Risk Management

• Identify the risk inherent in the following transactions

• Raising the capital i.e borrowing from other countries than the domestic country

• Lending or investment decisions in other countries than the domestic country

• Buying of raw material from foreign vendors

• Selling the finished goods to foreign customers

• Compensating employees working in foreign offices

 Risk Management

Can the risk be eliminated? Why and why not, substantiate with examples.
 Risk Management

• Therefore, the risk can only be passed on to other party. What is it called?

HEDGING

• What game it is?

ZERO-SUM GAME
 Risk Management

• Can risk management help in mitigating any embarrassments?

A BIG ‘YES’
 Foreign Exchange Market

• It is a market place that determines the exchange rate for currencies across the globe

• Participants can buy and sell various currencies in foreign exchange market

• Key players in foreign exchange market

• Foreign exchange dealers
• Commercial banks/firms
• Central banks i.e policy making banks
• Hedge funds
• Investment management firms
• Retail and Institutional investors
 Foreign Exchange Market

• Currency trading is always done in “pairs”

• “Pair” indicates the value of a currency relative another currency

• The pair, for instance “USDINR” indicates value of Indian rupees needed to USD and
vice versa

• In the above quote, USD is known as the base currency and INR is known as quoted or
counter currency
 Foreign Exchange Market

• In Indian forex market, “USDINR” is called a direct quote

• Therefore, in a direct quote domestic currency is a quoted or counter currency and always
variable.

• Therefore, in a direct quote base currency is always a foreign currency which is always one ‘1’.

• Quite opposite is called indirect quote

• A direct quote in a country is indirect quote to counter country and vice versa

• “EUROUSD” is cross currency quote in India.

 Foreign Exchange Market

• Quotes are of two types

• The quote is what the dealer displays his sell rate and his buy rate

• The dealer’s quotes are opposite to the customer

• Ask quote or Sell quote by a dealer i.e the units of quoted currency he takes from you in
order to give you one unit of base currency. Remember this is a buy for the customer.

• Bid quote or Buy quote by a dealer i.e the units of quoted currency he gives to you by
taking one unit of base currency. Remember this is a sell for the customer.

• The difference between “BID” and “ASK” quotes is called “SPREAD”, which is his profit.
 Foreign Exchange Market

• What is Pip or Pippet? A percentage in point.

• A smallest increment in forex trade.

• Major currencies are quoted with four decimal points

• Some currency pairs are quoted with two decimal points

 Foreign Exchange Market

• A small quiz question

• “USDINR” quote on day 1 is given as “81.5623”

• “USDINR” quote on day 2 is given as “82.7510”

• Which currency appreciated and which currency depreciated from day 1 to day 2?
 Foreign Exchange Market

• Quiz question

• “USDINR” quote on day 1 is given as “83.2550”

• “USDINR” quote on day 2 is given as “82.0500”

• Which currency appreciated and which currency depreciated from day 1 to day 2?
 Foreign Exchange Market

• Quiz question

• An importer of raw material from Europe will be worried about appreciation of INR or
depreciation of INR?

Depreciation of INR

• An exporter of raw material to Europe will be worried about appreciation of INR or depreciation of
INR?

Appreciation of INR
 Foreign Exchange Market

• Quiz question

• An Indian importer of raw material from Europe will be worried about appreciation of EURO or
depreciation of EURO?

Appreciation of EURO

• An Indian exporter of raw material to Europe will be worried about appreciation of EURO or
depreciation of EURO?

Depreciation of EURO
 Foreign Exchange Market

• Quiz question

• What is currency pegging?

• A country’s government fixes its currency rate against foreign currency, normally USD

• Which countries peg their currencies?

• Hong Kong, Bahmas, Bahrain and most of Caribbean Countries

• Why do countries peg their currencies

• To establish country’s currency stability

• To provide wider access to its currency trading across the globe with less risk
 Foreign Exchange Market

• Markets are of two types

• Spot Market: Buying and selling at instant or live price with immediate delivery i.e “T0”

• Forward Market: Locking buy price or sell price or both for delivery in future i.e at “T+”
 Tools and Techniques of Risk Management

• Derivative Contracts or simply Derivatives are of three major types

• Forward Contracts

• Futures Contracts

• Options Contract
 Comparison of forward contract and futures contract

Basis Forward Contract Futures Contract Options

Type Tailor made or customized Standardized Standardized

Platform Over The Counter (OTC) Exchange Exchange

Identity of the parties Known to each other Un-known Un-known

Counterparty default Yes No No
Risk
Collateral May not be required Required (initial Required (initial
margin) margin)
Size of the contract Variable Fixed i.e lot size Fixed i.e lot size
 Comparison of forward contract and futures contract

Basis Forward Contract Futures Contract Options

Maturity As per the terms and may Predetermined Predetermined
vary mutually
Regulation Self regulated Regulated by the Regulated by the
exchange exchange
Liquidity Very low Very high Very high

Physical delivery Possible Nil Nil

Honoring the contract Mandatory for both but Mandatory for seller
either party can default Mandatory for both but optional for
buyer
 Options Contracts

• A contract in which one party will have an option to honor and another party will have an
obligation to honor the contract

• A party who reserves the right honor or not is known the buyer of the option. Therefore, the
buyer of an option contract may or may not honor or exercise the contract.

• A party who is obligated to honor the contract is known as the seller of an option

• In order to buy the right whether to honor or not, the buyer of the contract will pay the
premium to the seller of the contract

• The buyer of the contract will forgo the premium irrespective of honoring the contract or not
 Terminology in Derivative contracts

• Underlying asset
• Strike or exercise price
• Spot price
• Lot size
• Contract value
• Organized exchange
• Standardization
• Near month (one month), next month (two months) and far month (three months)
• Clearing house
• Margin
• Marking to market (M2M)
 Currency risk hedging

• Infosys in India sells its software to foreign customer and hence such customers
would pay at time in foreign currency, say in USD.

• If the sales is ‘COD’, the firm will may convert USD into cash in spot market or may
hold it with a speculative motive

• If the sales is on credit and would receive USD, say at time ‘T+’

• Now treasury manager will be worried about?

• Appreciation of INR
and
• Depreciation of USD
 Currency risk hedging

• So, what should he do?

• Do nothing and convert USD into INR whenever he receives. This may result either in loss or gain,
depending upon the exchange rate between USD and INR at time ‘T+’

• Hedge the exchange rate risk through futures or options contract

• He can hedge either entire currency or partial currency.

• Partial hedging is done with a speculative motive

• The currency hedged upon total currency is called “Hedge Ratio”