PROJECT REPORT ON

“FOREX Transaction and FOREX Hedging”

SUBMITTED BY

AJINKYA R. CHAOBALROLL NO. 011

IN PARTIAL FULFILMENT OF THE REQUIREMENTS FORMASTER IN MANAGEMENT STUDIES

2010-2012

UNDER THE GUIDANCE OFDR. A. K. PRADHAN

UNIVERSITY OF MUMBAI

K.J.SOMAIYA INSTITUTE OF MANAGEMENT STUDIES & RESEARCHVIDYANAGAR, VIDYA VIHAR (E), MUMBAI-400 077

DECLARATION

I, AJINKYA R.CHAOBAL, a student of MMS-Finance, semester IV of University of Mumbai of 2010-2012 batch at SIMSR do hereby declare that this report entitled “FOREX Transactions and FOREX Hedging” has been carried out by me during this semester under the guidance of Dr. A.K.PRADHAN as per the norms prescribed by University of Mumbai, and the same work has not been copied from any source directly without acknowledging for the part / section that has been adopted from published / non-published works.

I further declare that the information presented in this project is true and original to the best of my knowledge.

Date: 15/03/2012

Place: Mumbai

AJINKYA R.CHAOBAL

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CERTIFICATE

I, Dr. A.K. PRADHAN, hereby certify that AJINKYA R. CHAOBAL studying in the second year of the Master in Management Studies, batch 2010-2012 at the K.J. Somaiya Institute of Management Studies & Research (SIMSR) has completed the project on “FOREX Transactions AND FOREX Hedging” under my guidance, as per the norms prescribed by the University of Mumbai, in the academic year 2011-2012.

I further certify that the information presented in this project is true and original to the best of my knowledge and belief.

Date:

Place: Mumbai

Dr. A.K.PRADHAN

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ACKNOWLEDGEMENT

I wish to express my gratitude towards my guide Dr. A.K. PRADHAN. His able guidance, valuable inputs and attention throughout the project work has been of immense help to me.

The knowledge gained through him helped me in completing the project successfully. The

project has been an immense learning experience which would help me throughout my career.

I also express my sincere thanks to all those who have helped me in this project directly or

indirectly.

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EXECUTIVE SUMMARY

Forex was established in 1971 and grew steadily throughout the 1970s, but with the technological advances of the 80s the forex market expanded from trading levels of $70 billion a day to the current level of about $3 trillion. The aim of this project is to study Forex market along with different Forex Transactions.

With development of the Forex market, the exposure of different companies and even countries has increased and so is risk associated with it. To hedge Forex risk we can use different tools, of which the most extensively used tool is derivatives. In this project I have studied the derivatives as a tool to hedge risk arisen due to Forex exposure.

In the last part of this report, a small case study has been included which studies the hedging of Forex by IT industry. Different strategies for hedging are applied in this case study and best possible strategies are suggested for hedging.

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Contents1. FOREX MARKET.........................................................................................................5

1.1. Introduction............................................................................................................5

1.2. How Foreign Currency Treasury Has Grown.........................................................7

1.3. The role of Forex in the Global Economy..............................................................7

1.4. Market size and liquidity.........................................................................................8

1.7. EXCHANGE RATE..............................................................................................13

1) PURCHASING POWER PARITY ( PPP )THEORY :..........................................13

2) BALANCE OF PAYMENTS THEORY:-...............................................................14

1.8 Determinants of Exchange rate............................................................................15

1.9 EXCHANGE RATE SYSTEMS.............................................................................17

FIXED EXCHANGE RATE......................................................................................17

Floating/ Flexible exchange rate..............................................................................17

1.10. AUTHORIZED DEALERS (AD).........................................................................18

1.11. LETTER OF CREDIT.........................................................................................19

PARTIES TO L/C:....................................................................................................19

TYPES OF L/C:.......................................................................................................21

Overview Of Flow Of Documentary Credit:..............................................................23

Operation of Documentary credit:............................................................................24

2 DERIVATIVES MARKET............................................................................................28

2.1. Introduction to Derivatives...................................................................................28

2.2. Participants and Functions...................................................................................29

FINANCIAL DERIVATIVES AS A RISK MANAGEMENT TOOL................................29

3. Case Study.................................................................................................................31

Conclusion:.................................................................................................................33

BIBLIOGRAPHY.........................................................................................................34

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1. FOREX MARKET

1.1. Introduction

The word Forex or FX stands for Foreign Exchange, and it is the simultaneous buying of

one currency and selling of another.it is the largest financial market in the world.

Currencies are traded in pairs, for example Euro/ US Dollar (EUR/US) or Great British

Pounds/ Japanese Yen (GBD/JPY). The forex market handles a huge volume of

transactions 24 hours a day, 5 days a week.

Foreign exchange is defined in the FEMA 1999 as

“Foreign Exchange means foreign currency and includes-

i) Deposits, credits and balances payable in any foreign currency,

ii) Drafts, traveller’s cheques, letters of credit or bills of exchange, expressed or drawn in Indian currency but payable in any foreign currency,

iii) Drafts, traveller’s cheques, letters of credit or bills of exchange drawn by banks, institutions or persons outside India, but payable in Indian currency”.

The foreign exchange market directly impacts every bond, equity, private property,

manufacturing asset and any investments accessible to foreign investors. Foreign

exchange rates play a major role in financing government deficits, equity ownership in

companies and real-estate holdings. Foreign exchange trading helps determine who

hires and fires employees, and who owns the banks at which you maintain your

corporate and personal accounts. The currency in your pocket is literally stock in your

country, and like a share, its value fluctuates on the international market providing

knowledgeable traders with substantial opportunities for profit or loss.

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1.2. How Foreign Currency Treasury Has Grown

Forex was established in 1971 and grew steadily throughout the 1970s, but with the

technological advances of the 80s the forex market expanded from trading levels of $70

billion a day to the current level of about $3 trillion. In comparison, the US Treasury

Bond market makes about $300 billion a day, and the combined American Stock

Markets Exchange makes about $28 billion a day, so one can make out how enormous

the forex markets really is. It actually equates to more than 3 times the total amount of

the stock and futures markets combined.

Major advances in technology, making possible instantaneous real-time transmission of

vast amounts of market information worldwide, immediate and sophisticated

manipulation of that information to identify and exploit market opportunities, and rapid

and reliable execution of financial transactions- all occurring with the level of efficiency

and reduced costs not dreamed possible a generation earlier.

Financial markets grew larger and more sophisticated, integrated and efficient. Foreign

exchange trading increased and changed intrinsically. The market has expanded from

one of banks to one in which many other kinds of financial and non-financial institutions

also participate-including NBFCs, investment firms, pension funds, and hedge funds. Its

focus has broadened from servicing importers and exporters to handling the vast

amounts of overseas investment 7 other capital flows that currently take place.

1.3. The role of Forex in the Global Economy

Over time, the foreign exchange market has been an invisible hand that guides the

sale of goods, services and raw materials on every corner of the globe. The forex

market was created by necessity. Traders, bankers, investors, importers and exporters

recognized the benefits of hedging risk, or speculating for profit. The fascination with

this market comes from its sheer size, complexity and almost limitless reach of

influence.

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The market has its own momentum, follows its own imperatives, and arrives at its

own conclusions. These conclusions impact the value of all assets -it is crucial for every

individual or institutional investor to have an understanding of the foreign exchange

markets and the forces behind this ultimate free-market system.

Inter-bank currency contracts and options, unlike futures contracts, are not traded

on exchanges and are not standardized. Banks and dealers act as principles in these

markets, negotiating each transaction on an individual basis. Forward "cash" or "spot"

trading in currencies is substantially unregulated - there are no limitations on daily price

movements or speculative positions.

1.4. Market size and liquidity

The foreign exchange market is unique because of

Its trading volumes,

The extreme liquidity of the market,

The large number of, and variety of, traders in the market,

Its geographical dispersion,

Its long trading hours: 24 hours a day (except on weekends),

The variety of factors that affect exchange rates.

The low margins of profit compared with other markets of fixed income

(but profits can be high due to very large trading volumes)

As such, it has been referred to as the market closest to the ideal perfect competition,

notwithstanding authorized market manipulation by central banks. According to the BIS

average daily turnover in traditional foreign exchange markets is estimated at $3.21

trillion. Daily averages in April for different years, in billions of US dollars, are presented

on the chart below:

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Fig. 1

  This $3.21 trillion in global foreign exchange market "traditional" turnover was broken

down as follows:

$1,005 billion in spot transactions

$362 billion in outright forwards

$1,714 billion in forex swaps

$129 billion estimated gaps in reporting

In addition to "traditional" turnover, $2.1 trillion was traded in derivatives.

Exchange-traded forex futures contracts were introduced in 1972 at the Chicago

Mercantile Exchange and are actively traded relative to most other futures contracts.

Forex futures volume has grown rapidly in recent years, and accounts for about 7% of the

total foreign exchange market volume, according to The Wall Street Journal Europe.

Average daily global turnover in traditional foreign exchange market transactions

totalled $2.7 trillion in April 2006 according to IFSL estimates based on semi-annual

London, New York, Tokyo and Singapore Foreign Exchange Committee data. Overall

turnover, including non-traditional foreign exchange derivatives and products traded on

exchanges, averaged around $2.9 trillion a day. This was more than ten times the size of

the combined daily turnover on all the world’s equity markets. Foreign exchange trading

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1988 1992 1995 1998 2001 2004 2007 20080

500

1000

1500

2000

2500

3000

3500

4000

4500

avg

increased by 38% between April 2005 and April 2006 and has more than doubled since

2001. This is largely due to the growing importance of foreign exchange as an asset class

and an increase in fund management assets, particularly of hedge funds and pension

funds. The diverse selection of execution venues such as internet trading platforms has

also made it easier for retail traders to trade in the foreign exchange market.

Because foreign exchange is an OTC market where brokers/dealers negotiate

directly with one another, there is no central exchange or clearing house. The biggest

geographic trading centre is the UK, primarily London, which according to IFSL estimates

has increased its share of global turnover in traditional transactions from 31.3% in April

2004 to 32.4% in April 2006

EXPORT-IMPORT GROWTHIndia exports to 235 countries and imports from 230 countries some of them are given as follow:-

Dated: 2/7/2009

Values in Rs. Lacs

COUNTRY INDIA’S EXP(07-08)

INDIA’S IMP(07-08)

INDIA’S EXP(08-09)(APR-DEC)

INDIA’S IMP(08-09)(APR-DEC)

CURR--ENCY

Australia 463,013.06 3,155,208.45

457,963.45 3,391,849.14

AUD

Austria 73,725.43 235,735.88 197,648.01 229,793.07 EUR

Bangladesh

1174321.29 103468.16 893747.31 117402.43 BDT

Brazil 1013178.34 381813.84 1052682.14 405066.14 BRL

Canada 509400.52 794017.52 450725.05 796551.07 CAD

Chile 100443.79 741939.93 149299.97 562477.36 CLP

China 4359741.55 10911606.87

2740339.14 10811628.99

CNY

France 1045415.11 2517563.52 973093.46 1050071.8 EUR

Germany 2059892.83 3973603.74 1954620.61 3710825.89 EUR

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Indonesia 869277.93 1942053.14 812379.49 2255431.43 IDR

Japan 1551559.20 2545779.99 1013649.54 2669771.85 JPY

Korea 1148153.52 2430790.73 1175654.79 2924211.37 KRW

Saudi Arab 1492255.46 7811031.55 1830649.14 7811031.55 SAR

Singapore 2966223.21 3268217.81 2933001.44 2604970.57 SGD

Spain 922504.63 400097.68 884869.09 351555.52 Euro

Taiwan 698497.17 966396.61 580734.01 925569.25 TWD

UK 2696748.37 1994147.98 2096875.27 2242164.31 Sterling

USA 8338806.9 8462513.18 7028392.75 6215320.93 USD

India’s total exp and imp

31020145.25

52635986.58

27226324.66

49075692.67

Table 1

WHAT DRIVES FOREX MARKET?

Different countries use different currencies; however cross border transactions takes

place. If the whole world used one currency only there would be no need for the

forex market to exist. The need for the forex market comes from the need of

exchange between countries, which in return reflect to the need for currency

exchange. The price of the currencies are determined by the supply and demand, so

unlike other markets that are subject for price manipulation it is simply too big for

one entity to control.

1.6. PARTICIPANTS IN FOREIGN EXCHANGE

1. Customer:

The customers who are engaged in foreign trade participate in foreign exchange market by availing of the services of banks. An exporter may require the services of the banks to convert his foreign currency receipts into domestic currency. Similarly an importer, who is requiring paying for the goods imported by him, utilizes the services of a bank to convert his local currency into foreign currency.

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Similar types of services may be required for settling in any international obligation i.e. payment of technical know how fees or repayment of foreign debt etc.

2. Commercial Banks:

Commercial banks dealing with international transactions offer services for conversion of one currency into another. They are the most active players in the Forex markets. These banks are specialized in international trades and other transactions. These banks act as intermediary between exporter and importer who are situated in different countries.

3. Central banks:

Central Banks are conservative in their approach and normally do not trade in foreign exchange markets for making profits. However there are some aggressive Central Banks but markets have punished them very badly for their adventurism. In recent past, Malaysian Central bank, Bank Negara lost billions of US Dollars in trades in foreign Exchange markets

4. Exchange Brokers:

In India, dealing is done in interbank market through Forex broker. The Forex brokers are not allowed to deal on their own account all over the world and also in India

5. Speculators:

Speculators play a very active role in foreign exchange markets. In fact, major chunk of foreign exchange dealings in forex markets is on account of speculators and speculative activities. The following are the major speculators in forex markets:

Banks dealing in Foreign exchange market Multinational corporations (MNC’s) and Transnational Corporations

(TNC’s) Individuals, share dealings, also undertake the activity of buying and

selling for booking short-term profits

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1.7. EXCHANGE RATEExchange rate can be defined as the rate at which one currency is converted into another currency. For example the Indian Rupees can be exchanged to obtain US dollar. Say one US dollar can be had by paying Rs 49. This exchange rate can be expressed in the form of either as Direct quote as USD 1 = INR 49, where the home currency is variable unit or alternatively, expressed in Indirect quote as INR 1 = USD 0.02040, where the home currency is taken as 1 unit. The principle adopted in exchanging the currency in direct quote is Buy Low and Sell High and similarly in the Indirect quote is Buy High or Sell Low.

There are two important theories behind determination of exchange rates. They are as follows:

Purchasing power parity theory. Balance of payments theory or Demand and Supply theory.

1) PURCHASING POWER PARITY ( PPP )THEORY :

According to the purchasing power parity theory, after the First World War, the rate of exchange between two currencies in the long run will be determined by their respective purchasing power. It emphasizes that the rate of exchange between two currencies must and essentially depend upon the quotient of the internal purchasing power of these currencies.

While the value of the unit of one currency in terms of another currency at any particular time is expressed by the market condition of demand and supply, in the long run the value is determined by the relative values of two currencies as indicated by their relative purchasing power over goods and services. In other words, the rate of exchange tends to rest at a point which expresses equality between the respective purchasing power of the two countries. This point is called the parity of purchasing power. The exchange rate between one country and another is in equilibrium when the domestic purchasing power at that rate of exchange is equivalent. For example assume that X commodity in India costs Rs:49/ per Kg and the same in U.S.A costs USD 1, then the exchange rate under purchase parity would be USD 1= INR 49. A change in the purchasing power of currencies will be reflected in their exchange rates. The index number of prices may be used to determine the purchasing power parity. If there is a change in the new equilibrium, the rate of exchange can be found out by the following formulae:

ER = Er ( Pd/Pf)

Where ER = Equilibrium exchange rate

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Er = Exchange rate in the reference period

Pd = Domestic price index

Pf = Foreign country’s price index.

CRITICISMS OF THE PPP THEORY:-

The purchasing power parity theory is subject to the following criticisms:

The theory makes use of the price index number to measure the changes in the equilibrium rate of exchange and hence the theory suffers from the various limitations of the price index number.

The composition of the national income varies in different countries and hence the types of goods and services include in the index number may vary from country to country.

The quality of goods and services may vary from country to country and Comparison of prices without regard to the quality is unrealistic.

The price index number includes the price of all commodities and services.

The theory ignores the trade barriers and cost of transportation in international trade.

It ignores the effects of international capital movements in the foreign exchange market causing changes in the exchange rate.

It ignores the impact of changes in the exchange rates on the prices.

It does not explain the demand for and supply of foreign exchange, whereas the exchange rate is determined largely by demand and supply conditions.

Despite many deficiencies, the purchasing power parity theory exposes some of very important aspects of exchange rate determination such as the relationship between the internal price levels/inflation and exchange rates, the state of the trade of a country as well as the nature of its demand of payments at a particular time etc.

2) BALANCE OF PAYMENTS THEORY:-

The Balance of Payments theory also known as the Demand and supply theory advocates that the foreign exchange rate, under free market conditions, is determined by demand and supply of currency in the foreign exchange market. Thus according to

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this theory the price of a currency i.e. the exchange rate is determined just like the price of any commodity by the free play of the market forces of demand and supply. The value of currency appreciates when the demand for it increases and depreciates when the demand falls, in relation to its supply in the foreign exchange market. The extent of the demand and supply of a country’s currency in foreign exchange market depends on the balance of payment position. When the balance of payment is in equilibrium the supply and demand for the currency are equal.

The balance of payments theory provides a fairly satisfactory explanation of the determination of rate of exchange. This theory has the following merits:

Unlike the purchasing power parity theory, the balance of payments theory recognizes the importance of all the items in the balance of payments in determining the exchange rate.

It is in the conformity with the general theory of value like the price of any commodity in free market.

It brings the determination of the rate of exchange within the purview of the general equilibrium theory. Therefore it is called as the general equilibrium theory of exchange rate determination.

It also indicates that the balance of payments disequilibrium can be corrected by adjustments in the exchange rate.

1.8 Determinants of Exchange rate

a) Balance of payments (Bop): Balance of payment represents the demand for and supply of foreign exchange. Exchange rate (ER) is influenced by the change in exports and imports of a country. If exports of a country exceed its imports, the demand for home currency increases due to greater flow of foreign exchange so that the ER moves in favour of home currency and it appreciates.

b) Interest rates: The movement of foreign exchange is also dependant on the arbitrage arising out of the interest rates between the domestic currency and other currencies. The difference in the interest rates lead to currency carry-trades. Currency carry-trades is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate.

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c) Inflation: It is the changes in relative price levels of two countries that cause changes in the exchange rate. In other words increase in price level reduces the purchasing power of common man.

d) Money supply : Volume of money supply also affects the movement of exchange rate. This includes the purchase and sale of currencies and negotiable instruments such as bank drafts, letters of credit, and Bills of exchange etc. The credit availability and fixation of bank rates also influence the exchange rate.

e) National income: The national income also influences the exchange rate. Higher GDP reflects stronger economy and currency commands a strong position in the international market. Growth in GDP shows increase in production, consumption and export of commodities/services thereby increase in inflow of foreign currencies thereby movement of exchange rate in favour of home currency.

f) Resources: The availability of natural resources in the country like, mines, minerals, natural gases, coastal lines etc. helps in improving the national income and increased participation in the international trade. It is important to make best use of the available resources in harnessing country’s growth and improve per capita income.

g) Movement of capital: Short term or long term capital movements of capital in the form of FII/FDI inflows or outflows also influence the exchange rate. Foreign Capital-in Flows tend to appreciate the value of the home currency. The exchange rate will move in favour of the capital-importing country and against the capital-exporting country.

h) Political factors: Political conditions in the country have a significant influence on the exchange rate. Political stability, strong and efficient governance create confidence in the mind of citizens as well as foreigners to invest their funds in the country in the form of joint ventures, acquisitions, deposits, equity participation etc.. With the inflow of capital, the demand for domestic currency rises and the exchange rate moves in favour of the home currency.

i) Market forces: Efficient and effective operation of Stock exchanges, operation in foreign securities, debentures, stocks and shares etc. exert significant influence on the exchange rate. If the stock exchanges play conducive role in the sale of securities, debentures, shares etc. to foreign investors, the demand for the domestic currency will rise and the exchange rate becomes favourable.

j) Speculation: The growth of speculative activities also influence the exchange rate. Speculation causes short- term movement of funds causing volatility in the movement of exchange rates. Uncertainty in the global financial market encourages speculation in foreign exchange. If the speculators expect a fall in the value of currency in the near

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future, they will sell to acquire appreciating currency to exchange later in the financial market.

k) Structural changes: It is another important factor which influences the exchange rate of the currency. These changes bring a shift in the consumer demand for commodities. They include technological changes, innovations, taste, preferences etc. which affect the demand for existing products and requirement of new products.

1.9 EXCHANGE RATE SYSTEMS

Broadly there are two important exchange rate systems, namely the Fixed exchange rate system and Flexible exchange rate system. They are brought out below:

FIXED EXCHANGE RATE

Countries following the fixed exchange rate (also known as stable rate or pegged exchange rate) system agree to keep their currencies at a fixed ratio or pegged rate to a major currency and change their value when the economic situation forces them to do so. For example, Chinese Yuan is pegged to US dollar. Under the gold standard, the values of currencies were fixed in terms of ounce of gold. Until the collapse of the “Bretton woods System”, each member country of the IMF defined the value of its currency in terms of gold or the dollar and agreed to maintain the market value of its currency within 1 percent of either side of the agreed rate. With the collapse of the Bretton woods System in August 1971, some of the members adopted floating currency method while others still embraced the fixed exchange rate system even subsequent to the Smithsonian agreement consequent to the failure of Bretton wood system.

Floating/ Flexible exchange rate

Under the floating exchange rate system, exchange rates are freely determined in an

open market environment based on the supply and demand for the currencies and there

is no intervention from regulatory authority to control the exchange rate. Whereas under

flexible exchange rate system, the exchange rate is fixed but subject to frequents

adjustments depending upon the market conditions by intervention of regulatory

authority. Balance of payment is an important factor in determining the exchange rate

under this system. A surplus in the balance of payments will create an excess demand

for the country’s currency and the exchange rate will tend to rise. This situation makes

foreign goods cheaper in terms of the domestic currency and domestic goods become

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more expensive in terms of the foreign currency. It encourages imports and discourages

exports, resulting in the restoration of the balance of payments equilibrium.

On the other hand, a deficit in the balance of payments will give rise to an excess

supply of the country’s currency and the exchange rate will tend to fall. If there is deficit

in balance of payments, the exchange rate falls and this makes domestic goods

cheaper in terms of the foreign currency and foreign goods more expensive in terms of

the domestic currency. This encourages exports, and discourages imports and thus

establishes the balance of payments equilibrium.

1.10. AUTHORIZED DEALERS (AD)

Only AD licensed by the RBI can participate directly in the Forex Market. These are

actually Scheduled Commercial Banks. In addition there are institutions like IFCI, IDBI,

ICICI etc. that have been granted a limited/ restricted AD licenses which permit them to

undertake certain forex activities. A set of participants who are the Full Fledged Money

Changers (FFMC) have been granted license to undertake certain currency transactions

with the general public. However the FFMC also need to cover their forex positions with

the AD. Once a license is issued to operate as an AD, it holds good for ever, unless it is

revoked.

The RBI acts as controller of foreign exchange operations of Ads while AD’S handle

customer’s export/ import business, inwards/outward remittance and provide the

required foreign exchange.

Having concluded a forex transaction with the customer, the AD may have an

overbought or oversold position in a foreign currency vis-à-vis INR. The exchange rate

quoted to the customer would usually be at the prevailing inter-bank exchange rate. To

realize this spread the AD would look to offload its position in the inter-bank market.

Depending upon the actual rate at which the AD manages to square its position in the

market, the spread earned would be higher, lower or same as the earlier envisaged

spread.

Apart from merchant transaction AD also take proprietary position i.e. positions on their

own account. These positions could be taken by the AD on the back of a customer

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transaction or could be initiated in the inter-bank market. These positions are subject to

daylight and overnight limits. The net overnight position which is termed as the Net

Overnight Open Position Limit (NOOPL) is approved by the RBI for each AD after the

latter’s BOD have approved the same.

1.11. LETTER OF CREDIT

It is the most important method of settling debts in international trade. In international

trade, the exporter wants to receive payment of the goods immediately after shipment of

goods. But the goods may not have reached the destination. While the importer wants

to pay only after receipt of the goods. There is a time lag between shipment of goods

and actual receipt of goods by the importer. This seemingly irreconcilable situation is

made possible through the establishment of L/C.

DEFINITION:

Documentary credit is defined to mean any arrangement, however, named or whereby

bank (the issuing bank) acting at the request and on the instruction of a customer (the

applicant of credit):

It is to make payment to or to the order of the third party (the beneficiary) or is to pay or

accept bills of exchange (drafts) by the beneficiary or authorises another bank to effect

such payments or to pay or to accept or negotiate such bills of exchange (drafts)

against stipulated documents, provided that the terms and conditions of the credit are

complied with.

Example: - Let us suppose goods worth USD 5000 are to be shipped but in installments

say, USD 1000 each. In such a case when goods are shipped worth USD 1000 then the

original LC is utilized and next time when goods worth USD 1000 are shipped again

then there is no need to open fresh LC, in such a case the original LC gets revolved

again and hence LC can be utilized up to the aggregate amount of USD 5000.

PARTIES TO L/C:

1. OPENER (IMPORTER/BUYER):

The buyer at whose instance the L/C is established by the issuing bank

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2. ISSUING BANK:

The bank, which establishes the credit at the instance of the importer, is known as

issuing bank/opening bank. The issuing bank is primarily responsible for payment under

the credit to the beneficiary.

3. BENIFICARY (the exporter/seller):

The party in whose favour the issuing bank at the instance of the importer establishes

the credit is known as beneficiary.

4. ADVISING BANK:

A L/C is normally advised to the beneficiary through a bank in the exporter’s country

(Advising bank is correspondent of the issuing bank) who is required to verify the

authenticity of the credit and advises the same to the beneficiary.

5. CONFIRMING BANK:

The bank, which adds its confirmation to the credit, is known as confirming bank. The

confirming bank has to make payment under the credit even if it is not able to recover

the amount from the opening bank.

6. NEGOTIATING BANK:

The bank, which negotiates documents tendered by the beneficiary, is known as

negotiating bank.

7. REIMBURSING BANK/PAYING BANK:

The bank, which makes payment/reimbursement as per the terms of credit, is known as

reimbursing bank.

8. ACCEPTING BANK:

Accepting bank is the bank nominated in the L/C to accept usance bills drawn under the

credit. If the bank so nominated accepts the nomination, its responsibility to the

beneficiary is not only to accept the drafts drawn, but also to make payment on their due

dates.

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TYPES OF L/C:

A documentary credit may be classified under the following types depending upon the

particular provisions it contains.

(1) REVOCABLE L/C:

Revocable L/C can be amended/modified/cancelled without the consent of the

beneficiary, provided the beneficiary has not altered his position by shipping the goods.

Hence, documents under revocable credits should not be negotiated by the bank. The

beneficiary of the credit runs the risk of cancellation of the credit any time during the

validity of the credit and hence this type of credit is very unsafe from the point view of

the beneficiary.

(2) IRREVOCABLE L/C:

It carries definite undertakings on the part of issuing bank to honour the documents

drawn strictly in conformity with the terms and conditions mentioned in the L/C. Hence,

irrevocable L/C cannot be cancelled/amended without the consent of all parties

concerned.

(3) CONFIRMED L/C:

Sometimes the beneficiary of the credit may not solely rely on the undertaking given by

an issuing bank. He may have a fear the issuing bank may not honour its commitment

due to the standing of the issuing bank or the FOREX position of the country in which

L/C opening bank is situated. So, the beneficiary may not take the risk of supplying

goods only on the strength of an unconfirmed L/C and he may insist on confirmation of

the credit by a reputed bank situated in his own country or in any other country. When

such a bank adds confirmation to the credit and gives a separate undertaking to honour

the documents strictly in compliance of the credit, the confirming bank is bound by the

undertaking provided the documents are submitted to them and are in conformity with

the credit. A confirmed irrevocable credit is the best form of credit available to the

exporter.

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(4) UNCONFIRMED CREDIT:

The credit, which does not carry the confirmation of the confirming bank but has the

undertaking of the issuing bank only is known as, unconfirmed credit.

(5) TRANSFERABLE L/C:

Here the issuing bank authorises the beneficiary to transfer the credit wholly or in part to

any third party. Transferable credits are generally opened in favour of intermediaries

who are not the manufacturers of the goods. Opening of this L/C at present does not

require prior permission of RBI. The issuing bank can transfer a credit only if it is

expressly designated as ‘transferable’. Terms such as divisible, fractional, assignable,

and transmissible do not render the credit transferable. If such terms are used, they

shall be disregarded.

Bank charges in respect of transfers are payable by the first beneficiary unless

otherwise specified. The transferring bank shall be under no obligation to affect transfer

until such charges are paid.

(6) BACK TO BACK L/C:

The beneficiary of an irrevocable L/C may not be the actual supplier of the goods.(He

would be a middleman as in the case of transferable credit). He will request his banker

to open a further L/C(the ‘back to back' credit) favouring the supplier, based on the

original credit. The terms of the second credit will thus need to be tailored to ensure that

the first beneficiary can meet the terms of the credit in his favour and he would

substitute certain documents to meet the requirement of the first credit.

(7) REVOLVING L/C:

Where a buyer requires a regular supply of goods periodically, he may approach his

banker to open a revolving L/C in favour of the beneficiary. The amount of the credit is

reinstated on the receipt of advice from the issuing bank to the effect that the previous

documents drawn under the credit are paid for. Revolving L/C stipulates maximum total

drawings under the credit. It is arranged where seller makes continuous shipments and

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once utilised is available again It saves necessity of raising fresh credit for each

shipment.

Overview Of Flow Of Documentary Credit:

Fig. 3

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Operation of Documentary credit:

Stage I Establishment of Letter of Credit:

Buyer and seller arrive at a ‘Contract’ for sale, specifying the terms of sale. Both the

parties may not know the financial capacity of each other. The seller wants an

assurance that he will get his payment immediately on dispatch of goods from his

country.

On the basis of this agreement, Buyer (applicant) requests his bank for undertaking the

payment obligation on his behalf in fulfil of the seller. The arrangement under which a

bank on behalf of the buyer undertakes the payment obligation, subject to fulfilment of

certain documentary conditions, is known as documentary credit.

Issuing bank establishes the Letter of credit and forwards the letter of credit to its

Correspondent bank in the seller’s country, which advises the Letter of Credit to the

beneficiary with their authentication.

At times, at the insistence of the seller, Buyer requests issuing bank to make suitable

arrangement with a bank in the Seller’s country for releasing the payment immediately

to the seller on submission of stipulated shipping documents. In such a case, the

issuing bank requests a bank in the seller’s country to undertake the payment obligation

on their behalf under this transaction. A bank in the seller’s country may agree for this

arrangement subject to their relationship with the Issuing bank. Thus, the seller is

assured of payment by a bank in the buyer’s country.

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Fig. 4

Step II Advising the LC

In this step, the issuing bank receives Letter of Credit either as hard copy or through

SWIFT. After receiving LC the Issuing Bank advises this LC that is, it prepares the

covering letter and the LC is authenticated by the officers. After that the Issuing Bank

Courier the LC to the Beneficiary Bank and end the transaction of Advising the Letter Of

Credit.

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Fig. 5

Stage III Negotiation of documents under Letter of Credit:

The beneficiary after shipping the goods will present the documents for payment to his

bank. In case of confirmed Letter of Credit he will be presenting the documents to the

confirming bank directly.

On the receipt of the documents, the Negotiating bank / Conforming bank will scrutinize

the documents thoroughly and if the documents are drawn 'credit complied', pay value

to the exporter/ beneficiary of the LC.

The bank, which has paid value to the beneficiary, will claim reimbursement from the

bank notified by the issuing bank in the letter of credit. Simultaneously, Negotiating bank

will forward the documents to the issuing bank, which will hand over the documents to

the Applicant after recovering the bill value. Applicant/Importer will accept the

documents and pay if the documents are as per the requirement.

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Step IV Realization of funds:

When the goods are as per the Letter of Credit then the customer authorizes the Bank

to make the payment and settle the transaction. The Bank checks the limits of the

customer, if it is found to be sufficient affect the payment. If the payment of the bill

exceeds Rs. 250000/- then the rate is to be taken by Treasury else the payment is

effected through Card rate.

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2 DERIVATIVES MARKET

2.1. Introduction to Derivatives

The emergence of market for derivative products, most notably forwards, futures and

options, can be traced back to the willingness of risk-averse economic agents to guard

themselves against uncertainties arising out of fluctuations in asset prices. By their very

nature, the financial markets are marked by a very high degree of volatility. Through the

use of derivative products, it is possible to partially or fully transfer price risks by locking-

in asset prices. As instruments of risk management, these generally do not influence the

fluctuations in the underlying asset prices. However, by locking-in asset prices,

derivative products minimize the impact of fluctuations in asset prices on the profitability

and cash flow situations of risk-averse investors.

Derivatives defined

Derivative is a product whose value is derived from the value of one or more basic

variables, called bases (underlying asset, index, or reference rate), in a contractual

manner. The underlying asset can be equity, forex, commodity or any other asset.

For example, wheat farmers may wish to sell their harvest at a future date to eliminate

the risk of a change in prices by that date. Such a transaction is an example of a

derivative. The price of the derivative is driven by the spot price of wheat which is the

“underlying”. In the Indian context the Securities Contracts (Regulation) Act, 1956

(SC(R) A) defines “derivative” to include:-

1. A security derived from a debt instrument, share, loan whether secured or

unsecured, risk instrument or contract for differences or any other form of

security.

2. A contract which derives its value from the prices, or index of prices, of

underlying securities.

Derivatives are securities under the SC(R) A and hence the trading of derivatives is

governed by the regulatory framework under the SC(R) A

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2.2. Participants and Functions

The participants in derivative market are as follow: -

The need for a derivatives market

The derivatives market performs a number of economic functions:

1. They help in transferring risks from risk adverse people to risk oriented people

2. They help in the discovery of future as well as current prices

3. They catalyse entrepreneurial activity

4. They increase the volume traded in markets because of participation of risk adverse

people in greater numbers

5. They increase savings and investment in the long run

FINANCIAL DERIVATIVES AS A RISK MANAGEMENT TOOL

The financial environment today has more risks than earlier. Successful business firms

are those that are able to manage these risks effectively. Due to changes in the

macroeconomic structures and increasing internationalization of businesses, there has

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They use futures or options markets to reduce or eliminate the risk associated with price of an asset

HEDGERS

Speculators use futures and options contracts to get extra leverage in betting on future movements in the price of an asset. They can increase both the potential gains and potential losses by usage of derivatives in a speculative venture.

SPECULATORS

Arbitrageurs are in business to take advantage of a discrepancy between prices in two different markets. If, for example, they see the futures price of an asset getting out of line with the cash price, they will take offsetting positions in the two markets to lock in a profit.

ARBITRAGEURS

been a dramatic increase in the volatility of economic variables such as interest rates,

exchange rates, commodity prices etc. Firms that monitor their risks carefully and

manage their risks with judicious policies enjoy a more stable business than those who

are unable to identify and manage their risks. There are many risks which are

influenced by factors external to the business and therefore suitable mechanisms to

manage and reduce such risks need to be adopted.

Defining Risk

Risk, in simple terms, may be defined as the uncertainty of returns. Risks arise because

of a number of factors, but can be broadly classified into two categories: as business

risks and financial risks.

Business risks include strategic risk, macroeconomic risk, competition risk and

technological innovation risk. Managers should be capable of identifying such risks,

adapting themselves to the new environment and maintaining their competitive

advantage.

Financial risk, on the other hand, is caused due to financial market activities and

includes liquidity risk and credit risk.

The role of financial institutions is to set up mechanisms by which firms can devolve the

financial risks to the institutions meant for this purpose and thereby concentrate on

managing their business risks. Financial institutions float various financial instruments

and set up appropriate mechanisms to help businesses manage their financial risks.

They help businesses through:

Lending/ Borrowing of cash to enable the firms to adjust their future cash flows.

Serving as avenues for savings and investments, helping individuals and firms in

accumulating wealth and also earn a return on their investment.

Providing insurance, which protects against operational risks such as natural

disasters, terrorist attacks etc.

Providing means for hedging for the risk-averse who want to reduce their risks

against any future uncertainty

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3. Case StudyTCS posted a forex loss of Rs 300 crore in Q3 of FY 2011-2012.

Excerpts from Indian Express Jan 18, 2012

“Tata Consultancy Services, India’s largest software services exporter, has reported a

18.2 per cent rise in net profit for the third quarter driven of FY’12 by double-digit growth

in Europe and US markets. The company’s business grew 18.1 per cent in Europe,

despite the volatilities in the region and 13.5 per cent in the US market.

Net profit for the quarter stood at Rs 2,803 crore as against Rs 2,370 crore in the same

quarter last year. Net revenues for the quarter stood at Rs 13,204 crore, a growth of

36.6 per cent over Rs 9,663 crore in the same quarter last year. Sequentially, net profit

rose 22 per cent. TCS posted a forex loss of Rs 300 crore in Q3. “Currency has had a

2.82 per cent margin impact for Q3,” says S Mahalingam, chief financial officer at TCS.

The company has hedged $1.3 billion for the next quarter for the current financial year

at Rs 49 per US dollar. TCS shares fell 0.28 per cent to Rs 1,104.30 in a strong market.

“Clients are shifting towards more cost-efficient and innovative models that can aid in

quick decision making,” says N Chandrasekaran, chief executive officer and managing

director at TCS. “While technology budgets are still being set for next fiscal, there is little

doubt that technology is a key resource to help global businesses optimise their

operations and fuel growth in the current economic climate. In this environment TCS is

partnering with clients to achieve their objectives using our integrated portfolio of

solutions,” he said.

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TCS incurred loss of Rs300 cr. The company has hedged $1.3 billion for the next quarter for the current financial year at Rs 49 per US dollar. But Re depreciated to around 52.35 in Dec 2012 with average price for quarter at around Rs51.3 per $. The company entered in forward contract for selling $1.3Bn at Rs 49. But Re depreciated and thus TCS has to incur loss of around Rs300 Cr due to Forex volatility.

Now we will see different strategies which TCS could have used to tackle this problem and minimize the loss.

1. Long Put Option:

In this strategy, TCS could have bought Put option at strike price Rs 49. This could have been useful to limit the loss to the premium paid for the option. The premium for this option at that time taking into consideration volatility and interest rates would be 0.54. So the loss could have been limited to Rs70 Cr.

Loss = Premium*1.3Bn

= 0.54*1.3 Bn

= Rs 70 Cr

2. Long Straddle:

Buy a put and call at the same strike rate i.e. Rs 49. The profit will be unlimited for decrease or increase in underlying and loss will be limited to the premium paid. The loss will be maximum if the prize is same as strike prize at expiry. Had TCS used this strategy they could have kept the loss at maximum around Rs 70 Cr.

3. Long Call option along with the forward contract:

Buy a call option at same strike price as that of forward contract i.e. at Rs49. So now as the spot rate is Rs 52.35, TCS could sell $1.3Bn in spot market at the spot rate so would have incurred no loss. The only scenario of loss was if spot price goes below strike price but the loss is limited to the premium of option.

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Conclusion:

By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives. These instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it

In the above case also we can see that the losses of the company can be minimized by using different derivatives and their strategies. TCS lost Rs300Cr due to hedging and entering into forward contracts but this impact could have been minimized. Also the company could have lost more money if the foreign exchange market had gone the other way round, i.e. appreciation of re, in case they had not hedged using financial tools like derivatives.

So we can conclude that in today’s volatile markets, derivatives are the tool which can be used to minimize the risk. However, it depends on the proper selection and use of these products, the amount of risk which gets covered. Derivatives can also lead to loss if not used in properly and astutely.

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BIBLIOGRAPHY Hull C John, “Options, Futures & Other Derivatives”. Prakash G Apte “International Finance”, Tata McGraw-Hill Publications, 2008. Raju Vadi “Foreign Exchange & Risk Management”, Himalaya Publications, 2007 www.rbi.org www,ecb.int www.boi.co.in www.financialexpress.com

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