Professional Documents
Culture Documents
Forex Exposure Management
Forex Exposure Management
Forex Exposure Management
P R O J E C T R E P O R T
By
S.SHREEKANT
MFM-IIIB, ROLL NO - 142
NARSEE MONJEE INSTITUTE OF MANAGEMENT STUDIES,
VILE PARLE, MUMBAI
ACADEMIC YEAR 2001-2002
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TABLE OF CONTENTS
STRUCTURE OF LIMITS...................................................................................................................38
1.26 OVERALL LIMITS............................................................................................................... 38
1.27 INDIVIDUAL DEALER LIMITS.............................................................................................. 38
INTERNAL CONTROLS.....................................................................................................................43
1.31 BALANCE OF PAYMENT.............................................................................................. 44
1.31.1 SOME BASIC CONCEPTS.............................................................................................44
1.32 COMPONENTS OF BALANCE OF PAYMENTS:........................................................................45
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INFORMATION ON EURO................................................................................................................99
1.82 EVOLUTION OF EURO MARKET........................................................................................... 99
1.83 WHAT ARE EURO MARKETS?.............................................................................................. 99
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1 Foreign Exchange-Introduction
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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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.
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
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b. Commercial Banks
c. Central Banks
1. Reserve Management
d. Exchange Brokers
e. Speculators
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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.
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.
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Overseas Transaction
Global Forex market has taken quantum jump and the Indian market has
followed suit.
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.
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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.
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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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.
An importer, who buys goods priced in foreign currency, faces the risk that
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.
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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.
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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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.
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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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.
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M/s CSCIL was incorporated in the year 1975 on the 1 st 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
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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60
Year
CRORES
40
RS.
95-96
99-00
20
98-99
96-97
97-98
0 96-97 97-98
95-96
Year
1 2
98-99
YEAR 99-00
22.97
63.52 95-96
164.95 96-97
97-98
98-99
99-00
89.13
64.49
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9 Background
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.
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.
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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:
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.
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.
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11 Analysis
These exposures will be analysed and the following aspects will be studied:
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.
It means that the values covered should never be below 25% of the
exposure & not beyond 75% of the exposures.
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COVER COVER
(MINIMUM) (MAXIMUM)
1 For professionally managed 35% 65%
and/or some what aggressive
Organisation
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
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%?
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Very few organisations have an elaborate forex policy. Even among those,
very few have performance evaluation criteria. Why?
1. Forex business exceeds USD 1000 billion every day. There are many
large players trying to outperform each other.
4. Like any other market, forex is a zero sum game. Rewards normally
depend upon the risk one is taking.
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In the light of the above, we shall study, in detail the primary components
of risk management process at CSCIL.
Using these, the Corporate Treasurer defines the net position and
gaps/maturity of the company.
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In this context a foreign exchange risk impacting the P&L Account would
arise on account of:
A foreign exchange risk impacting the Balance Sheet (B/S) would be:
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.
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Imports
Nature of Exposure
Exports
Royalty
Technical Know
How Fees
Indent
Commission
Dividend @ 50%
p.a.
18 Recognition of Exchange risks
Income from
Research and
There are theoretically a number of alternatives when a companyDevelopment
should
recognise the existence of a foreign exchange exposure.
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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4. Settlement Risk
5. Operating Risks
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.
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
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5. Operating Risks
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.
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
Circular trading
Undisclosed Personal trading
Insider trading
Routing deals to select brokers
Custodial
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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.
Systems
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.
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Contingency Planning
Internal Audits
Daily reconciliations
Ethical standards and codes of conduct
Dealing discipline
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.
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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.
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
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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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I) there should be well laid down forex policy, separately for imports
and exports. The policy should be reviewed every year.
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.
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:
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23-Oct-2001 0915 hrs
25-Oct-01
Currency Inter Spot 1 month 1 month 2 month 3 month 3 month 6 month
% %
Bank TT buy TT Sell TT buy TT Sell premia TT buy TT Sell TT buy TT Sell premia TT Buy
0. 48.4 48.8 0.
U.S. Dollar 47.99 47.79 48.19 47.99 48.39 05 48.22 48.62 4 4 05 49.15
0. 42.7 43.8 0.
Euro 0.89 42.26 43.33 42.41 43.49 04 42.58 43.66 6 4 05 43.32
0. 21.8 22.4 0.
Deutsche Mark 2.19 21.61 22.16 21.69 22.24 04 21.77 22.32 6 2 05 22.15
0. 39.6 40.4 0.
Jap. Yen (100) 122.52 38.78 39.55 39.07 39.85 09 39.36 40.15 6 5 09 40.58
0. 29.1 29.6 0.
Swiss Franc 1.66 28.73 29.45 28.87 29.39 02 29.01 29.54 6 9 05 29.63
0. 68.4 69.7 0.
Pound Sterling 1.43 67.74 69.03 67.96 69.25 04 68.21 69.50 5 5 04 69.22
0. 1.0 1.0 0.
Belgian Franc 45.23 1.05 1.07 1.05 1.08 04 1.06 1.08 6 9 05 1.07
0. 6.5 6.6 0.
French Franc 7.36 6.44 6.61 6.47 6.63 04 6.49 6.66 2 8 05 6.60
0. 2.2 2.2 0.
Italian Lira (100) 2,171.19 2.18 2.24 2.19 2.25 04 2.20 2.25 1 6 05 2.24
0. 19.4 19.8 0.
Dutch Guilder 2.47 19.18 19.66 19.25 19.74 04 19.32 19.81 0 9 05 19.66
0. 30.5 31.0 0.
Canadian Dollar 1.58 30.13 30.65 30.24 30.77 05 30.37 30.90 0 2 05 30.91
0. 3.1 3.1 0.
Austrian Schilling 15.43 3.07 3.15 3.08 3.16 04 3.09 3.17 1 9 05 3.15
0. 5.7 5.8 0.
Danish Kroner 8.34 5.70 5.81 5.72 5.83 04 5.74 5.85 6 7 04 5.83
0. 26.5 26.9 0.
Singapore Dollar 1.83 26.06 26.48 26.20 26.63 06 26.36 26.78 1 3 07 26.98
0. 4.5 4.5 0.
Swedish Kroner 10.67 4.46 4.54 4.47 4.55 04 4.49 4.57 1 9 05 4.57
0. 24.3 25.0 0.
Australian dollar 0.51 24.13 24.81 24.20 24.89 04 24.29 24.97 7 6 04 24.64
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
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may be due on the 1st of the month and an export payment for the same
amount would be receivable of the 15 th 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 15 th through
the money market or through Foreign Exchange forward markets.
We shall see now how the exposures are reported to the General Manager
Finance in case of exports and imports.
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
PYMN
T TYPEPO NO PO DATE SHIPMENT BANK STATUS FC C/X FC AMT BUG SET BUDGTD BUDGTD
TERM DATE RATE AMT
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
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NOTE:
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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:
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.
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 .
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.
Corporate Treasurer
Dealers
Position and gap limit of each authorised dealer. Each dealer can have a
different limit based on his experience and expertise.
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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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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.
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.
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.
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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.
Persons authorised to create risk positions and the spot position limit
and gap limit of each trader so authorised.
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.
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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.
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).
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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.
D IR 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 IO N ) ( C O N T R O L & A /C 'S )
S R . M A N A G E R S R . M A N A G E R
F R O N T O F F IC E B A C K O F F IC E (S T A T ) (M IS )
D E A L E R S S U P P S E R V IC 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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31 BALANCE OF PAYMENT
Thus, receipt and payments on account of all the three components make
the “Balance of Payments” of the country.
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
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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.
32.3 Invisibles
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1. BOP is a double entry accounting record and hence must balance except
for errors and omissions.
5. The items below the line are "compensatory" in nature. They "finance or
settle" the imbalance above the line.
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.
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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.
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(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.
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.
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of where the market expects currencies to go. And these contracts offer the
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.
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.
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.
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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.
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.
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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
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.
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.
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Interwar instability and Bretton Woods, Change over from fixed exchange
rates to fluctuating exchange rates.
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.
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
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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.
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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.
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44 Market Size
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.
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.
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The expected rate of change of the exchange rate = The interest rate
differential
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.
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.
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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.
46 Identifying Exposure
Clearly, such time your assets in the currency in which they are
denominated" applies in general to banks and similar firms.
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1. Accounting data do not capture all commitments of the firm that give rise
to exchange risk.
More importantly, accounting data reveals very little about the ability of the
firm to change costs, prices and markets quickly. Alternatively, the firm
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Finally, translation rules do not take account of the fact that exchange rate
changes have two components:
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.
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
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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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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.
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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
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.
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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
an example of a situation where the definition of exposure has a direct
impact on the firm's hedging decisions.
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.
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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.
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?
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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.
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.
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.
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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
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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.
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.
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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.
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.
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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.
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.
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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54 Market Players:
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".
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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:
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.
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62 Margin Requirement:
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.
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
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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
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.
3. Another difference is that forwards are traded by phone and telex and
are completely independent of location or time. Futures, on the other
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4. But the most important feature of the futures contract is not its
standardization or trading organization but in the time pattern of the
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.
An example :
The cost of this money market hedge is the difference between the
Canadian dollar interest rate paid and the US dollar interest rate earned.
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
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ends up borrowing from one bank and lending to another, thus losing on
the spread.
Example
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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
than taking your chances in the market, and you're not locked into a rock-
bottom forward rate.
63.5 Swap
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.
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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 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
Similarly, if the cross rate currency for any currency is known then it is
possible to arrive at the rate of the desired currency.
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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.
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.
64 Market Forecasts
The company will focus on forecasts for the next 6 months, as forecasts
for periods beyond 6 months can be unreliable.
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65 Market Participants
67 Hedge Funds
68 Dealing Rooms
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69 Information Systems
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.
71 Risk Appraisal
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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.
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
72 Benchmarking
This exercise aims to state where the company would like its exposures
to reach.
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Room for error in keeping with the Stop Loss Policy to be decided
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.
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.
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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
FRAs
Currency Swaps
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.
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:
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1. To err is human
2. A stitch in time saves nine
Suggestions:
Stop Losses should be activated when
Critical levels in the rate being monitored are reached, which
clearly tell that the view held has been proven wrong.
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.
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Reporting
Review
Points to be
Issue On the basis of
reviewed
Exposure Exposure NAV Report Is the
Performance Benchmark
being met/
bettered?
Reasons for
the
Benchmark
being violated
on the wrong
side
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changed?
Does the
Benchmark
Benchmarking The above two
need to be
changed?
Is the
strategy
working well?
Hedging
MTM and Exposure NAV Reports Or does it
Strategy
need to be
fine-tuned/
overhauled?
Operational
Operational
Exposure Manager's experiences problems to
issues
be solved
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.
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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....
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
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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.
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.
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.
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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.
78 Definitions
(iii) `Cash delivery ' means delivery of foreign exchange on the day of
transaction ;
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(x) The words and expressions used but not defined in these
Regulations shall have the same meanings respectively assigned to
them in the Act.
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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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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.
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INFORMATION ON EURO
82 Evolution of Euro market
Instruments
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
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c. Three and Six months LIBORs are normally available. A Euro currency
deposits range in maturity from overnight to one year.
d. LIBOR varies according to the currency and the term.
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B. Print Media