...........................................................Error! Bookmark not defined.52
5.5 RBI Guidelines for Foreign Exchange ManagementError! Bookmark not defined.54
5.5.1 Forward Exchange Contracts........................Error! Bookmark not defined.54
5.5.2 Foreign Currency - Rupee Swaps:................Error! Bookmark not defined.55
 Foreign Exchange Risk Management Using Derivatives

5.5.3 Hedging of Loan Exposures..........................Error! Bookmark not defined.55

5.5.3 Other Derivatives - Foreign Currency Options................................................56

Chapter 6 Forex Risk Management at Tata International......57

6.1 Risk Management Policy.....................................Error! Bookmark not defined.57
6.2 Default Risk.....................................................Error! Bookmark not defined.57
6.3 Exchange Rate Risk.........................................Error! Bookmark not defined.58
6.4 Performance Appraisal............................................................................................64
6.5 Mc. Donald's case study of Foreign Exchange Risk Management using derivatives….64
6.6 An Overview of the hedging practices adopted in India by different companies……..68

Chapter 7 Recommendations and ConclusionError! Bookmark not

defined.74
Some special recommendations and suggestions for the Indian companies……………………76.
Bibliography