NMIMS Global Access

School for Continuing Education (NGA-SCE)

Course: International Banking & Foreign Exchange Management
Internal Assignment for December 2022 Examination

Question 1: Your company is planning to expand its operations to other countries. Imagine
yourself in the role of company’s financial manager. Management has asked you to explain them
about the forex market and its functioning and how their company business would get affected
by it?
Answer:
The forex market allows participants, such as banks and individuals, to buy, sell or exchange currencies
for both hedging and speculative purposes. The foreign exchange (forex) market is the largest financial
market in the world and is made up of banks, commercial companies, central banks, investment
management firms, hedge funds, retail forex brokers, and investors.
The forex market is not dominated by a single market exchange, but a global network of computers and
brokers from around the world. Forex brokers act as market makers as well and may post bid and ask
prices for a currency pair that differs from the most competitive bid in the market.
The forex market is made up of two levels—the interbank market and the over-the-counter (OTC)
market. The interbank market is where large banks trade currencies for purposes such as hedging,
balance sheet adjustments, and on behalf of clients. The OTC market, on the other hand, is where
individuals trade through online platforms and brokers.
Type of Forex Markets
Three are three key types of forex markets: spot, forward, and futures.
Spot Forex Market
The spot market is the immediate exchange of currency between buyers and sellers at the current
exchange rate. The spot market makes up much of the currency trading. The key participants in the spot
market include commercial, investment, and central banks, as well as dealers, brokers, and speculators.
Large commercial and investment banks make up a major portion of spot trades, trading not only for
themselves but also for their customers.
Forward Forex Market
In the forward markets, two parties agree to trade a currency for a set price and quantity at some future
date. No currency is exchanged when the trade is initiated. The two parties can be companies,
individuals, governments, or the like. Forward markets are useful for hedging. On the downside,
forward markets lack centralized trading and are relatively illiquid (since there are just the two parties).
As well, there is counterparty risk, which is that the other part will default.
Futures Forex Market
Future markets are similar to forward markets in terms of basic function. However, the big difference
is that future markets use centralized exchanges. Thanks to centralized exchanges, there are no
counterparty risks for either party. This helps ensure future markets are highly liquid, especially
compared to forward markets.

Big Players in the Forex Market

The U.S. dollar is by far the most-traded currency. The second is the euro and the third is the Japanese
yen. JPMorgan Chase is the largest trader in the forex market. Chase has 10.8% of the global forex
market share. They have been the market leader for three years now. UBS is in second, with 8.1% of
the market share. XTX Markets, Deutsche Bank, and Citigroup make up the remaining places in the top
five.
Advantages
One of the biggest advantages of forex trading is the lack of restrictions and inherent flexibility. There’s
a very large amount of trading volume and markets are open almost 24/7. With that, people who work
nine-to-five jobs can also partake in trading at night or on the weekends (unlike the stock market).
There’s a large amount of optionality when it comes to available trading options. There are hundreds of
currency pairs, and there are various types of agreements, such as a future or spot agreement. The costs
for transactions are generally very low versus other markets and the allowed leverage is among the
highest of all financial markets, which can magnify gains (as well as losses).

Disadvantages
With forex markets, there are leverage risks—the same leverage that offers advantages. Forex trading
allows for large amounts of leverage. The leverage allowed is 20-30 times and can offer outsized
returns, but can also mean large losses quickly.
Although the fact that it operates nearly 24 hours a day can be a positive for some, it also means that
some traders will have to use algorithms or trading programs to protect their investments while they are
away. This adds to operational risks and can increase costs.
Forex, or foreign exchange, can be explained as a network of buyers and sellers, who transfer currency
between each other at an agreed price. It is the means by which individuals, companies and central
banks convert one currency into another – if you have ever travelled abroad, then it is likely you have
made a forex transaction.
While a lot of foreign exchange is done for practical purposes, the vast majority of currency conversion
is undertaken with the aim of earning a profit. The amount of currency converted every day can make
price movements of some currencies extremely volatile. It is this volatility that can make forex so
attractive to traders: bringing about a greater chance of high profits, while also increasing the risk.
Exchange rates are the price of foreign currency that an amount of one currency can buy e.g. one-pound
sterling. An increase in the value of the sterling means one pound can buy an increased amount of
foreign currency, meaning you are getting more for the same amount of money. Businesses that import
and export goods need to pay close attention to these exchange rates as the value of goods are highly
sensitive, chopping and changing with the constant fluctuations. Businesses that trade domestically
must also be aware of changes in exchange rates as they will have an indirect impact by virtue of the
wider economy. So, how exactly do exchange rates affect a business? We will look at some examples
below and click here to see how your business can stay protected.
Exchange rate volatility can also have an effect on competition. Depreciation of your local currency
makes the cost of importing goods more expensive, which could lead to a decreased volume of imports.
Domestic companies should benefit from this as a result of increased sales, profits and jobs.
Question 2: An Indian import export house has a currency exposure to 10 million Japanese Yen.
Assume that Yen is not directly quoted against INR. The current spot rates are USD/INR = 79.97
and USD/JPY =137.56. It is estimated that Yen will depreciate to 164 level and Rupee to
depreciate against Dollar to 83. The Forward rate for December 2022 USD/YEN = 147.56 and
USD/INR 82.52. Given that the actual spot rate on 30 December 2022 was USD/YEN = 137.85 and
USD/INR = 79.99, what hedging decisions an Indian company should take?
Answer:
Hedging is a risk management strategy employed to offset losses in investments by taking an opposite
position in a related asset. The reduction in risk provided by hedging also typically results in a reduction
in potential profits. Hedging requires one to pay money for the protection it provides, known as the
premium. Hedging strategies typically involve derivatives, such as options and futures contracts.
The best way to understand hedging is to think of it as a form of insurance. When people decide to
hedge, they are insuring themselves against a negative event's impact on their finances. This doesn't
prevent all negative events from happening. However, if a negative event does happen and you're
properly hedged, the impact of the event is reduced.
Portfolio managers, individual investors, and corporations use hedging techniques to reduce their
exposure to various risks. In financial markets, however, hedging is not as simple as paying an insurance
company a fee every year for coverage. Hedging against investment risk means strategically using
financial instruments or market strategies to offset the risk of any adverse price movements. Put another
way, investors hedge one investment by making a trade in another.
Technically, to hedge requires you to make offsetting trades in securities with negative correlations. Of
course, you still have to pay for this type of insurance in one form or another. For instance, if you are
long shares of XYZ corporation, you can buy a put option to protect your investment from large
downside moves. However, to purchase an option you have to pay its premium. A reduction in risk,
therefore, always means a reduction in potential profits. So, hedging, for the most part, is a technique
that is meant to reduce a potential loss (and not maximize a potential gain). If the investment you are
hedging against makes money, you have also usually reduced your potential profit. However, if the
investment loses money, and your hedge was successful, you will have reduced your loss.

Understanding Hedging
Hedging techniques generally involve the use of financial instruments known as derivatives. Two of
the most common derivatives are options and futures. With derivatives, you can develop trading
strategies where a loss in one investment is offset by a gain in a derivative.
Suppose you own shares of Cory's Tequila Corporation (ticker: CTC). Although you believe in the
company for the long run, you are worried about some short-term losses in the tequila industry. To
protect yourself from a fall in CTC, you can buy a put option on the company, which gives you the right
to sell CTC at a specific price (also called the strike price). This strategy is known as a married put. If
your stock price tumbles below the strike price, these losses will be offset by gains in the put option.
Hedging is an important protection that investors can use to protect their investments from sudden and
unforeseen changes in financial markets.
Types of Hedging Strategies
Hedging strategies are broadly classified as follows:
Forward Contract: It is a contract between two parties for buying or selling assets on a specified date,
at a particular price. This covers contracts such as forwarding exchange contracts for commodities and
currencies.
Futures Contract: This is a standard contract between two parties for buying or selling assets at an
agreed price and quantity on a specified date. This covers various contracts such as a currency futures
contract.
Money Markets: These are the markets where short-term buying, selling, lending, and borrowing
happen with maturities of less than a year. This includes various contracts such as covered calls on
equities, money market operations for interest, and currencies.
Advantages of Hedging
Hedging limits, the losses to a great extent.
Hedging increases liquidity as it facilitates investors to invest in various asset classes.
Hedging requires lower margin outlay and thereby offers a flexible price mechanism.
Since the direct Quote for X & Y is not available it will be calculated by cross exchange rate as follows:
79.97/137.56 = .5813 i.e spot rate on the day of export
Expected rate = 85/164 = .5182
Forward Rate = 82.52/147 = .5613
Calculation of Expected Loss without Hedging
Value of Export at the time of Export = .5813*10,000,000 = 5813000
Estimated payment received = .5182*10,000,000= 5182000
Loss = 631,000
Hedging of loss under forward contract
Value of Export at the time of Export = 5813000
Payment to be received by forward cover .5613* 10,000,000 = 5613000
Loss= 200,000
By taking forward cover loss is reduced to 200,000
Actual Rate = 79.99/137.85 = .5802
Value of export = 5813000
Estimated payment = 5802000
Loss = 11000
Therefore, it better to use Active Rate.
Conclusion
Hedging provides a means for traders and investors to mitigate market risk and volatility. It minimises
the risk of loss. Market risk and volatility are an integral part of the market, and the main motive of
investors is to make profits. However, you are not in a position to control or manipulate markets in
order to safeguard your investments. Hedging might not prevent losses, but it can considerably reduce
the effect of negative impacts.
Question 3: Open currency position is subjected to exchange rate risk. Suppose you are doing
training in the treasury department of bank. The manager has asked you to prepare report on
the following:
a. Position limits on a currency that a dealer can carry during regular trading hours.
Answer:
As a trader, your success will be solely dependent on the strategy you use. As a result of the volume of
daily trades and the number of people and institutions involved in trading, there is equally a high number
of trading strategies in the market. As a trading strategy, hedging is a complicated process which entails
the use of two securities or assets which have a negative correlation. You hedge an investment by
making another investment. The goal of hedging is not to increase the profits for a trader. In fact, in the
financial market, you can never get away from the risk-return trade off. Therefore, if you avoid a certain
amount of risk, you on the other hand reduce the potential profits you can make.
Hedging is the act of taking out an opposing position to one or more existing positions that will offset
these positions in the event of a loss. A hedging position will almost invariably be smaller than the main
position, but a hedge can sometimes make a failed trade profitable if the hedging position was acquired
on favourable terms. Part of the explosive rise in the popularity of derivatives is the result of their
suitability for hedging positions. An Example of Hedging: Suppose that a trader opens a long position
in the shares of Company A worth $1,000 at 50$ per share. The trader believes that the stock is currently
undervalued and expects the value to steadily rise over the next earnings season. However, the company
is currently facing some legal headwinds that are expected to blow over, but could be costly in the event
of the court ruling against them. In this case the trader may hedge their long position in Company A by
taking out an opposing short position using put options for the shares of Company A.
Many highly successful day trading strategies, particularly in the market for derivatives, are based on
the concept of hedging. These day trading strategies use offsetting positions and windows of
profitability to make extremely precise short-term bets that can pay off tremendously in the very near
term when successful. For example, a day trader may purchase derivatives to construct a position that
only pays out when the price of a share increases from $40 to $45 per share in a one-day period, facing
mounting losses as it increases past the $45 point or decreasing below the $40.
Since the day trader is taking such a short-term position, less than one day, they can be reasonably
assured that any price change will be small enough to stay within this window, thus allowing them to
profit far more from a long position than they would by simply purchasing shares and holding them for
the day. From traders protecting relatively small individual positions to institutions developing broadly
diversified portfolios to derivatives traders constructing highly sophisticated and complex positions, the
principle of hedging drives many of the actions that are taken in today’s markets. Day traders who
understand the principle of hedging and how it drives market behaviour can make successful trades by
predicting the hedging activity of other market participants.
What may be a small price to pay for insurance on a position for a large institution could represent an
enormous payday for a day trader who has positioned himself to profit from this hedging action.
 b. Position limits on a currency that a dealer can carry over to the next day up to this limit.
Answer:
An overnight limit, or an overnight position limit, is a restriction on the number of currencies positions
a trader may carry over from one trading day to the next. It is also a restriction on the total size of a
position or a set of positions a currency dealer may carry over from one trading day to the next.
Position limits are put in place to keep anyone from using their ownership control, directly or via
derivatives, to exercise unilateral control over a market and its prices. For instance, by buying call
options or futures contracts, large investors, or funds, can build controlling positions in certain stocks
or commodities without having to buy actual assets themselves. If these positions are large enough, the
exercise of them can change the balance of power in corporate voting blocks or commodities markets,
creating increased volatility in those markets.
Overnight Limits in Forex Markets
An overnight position in the foreign exchange market is any position (whether long or short) that is not
closed (that is, settled) but remains open at the end of official trading hours, which is after 5 p.m. ET.
At 5 p.m., the trader's account either pays out or earns interest on each open position depending on the
underlying interest rates of the two currencies involved in the currency trade.
This pay out process—the interest paid, or earned, for holding the position overnight—is called the
rollover rate. The rollover rate converts net currency interest rates, which are given as a percentage, into
a cash return for the position. A rollover interest fee is calculated based on the difference between the
two interest rates of the traded currencies. If the rollover rate is positive, it’s a gain for the investor. If
the rollover rate is negative, it’s a cost for the investor. As a result, a rollover may show as either a
credit or a debit on a trader's account.
Calculating Rollover Payments
Let's posit that the interest rate set by the Bank of Japan (BOJ) is 1.25% and the federal funds rate set
by the Federal Reserve is 2.5%. You decide to open a short position JPY/USD for 100,000, commonly
known as a lot in the retail FX arena. Here, you are primarily selling 100,000 JPY, borrowing at a rate
of 1.25%.
In selling JPY/USD, you are buying USD, which pays out at 2.5% interest, and selling JPY, which costs
1.25%. When the interest rate of the country whose currency you are buying is less than the interest rate
of the country whose money you are selling, your account receives a credit for the difference, as in the
example above. If the interest rate is higher in the country whose currency you are selling, your account
will show a deduction for the difference. Also, a forex broker may also charge fees at the same time
that storage is added or subtracted from your account.
A bank or other financial institution may impose limits on its customers or traders to manage risk.