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A
Project ReportOn
Undertaken at
VADILAL ENTERPRISES LTD.
In partial fulfillment of Summer Training (1styear MBA)
Submitted to
AES PG Institute of Business Management
Gujarat University
Ahmedabad
Submitted by
Urvija Shah (48)
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PREFACE
every field of education imparted to the student, working on project plays an
hen it comes to the practical knowledge in Financial field, there are number
ut amongst all these fields tremendous opportunities are residing in the
etting the deep and practical knowledge of this field can be of great help to
uly 20, 2006 Urvija Shah
In
immense role in bringing out and exhibiting the qualities which are helpful in
implementing students knowledge in the practical life.
W
of areas to be specialized in. one can go for core finance like working capital
management, Investment decisions, capital structure decisions, credit policies
etc, and one can look forward to equity and forex markets as well. Both are
important part of the Finance.
B
Foreign Exchange field. As in India, the FOREX system is main fundamental
thing for any kind of International business.
Gthe students who are interested in finance. This kind of training and projects
can help the students to use their theoretical knowledge on the practical
aspects of the field.
JAhmedabad
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ACKNOWLEDGEMENT
tudy of business management is all about gaining knowledge from the
was given this opportunity by one of the best Foreign Exchange Exposure
wish to express my heartfelt gratitude to Mr. ASPY Bharucha, President, and
also thank Dr. Mayank Joshipura for his kind help in the subject and I am
inally, not to miss anyone, I thank all the people who have directly or
rvija shah______________
S
experience one gets from the corporate world. When students get into the
corporate world to gain the knowledge, he is a novice. They need and
opportunity and of-course help of his/her senior to explore the aspects of
business management.
I
management companies: VADILAL Enterprises Ltd. I am obliged to
VADILAL Enterprises Ltd. for providing me an opportunity to undergo training
in their esteemed organization.
I
Mr. Victor Saldanha, Consultant Advisor, FOREX, VADILAL Enterprises Ltd
for their immense help in making my training and project fruitful. I would also
like to thank all the employees of FOREX division for their needed help.
I
thankful to all other faculty members at AES PGIBM for their kind support.
F
indirectly helped me a lot throughout the training period and in completion of
my project successfully.
U
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EXECUTIVE SUMMARY
The main plot for my project was to study Indian Foreign Exchange
hapter 1 contains some basic information on the Foreign Exchange. i.e. what
hapter 2 contains information about FOREX markets (Indian as well as global)
hapter 3 is built around the FOREX Market rates. The initial part is packed
OREX market is not a market where anyone who has money can come and
very business opportunity is combined with the risk. Chapter 5 gives us the
ow once we find out the risk in market, it is very much necessary to know, to
market. To find out the risk involved in the Foreign Exchange market and
to learn about the tools for managing FOREX tools.
C
exactly Foreign Exchange and what does it include as well as provide.
C
and its general workings (how it operates) and participants of the market.Getting this knowledge can help in detailed information in the next chapters. It
also contains basic information of modified Liberalized Exchange Rate
Management System
C
with the direct rate and indirect rate and how they are defined, then the cross
rate and the methods for calculating the same. Finally, the forward rate,
importance of the same for the importer and exporter and its calculations.
F
participate; it has its own guidelines. In chapter 4 these guidelines which are
necessary for FOREX market and which has been given by RBI are covered.
Also the guidelines given by FEDAI are included.
E
basic knowledge about all kind of risk which has been involved in the FOREX
market activities.
N
understand or say to learn how to manage that risk; so chapter 6 contains detail
about Risk Management procedure and tools/products in FOREX markets.
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RESEARCH M THODOLOGYE
Objective:
Foreign Exchange markets
Sub object
ding out risk involved in foreign exchange transaction
tools and techniques for managing
trategy for effective management
the advices or study outcomes
cope:
e project looks into the actual workings of VADILAL Enterprises Ltd.
ata collection:
ta collected from Vadilal Enterprises Ltd. regarding their
Main objective:
To study
To learn FOREX Risk management
ives:
Fin
of an organization.
Finding out various
foreign exchange risk.
Develop appropriate s
of foreign exchange risk.
To evaluate the effect of
in real time application in Vadilals client industry.
S
Th
In this Forex System study I tried to cover every objective of the
project, mentioned above and various aspects of the Forex Risk
Management. Scope of my project study is restricted to managing
Transaction Exposure part of Forex risk by using most effective
hedging tools.
D
Primary da
processes and secondary data from relevant literature along with the
websites are the main sources of information. The primary information
is collected through discussions with the personnel of Vadilal
Enterprises Ltd. and from the documents provided by them.
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Limitations:
nstraints
ts
ss operations
type of industry engaged in
Industrial Application:
With extinction of geographical boundaries and increase in foreign
Time co
Resource constrain
Confidentiality of busine
Restricted study of a particular
manufacturing and exports
trade each and every firm is facing more foreign exchange exposure
and thus foreign exchange risk they have ever faced. Though there are
many tools available for managing foreign exchange exposure nothing
comes without cost. So a business house has to find out a proper mix
of hedging tools which offers them maximum risk cover at minimum
cost and maximum flexibility. I have tried to make a humble attempt to
handle this one of the most important issue of foreign exchange risk
management. To fulfill my objective I have conducted a study of foreign
exchange risk management at Harsha Engineering Ltd
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TABLE OF CONTENTS
troduction to VADILAL Enterprises Limited
.
25
.
nnex Re
In. Introduction1
1.1 What is Foreign Exchange? 11.2 What does FX involve? 21.3 What does FX provide? 2
. Foreign Exchange market 32
2.1 Market participants 4
2.2 Indian FX market 62.3 Modified LERMS 8
3 Exchange Rates
3.1 Type of rates and its working 93.1.1 Direct rate 10
3.1.2 Indirect rate 103.1.3 Cross rate 113.1.4 Forward rate 13
3.2 Factors affecting exchange rates 21
. Guidelines4
4.1 RBI4.2 FEDAI 27
5 Export Finance 28
. Types of risk involved in FX market 306
f Risk management 347. Tools o. Development of appropriate strategy for Risk Management 548
8.1 Strategy development 558.2 Field Report at Harsha Engineers Ltd. 57
ure: ports provided by Vadilal Enterprises LimitedA
Bibliography
lossaryG
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INTRODUCTION TO VADILAL ENTERPRISES LIMITED
VADILAL ENTERPRISES LIMITED
FORE SIONwww.vadilalmarkets.comX ADVISORY & FFMC DIVI
VADILAL FOREX & FFMC Division provides customers who are engaged
ith the opening up of the Indian economy and financial markets several
reign Exchange Management, Commodity Market Advisory, is gaining
in Export / Import and trading in commodities a personal link with
markets.
W
changes have hit the market in recent past. Our country is now counted
among the developed countries in matters of current account transactions
scenario, treasury and financial markets, international trade and
commerce activities. Volatility world FOREX markets has increased
manifold. Foreign exchange valuation of the country depends upon
several factors in that fluctuation in exchange rate is now linked with
Currency Risk.
Fo
importance now a days on account of its complexity, as also requires
expert comments, advise, guidance, and also utmost importance in view
of the fact that the whole of FOREX and Commodity markets becoming
very closely integrated. Treasury Management concept has been
accepted by large organizations. Forex Advisory as a tool is also
accepted widely by Exporters, Importers and Commodity Traders,
because of timely and appropriate advice in relation to movements of the
currency, commodity and money markets.
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VADILALFOREXoffers different area of services to suit most Exporters
and Importers, those engaged in trading / imports of Metals [Base and
Minor] and Precious Metals Gold / Silver. The FOREX Division offers
the area of service in relation to:
FOREX Advisory and FOREX EXPOSURE MANAGEMENT to
Importers and Exporters. A thorough service connected with Banking,
ECD-RBI, FEDAI rules and guidelines, etc.
LME-METAL Advisory service of most base metal quotes at LME,
COMEX, NYMEX, Shanghai, markets, and complete guide and
informative service on forward, futures and relative data.
BULLION Informative service of Gold, Silver, and Precious metals on
International trading, quotes, rates, forwards, futures, etc., on various
international markets, inclusive of COMEX/NYMEX;
Vadilals business motto
TO UPDATE YOUR NEEDS AND REQUIREMENTS
&
BRING GLOBAL MAREKT CLOSER TO YOU
PERSONNEL:
A team of experienced, competent, qualified and, professional staff
consisting of ex-bankers with Treasury Management experience both
in India and abroad, Analysts, qualified Chartered Financial Analysts
(CFA), MBAs; Post Graduates, etc.
The Team is totally dedicated and committed to provide exclusive
guidance and advice to all its customers in relation to the area of
activities listed above.
INFRASTRUCTURE:
TELERATE Money line service.
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FOREX ADVISORY AND EXPOSURE MANAGEMENT service segments
Access to websitevadilalmarkets.com on a continuous process of
up-gradation of quotes of crosses, Indian Rupees, news,
comments, etc.
FOREX (daily four reports)* at different time zones to carry all
related information on INRupee, Cross currencies, forward
positions and relative information on Money and Stock Markets. All
4 reports are provided on e-mail, and on web-site, and also
includes important one at 10.30 morning on fax to attract direct
attention;
Weekly, Monthly reports; [conversion rates, bank reference rates,
Customs rates, FEDAI rates, etc.,*
Periodic Forex up-dates, EXIM up-dates, etc.
Exposure Management (on confirmed arrangement) taken well
care of exposure by experienced staff having banking knowledge
and expertise;
Arrangement on Import Bill discounting, for exports - Forfeiting and
Factoring, and ECB arrangement at the concessional service cost.
* All the reports are attached as annexure
ADDITIONAL SERVICE:
On-line service (real time value information) to ascertain level of
the currencies, forward differences, etc., between 9.30 am till
closing of NY markets.
Response to any query on FOREX related matter linked with
Banking, RBI, FEDAI rules, etc.,
In-house session on FOREX and Risk Management in relation to
banking, RBI and FEDAI directives and EXIM related matters,
Workshops Seminars on periodic basis on Foreign Exchange
and Risk Management and EXIM related matters.
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FFMC = FULL FLEDGED MONEY CHANGER
RBI authorized FFMC agent to release foreign exchange
entitlements; in relation to Business Travels, and BTQ : Basic Travel
Quota (general permission)
Authorized to sell financial products of AMEXCO American Express
Banking Travel Related Service.
SERVICE OFFERED with
Value Added, High-Tech Sophistication, and personalized
professionalism
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What is Foreign Exchange?
Countries of the world have been exchanging goods & services amongst
themselves from time immemorial. The world has come a long way from the
days of barter trade. With the inventions of money, the rigors & problems of
barter trade have disappeared. Barter trade has made way to exchange of
goods & services for money instead of exchange for other goods & services.
As every sovereign nation has a distinct national currency, international trade
has involved exchange of currencies. It is said that although the business of
changing money is as old as money itself, the foreign exchange markets
where currencies of different countries are exchanged, started taking shape
only in late nineteenth century. The exchange of currencies has brought about
the concept of exchange rates.
Like any other commodity, the price of one unit of foreign currency can be
stated in terms of domestic currency; in fact a unit of one currency can be
stated in terms of any other currency. Rate of exchange means the price of
one currency in terms of other currency. To state differently, the exchange
rate is said to be the rate at which a number of units of one currency can be
exchanged for a number of units of another currency. Simply defined,
exchange rate is nothing but value of one currency expressed in terms of
another currency. For example, the price of US Dollar (USD) of Japanese Yen
(JPY) or Pound Sterling (GBP) can be expressed in terms of Indian Rupees
(INR). Thus, if we say USD 1 = INR 47.00. It means the exchange of US
Dollar & Indian Rupees is 1:47.00. Similarly, GBP 1= INR 77 meaning that the
exchange rate of Sterling Pounds & Indian Rupee is 1:77.
Different countries have adopted different exchange rate system at different
times.
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What Does FX Involve?
A foreign exchange deal involves:
Exchange of two currencies
As an agreed exchange rate
For a specified settlement date
Settlement instructions for receipt and payment, and
Confidence that the terms of the trade will be adhered to i.e. limits
What Does FX provide?
Foreign exchange provides us:
The method or mechanism to conduct and settle the proceeds of
international trade
The means to obtain / provide technology, expertise and the sharing of
information
The means to minimize the risks of currency fluctuations primarily
through the use of various tools and financial instruments, and
Trading opportunities to generate incremental income.
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For any currency the main foreign exchange market is the country's financial
centre - viz. for genuine, trade related corporate business. This is the centre
where the country's central bankers and monetary authorities determine and
implement their monetary policies, its investment strategies and above all its
intervention polices to ensure stability in its currency markets. This is the
centre where the country's business leaders transact their trade related
financial deals and where the rest of the world comes to as a last resort to
cover its requirements.
However, for major world currencies, the world is a 24 hour market thatstretches from Wellington to Los Angeles. In this global marketplace there are
certain major trading centers called "money centers" and these are Tokyo,
Hong Kong, Singapore, Bahrain, London, Frankfurt, Zurich, New York and
Los Angeles.
The FX Market is a facilitating mechanism through which currencies are
exchanged. It comprises FX traders connected across the world through an
advanced telecommunication network
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MARKET PARTICIPANTS
(I) Corporate Customers
Institutional and Individual Customers, Exporters, Importers, Foreign Currency
Borrowers and Lenders, Investors and Fund Managers all form corporate
customers. These players can be major participants in markets where there
are exchange controls and restricted currency trading.
(II) Banks
Banks are the most active market participants. They essentially perform the
task of market makers. With their ability to take on foreign exchange positions,
they can quote prices for their own account. They have the communication
network, branches, support from exchange brokers, access to overseas
markets and limits with overseas banks which enable them to be market
makers. In India, RBI license to engage in FX transactions is required and
those that are granted this license are called Authorized Dealers. The
authorized dealers collectively constitute the Interbank Foreign Exchange
(FOREX) market in India.
(III) Central Banks
Central Banks world-wide are entrusted the responsibility of determining and
monitoring the external value of the currency of the country. The main role of
the Central Bankers is to avoid volatility, instability and wild fluctuations in theFX markets. To this end, Central Bankers, from time to time, are key players
in FX markets.
(IV) Exchange Brokers
Exchange brokers provide an important service to FX markets all over.
They are instrumental in bringing buyers and sellers together by providing
rates, market information and their network across various centers. Forex
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brokers generally deal with banks. In India, they are not allowed to deal on
their own account.
(V) Overseas FX Markets
FX markets world-wide have an astronomical turnover which is estimated to
run into hundreds of billions of dollars. Of the total volume of FX trade,
genuine corporate demand is estimated to constitute only around 5% of the
total volume. The FX market is largely supported by a very advanced
communication network which not only provides uninterrupted information on
world currencies, economies, politics and the like, it also is characterized by a
very large number of participants. This is what gives the market the depth andthe clout it has. Some of the most popular communication systems available
in the market today are Reuters Information Service, Telerate, Reuters
Technical Analysis, Reuters TV, Knight Ridder, Reuters Dealing System etc.
(VI) Speculators
Speculators are in the market mainly to generate trading income. The growth
in volumes, better communications, pressures to constantly generate profits
and a general improvement in competence have all contributed to see the
emergence of the speculators as a force to reckon with. Banks and corporate,
at different times, can be speculators as well.
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INDIAN FX MARKETS
Foreign Exchange business in India is regulated closely by the RBI. With
Exchange Control Regulations, the RBI ensures that involvement in the
Foreign Exchange business is restricted to certain sections of the business
community only.
The main market participants here are:
1. Corporate: Importers, Exporters and Customers for genuine trades or
merchant transactions.
2. Banks: One authorized dealer dealing with another to generate profit
or cover its open exposure.
3. Overseas Traders: Banks in India are permitted to buy and sell
currencies abroad in cover of customer requirements. They have very
recently been permitted to initiate positions abroad too. Overseas
banks call banks in India to cover their Indian Rupee requirements.
4. Authorized Dealers v/s RBI: This occurs only when the RBI
intervenes in the market and not in the normal course.
RBI restrictions in terms of participation in foreign currencies can be
summarized as under.
Corporate: Individuals as per the Exchange Control Manual (Retail)
Importers, Exporters and Borrowers of Foreign Currencies
(Wholesale)
Banks/Others:Money Changers (RMC's and FFMC's) licensed by the RBI to buy/sell
Foreign Currency Notes and Travelers Cheque from individuals
(Retail)
Banks licensed by the RBI, to carry out foreign exchange business on
a Commercial wholesale level, called Authorized Dealers.
Brokers:
Brokers are permitted to bring together buyers and sellers but cannot
trade for their own account. This means they have to strike the deal
with the buyers and sellers simultaneously.
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The Indian FX Market has seen a remarkable growth in the last few years.
The reasons for are:
Relaxation of controls by RBI and permitting banks to deal freely in the
Inter-bank market - this essentially is the process of economic reforms.
Better communication and availability of information - Reuters,
Telerate, Knight Ridder, RTA, Dealing System, Swift etc.
A virtual explosion in volumes in global FX market and Indian markets
follows suit.
General improvement in competence, freehand to trade and generate
incremental income and
The likelihood of full convertibility of rupee in the near future.
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MODIFIED LIBERALISED EXCHANGE RATE MANAGEMENT SYSTEM
In the process of liberalization it was decided by RBI to make the Rupee fully
floating with effect from March 1, 1993. The new arrangement is called
Modified LERMS. Its salient features are as under:
Effective March 1, 1993, all foreign exchange transactions, receipts and
payments, both under current and capital accounts of balance of payments
are being put through by authorized dealers at market determined exchange
rates. Foreign exchange receipts and payments, however, continued to be
governed by Exchange Control Regulations. Foreign exchange receipts are to
be surrendered to the authorized dealers except in cases where the residents
have been permitted by RBI to retain them either with the banks in India or
abroad. Authorized dealers are free to retain the entire foreign exchange
surrendered to them for being sold for permissible transactions and are not
required to surrender to the Reserve Bank any portion of such receipts.
Reserve Bank of India, under Section 40 of RBI Act, 1934, was obliged to buy
and sell foreign exchange to the authorized dealers. Reserve Bank is now
required to sell any authorized person at its offices/branches US Dollars for
meeting foreign exchange payments at its exchange rates based on the
market rate only for such purposes as are approved by the Central
Government. The RBI buys spot US Dollars from authorized dealers at its
exchange rate. Reserve Bank does not ordinarily buy spot Pound Sterling,
Deutsche Mark and Japanese Yen. It does not buy forward any currency. Theexchange rate at which the RBI buys and sells foreign exchange is in the
5% band of the market rate. Also, the RBI announces the reference rate at
12:00 hours which is the rate at which transactions with IMF/IBRD etc. are
undertaken.
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EXCHANGE RATE ARITHMETIC & MARKET CONVENTION
The FX market is characterized by professional and competitive participants
who always quote a two way price i.e. buying rate and selling rate.
Bid rate: The buying rate
Ask or Offer rate: The selling rate
Spread: The difference between the Selling rate and the buying rate
Market participants expect to make a profit by trading in the FOREX market
and this is reflected in the spread. How wide or narrow the spread is, is a
function of the competitiveness and the volatility in the markets.
TYPES OF RATES
There are mainly four types of rates:
1. Direct rate
2. Indirect rate
3. Cross rate
4. Forward rate
1. Direct rate:
Direct rate is an example of the value of foreign currency in domestic currency
terms. For example,
1 USD = INR 46.40 1 GBP = INR 78.00
100 JPY = INR 40.46 1EUR = INR 58.00
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2. Indirect rate:
Indirect rate is an expression of the value of domestic currency in foreign
currency terms. Indirect rates are also known as reciprocal rates. For
example,
100 INR = USD 2.1368 100 INR = GBP 1.298
100 INR = JPY 250.63 100 INR = EUR 1.8265
The direct rate for one country becomes reciprocal for the corresponding
country.
In international markets though, practice is to quotes rates for a unit of
USD in terms of the other currency, such as
1 USD = CHF 1.2285 1 USD = CAD 1.2600
1 USD = JPY 107.50 1 USD = SAR 3.7500
1 USD = INR 46.23
There is an exception to this rule though in the case of just 4 currencies
GBP, EUR, AUD & NZD
Market practice is to quote the value of these currencies in terms of USD. Forexample,
1 GBP = USD 1.8285 1EUR = USD 1.2585
1 AUD = USD 0.7610 1NZD = USD 0.7135
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3. Cross rate:
Cross rate is an expression of the value of one foreign currency versus
another foreign currency neither of which is a domestic currency. For
example,
USD / CHF = 1.2900 USD / JPY = 117.35
EUR / USD = 1.1700 etc.
These would all be cross currencies for us in India as neither of the currency
in the set is Indian Rupee. However in international markets cross rates refer
to those where neither of the currency is the USD.
To calculate the cross currency rate care should be taken to determine the
following:
The terms i.e. the base currency and the foreign currency
The rates to be used i.e. bid or offer rate
The method of conversion i.e. divide or multiply
Suppose we have following rates on a given day in the local market:
USD/INR = 46.80 GBP/INR = 77.00
CHF/INR = 36.30 EUR/INR = 54.75
To work out the cross rates versus USD for say CHF we would have to:
(I) Determine the terms i.e. we need to find out say USD/CHF. So CHF
is the base (or domestic) currency and USD is the foreign currency.
This is popularly called CHF terms.
(II) Next the rates to be used i.e. USD/INR and CHF/INR. This is
particularly important where we have bid/offer rates. Care should be
taken to use the correct bid rate for one and the offer rate for the
other to derive at the cross rate.
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(III) Finally, the conversion method. i.e. divide the USD/INR rate by the
CHF/INR
Expressed in the formula this is:
CHF 36.30 = INR 46.80 = USD 1
So, USD 1 = 46.80 36.30 = 1.2892
USD/CHF = 1.2892
Now suppose we have USD/INR 46.80 46.85 (bid/offer) and the CHF/INR
36.27-36.32 (bid/offer). To work out the cross bid/ offer rates for USD/CHF,
the rates to be used are:
For, USD/CHF bid rate use 46.80 (bid of USD/INR) and 36.32 (offer of
CHF/INR) So, 46.80 36.32 = 1.2885
For, USD/CHF offer rate use 46.85 (offer of USD/INR) and 36.27 (bid of
CHF/INR) So, 46.85 36.27 = 1.2917
It is important to remember the market convention when it comes to quoting of
exchange rates. Some currencies are quoted to 2 decimal points such as
USD/JPY and the erstwhile USD/ITL, some to 5 decimal points such as
USD/KWD, USD/BHD, while most of the others are quoted to 4 decimal
points. As a rule of thumb, most currencies with a low absolute value to the
USD are quoted to 2 decimal points; those with a high absolute value are
quoted to 5 decimal points and the rest to four decimal points.
Settlement Date
FX Contracts have to be settled and currencies exchanged. Normal market
practice is to settle FX Contracts on a T+2 basis, i.e. 2 working days after
transaction date. This is called Value Spot. All market quotes are for Value
Spot.
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4. FORWARD POINTS:
Forward point is the adjustment made to the spot rate to derive a forward
exchange rate. As we know market rates are quoted for value spot. But where
an exchange has to be made for a forward date, an adjustment has to be
made to the spot rate. This adjustment depends on whether a currency is at a
premium, discount or par in relation to the corresponding currency in the
exchange.
Forward points reflect, in the long term, the interest rate differential between
the currencies for the different settlement / value dates.
The factors that determine the forward points are:
Demand and supply of the currency for the particular settlement date.
Market expectations over the given period both in the FX and interest
rates.
Interest differentials between the currencies, for the period involved.
In the case of direct quotes, premium is positive forward points while discountis negative forward points and par reflects no forward points.
FORWARD FOREIGN EXCHANGE RATES
Forward FX rate is the rate at which exchange of currencies take place for the
agreed forward date.
A forward rate has two components:1. Spot rate
2. Forward Points
Where there are no restrictions on capital flows, the only factor determining
forward points is the interest rate differential between the currencies involved.
How do Forward Points arise?
Suppose market rates are as follows:
Spot USD / CAD = 1.3500
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1 year USD interest rates = 1.25% and
1 year CAD interest rates = 3.00%
1 year forward USD/CAD = 1.3500
To take advantage of this interest rate differential one would
Borrow USD on spot @ 1.25%
Convert the USD to CAD @ 1.3500
Lend CAD for 1 year @ 3.00% and
Reconvert CAD back to USD on maturity @ 1.3500
The cash flow from these transactions would be as under:
USD CAD
+ - + -
Borrow USD on spot @ 1.25% 1000.00
Spot FX @ 1.3500 1000.00
Lend CAD on Spot for 1 year @
3.00%1350.00
Interest Flows 12.50 40.50
P I on maturity 1012.50 1390.50
FX on maturity @ 1.3500 1030.00 1390.50
NET 17.50 0 0 0
The example suggests one who borrows USD 1000.00, coverts to CAD, lends
the CAD and converts back to USD on maturity makes a profit of USD 17.50.
The market, in such a situation, provides what is called an arbitrage
opportunity, i.e. an opportunity to take advantage of various markets,
currencies or products to generate risk free profit. This cannot last long
because every speculator would do the same while no one would want to lend
USD or sell CAD. Alternatively, every lender of USD would demand a rate
higher than 1.25% and no borrower of CAD would pay 3.00%. There would be
a series of corrections or amendments till equilibrium is reached.
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The change could be in any of the following areas:
USD interest rates moving higher
CAD interest rates moving lower
Forward rate moving towards it being (P + I of DC) (P + I of FC)
More accurately, there is fundamental flaw in this example i.e. the
assumptions that the Forward FX rate is the same as Spot rate.
The forward rate has to reflect the interest differentials and a true forward FX
rate for USD / CAD would take into account the total CAD inflow and total
USD outflow.
Therefore the FX rate USD/CAD 1 year forward would be
USD 1012.50 = CAD 1390.50
USD 1 = 1390.50 1020.50
= 1.3733
We now have the following:
Spot USD/CAD = 1.3500
Forward USD/CAD = 1.3733
Forward points = Forward rate spot rate
= 1.3733 1.3500
= +0.0233
In our example, USD is at forward premium to the CAD (as forward USD/CAD
is higher then Spot USD/CAD) and the CAD at a discount to the USD.
Because always FR > SR it means DCIR > FCIR and foreign currency is at
premium and domestic/base currency is at discount.
Since USD/CAD @ 1.3500 is a direct quote, we add the premium to the spot
rate to give us the Forward FX rate.
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CALCULATION OF FORWARD POINTS
The formula for calculation of forward points is:
Forward points = (spot rate interest differential period 100) Basis
Where, interest differential is Domestic Currency Interest Rate Foreign
Currency Interest Rate.
This formula, called the Interest Rate Differential Method, is used widely in
Indian markets. The formula takes into account interest rate differentials as
opposed to total inflows and outflows. Besides, the formula has an
assumption i.e. the basis for the two currencies are the same. This, we
have seen, is not always the case, a classic example being USD versus
Indian Rupees. US Dollars having a 360 day basis and the Indian Rupees
having a 365 day basis. The forward point worked out using this formula is not
accurate.
If we apply the formula in our earlier example we would have:Forward points = 1.3500 1.75 100 = 0.0236
Which is quite different from that we worked out earlier i.e. 0.0233
The more accurate formula id one which takes total inflows and outflows into
account called the Round Robin Method. Where,
Forward rate = {(Domestic Currency P + I) (ForeignCurrency P + I)}
Where, P represents the Spot Values of the respective currencies and
I is the interest amount over the period.
While calculating the interest for the currencies care should be taken while
using the basis and the actual number of days involved.
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Forward Rate = Spot Rate + Forward Points, and
Forward Points = Forward Rate Spot Rate
As in Spot rates, forward rates too are quoted for buying and selling i.e. Bid /
Offer rates. Both of these rates are quoted in points of the spot / forward
rates. However, in the case of Forward Rates the forward points reflect the
premium or discount, as the case may be. As we know premium is added to
the spot rate and discount is deducted from the spot rate. In the case of
premium, the bid rate is lower than the offer rate. Whereas, the way market
quotes rates, bid rate appears to be higher than the offer arte in the case of
discount.
CROSS FORWARD FX RATES
The principle is exactly the same as the spot cross rates but care should be
taken while adjusting for forward points. For example,
Spot USD/INR = 46.80/46.85
Spot CHF/INR = 36.27/36.32
So, Spot USD/CHF = 1.2900/1.2905
3 months USD/INR Forward Points = 5/7
3 months CHF/INR Forward Points = 25/30
So, 3 months Forward USD/INR Rate = 46.85/46.92
3 months Forward CHF/INR Rate = 36.52/36.62
3 months Forward USD/CHF Rate = 1.2794/1.2848
From these rates we can also work out 3 months USD / CHF forward points
Forward Rate Spot Rate = Forward Points
1.2794 1.2900 = -0.0106, and
1.2848 1.2905 = -0.0057
Based on this market quote 3 months USD / CHF would be 106/57
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Forward Rates
Where settlement is sought for any date other than Spot, the applicable rate is
not the Spot Rate. An adjustment arises due to differences in interest rates inthe currencies involved. The forward value of a currency may be higher
(premium), lower (discount) or the same (par) as the Spot Value
The forward value is a function of the Interest Rate Differential in the
currencies. Therefore, to calculate the forward rate, it is necessary to know
the prevailing interest rates for the duration.
Interest Differential (or Annualized Premium) is INR Interest Rate (DCIR)
minus FC Interest Rate (FCIR)
The formula for Forward Rate is:
SR + {(SR x ID xDuration) 365}
Say Spot USD/INR = 43.50,
3 months Annualized Interest Rates for USD 3.30% and INR 4.50%
ID = DCIR FCIR = 4.50% - 3.30% = 1.20%
FR = 43.50 + {(43.50 x 1.20% x3) 12}
Then FR = 43.50 + 0.1305 = 43.6305
Likewise forward rates can be calculated for any duration, from 1 day to 6
months and beyond. All one needs to know is the interest rates in the
currencies or the Interest Differential, but there exists a vibrant forward market
where rates are available for month-ends of successive calendar months
There may be instances when a requirement is not for a month-end.
An exporter has a receivable or an importer a payable for say 11th August
2005. Forward rates available are for 29th July and 31st August of 43.60
and 43.65. To calculate the rate for 11th August one merely needs to
extrapolate the rate
So {(43.65 43.60) 33} x13 = 0.0197
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You need to add this adjustment to the earlier date rate, i.e., of 29th July
43.60 + 0.0197 = 43.6197, the rate for 11/08
This is market practice for calculating what is called broken date forward
ratesby the extrapolation method
Prior to Spot
Often a corporate needs to settle a contract immediately, i.e. even before
Spot Value
For example, say today is 1st June so Spot Value is 3rd June and an exporter
receives proceeds today. He has not covered the exposure as yet and needs
to convert today. The bank would calculate the 2 day adjustment from 3rd to
1st JuneThe calculation is the same as for any other forward using the sameformula. However since the adjustment is for a date prior to Spot the
adjustment has to be reversed
Premium has to be deductedfrom the Spot Rate and Discount added to the
Spot Rate. This is what is known as Cash-Spot.
Similar would be the treatment when an adjustment is to be made to 2nd
June, i.e. a 1 day adjustment. The settlement for 2nd June is popularly known
as Tom-Spot
As in Cash Spot, for Tom-Spot too, the Premium is deducted from and
Discount added to the Spot.
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Rates for an Exporter
An exporter needs to sell FC to the bank. The bank will quote its Bid (Buying)
Rate, the lower rate. Where an exporter wants to sell forward, the bank would
quote the forward bid rate. To an exporter the bank quotes its buying rate for
Value Cash where proceeds come in and the same has not been covered as
yet
Rates for an Importer
An importer needs to buy FC from the bank to pay for the import. The bank
will quote its Offer (Selling) Rate, the higher rate. Where an importer wants to
buy forward, the bank would quote the forward offer rate. To an importer the
bank quotes its selling rate for Value Cash where immediate payment has to
be made and the same has not been covered as yet.
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FACTORS AFFECTING EXCHANGE RATES
The Bretton Woods conference in July 1944 resulted into a new monetary
order. The main objectives of this were to establish an international monetary
system with stable exchange rates, to eliminate exchange controls, and to
bring about convertibility of all currencies. This required the central banks of
various countries to declare their parity to gold or to the US Dollar. In turn,
USA agreed to exchange US Dollar for gold at 35 dollars per ounce. The
Central banks were expected to keep the rate fluctuations within 1%.
However, due to chronic US balance of payments deficits there was a general
loss of confidence in the US Dollar. This culminated in the demise of the
Bretton Woods System in 1971. At the monetary conference held on
December 17 and 18, 1971, a new arrangement, popularly known as
Smithsonian Agreement was at. Under the system intervention points range
was widened to 2.25%. However, as the USA had done away with the
convertibility of Dollars into Gold, the arrangement under Smithsonian
Agreement could not continue for long and ultimately in 1973 many countries
started floating their currencies. This development gave rise to fluctuatingexchange rates. Although in a free market it is the demand and supply of the
currency which should determine the exchange rates there are many more
factors responsible for these fluctuations. The volatility of exchange rates
cannot be traced to a single reason and consequently it becomes difficult to
precisely define the factors that affect the exchange rates. However, the
important among them are:
(I) Balance of payments
Balance of payments position of a country is a definite indicator of the
demand and supply of foreign exchange. If a country has a favorable balance
of payments position it implies that there is more supply of foreign exchange
and therefore foreign currencies will tend to be cheaper vis--vis domestic
currency. However, if balance of payments position is unfavorable, it indicates
that there is more demand for foreign exchange and this will result in the priceof foreign exchange vis--vis domestic currency firming up.
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(II)Strength of the economy
The relative strength of the economy also has an effect on the demand and
supply of foreign currencies. If an economy is growing at a faster rate it is
generally, in the long-run, expected to have a better performance on balance
of trade. However, in the short run increasing economic activity in the country
may necessitate higher imports and exports may take sometime to increase.
The economic growth is indicated by various parameters like relative rate of
growth in industrial production and capacity utilization, rate of increase in
Gross National Product and fall in employment rate, etc.
(III)Fiscal policy
The fiscal policy followed by government has an impact on the economy of
the country which in turn affects the exchange rates. If the government follows
an expansionary policy by having low interest rates, it will fuel the engine of
economic growth and will lead to better trade performance. However, a word
of caution is necessary here. If the government is following an expansionary
policy by resorting to high budget deficit and monetizing the deficit, this will
lead to high inflation in the economy. This will prove to be counter productive
as far as growth in exports is concerned.
(IV) Interest rate
High interest rates make the speculative capital move between countries and
this affects the exchange rates. The capital is attracted, provided there are no
controls towards currencies yielding high interest rates. If interest rates of
domestic currency are raised this will result in more demand for domestic
currency and more supply of the foreign currency, thus making the latter
cheaper vis--vis the former.
(V) Monetary policy
The central banks of various countries have a control on the monetary policy
to be pursued although it is generally in consonance with the fiscal policies of
the government. Monetary policy is a very effective tool for controlling money
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supply, and is used particularly for keeping a tab on the inflationary pressures
in the economy. The main objective of the monetary policy of any economy is
to maintain the money supply in the economy at a level which will ensure
price stability, full employment and growth in the economy. Pursued by the
central bank, it also gives a hint about the future interest rates. If the money
supply in an economy is more it will lead to inflation and the central bank will
raise interest rates, sell government securities through open market
operations, raise cash reserve requirement thus giving a signal for tight
money supply policy. On the other hand, to spur the growth in the economy
the central bank may lower interest rates, buy government securities in the
market, and lower the cash reserve requirements thus heralding an era of
easy monetary policy. This will be a sign for low interest rates in future. It will
be clear from the above that monetary policy influences interest rates,
inflation, employment, etc. and consequently, affects the exchange rates.
(VI) Political factors
If a change is expected in the government on account of elections or if there is
change in the incumbency in the government, the exchange rates may be
affected. Market thrives on stability and any perception of political instability is
sufficient to move exchange rates significantly. However, whether the
currency of the country concerned will become stronger or weaker will depend
upon expected policies to be pursued by the new government which is likely
to take over. But there are some currencies, like the US Dollar, Swiss Franc
etc. in which people have confidence and at times of any international crisis
foreign funds move into these currencies. These are known as safe
havencurrencies. War also affects the exchange rates of the currencies of the
country involved. Sometimes it affects the currencies of other countries too.
(VII) Exchange control
Exchange control is generally aimed at disallowing free movement of capital
flows and it therefore affects exchange rates. Sometimes countries exercise
control through exchange rate mechanism by keeping the price of their
currency at an artificial level. If a country wants to give a boost to exports, it
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will keep the value of its currency low vis--vis the foreign currency. This will
help exporters in realizing more units of the local currency for the same units
of foreign currency received by them as export earnings. However, reverse
would be the case if the government decides to follow a liberal import policy.
(VIII) Central Bank intervention
Buying or selling of foreign exchange in the market by the central bank with a
view to increase the supply or demand, thereby affecting the exchange rates
is known as intervention. If a central bank is of the opinion that local currency
is becoming stronger thereby affecting the exports, it will buy foreign currency
and sell local currency. It will increase the demand for foreign currency andthe rates of foreign currency vis--vis local currency will go up. However, if the
rate of exchange is kept artificially at low levels, it tends to accelerate inflation.
Therefore, the central bank has to take into consideration many factors before
intervening in the market.
(IX) Speculation
In FOREX markets, a dealer taking speculative positions is common. If a few
big speculative operators are buying/selling a particular currency in a big way,
others may follow suit and that currency may strengthen/weaken in the short
run. This is popularly known as the bandwagon effectand this can affect
exchange rates significantly, particularly in the near term.
(X) Technical factors
Technical factors particularly in the short run can influence exchange rates. If,
for example, regulations by the central bank make it necessary to limit the
size of open position and if banks have a big short position, they may, in
order to cover such a position, buy foreign exchange. This will result in higher
short-term demand which is not genuine. Similarly, reserve requirement of the
central bank may also create a technical position thus influencing the
exchange rates.
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RBI (RESERVE BANK of INDIA) Guidelines
1. Category Exporter
Importer
Foreign Currency Borrower
2. Currency Blanket Permission. The currency which has no blanket
permission has to go through RBI reference or say RBI reference is
necessary for those currencies for doing any kind of trading. The
currencies with blanket permission are USD, EUR, GBP, CHF, JPY,AUD and CAD. These currencies are used for payment of Imports;
accept of Exports and for borrowing.
3. Trade Amount (expect for borrower)
4. Duration
On the date or above the starting period and before the end date
5. Speculation
No speculation is allowed as per RBI
6. Trading
Exporter he has receivables so if foreign currency goes up he
has profit and if FC goes down than it is risk for him. An
exporters risk starts on receipt of an export order or an Export
L/C. Risk ends when payment is due; On shipment (DP Basis)
or end of credit period (DA Basis)
Importer he has payment to make so if foreign currency goes
down he has profit and if FC goes up than it is risk for him. An
importers risk starts on placing an import order or opening of
Import L/C and it ends when payment is due, either on receipt of
documents (DP Basis) or end of credit period (DA Basis)
RBI permits importers and exporters to hedge their exposures
(partial or full) at any time from the commencement to the
termination of the FX risk
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Banks are authorized to provide cover against confirmed orders
or L/C. They may also quote rates against past performance
RBI also permits exporters/importers to hedge their exposures
against cross currencies. Trading in cross currencies requires a
thorough understanding of currency markets and a pro-active
participation in the market
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F E D A I - FOREIGN EXCHANGE DEALERS ASSOCIATION OF INDIA
Foreign Exchange business in India was confined to few foreign banks only
till the period 1959. The said group banks were known as Exchange Banks.They had formed an Association, which was known as the "Exchange
Banks' Association". It was mainly covering the areas of activities within
Bombay (now Mumbai), Calcutta (now Kolkata), Madras (now Chennai),
Delhi and Amristsar. On introduction of the exchange control in India during
1939, the said Association was functioning within rules framed by RBI. The
rules and regulations - introduced and practiced were also covered by RBI
approval. On account of expansion in the foreign trade, and business, RBI
allowed schedule commercial banks also to undertake foreign exchange
transactions. Those banks which were allowed and permitted by RBI to deal
in foreign exchange transactions were known as AD - Authorised Dealers.
The FEDAI - Foreign Exchange Dealers' Association of India was formed
with approval of RBI during August 1958. It was under ECM-RBI directives
under reference ECS/198/86-58-Gen dated 16th August, 1958, authorized
the banks to handle foreign exchange business.
All Public sector banks, foreign banks, private sector and co-operative banks
and certain Financial institutions are the members of FEDAI. FEDAI is a
non-profit making Association and relative expenses are shared by all its
member banks. FEDAI acts as a facilitating body and in consultation with
Reserve Bank of India, frames rules / regulations for AD in India for conduct
of the foreign exchange business related transactions.
FEDAI is the Association of the member Banks. Naturally, the guidelines and
rules prepared were of interest of the member Banks. However, on account of
liberalization and reforms introduced during 1991 to boost the foreign trade to
and fro India, it becomes imperative by FEDAI to review Rules and
Guidelines. FEDAI has also taken due care of the interest of both Importers
and Exporters while revising rules and guidelines.
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To promote exports the RBI has directed commercial banks to offer export
finance at subsidized rates. But export finance is of course subject to the bank
sanctioning such a facility. Exporters must approach their bankers in advance,
to get the limit approved
Banks provide finance, both before and after shipment, to facilitate
exports.
Export finance is given for the purpose of procuring raw materials,
process, production, packing and shipment of goods for exports
The subsidy that is available is conditional on actual exports
Pre-Shipment Finance
Finance that is given for procuring raw materials, production, packing
and shipment is classified as Pre-Shipment Finance or Packing Credit
Banks normally provide packing credit only against confirmed Letters of
Credit which have to be lodged with the bank. For prime clients, banks
offer Packing Credit against export orders, as well.
Pre-shipment finance has to be liquidated by submission of documents
evidencing exports
Post-Shipment Finance
When an exporter-borrower submits export documents to liquidate
Packing Credit, banks either purchase or negotiate or discount these
documents.
This is referred to as Post-Shipment finance
This finance has to be liquidated from export proceeds received from
abroad, through banking channels
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Export Finance
Export finance can be availed of either in rupees (EPC) or in the
foreign currency (PCFC) of invoicing
PCFC is cost-effective as borrowing cost in FC is generally lower than
those in rupees but this is subject to availability of foreign currency with
the commercial bank
Availing export finance in foreign currency liquidates the FX Risk
On the other hand when packing credit is taken in rupees, the exporter
still needs to convert the foreign currency when the proceeds come in.
The FX Risk therefore remains open
The RBI subsidizes the rate of interest on export finance
Export Finance Rates
The lending rates for export finance is linked to market rates; PLR in
the case of Rupees and LIBOR for foreign currencies (PCFC).
Since RBI subsidizes the rate, rupee finance can be obtained at sub-
PLR. No subsidy is available when export finance is availed in foreign
currency
But given current market scenario it is possible to reduce the borrowing
cost to below rupees when availing PCFC
An example would clarify the point better
Rupee PLR 10.00% less 2.50% RBI subsidy. So net cost in Rupees
7.50%. USD 3m LIBOR 4.35% plus bank margin 0.75% (max. as per
RBI directive but almost 1%), plus 3m cover cost 0.70%. So net cost in
USD 5.80%. Similar would be the cost if export finance is availed in the
other major currencies
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FOREIGN EXCHANGE RISK
FX Risk pertains to the risk of adverse movement in exchange rates:
On Exports
On Imports
On Foreign Currency Borrowings, Installments Payments and
Repayments
The FX risk arises primarily due to:
Developments in overseas markets
Central Bank Intervention
Activities of major market players
Political Turmoil
Economic Developments
Lack of depth or liquidity in the market
Non - availability of enough hedging tools
Development in other markets such as - domestic and overseas stock
markets, turmoil in other currencies, commodities markets, oil prices
etc.
The RBI recognizing the financial risks associated with international trade, has
laid down several Directives and Rules in the Exchange Control Manual. We
are primarily concerned with the directives, rules and guidelines associated
with the management of Foreign Exchange and Interest Rate Risks.
Imports
The RBI permits cover of the FX risks on imports as soon as the import L/C is
opened or as soon as a confirmed order is placed. When the documents
under the L/C are received - the L/C opening bank is due to make payment to
the exporter. This is done by debit to the importer's domestic account -
meaning the FX risk terminates. The bank debits the importer's rupee account
and pays the exporter (or his bank) in foreign currency. An importer has the
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time from opening of the L/C to date of receipt of the documents to manage
the foreign currency exposure. A 10 day grace period is normally permitted by
the RBI to the customers to pay for imports.
Exports
The FX risk on exports can be covered immediately on receipt of an export
order (or L/C). The RBI also stipulates that FX realizations should be
converted into rupees immediately on negotiation of documents. This implies
that the FX exposure on exports can be managed only between the times an
order is received to the date of shipment. Commercial banks are allowed to
grant 10 days grace for receipts of export proceeds beyond which
concessional rate finance is not extended
Category Risk Commencement/Start of Risk Termination /End of Risk
EXPORTER FC Receipt of Export order or L/C Shipment
IMPORTERFC
Opening of Import L/C or placing
of import orderReceipt of documents
FCBORROWER
FC Utilization or draw-down of loan Final repayment
Example
An exporter in India contracts to sell to a firm in London machinery at a price
of GBP 10,000. Before agreeing to this price, the exporter calculates his cost
of production adds a reasonable amount of profit and satisfies that the
proceeds of GBP 10,000 would cover this amount. He bases his calculations
on the exchange rate prevailing as on the date of his quotation. For example,
if the exchange rate on the date is Rs. 70 per sterling pound, he expects to
receive Rs. 7, 00,000 on executing the contract.
The exchange rate is not stable: it is changing every day. By the time the
exporter executes his contract and his bill is realized, which may be after a
lapse of 3 months or 6 months, the rate of exchange might have turned
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adverse for him. For example, if the rate prevailing on the date the bill is
realized or purchased by his banker is Rs. 65, he would receive only Rs. 6,
50,000 as against his estimate of Rs. 7, 00,000. Thus he may have to bear a
shortfall of Rs. 50,000. True, the rate may turn favorable to him and bring him
unexpected profits. But the fact remains that the amount that he would receive
on execution of the contract remains uncertain.
This uncertainty about the rate that would prevail on a future date is known as
the exchange risk. For the exporter, the exchange risk is that the foreign
currency in which the transaction is designated may depreciate in future and
may bring less than the expected realization in local currency terms.
The importer too faces exchange risk when the transaction is designated in a
foreign currency. The risk is that the foreign currency may appreciate in value
and he may be compelled to pay in local currency an amount higher than that
was originally contemplated. Importers generally make arrangements for
loans for payment for the imports. If the foreign currency appreciates
subsequent to the arrangement of the loan, the importer may find that the
resources are not sufficient to meet the importer bill putting him in a difficult
situation.
FOREX Risk Management
Foreign Exchange dealing is a business that one gets involved in, primarily to
obtain protection against adverse rate movements on their core international
business. But, as we have seen earlier, it provides plenty of trading
opportunities as well.
Foreign Exchange dealing is essentially a risk reward business where profit
potential is substantial but it is extremely risky too.
It is in this context that it is absolutely vital that controls are in place which
would enable the department to maintain a check on losses and shocks.
FX business has the certain peculiarities that make it a very risky business.These would include:
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1. FX deals are across country boarders and therefore, often foreign
currency prices are subject to controls and restrictions imposed by
foreign authorities. Needless to say, these controls and restrictions are
invariably dictated by their own domestic factors and economy.
2. FX deals involve two currencies and therefore, rates ate influenced by
domestic as well as international factors.
3. The FX market is a 24 hour global market and overseas
developments can affect rates significantly.
4. The FX market has great depth and numerous players shifting vast
sums of money. FX rates therefore can move considerably, especially
when speculation against a currency rises.
5. FX markets are characterized by advanced technology,
communications and speed. Decision making has to be instantaneous.
With the growth in the Indian FX markets a lot of the features and
characteristics of the global FX markets are present in our very midst.
Indian banks get involved in FX market with a view to generate trading
income.
With the RBI guidelines loosening its controls, granting greater operational
and trading freedom, more and more corporate are getting involved in FX
markets with a view to generating trading income.
With time, as the Indian Rupee gets fully convertible and as the Indian FX
markets get fully integrated with global markets the risks will be more
pronounced in our own exchange market.
It is, therefore, imperative to get the right controls in place prior to any
involvement in FX markets.
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RISK MANAGEMENTTOOLS
FORWARD CONTRACT CURRENCY OPTIONS
1. Forward exchange contract
Forward Exchange Contract is a device which can afford adequate protection
to an importer or an exporter against exchange risk.
Under a forward exchange contract a banker and a customer or another
banker enter into a contract to buy or sell a fixed amount of foreign currency
on a specified future date at a predetermined rate of exchange.
Our exporter, for instance, instead of groping in the dark or making a wild
guess about what the future rate would be, enters into a contract with his
banker immediately. He agrees to sell foreign exchange of specified amount
and currency at a specified future date. The banker on his part agrees to buy
this at a specified rate of exchange. The exporter is thus assured of his price
in local currency. For example, the exporter may into a forward contract with
the bank for 3 months delivery at Rs. 49.50. This rate, as on the date of
contract, is known as 3 month forward rate. When the exporter submits his bill
under the contract, the banker would purchase it at the rate of Rs. 49.50
irrespective of the spot rate then prevailing.
CURRENCY FUTURES
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Fixed and Option Forward Contract
The forward contract under which the delivery of foreign exchange should
take place on a specified future date is known as Fixed Forward Contract.
For instance, if on 5thmarch a customer enters into 3 months forward contract
with his bank to sell GBP 10, 000, it means the customer would be presenting
a bill or any other instrument on 7th June to the bank for GBP 10,000. he
cannot deliver foreign exchange prior to or later than the determined date.
Forward contract is a device through which the customer tries to cover the
exchange risk. The purpose will be defeated if he is unable to deliver foreign
exchange exactly on the due date.
With a view to eliminating the difficulty in fixing the exact date for delivery of
foreign exchange, the customer may be given a choice of delivering the
foreign exchange during a given period of days.
An arrangement whereby the customer can sell or but from the bank foreign
exchange on any day during a given period of time at a predetermined rate of
exchange is known as Time Option Forward contract.
The rate at which the deal takes place is the option forward rate. For example,
on 15thSeptember a customer enters into two months forward sale contract
with the bank with option over November. It means the customer can sell
foreign exchange to the bank on any day between 1st November and 30th
November. The period from 1st to 30th November is known as the Option
Period
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Booking of forward contracts
The steps involved in booking and utilization of a forward contract may be
summarized as under:
Step 1: The transaction of booking of forward contract is initiated with
the customer enquiring of his bank the rate at which the required
foreign currency is available. Before quoting a rate the bank
should get details about (i) the currency, (ii) the period of
forward cover, including the particulars of option, and (iii) the
nature and tenor of the instrument.
Step 2: The branch may not be fed with forward rates of all currencies
by the Dealing Room. Even for major currencies forwards rates
for standard delivery period may only be available at the branch.
If the rate for the currency and/or delivery period is not available,
the branch should contact the Dealing Room over phone or telex
and obtain rate.
Step 3: If the rate quoted by the bank is acceptable to the customer, he
is required to submit an application to the bank along with
documentary evidence to support the application, such as the
sale contract.
Step 4: After verification of the application and the documentary
evidences submitted, the bank prepares a Forward Exchange
Contract.
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2. Currency Options
DEFINITION
An option is a unique financial instrument or contract that confers upon
the holder or the buyer thereof, the right but not an obligation to buy or
sell an underlying asset, at a specified price, on or up to a specified
date. In short, the option buyer can simply let the right lapse by not
exercising it. On the other hand, if the option buyer chooses to exercise
the right, the seller of the option has an obligation to perform the
contract according to the terms agreed.
Participants in the Options Market
There are four types of participants in options markets depending on the
position they take:
1. Buyer of call
2. seller of call
3. buyer of put
4. seller of put
People who buy options are called holders and those who sell options
are called writers; furthermore, buyers are said to have long positions,
and sellers are said to have short positions.
Here is the important distinction between buyers and sellers:
Call holders and put holders (buyers) are not obligated to buy or
sell. They have the choice to exercise their rights if they choose.
Callwritersand put writers (sellers), however, are obligated to
buy or sell. This means that a seller may be required to make
good on a promise to buy or sell.
OPTIONS TERMINOLOGY
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Call Option:
A call option gives the option buyer the right to buy one currency X
against another Y at a stated price on or before a stated date.
Put Option:
A put option gives the option buyer the right to sell one currency X
against another currency Y at a stated price on or before a stated date.
In foreign exchange transactions one currency is bought by selling
another currency. Thus if we consider the EUR/USD currency pair, a
call option on the euro is no different from a put option on the dollar.
Similarly, a put option on the euro is nothing but a call option on the
dollar.
Strike Price:
This is the price specified in the option contract at which the option
buyer can buy or sell currency X against currency Y or for instance the
euro against the dollar.
Maturity Date:
The date on which the option expires.
American Option:
A call or put option that can be exercised by the buyer on any businessday up to and including the maturity date.
European Option:
A call or put option that can be exercised only on the maturity date.
Premium (Option Price or Option Value):
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The upfront fee that option writer or seller charges the buyer for giving
the latter the right inherent in the option. If the option lapses
unexercised, the buyer loses this amount. This premium can be split
into 2 parts: intrinsic value and time value.
Premium = Intrinsic value + Time value.
Intrinsic value is the amount an option would be worth was it to be
exercised immediately. For instance, if an American call option on EUR
has a strike price of $0.85 and the current spot EUR/USD rate is say
$0.88, the intrinsic value is $0.03 per euro. European options can be
exercised only at maturity. Even so, they can have intrinsic value.European call options will have intrinsic value if the forward rate
applicable for the maturity date exceeds the strike price.
An option with an intrinsic value is called an in-the-money option. An
American/European option is said to be at-the-money if the strike price
equals the spot price/maturity forward price. Lastly,
American/European call options are said to be out-of-the-money if
strike price exceeds the spot price/maturity forward price.
American/European put options are said to be out-of-the-money if the
strike price is less than the spot price/maturity forward price.
An option can have time valueonly if it has some time remaining to
expiry. Time value depends on the chances of the option gaining in
value before expiry. At-the-money and out-of-the-money options have
no intrinsic value and can have only time value.
The time value of a currency option thus depends upon a number of
factors such as the spot price, strike price, time to maturity, volatility of
the market price, domestic interest rate and the foreign interest rate.
Two primary factors affect the time value:
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1. The length of time remaining until expiration.
2. The volatilityof the underlying futures price.
Other factors such as underlying futures price, strike price and general
interest levels in the economy will also influence the option premiums.
Usually decreases with length of time until expiration, but does
increase as price volatility of the underlying futures contract increases.
All else remaining equal, the more time an option has until expiration,
the higher its premium because it has more time to increase in value.
But the options time value will erode much rapidly as the option
approaches expiration. An option value at the expiration will be equal to
its intrinsic value the amount by which it is in the money. This is why
options are sometimes described as decaying assets.
In-the-Money (ITM) options have intrinsic value where as Out-of the-
Money (OTM) options have no intrinsic value. They only have time
value left in the premiums.
What is meant by ITM and OTM? Let us know about these.
An option whose strike price is roughly the same as the underlying
futures price is said to be At-the-Money, while an option that would
result in a loss if exercised is said to be Out-of the-Money. An option
that would result in a profit if exercised is said to be In-the-Money.
A call option is said to be:
In-the-Money (ITM), if Strike price is less than Futures price
At-the-Money (ATM) If Strike price equal to Futures price.
Out-of-the-Money (OTM) If Strike price greater than Futures
price.
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Comparison of Forward Contract and Currency Options
Importer
An Importer has the risk of FC appreciating. To hedge this risk he can eitherbuy FC forward or buy a Call Option. If on the expiry date, FC has
appreciated, he would exercise the option. If FC has depreciated, he would let
the contract lapse
An example of Strategy for Importers
An Importer has a payable after 3 months and has the risk of FC
appreciating
To cover this risk he has two choices
Buy currency forward
Buy a Call Option for the forward date
Suppose Current USD/INR Spot Rate is 45.98-46.00 and 3 months
Premium is 13-15. If he decides to cover the forward his cost is 46.00 +
0.15 = 46.15
If he decides to buy a Call at a Strike Price of 46.15 and if he has to pay
Option Premium of say 25 paisa, his all-in cost would then come to
46.40
Where an importer covers the forward his risk is protected as the cover
rate is fixed
Market rate on the forward date could be 46.15, higher or lower
He would have to settle the contract irrespective of what the market rate
is. If market rate is lower than the cover rate the importer has an
opportunity cost. Unfortunately a forward contract does not provide any
flexibility in such a case
But a Call Option could provide the answer
Let us understand one thing an option contract provides protection
against the unexpected.
And the unexpected for an importer is a fall in FC value
Given the volatility that we have seen in currency markets, it is
impossible to forecast rates with any degree of certainty
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On a positive note, volatility in markets offer opportunities which can be
exploited to reduce cost of hedging
When an importer buys a Call, he gets protection against appreciation in
FC. But what if FC falls? Moreover all of us want to reduce costs. So how
can we go about tackling these dual tasks, of a falling FC and cost
reduction?
Let us take three scenarios: Foreign Currency rises, remains same and
falls
Suppose FC rises above 46.15 before the expiry date.
Though the Call Option becomes In-the-Money no action need to be
taken because risk is FC may continue to rise further or remain above
the Strike Price till expiry.
Call Options provide protection in this very situation
If FC remains same at 46.15 then no point in doing anything.
But what if FC depreciates to below the strike price?
If USD/INR drops to say 45.50 before expiry. Cover the forward and
leave the Option open till expiry. This would help recover all of the
premium and more.
Later, on expiry, to exercise or lapse the Option would depend on the
market rate prevailing then
But if the market moves up before expiry but after doing the forward you
get an opportunity to reduce cost
If USD/INR moves to above 46.15 (say 46.50) liquidating the option
before expiry results in a profit (cost reduction)
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Exporter
An Exporter has the risk of FC depreciating. He can either Sell FC forward or
buy a Put Option to cover this risk. If on the expiry date, FC has depreciated,
he would exercise the option. However if FC has appreciated, he would let the
contract lapse
An example of Strategy for Exporters
An exporter has a receivable say after 3 months and has the risk of FC
depreciating
To cover this risk he has two choices
Sell currency forward
Buy a Put Option for the forward date
If he decides to cover the forward rate is 45.98 + 0.13 = 46.11
If he buys a Put at 46.11 and if he has to pay Option Premium of 25
paisa, his all-in rate would then come to 46.36
Where an exporter covers the forward his risk is protected as the cover
rate is fixed
Market rate on the forward date could be 46.11, higher or lower
He would have to settle the contract irrespective of what the market rate
is. If market rate is higher than the cover rate the exporter has an
opportunity cost.
Unfortunately a forward contract does not provide any flexibility in such a
case
But a Put Option could provide the answer
The unexpected in this case is a rise in FC value
When an exporter buys a Put, he gets protection against depreciation in
FC. But what if FC rises? Moreover every exporter wants to maximize his
return.
So how can we go about tackling these dual tasks, of a rising FC and
ensuring maximum return?
Let us take three scenarios: FC falls, remains same and rises
Suppose FC falls below 46.11 before the expiry date.
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Though the Put Option becomes In-the-Money no action need to be
taken because risk is FC may continue to fall further or remain below the
Strike Price till expiry.
Put Options provide protection in this very situation. If FC remains stable
at 46.11 then no point in doing anything. But what if FC goes above the
strike price?
If USD/INR rises to say 46.50 before expiry. Cover the forward and leave
the Option open till expiry. This would help recover at least some of the
premium
Later, on expiry, to exercise or lapse the Option would depend on the
market rate prevailing then
But if the market goes down before expiry but after doing the forward you
get an opportunity to earn out of the option
If USD/INR moves below 46.11 (say 45.85) liquidating the option before
expiry would be beneficial
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INDIAN Options market
What are available in India are OTC Options contracts only. There is no
exchange where Rupee options are quoted. The market for rupee options
is thin and prices tend to vary widely. Some of the more aggressive banks
market exotic options which do not involve any premium payout. These
have knock-in or knock-out rates which increase the exposure in the event
of it going wrong. This increases risks substantially going against the
very essence of options being a No-Risk product
Look at Options as Insurance, simply because an Option Contract is
designed to provide protection. As in any insurance policy, whose aim is to
obtain protection, an option too, is meant to provide protection to the buyer
And protection at no cost, as a concept, is inherently flawed. A plain
vanilla option is one that provides protection at a price. Such a contract
has no hidden conditions and no risk. Once you buy a plain vanilla option
you obtain protection from any and all future risks. Besides you have
unlimited profit potential. For such a product (facility) there is a price to be
paid, i.e. the Premium. Surely one needs to weigh the risk versus the cost
of protection. As in any insurance plan, consider the risk that you want
protected against cost of obtaining protection. If it makes sense, go ahead
and get the protection have unlimited profit potential. When the risk is high,
as we have seen in currency markets, we need to take steps to protect our
margins. And option premium, we believe, is a small price to pay in these
volatile markets. While a mix of options and forwards could provide a
good hedge, trading strategies are possible in options as well. Indian
corporate are skeptical of Options, the way they exist at the moment,
particularly the so called zero cost ones. Banks appear to be charging
exorbitantly high premium, Market is thin and getting comparative prices is
difficult. Banks do not quote two-way prices making their quotes biased
and unprofessional.
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Types of options
Mainly three types of options are in use:
a. Purchased Plain Vanilla Option Contracts
b. Range Forward (Zero cost) Option
c. Exotic Option
I. A Purchased Plain Vanilla Option Contract
A Purchased Foreign Currency Option Contract is a transaction which gives
the buyer (corporate) of the option contract the right but not the obligation to
settle the contact at a predetermined price (strike price) for a predetermined
maturity and amount. A CALL option gives the buyer the right but not the
obligation to buy the base currency and a PUT option give the buyer the right
but not the obligation to sell the base currency. The authorized dealer
(writer/seller of the option contract) charges an up front premium for the
transaction.
Risks
Premium paid has built in margins of Bank dealers and is not
transparent
European Options cannot be exercised before maturity
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Inputs:
PurchasedPlain
Vanilla
Option
Contract
Exposure type
Business Unit Name
Underlying Transaction
Details
Currency
Amount
Bank Details
Process chart - Purchased Plain Vanilla Option Contracts
Outputs:
Best negotiated
Option Premium
paid
Bank advice
Deal Slip
Confirmation letter to
Bank
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Work out CALL/PUT option strike price, Amount, maturity and Option Typefor the identified Currency pair.
Consult REUTERS/Bloomberg for the given structure
Calculate premium amount payable using Option Premium Calculator
Obtain quotes for premium for required structure from at least TWO BANKSand verify with own calculations
Select authorized Bank where the premium offered is lower
Call the FX Desk of the selected Bank, ask Dealers name
Mention purchase of CALL/PUT option with structure details and negotiatepremium percentage %
Confirm deal
Give the underlying contract details.Confirm American / European option, CALL/PUT, currency Pair, maturity,
strike price. Premium to be paid in INR
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II. Range Forward (zero cost) Option Contracts
A range forward deal involves the simultaneous purchase and sale of call and
put options, for the same principal amount and period, but at different strike
prices. Here the corporate gives up some of the profit potential in return for a
reduced premium liability. A zero cost range forwards is a particular type of
range forward where the strike prices for the call and put options are chosen
in such a manner that there is no premium payable i.e. the premium payable
for the options bought are exactly offset by the premium to be received on
account of the options sold.
Risks
Valuation of option contract is difficult.
Premium paid has built in margins of Bank dealers and is not
transparent
European options cannot be exercised before maturity
Range
Forward
(Zero Cost)
Options
Contract
Outputs:Inputs: Spot price risk hedged
for short maturity Premium to be paid
on purchased option Payment of premium
to Bank (if any) Premium to be
received on soldoption Limited FX Desk profit
over and abovepremium paid (if any),when strike price isnot exercised
Range of prices forexercising strikeprice
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Example Transaction
Underlying exposure:
Imports in Japanese Yen (purchase order amount = 29,250,000)
1 month Forward USD / JPY = 117.00
corporate FX desk buys USD 2,50,000 ATM European Call option on
Japanese Yen for 1 month at strike price of USD / JPY = 117.00, and pays a
premium of 2% (234 pips).
corporate also writes (sells) a USD 2,50,000 OTM Put option on the Japanese
Yen for the identical maturity to the counter party at a strike price of 120.00
and receives a premium of 1.5% (180 pips) from the counter party.
(Assumptions Spot USD / INR = 47)
Net premium paid to the counter party = 234 180
= 54 / 100pips (47 / 117) 250000
= INR 54, 234 /-
USD / JPY USD / JPY USD / JPY USD / JPY= 110 = 117 = 120 = 125
Counter partys profit profile
Corporate profit profile
Corporate will exercise its strike price at 117.00 if the USD / JPY exchange
rate is below 117 on maturity.
Counter party will exercise its strike price at 120.00 if the USD / JPY
exchange rate is above 120 on maturity.
118
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Spot rate on Option
Expiry DateHas the hedge worked?
US