Executive Summary

This project gives an in-depth analysis and understanding of Foreign Exchange Markets
in India. It helps to understand the History and the evolution of the foreign market in
India.
It gives an overview of the conditions existing in the current global economy. It gives an
overview of the Foreign exchange market.
It talks about the foreign exchange management act applicable and also gives details
about the participants in the forex markets.
It also talks about what are the sources of demand and supply of foreign exchange in
the market all over the world.
The report also talks about the Foreign Exchange trading platform and how the
efficiency and the transparency is maintained.
The report focuses on corporate hedging for foreign exchange risk in India. The report
contains details about some companies Foreign Exposure and how they have
maintained it.
It also talks about the determinants to be taken care of while taking corporate hedging
decisions. It gives insights about the Regulatory guidelines for the use of Foreign
Exchange derivatives, Development of Derivatives markets in India and also the
Hedging instruments for Indian firms.
The report gives an in-depth analysis of the currency risk management by talking about
what currency risk is, the types of currency risk Transaction risk ,Translation risk and

Economic risk. It also contains details about the companies in the index sensex and
nifty showing their transaction is foreign currency like the imports, exports, Loans,
Interst payments and the other expenses. It then shows the sensitivity analysis of how
the currency rates impact the gains/ profits of the company.

Contents
Foreign Exchange Market Overview.................................................................................5
...........................................................................................................................................9
Basic Concepts in Forex Trading.....................................................................................13
Currency Traded Across Globe & India...........................................................................14
Trading Platforms.............................................................................................................15
Factors Affecting Foreign Exchange................................................................................17
Foreign Exchange Management Act, 1999.....................................................................18
Participants in foreign exchange market.........................................................................19
Exchange rate System.....................................................................................................22
Foreign Exchange Market Structure................................................................................24
Fundamentals in Exchange Rate....................................................................................25
Factors Affecting Exchange Rates..................................................................................26
Sources of Supply and Demand in the Foreign exchange..............................................28
Corporate Hedging for Foreign Exchange Risk in India..................................................32
Foreign Exchange Risk Management Framework..........................................................38
Hedging Strategies/ Instruments.....................................................................................40
Determinants of Hedging Decisions................................................................................43
An Overview of Corporate Hedging in India....................................................................45
Currency Risk Management............................................................................................50

Foreign Exchange Market

The foreign exchange market (forex or FX for short) is one of the most exciting, fastpaced markets around. Until recently, forex trading in the currency market had been the
domain of large financial institutions, corporations, central banks, hedge funds and
extremely wealthy individuals. The emergence of the internet has changed all of this,
and now it is possible for average investors to buy and sell currencies easily with the
click of a mouse through online brokerage accounts.
Daily currency fluctuations are usually very small. Most currency pairs move less than
one cent per day, representing a less than 1% change in the value of the currency. This
makes foreign exchange one of the least volatile financial markets around. Therefore,
many currency speculators rely on the availability of enormous leverage to increase the
value of potential movements. In the retail forex market, leverage can be as much as
250:1. Higher leverage can be extremely risky, but because of round-the-clock trading
and deep liquidity, foreign exchange brokers have been able to make high leverage an
industry standard in order to make the movements meaningful for currency traders.

Extreme liquidity and the availability of high leverage have helped to spur the markets
rapid growth and made it the ideal place for many traders. Positions can be opened and
closed within minutes or can be held for months. Currency prices are based on
objective considerations of supply and demand and cannot be manipulated easily
because the size of the market does not allow even the largest players, such as central
banks, to move prices at will.
There are several avenues for retail customers to make investments. Individuals can
use investments instruments in financial markets by using long term goals or short term
trading i.e. shares, options, derivatives, swaps, commodity, real estate, gold, silver,
bonds etc., some of these instruments give an opportunity for people to make money.
Indian financial market is still only 2+ decades old and requires lot of maturity.
Recently some of trading instruments are available in the market because of the online
facility and many folks are using the technology to make additional money by trading in
futures or cash market along with commodity. There are bound to be many changes
going to happen in the coming years because of the stake taken in BSE and NSE by
foreign exchanges and substantial developments are going to happen with technology
and access to retail investors.
There are many new products will be launched in the financial market, which provides
easy access for retail investors to benefit from the same. One such trading activity is
FOREX, which is now accessible for many retail investors. Most of the folks are not
aware of how to use this trading avenue to make additional money and the beauty of
this product is that you can trade 24hrs which provides opportunity for folks who can do
some bit of trading during later hours or after work or early in the morning. As we all
know that FOREX trading is the biggest market globally and there are so many
combinations individuals can hedge.

Overview

Globally, operations in the foreign exchange market started in a major way after the
breakdown of the Bretton Woods system in 1971, which also marked the beginning of
floating exchange rate regimes in several countries. Over the years, the foreign
exchange market has emerged as the largest market in the world. The decade of the
1990s witnessed a perceptible policy shift in many emerging markets towards
reorientation of their financial markets in terms of new products and instruments,
development of institutional and market infrastructure and realignment of regulatory
structure consistent with the liberalized operational framework. The changing contours
were mirrored in a rapid expansion of foreign exchange market in terms of participants,
transaction volumes, decline in transaction costs and more efficient mechanisms of risk
transfer.
The origin of the foreign exchange market in India could be traced to the year 1978
when banks in India were permitted to undertake intra-day trade in foreign exchange.
However, it was in the 1990s that the Indian foreign exchange market witnessed far
reaching changes along with the shifts in the currency regime in India. The exchange
rate of the rupee, that was pegged earlier was floated partially in March 1992 and fully
in March 1993 following the recommendations of the Report of the High Level
Committee on Balance of Payments (Chairman: Dr.C. Rangarajan). The unification of
the exchange rate was instrumental in developing a market-determined exchange rate
of the rupee and an important step in the progress towards current account
convertibility, which was achieved in August 1994. 6.3 A further impetus to the
development of the foreign exchange market in India was provided with the setting up of
an Expert Group on Foreign Exchange Markets in India (Chairman: Shri O.P. Sodhani),
which submitted its report in June 1995. The Group made several recommendations for
deepening and widening of the Indian foreign exchange market. Consequently,
beginning from January 1996, wide-ranging reforms have been undertaken in the Indian
foreign exchange market. After almost a decade, an Internal Technical Group on the
Foreign Exchange Market (2005) was constituted to undertake a comprehensive review

of the measures initiated by the Reserve Bank and identify areas for further
liberalization or relaxation of restrictions in a medium-term framework.
The momentous developments over the past few years are reflected in the enhanced
risk-bearing capacity of banks along with rising foreign exchange trading volumes and
finer margins. The foreign exchange market has acquired depth (Reddy, 2005). The
conditions in the foreign exchange market have also generally remained orderly (Reddy,
2006c). While it is not possible for any country to remain completely unaffected by
developments in international markets, India was able to keep the spillover effect of the
Asian crisis to a minimum through constant monitoring and timely action, including
recourse to strong monetary measures, when necessary, to prevent emergence of self
fulfilling speculative activities
In todays world no economy is self sufficient, so there is need for exchange of goods
and services amongst the different countries. So in this global village, unlike in the
primitive age the exchange of goods and services is no longer carried out on barter
basis. Every sovereign country in the world has a currency that is legal tender in its
territory and this currency does not act as money outside its boundaries. So whenever a
country buys or sells goods and services from or to another country, the residents of two
countries have to exchange currencies. So we can imagine that if all countries have the
same currency then there is no need for foreign exchange.
Need for Foreign Exchange:
Let us consider a case where Indian company exports cotton fabrics to USA and
invoices the goods in US dollar. The American importer will pay the amount in US dollar,
as the same is his home currency. However the Indian exporter requires rupees means
his home currency for procuring raw materials and for payment to the labor charges etc.
Thus he would need exchanging US dollar for rupee. If the Indian exporters invoice their
goods in rupees, then importer in USA will get his dollar converted in rupee and pay the
exporter. From the above example we can infer that in case goods are bought or sold
outside the country, exchange of currency is necessary. Sometimes it also happens that

the transactions between two countries will be settled in the currency of third country. In
that case both the countries that are transacting will require converting their respective
currencies in the currency of third country. For that also the foreign exchange is
required.
About foreign exchange market:
Particularly for foreign exchange market there is no market place called the foreign
exchange market. It is mechanism through which one countrys currency can be
exchange i.e. bought or sold for the currency of another country. The foreign exchange
market does not have any geographic location. Foreign exchange market is described
as an OTC (over the counter) market as there is no physical place where the participant
meets to execute the deals, as we see in the case of stock exchange. The largest
foreign exchange market is in London, followed by the New York, Tokyo, Zurich and
Frankfurt. The markets are situated throughout the different time zone of the globe in
such a way that one market is closing the other is beginning its operation. Therefore it is
stated that foreign exchange market is functioning throughout 24 hours a day. In most
market US dollar is the vehicle currency, viz., the currency sued to dominate
international transaction. In India, foreign exchange has been given a statutory
definition. Section 2 (b) of foreign exchange regulation ACT, 1973 states:

Foreign

exchange means foreign currency and includes:

All deposits, credits and balance payable in any foreign currency and any draft,
travelers cheques, letter of credit and bills of exchange. Expressed or drawn in
India currency but payable in any foreign currency.
Any instrument payable, at the option of drawee or holder thereof or any other party
thereto, either in Indian currency or in foreign currency or partly in one and partly in the
other.

In order to provide facilities to members of the public and foreigners visiting

India, for exchange of foreign currency into Indian currency and vice-versa RBI has
granted to various firms and individuals, license to undertake money-changing business
at seas/airport and tourism place of tourist interest in India. Besides certain authorized

dealers in foreign exchange (banks) have also been permitted to open exchange
bureaus. Following are the major bifurcations:
Full fledge moneychangers they are the firms and individuals who have been
authorized to take both, purchase and sale transaction with the public.
Restricted moneychanger they are shops, emporia and hotels etc. that have been
authorized only to purchase foreign currency towards cost of goods supplied or services
rendered by them or for conversion into rupees.
Authorized dealers they are one who can undertake all types of foreign exchange
transaction. Banks are only the authorized dealers. The only exceptions are Thomas
cook, western union, UAE exchange which though, and not a bank is an AD.

Even

among the banks RBI has categorized them as follows:

Branch A They are the branches that have Nostro and Vostro account.
Branch B The branch that can deal in all other transaction but do not maintain Nostro
and Vostro a/cs fall under this category. For Indian we can conclude that foreign
exchange refers to foreign money, which includes notes, cheques, bills of exchange,
bank balance and deposits in foreign currencies.
Foreign Exchange Market: An Assessment
The continuous improvement in market infrastructure has had its impact in terms of
enhanced depth, liquidity and efficiency of the foreign exchange market. The turnover in
the Indian foreign exchange market has grown significantly in both the spot and
derivatives segments in the recent past. Along with the increase in onshore turnover,
activity in the offshore market has also assumed importance. With the gradual opening
up of the capital account, the process of price discovery in the Indian foreign exchange
market has improved as reflected in the bid-ask spread and forward premia behaviour.
Foreign Exchange Market Turnover

As per the Triennial Central Bank Survey by the Bank for International Settlements (BIS)
on
Foreign Exchange and Derivatives Market Activity, global foreign exchange market
activity rose markedly between 2001 and 2004 (Table 6.4). The strong growth in
turnover may be attributed to two related factors. First, the presence of clear trends and
higher volatility in foreign exchange markets between 2001 and 2004 led to trading
momentum, where investors took large positions in currencies that followed persistent
appreciating trends. Second, positive interest rate differentials encouraged the so-called
carry trading, i.e., investments in high interest rate currencies financed by positions in
low interest rate currencies. The growth in outright forwards between 2001 and 2004
reflects heightened interest in hedging. Within the EM countries, traditional foreign
exchange trading in Asian currencies generally recorded much faster growth than the
global total between 2001 and 2004. Growth rates in turnover for Chinese renminbi,
Indian rupee, Indonesian rupiah, Korean won and new Taiwanese dollar exceeded 100
per cent between April 2001 and April 2004 (Table 6.5). Despite significant growth in the
foreign exchange market turnover, the share of most of the EMEs in total global
turnover, however, continued to remain low.
The Indian foreign exchange market has grown manifold over the last several years.
The daily average turnover impressed a substantial pick up from about US $ 5 billion
during 1997-98 to US $ 18 billion during 2005-06. The turnover has risen considerably
to US $ 23 billion during 2006-07 (up to February 2007) with the daily turnover crossing
US $ 35 billion on certain days during October and November 2006. The inter-bank to
merchant turnover ratio has halved from 5.2 during 1997-98 to 2.6 during 2005-06,
reflecting the growing participation in the merchant segment of the foreign exchange
market (Table 6.6 and Chart VI.2). Mumbai alone accounts for almost 80 per cent of the
foreign exchange turnover.
6.60 Turnover in the foreign exchange market was 6.6 times of the size of Indias
balance of payments during 2005-06 as compared with 5.4 times in 2000-01 (Table 6.7).
With the deepening of the foreign exchange market and increased turnover, income of

commercial banks through treasury operations has increased considerably. Profit from
foreign exchange transactions accounted for more than 20 per cent of total profits of the
scheduled commercial banks during 2004-05 and 2005-06

Basic Concepts in Forex Trading

:
Bid and Ask Rate:
The bid/ask spread is the difference between the price at which a bank or market
maker will sell ("ask", or "offer") and the price at which a market taker will buy ("bid")
from a wholesale or retail customer. The customer will buy from the market-maker at the
higher "ask" price, and will sell at the lower "bid" price, thus giving up the "spread" as
the cost of completing the trade.
Margin Trading:
Foreign exchange is normally traded on margin. A relatively small deposit can control
much larger positions in the market. For trading the main currencies, Saxo Bank
requires a 1% margin deposit. This means that in order to trade one million dollars, you
need to place just USD 10,000 by way of security.

In other words, you will have obtained a gearing of up to 100 times. This means that a
change of, say 2%, in the underlying value of your trade will result in a 200% profit or
loss on your deposit.
Stop-loss discipline:
There are significant opportunities and risks in foreign exchange markets. Aggressive
traders might experience profit/loss swings of 20-30% daily. This calls for strict stop-loss
policies in positions that are moving against you.
Fortunately, there are no daily limits on foreign exchange trading and no restrictions on
trading hours other than the weekend. This means that there will nearly always be an
opportunity to react to moves in the main currency markets and a low risk of getting
caught without the opportunity of getting out. Of course, the market can move very fast
and a stop-loss order is by no means a guarantee of getting out at the desired level. For
speculative trading, it is recommended to place protective stop-loss orders.
Spot and forward trading:
When you trade foreign exchange you are normally quoted a spot price. This means
that if you take no further steps, your trade will be settled after two business days. This
ensures that your trades are undertaken subject to supervision by regulatory authorities
for your own protection and security. If you are a commercial customer, you may need
to convert the currencies for international payments. If you are an investor, you will
normally want to swap your trade forward to a later date. This can be undertaken on a
daily basis or for a longer period at a time. Often investors will swap their trades forward
anywhere from a week or two up to several months depending on the time frame of the
investment.
Although a forward trade is for a future date, the position can be closed out at any time the closing part of the position is then swapped forward to the same future value date.

FOREX TRADING EXAMPLES

Example 1
An investor has a margin deposit with Saxo Bank of USD100,000.
The investor expects the US dollar to rise against the Swiss franc and therefore decides
to buy USD2,000,000 - his maximum possible exposure.
The Saxo Bank dealer quotes him 1.5515-20. The investor buys USD at 1.5520.
Day 1: Buy USD2,000,000 vs CHF 1.5520 = Sell CHF3,104,000.
Four days later, the dollar has actually risen to CHF1.5745 and the investor decides to
take his profit.
Upon his request, the Saxo Bank dealer quotes him 1.5745-50. The investor sells at
1.5745.
Day 5: Sell USD2,000,000 vs CHF 1.5745 = Buy CHF3,149,000.

As the dollar side of the transaction involves a credit and a debit of USD2,000,000, the
investor's USD account will show no change. The CHF account will show a debit of
CHF3,104,000 and a credit of CHF3,149,000. Due to the simplicity of the example and
the short time horizon of the trade, we have disregarded the interest rate swap that
would marginally alter the profit calculation.
This results in a profit of CHF45,000 = approx. USD28,600 = 28.6% profit on the deposit
of USD100,000.
Example 2:
The investor follows the cross rate between the Euro and the Japanese yen. He
believes that this market is headed for a fall. As he is less confident of this trade, he
does not fully use the leverage available on his deposit. He chooses to ask the dealer
for a quote in EUR1,000,000. This requires a margin of EUR1,000,000 x 5% =
EUR50,000 = approx. USD52,500 (EUR/USD1.05).
The dealer quotes 112.05-10. The investor sells EUR at 112.05.
Day 1: Sell EUR1,000,000 vs JPY 112.05 = Buy JPY112,050,000.
He protects his position with a stop-loss order to buy back the euro at 112.60. Two days
later, this stop is triggered as the euro strengthens short term in spite of the investor's
expectations.
Day 3: Buy EUR1,000,000 vs JPY 112.60 = Sell JPY112,600,000.
The EUR side involves a credit and a debit of EUR1,000,000. Therefore, the EUR
account shows no change. The JPY account is credited JPY112.05m and debited
JPY112.6m for a loss of JPY0.55m. Due to the simplicity of the example and the short
time horizon of the trade, we have disregarded the interest rate swap that would
marginally alter the loss calculation.

This results in a loss of JPY0.55m = approx.USD5,300 (USD/JPY 105) = 5.3% loss on

the original deposit of USD100,000.

Currency Traded Across Globe & India

The FOUR major currency pairs

EUR/USD
USD/JPY
USD/CHF
GBP/USD

Currency Crosses

EUR/CHF
EUR/JPY
GBP/JPY
EUR/GBP

Currencies traded in India:

USD/INR
EUR/INR
GBP/INR
JPY/INR
Currency Exchanges in India:
1. MCX Stock Exchange (MCX SX)
2. National Stock Exchange (NSE)
3. United Stock Exchange (USE)
The daily turnover of NSE and MCX SX together is around 30,000 cr.

Factors Affecting Foreign Exchange

There are various factors affecting the exchange rate of a currency. They can be
classified as fundamental factors, technical factors, political factors and speculative
factors.
Fundamental factors:
The fundamental factors are basic economic policies followed by the government in
relation to inflation, balance of payment position, unemployment, capacity utilization,
trends in import and export, etc. Normally, other things remaining constant the
currencies of the countries that follow sound economic policies will always be stronger.
Similarly, countries having balance of payment surplus will enjoy a favorable exchange
rate. Conversely, for countries facing balance of payment deficit, the exchange rate will
be adverse.
Technical factors:
Interest rates: Rising interest rates in a country may lead to inflow of hot money in the
country, thereby raising demand for the domestic currency. This in turn causes
appreciation in the value of the domestic currency.
Inflation rate: High inflation rate in a country reduces the relative competitiveness of the
export sector of that country. Lower exports result in a reduction in demand of the
domestic currency and therefore the currency depreciates.
Exchange rate policy and Central Bank interventions: Exchange rate policy of the
country is the most important factor influencing determination of exchange rates. For
example, a country may decide to follow a fixed or flexible exchange rate regime, and
based on this, exchange rate movements may be less/more frequent. Further,
governments sometimes participate in foreign exchange market through its Central
bank in order to control the demand or supply of domestic currency.
Political factors:

Political stability also influences the exchange rates. Exchange rates are susceptible to
political instability and can be very volatile during times of political crises.
Speculation:
Speculative activities by traders worldwide also affect exchange rate movements. For
example, if speculators think that the currency of a country is overvalued and will
devalue in near future, they will pull out their money from that country resulting in
reduced demand for that currency and depreciating its value.

Participants in foreign exchange market

Market Players
Players in the Indian market include (a) ADs, mostly banks who are authorised to deal in
foreign exchange, (b) foreign exchange brokers who act as intermediaries, and (c)
customers individuals, corporates, who need foreign exchange for their transactions.
Though customers are major players in the foreign exchange market, for all practical
purposes they depend upon ADs and brokers. In the spot foreign exchange market,
foreign exchange transactions were earlier dominated by brokers. Nevertheless, the
situation has changed with the evolving market conditions, as now the transactions are
dominated by ADs. Brokers continue to dominate the derivatives market.
The Reserve Bank intervenes in the market essentially to ensure orderly market
conditions. The Reserve Bank undertakes sales/purchases of foreign currency in
periods of excess demand/supply in the market. Foreign Exchange Dealers Association
of India (FEDAI) plays a special role in the foreign exchange market for ensuring
smooth and speedy growth of the foreign exchange market in all its aspects. All ADs are
required to become members of the FEDAI and execute an undertaking to the effect
that they would abide by the terms and condition stipulated by the FEDAI for transacting

foreign exchange business. The FEDAI is also the accrediting authority for the foreign
exchange brokers in the interbank foreign exchange market.
The licences for ADs are issued to banks and other institutions, on their request, under
Section 10(1) of the Foreign Exchange Management Act, 1999. ADs have been divided
into different categories. All scheduled commercial banks, which include public sector
banks, private sector banks and foreign banks operating in India, belong to category I of
ADs. All upgraded full fledged money changers (FFMCs) and select regional rural banks
(RRBs) and co-operative banks belong to category II of ADs. Select financial institutions
such as EXIM Bank belong to category III of ADs. Currently, there are 86 (Category I)
Ads operating in India out of which five are co-operative banks (Table 6.3). All merchant
transactions in the foreign exchange market have to be necessarily undertaken directly
through ADs. However, to provide depth and liquidity to the inter-bank segment, Ads
have been permitted to utilise the services of brokers for better price discovery in their
inter-bank transactions. In order to further increase the size of the foreign exchange
market and enable it to handle large flows, it is generally felt that more ADs should be
encouraged to participate in the market making. The number of participants who can
give two-way quotes also needs to be increased.
The customer segment of the foreign exchange market comprises major public sector
units, corporates and business entities with foreign exchange exposure. It is generally
dominated by select large public sector units such as Indian Oil Corporation, ONGC,
BHEL, SAIL, Maruti Udyog and also the Government of India (for defence and civil debt
service) as also big private sector corporates like Reliance Group, Tata Group and
Larsen and Toubro, among others. In recent years, foreign institutional investors (FIIs)
have emerged as major players in the foreign exchange market.
The main players in foreign exchange market are as follows:
1. Customers:
The customers who are engaged in foreign trade participate in foreign exchange market
by availing of the services of banks. Exporters require converting the dollars in to rupee

and importers require converting rupee in to the dollars, as they have to pay in dollars
for the goods/services they have imported.
2. Commercial Bank:
They are most active players in the forex market. Commercial bank dealings with
international transaction offer services for conversion of one currency in to another.
They have wide network of branches. Typically banks buy foreign exchange from
exporters and sells foreign exchange to the importers of goods. As every time the
foreign exchange bought or oversold position. The balance amount is sold or bought
from the market.
3. Central Bank:
In all countries Central bank have been charged with the responsibility of maintaining
the external value of the domestic currency. Generally this is achieved by the
intervention of the bank.
4. Exchange Brokers:
Forex brokers play very important role in the foreign exchange market. However the
extent to which services of foreign brokers are utilized depends on the tradition and
practice prevailing at a particular forex market center. In India as per FEDAI guideline
the Ads are free to deal directly among themselves without going through brokers. The
brokers are not among to allowed to deal in their own account allover the world and also
in India.
5. Overseas Forex Market:
Today the daily global turnover is estimated to be more than US $ 1.5 trillion a day. The
international trade however constitutes hardly 5 to 7 % of this total turnover. The rest of
trading in world forex market is constituted of financial transaction and speculation. As
we know that the forex market is 24-hour market, the day begins with Tokyo and
thereafter Singapore opens, thereafter India, followed by Bahrain, Frankfurt, Paris,
London, New York, Sydney, and back to Tokyo.

6. Speculators:
The speculators are the major players in the forex market. Bank dealing are the major
speculators in the forex market with a view to make profit on account of favorable
movement in exchange rate, take position i.e. if they feel that rate of particular currency
is likely to go up in short term. They buy that currency and sell it as soon as they are
able to make quick profit.
Corporations particularly multinational corporation and transnational corporation
having business operation beyond their national frontiers and on account of their cash
flows being large and in multi currencies get in to foreign exchange exposures. With a
view to make advantage of exchange rate movement in their favor they either delay
covering exposures or do not cover until cash flow materialize.
Individual like share dealing also undertake the activity of buying and selling of foreign
exchange for booking short term profits. They also buy foreign currency stocks, bonds
and other assets without covering the foreign exchange exposure risk. This also results
in speculations.

Exchange rate System

Countries of the world have been exchanging goods and services amongst themselves.
This has been going on from time immemorial. The world has come a long way from the
days of barter trade. With the invention of money the figures and problems of barter
trade have disappeared. The barter trade has given way ton exchanged of goods and
services for currencies instead of goods and services. The rupee was historically linked
with pound sterling. India was a founder member of the IMF. During the existence of the
fixed exchange rate system, the intervention currency of the Reserve Bank of India

(RBI) was the British pound, the RBI ensured maintenance of the exchange rate by
selling and buying pound against rupees at fixed rates. The inter bank rate therefore
ruled the RBI band. During the fixed exchange rate era, there was only one major
change in the parity of the rupee- devaluation in June 1966. Different countries have
adopted different exchange rate system at different time.
The following are some of the exchange rate system followed by various countries.
The Gold Standard
Many countries have adopted gold standard as their monetary system during the last
two decades of the 19he century. This system was in vogue till the outbreak of World
War 1. Under this system the parties of currencies were fixed in term of gold. There
were two main types of gold standard:
1) Gold specie standard
Gold was recognized as means of international settlement for receipts and payments
amongst countries. Gold coins were an accepted mode of payment and medium of
exchange in domestic market also. A country was stated to be on gold standard if the
following condition were satisfied:

Monetary authority, generally the central bank of the country, guaranteed to buy
and sell gold in unrestricted amounts at the fixed price.

Melting gold including gold coins, and putting it to different uses was freely
allowed.

Import and export of gold was freely allowed.

The total money supply in the country was determined by the quantum of gold available
for monetary purpose.
2) Gold Bullion Standard:
Under this system, the money in circulation was either partly of entirely paper and gold
served as reserve asset for the money supply. However, paper money could be

exchanged for gold at any time. The exchange rate varied depending upon the gold
content of currencies. This was also known as Mint Parity Theory of exchange rates.
The gold bullion standard prevailed from about 1870 until 1914, and intermittently
thereafter until 1944. World War I brought an end to the gold standard.
Bretton Woods System
During the world wars, economies of almost all the countries suffered. In order to
correct the balance of payments disequilibrium, many countries devalued their
currencies. Consequently, the international trade suffered a deathblow. In 1944,
following World War II, the United States and most of its allies ratified the Bretton
Woods Agreement, which set up an adjustable parity exchange-rate system under
which exchange rates were fixed (Pegged) within narrow intervention limits (pegs) by
the United States and foreign central banks buying and selling foreign currencies. This
agreement, fostered by a new spirit of international cooperation, was in response to
financial chaos that had reigned before and during the war. In addition to setting up
fixed exchange parities (par values) of currencies in relationship to gold, the agreement
established the International Monetary Fund (IMF) to act as the custodian of the
system. Under this system there were uncontrollable capital flows, which lead to major
countries suspending their obligation to intervene in the market and the Bretton Wood
System, with its fixed parities, was effectively buried. Thus, the world economy has
been living through an era of floating exchange rates since the early 1970.
Floating Rate System
In a truly floating exchange rate regime, the relative prices of currencies are decided
entirely by the market forces of demand and supply. There is no attempt by the
authorities to influence exchange rate. Where government interferes directly or through
various monetary and fiscal measures in determining the exchange rate, it is known as
managed of dirty float. PURCHASING POWER PARITY (PPP) Professor Gustav
Cassel, a Swedish economist, introduced this system. The theory, to put in simple terms
states that currencies are valued for what they can buy and the currencies have no
intrinsic value attached to it. Therefore, under this theory the exchange rate was to be

determined and the sole criterion being the purchasing power of the countries. As per
this theory if there were no trade controls, then the balance of payments equilibrium
would always be maintained. Thus if 150 INR buy a fountain pen and the same fountain
pen can be bought for USD 2, it can be inferred that since 2 USD or 150 INR can buy
the same fountain pen, therefore USD 2 = INR 150.For example India has a higher rate
of inflation as compared to country US then goods produced in India would become
costlier as compared to goods produced in US. This would induce imports in India and
also the goods produced in India being costlier would lose in international competition to
goods produced in US. This decrease in exports of India as compared to exports from
US would lead to demand for the currency of US and excess supply of currency of
India. This in turn, cause currency of India to depreciate in comparison of currency of
US that is having relatively more exports.

Fundamentals in Exchange Rate

Exchange rate is a rate at which one currency can be exchange in to another currency,
say USD = Rs.48. This rate is the rate of conversion of US dollar in to Indian rupee and
vice versa.
Methods of Quoting Rate
There are two methods of quoting exchange rates.
1) Direct method:
Foreign currency is kept constant and home currency is kept variable. In direct
quotation, the principle adopted by bank is to buy at a lower price and sell at higher
price.
2) Indirect method:
Home currency is kept constant and foreign currency is kept variable. Here the strategy
used by bank is to buy high and sell low. In India with effect from august 2, 1993, all the
exchange rates are quoted in direct method. It is customary in foreign exchange market
to always quote two rates means one for buying and another rate for selling. This helps

in eliminating the risk of being given bad rates i.e. if a party comes to know what the
other party intends to do i.e. buy or sell, the former can take the letter for a ride. There
are two parties in an exchange deal of currencies. To initiate the deal one party asks for
quote from another party and other party quotes a rate. The party asking for a quote is
known as asking party and the party giving a quotes is known as quoting party. The
advantage of twoway quote is as under

The market continuously makes available price for buyers or sellers

Two way prices limit the profit margin of the quoting bank and comparison
of one quote with another quote can be done instantaneously.

As it is not necessary any player in the market to indicate whether he

intends to buy or sale foreign currency, this ensures that the quoting bank
cannot take advantage by manipulating the prices.

It automatically insures that alignment of rates with market rates.

Two way quotes lend depth and liquidity to the market, which is so very
essential for efficient market. In two way quotes the first rate is the rate for
buying and another for selling.

We should understand here that, in India the banks, which are authorized dealer,
always, quote rates. So the rates quoted- buying and selling is for banks point of view
only. It means that if exporters want to sell the dollars then the bank will buy the dollars
from him so while calculation the first rate will be used which is buying rate, as the bank
is buying the dollars from exporter. The same case will happen inversely with importer
as he will buy dollars from the bank and bank will sell dollars to importer.

Factors Affecting Exchange Rates

In free market, it is the demand and supply of the currency which should determine the
exchange rates but demand and supply is the dependent on many factors, which are
ultimately the cause of the exchange rate fluctuation, some times wild. The volatility of
exchange rates cannot be traced to the single reason and consequently, it becomes

difficult to precisely define the factors that affect exchange rates. However, the more
important among them are as follows:
Strength of Economy
Economic factors affecting exchange rates include hedging activities, interest rates,
inflationary pressures, trade imbalance, and euro market activities. Irving fisher, an
American economist, developed a theory relating exchange rates to interest rates. This
proposition, known as the fisher effect, states that interest rate differentials tend to
reflect exchange rate expectation. On the other hand, the purchasing- power parity
theory relates exchange rates to inflationary pressures. In its absolute version, this
theory states that the equilibrium exchange rate equals the ratio of domestic to foreign
prices. The relative version of the theory relates changes in the exchange rate to
changes in price ratios.
Political Factor
The political factor influencing exchange rates include the established monetary policy
along with government action on items such as the money supply, inflation, taxes, and
deficit financing. Active government intervention or manipulations, such as central bank
activity in the foreign currency market, also have an impact. Other political factors
influencing exchange rates include the political stability of a country and its relative
economic exposure (the perceived need for certain levels and types of imports). Finally,
there is also the influence of the international monetary fund.
Expectation of the Foreign Exchange Market
Psychological factors also influence exchange rates. These factors include market
anticipation, speculative pressures, and future expectations. A few financial experts are
of the opinion that in todays environment, the only trustworthy method of predicting
exchange rates by gut feel. Bob Eveling, vice president of financial markets at SG, is

corporate finances top foreign exchange forecaster for 1999. evelings gut feeling has,
defined convention, and his method proved uncannily accurate in foreign exchange
forecasting in 1998.SG ended the corporate finance forecasting year with a 2.66% error
overall, the most accurate among 19 banks. The secret to evelings intuition on any
currency is keeping abreast of world events. Any event, from a declaration of war to a
fainting political leader, can take its toll on a currencys value. Today, instead of formal
modals, most forecasters rely on an amalgam that is part economic fundamentals, part
model and part judgment.
Fiscal policy
Interest rates
Monetary policy
Balance of payment
Exchange control
Central bank intervention
Speculation
Technical factors

Foreign Exchange Risk Management Framework

Once a firm recognizes its exposure, it then has to deploy resources in managing it. A
heuristic for firms to manage this risk effectively is presented below which can be
modified to suit firm-specific needs i.e. some or all the following tools could be used.

Forecasts: After determining its exposure, the first step for a firm is to develop a
forecast on the market trends and what the main direction/trend is going to be on the
foreign exchange rates. The period for forecasts is typically 6 months. It is important
to base the forecasts on valid assumptions. Along with identifying trends, a
probability should be estimated for the forecast coming true as well as how much the
change would be.

Risk Estimation: Based on the forecast, a measure of the Value at Risk (the actual
profit or loss for a move in rates according to the forecast) and the probability of this
risk should be ascertained. The risk that a transaction would fail due to marketspecific problems4 should be taken into account. Finally, the Systems Risk that can

arise due to inadequacies such as reporting gaps and implementation gaps in the
firms exposure management system should be estimated.

Benchmarking: Given the exposures and the risk estimates, the firm has to set its
limit for handling foreign exchange exposure. The firm also has to decide whether to
manage its exposures on a cost centre or profit centre basis. A cost centre approach
is a defensive one and the main aim is ensure that cash flows of a firm are not
adversely affected beyond a point. A profit centre approach on the other hand is a
more aggressive approach where the firm decides to generate a net profit on its
exposure over time.

Hedging: Based on the limits a firm set for itself to manage exposure, the firms then
decides an appropriate hedging strategy. There are various financial instruments
available for the firm to choose from: futures, forwards, options and swaps and issue
of foreign debt. Hedging strategies and instruments are explored in a section.

Stop Loss: The firms risk management decisions are based on forecasts which are
but estimates of reasonably unpredictable trends. It is imperative to have stop loss
arrangements in order to rescue the firm if the forecasts turn out wrong. For this,
there should be certain monitoring systems in place to detect critical levels in the
foreign exchange rates for appropriate measure to be taken.

Reporting and Review: Risk management policies are typically subjected to review
based on periodic reporting. The reports mainly include profit/ loss status on open
contracts after marking to market, the actual exchange/ interest rate achieved on
each exposure, and profitability vis--vis the benchmark and the expected changes
in overall exposure due to forecasted exchange/ interest rate movements. The
review analyses whether the benchmarks set are valid and effective in controlling
the exposures, what the market trends are and finally whether the overall strategy is
working or needs change.

TOOLS FOR MANAGING RISK IN FOREX MARKET

THE SPOT MARKET
1. Introduction
The spot market accounts for nearly a third of global foreign exchange turnover. It can
be broadly divided into two tiers:
The interbank market where currency is bought and sold for delivery and settlement
within two days, with the banks acting as wholesalers or market makers.
The retail market made up of private traders, who deal over the telephone or the
internet through intermediaries (brokers).
The forex market has no centralized exchanges. All trades are over-the-counter deals,
agreed and settled by individual counterparties known to one another. The forex market
is truly global and operates 24 hours a day, Monday to Friday. Daily trading commences
in Wellington, New Zealand and follows the sun to (inter alia) Sydney, Tokyo, Hong
Kong, Singapore, Bahrain, Frankfurt, Geneva, Zurich, Paris, London, New York,
Chicago and Los Angeles before starting again.
2. Currency pairs and the rate of exchange
Every foreign exchange transaction is an exchange between a pair of currencies. Each
currency is denoted by a unique three-character International Standardization
Organization (ISO) code (e.g. GBP represents sterling and USD the US dollar).
Currency pairings are expressed as two ISO codes separated by a division symbol (e.g.
GBP/USD), the first representing the base currency and the other the secondary
currency.
The rate of exchange is simply the price of one currency in terms of another. For
example GBP/USD = 1.5545 denotes that one unit of sterling (the base currency) can
be exchanged for 1.5545 US dollars (the secondary currency). The base currency is the
one that you are buying or selling. This elementary point is often lost on beginners.

Exchange rates are usually written to four decimal places, with the exception of
Japanese yen which is written to two decimal places. The rate to two (out of four)
decimal places is known as the big figure while the third and fourth decimal places
together measure the points or pips. For instance, in GBP/USD = 1.5545 the big
figure is 1.55 while the 45 (i.e. the third and fourth decimal places) represents the
points.
2.1. Bid offer spread
As with other financial commodities, there is a buying price (offer or ask price) and a
selling price (bid price). The difference is known as the bid-offer spread or the
spread.
The spread is written in a particular format, best demonstrated by way of an example.
GBP/USD = 1.5545/50 means that the bid price of GBP is 1.5545 USD and the offer
price is 1.5550 USD. The spread in this case is 5 points.
2.2.The

major

pairings

All pairings with the US dollar are known as the majors. The big four majors are: EUR/USD
GBP/USD

denoting
denoting

USD/JPY

sterling/US

denoting

US

euro/USdollar
dollar

(known

dollar

as

/Japanese

cable)
yen

USD/CHF denoting US dollar/Swiss franc.

2.3.Crossrates
Pairings of non-US dollar currencies are known as crosses. We can derive cross
exchange rates for GPB, EUR, JPY and CHF from the aforementioned major pairs.
Exchange rates must be consistent across all currencies, or else it will be possible to
roundtripand

make

riskless

profits.

The following major exchange rates (red) imply the cross rates (blue). An illustration
of how cross rates are computed is given in Appendix A.

3. Buying equals selling

Every purchase of the base currency implies a reciprocal sale of the secondary
currency. Likewise, sale of the base currency implies the simultaneous purchase of the
secondary

currency.

For example, when I sell 1 GBP, I am simultaneously buying 1.5545 USD. Likewise,
when

buy

GBP,

am

simultaneously

selling

1.5550

USD.

We can express this equivalence by inverting the GBP/USD exchange rate and rotating
the

bid

USD/GBP

and
=

offer

reciprocals,

(1/1.5550)

bid;

to

derive
(1/1.5545)

the

USD/GBP

offer

rate

i.e.

0.6431/33

This means that the bid price of one USD is 0.6431 GBP (or 64.31p) and the offer price
of one USD is 0.6433 GBP (or 64.33p). Note that USD has now become the base
currency and that the spread is 2 points.
4. Practical spot trading
4.1 Units of trading lots
As we have already seen, every forex transaction is an exchange of one currency for
another. The basic unit of trading for private investors is known as a lot which consists
of 100,000 units of the base currency (although some brokers may arrange trading in
mini-lots).
Using the data in Table A, the purchase of a single lot of GBP/USD will involve the
purchase of 100,000 GBP at a price of 1.5852 USD = 158,520 USD.
Similarly, the sale of a single lot of GBP/USD entails the sale of 100,000 GBP at
1.5847 USD = 158,470 USD.

4.2 Margin
A private investor who purchases a GBP/USD lot does not have to put down the full
value of the trade (158,520 USD). Instead, the buyer is required to put down a deposit
known as margin which enables the investor to gear up the trade size to institutional

level.
Since the sale of one currency involves the simultaneous purchase of another, the seller
of a GBP/USD lot will have bought a volume of USD, and will also have to put down
margin

for

the

value

of

the

deal

(158,470

USD).

The normal margin requirement is between 1% and 5% of the underlying value of the
trade.
The currency denomination depends on the brokerage through which you execute your
trade. If you are dealing through an American broker (say online), then it is likely that
you will have to deposit margin in USD even if you are resident in the UK.
With 5,000 USD in your margin account and with margin requirement of 2.5%, you can
open positions worth 200,000 USD. Your positions will be valued continuously. If the
funds in your margin account drop below the minimum required to support your open
positions, then you may be asked to provide additional funds. This is known as a
margin

call.
If your trade is denominated in a currency other than that accepted by the

broker, you will have to convert your gains and losses back into an acceptable currency.
For example, if you trade a USD/JPY pair, then your gains and losses will be
denominated in JPY. If your brokers home currency is USD, then your profits and
losses will be converted back to USD at the relevant USD/JPY offer rate.
4.3 Closing out
An open position is one that is live and ongoing. As long as the position is open, its
value will fluctuate in accordance with the exchange rate in the market. Any profits and
losses will exist on paper only and will be reflected in your margin account.
To close out your position, you conduct an equal and opposite trade in the same
currency pair. For example, if you have gone long in one lot of GBP/USD (at the
prevailing offer price) you can close out that position by subsequently going short in one
GBP/USD lot (at

the

prevailing

bid

price).

Your opening and closing trades must the conducted through the same intermediary.
You cannot open a GBP/USD position with Broker A and close it out through Broker B.
5. Worked example
5.1 Betting on a rise
Assume that you start with a clean slate and that the current GPB/USD rate is
1.5847/52.
You expect the pound to appreciate against the US dollar, so you buy a single lot of
100,000

GBP

at

the

offer

price

of

1.5852

USD.

The value of the contract is 100,000 X $1.5852 = $158, 520.

The broker wants margin of 2.5% in USD, so you must ensure that you deposit at least
2.5%

of

158,520

USD

3,963

USD

in

your

margin

account

GBP/USD duly appreciates to 1.6000/05 and you decide to close out your position by
selling

your

sterling

for

US

dollars

at

the

bid

rate.

Your

gain

is:

100,000 X (1.6000 1.5852) USD = 1,480 USD, the equivalent of 10 USD per point
Your rate of return is 1,480/3,963 = 37.35%, on an exchange rate movement of less
than

1%.

Had

This

illustrates

GBP/USD

fallen

the
to

positive

1.5700/75,

effect
your

of

buying

on

loss

would

have

margin.
been:

100,000 X (1.5852 1.5700) USD = 1,520 USD, a return of 38.35%

The lesson is that margin trading magnifies your rate of profit or loss.
6. Screen-based spot trading
The technology for trading forex has evolved from the telephone and telex (not
forgetting voice dealing) through to the modern Electronic Broking System (EBS) that
enables straight through processing (STP) with integrated quotation, transactional and
administrative

functionality.

EBS-type technology is now available to individual, private investors who can receive
live, streaming data from and transact directly through their chosen brokers. The private
dealer, however, does not deal on the highly competitive inter-bank market with its tight
spreads. In practice, brokers add points to the price spread in lieu of dealing

commission.
A private trader requires:
A margin account broker with internet access and a fast connection
A computer terminal capable of running several programmes simultaneously
Proprietary software to open and manage positions and to display technical analysis
tools.
Sufficient monitors to handle market data, submit dealing instructions, display
technical analysis; and for keeping tabs on open positions, managing orders (e.g. stop
loss, TPO, limit etc.) and viewing the state of the margin account. For demonstrations of
the

kind

of

proprietary

(www.pronetanalytics.com)

software
and

available,

Nostradamus

visit

Pronet

Analytics

(www.nostradamus.co.uk)

Pronet Analytics provides the only chart-based software package approved by

Association of Cambistes Internationale, the governing body of professional forex
trading.
From early 2003, a new spot trading software package from US provider Gain Capital
will

be

available

through

the

UK

online

margin

broker

Easy2Trade

(www.easy2trade.com), better known for its futures online global trading platform. We
will build our required margin into the bid-offer spread, says Easy2Trade chief
executive

David

Wenman.

It

will

be

free

to

use

after

that.

Before you splash out on the full kit, why not does a test drive by renting a dealing desk
at an organization like TraderHouse (www.traderhouse.net).

Fundamental and technical analysis

Without the apparatus for making sense of the currency market, any trade represents a
pure gamble. There are two broad schools of analysis, which are not mutually exclusive.

Fundamentalanalysis
Fundamental analysis is the application of micro and macroeconomic theory to markets,
with the aim of predicting future trends. So what fundamental forces drive currency
markets?
(a). The balance of trade: Currencies that are associated with long term trade
surpluses will tend to strengthen against those associated with persistent deficits simply because there is net buying of surplus currencies corresponding to the excess of
exports

over

imports.

Trends are important too. An improving balance of trade should cause the relevant
currency to appreciate relative to those associated with a deteriorating or stable balance
of

trade.

(b). Relative inflation rates: If country A is suffering a higher rate of price inflation than
country B, then As currency ought to weaken relative to Bs in order to restore
purchasing power parity.
(c). Interest rates: International capital flows seek the highest inflation-adjusted returns,
creating additional demand for high real interest-rate currencies and pushing up their
rates of

exchange.

(d). Expectations and speculation: Markets anticipate events. Speculation on, say,
the future rate of inflation may be enough to move the exchange rate - long before the
actual trend becomes

apparent.

It should be understood that these economic forces act in concert. It is a supremely

difficult task, however, to establish where the sum of interacting economic forces will
take the market. The solution, some argue, lies in technical analysis.

Technical analysis

Technical analysis is concerned with predicting future price trends from historical price
and volume data. The underlying axiom of technical analysis is that all fundamentals
(including expectations) are factored into the market and are reflected in exchange
rates.
The tools of technical analysis are now freely available to private investors in support of
their trading decisions. It cannot be stressed too heavily, however, that such tools are
only estimators

and

are

not

infallible.

The following is the briefest of introductions to the technical analytical tools used to
identify trends and recurring patterns in a volatile marketplace. Aspiring forex dealers
are advised to undergo proper training in technical analysis, although true proficiency
comes with practice, endurance and experience.

Hedging Strategies/ Instruments

A derivative is a financial contract whose value is derived from the value of some other
financial asset, such as a stock price, a commodity price, an exchange rate, an interest
rate, or even an index of prices. The main role of derivatives is that they reallocate risk
among financial market participants, help to make financial markets more complete.
This section outlines the hedging strategies using derivatives with foreign exchange
being the only risk assumed.

Forwards
A forward is a made-to-measure agreement between two parties to buy/sell a
specified amount of a currency at a specified rate on a particular date in the future.
The depreciation of the receivable currency is hedged against by selling a currency
forward. If the risk is that of a currency appreciation (if the firm has to buy that
currency in future say for import), it can hedge by buying the currency forward. E.g if
RIL wants to buy crude oil in US dollars six months hence, it can enter into a forward
contract to pay INR and buy USD and lock in a fixed exchange rate for INR-USD to
be paid after 6 months regardless of the actual INR-Dollar rate at the time. In this
example the downside is an appreciation of Dollar which is protected by a fixed

forward contract. The main advantage of a forward is that it can be tailored to the
specific needs of the firm and an exact hedge can be obtained. On the downside,
these contracts are not marketable, they cant be sold to another party when they
are no longer required and are binding.

Futures
A futures contract is similar to the forward contract but is more liquid because it is
traded in an organized exchange i.e. the futures market. Depreciation of a currency
can be hedged by selling futures and appreciation can be hedged by buying futures.
Advantages of futures are that there is a central market for futures which eliminates
the problem of double coincidence. Futures require a small initial outlay (a proportion
of the value of the future) with which significant amounts of money can be gained or
lost with the actual forwards price fluctuations. This provides a sort of leverage.
The previous example for a forward contract for RIL applies here also just that RIL
will have to go to a USD futures exchange to purchase standardised dollar futures
equal to the amount to be hedged as the risk is that of appreciation of the dollar. As
mentioned earlier, the tailorability of the futures contract is limited i.e. only standard
denominations of money can be bought instead of the exact amounts that are
bought in forward contracts.

Options
A currency Option is a contract giving the right, not the obligation, to buy or sell a
specific quantity of one foreign currency in exchange for another at a fixed price;
called the Exercise Price or Strike Price. The fixed nature of the exercise price
reduces the uncertainty of exchange rate changes and limits the losses of open
currency positions. Options are particularly suited as a hedging tool for contingent
cash flows, as is the case in bidding processes. Call Options are used if the risk is
an upward trend in price (of the currency), while Put Options are used if the risk is a
downward trend. Again taking the example of RIL which needs to purchase crude oil
in USD in 6 months, if RIL buys a Call option (as the risk is an upward trend in dollar

rate), i.e. the right to buy a specified amount of dollars at a fixed rate on a specified
date, there are two scenarios. If the exchange rate movement is favourable i.e the
dollar depreciates, then RIL can buy them at the spot rate as they have become
cheaper. In the other case, if the dollar appreciates compared to todays spot rate,
RIL can exercise the option to purchase it at the agreed strike price. In either case
RIL benefits by paying the lower price to purchase the dollar

Swaps
A swap is a foreign currency contract whereby the buyer and seller exchange equal
initial principal amounts of two different currencies at the spot rate. The buyer and
seller exchange fixed or floating rate interest payments in their respective swapped
currencies over the term of the contract. At maturity, the principal amount is
effectively re-swapped at a predetermined exchange rate so that the parties end up
with their original currencies. The advantages of swaps are that firms with limited
appetite for exchange rate risk may move to a partially or completely hedged
position through the mechanism of foreign currency swaps, while leaving the
underlying borrowing intact. Apart from covering the exchange rate risk, swaps also
allow firms to hedge the floating interest rate risk. Consider an export oriented
company that has entered into a swap for a notional principal of USD 1 mn at an
exchange rate of 42/dollar.
The company pays US 6months LIBOR to the bank and receives 11.00% p.a. every
6 months on 1st January & 1st July, till 5 years. Such a company would have
earnings in Dollars and can use the same to pay interest for this kind of borrowing
(in dollars rather than in Rupee) thus hedging its exposures.

Foreign Debt
Foreign debt can be used to hedge foreign exchange exposure by taking advantage
of the International Fischer Effect relationship. This is demonstrated with the
example of an exporter who has to receive a fixed amount of dollars in a few months
from present. The exporter stands to lose if the domestic currency appreciates
against that currency in the meanwhile so, to hedge this, he could take a loan in the

foreign currency for the same time period and convert the same into domestic
currency at the current exchange rate. The theory assures that the gain realised by
investing the proceeds from the loan would match the interest rate payment (in the
foreign currency) for the loan.

Determinants of Hedging Decisions

The management of foreign exchange risk, as has been established so far, is a fairly
complicated process. A firm, exposed to foreign exchange risk, needs to formulate a
strategy to manage it, choosing from multiple alternatives. This section explores what
factors firms take into consideration when formulating these strategies.
Production and Trade vs. Hedging Decisions
An important issue for multinational firms is the allocation of capital among different
countries production and sales and at the same time hedging their exposure to the
varying exchange rates. Research in this area suggests that the elements of exchange
rate uncertainty and the attitude toward risk are irrelevant to the multinational firm's
sales and production decisions (Broll,1993). Only the revenue function and cost of
production are to be assessed, and, the production and trade decisions in multiple
countries are independent of the hedging decision.
The implication of this independence is that the presence of markets for hedging
instruments greatly reduces the complexity involved in a firms decision making as it can
separate production and sales functions from the finance function. The firm avoids the
need to form expectations about future exchange rates and formulation of risk
preferences which entails high information costs.
Cost of Hedging
Hedging can be done through the derivatives market or through money markets (foreign
debt). In either case the cost of hedging should be the difference between value

received from a hedged position and the value received if the firm did not hedge. In the
presence of efficient markets, the cost of hedging in the forward market is the difference
between the future spot rate and current forward rate plus any transactions cost
associated with the forward contract. Similarly, the expected costs of hedging in the
money market are the transactions cost plus the difference between the interest rate
differential and the expected value of the difference between the current and future spot
rates. In efficient markets, both types of hedging should produce similar results at the
same costs, because interest rates and forward and spot exchange rates are
determined simultaneously. The costs of hedging, assuming efficiency in foreign
exchange markets result in pure transaction costs. The three main elements of these
transaction costs are brokerage or service fees charged by dealers, information costs
such as subscription to Reuter reports and news channels and administrative costs of
exposure management.
Factors affecting the decision to hedge foreign currency risk
Research in the area of determinants of hedging separates the decision of a firm to
hedge from that of how much to hedge. There is conclusive evidence to suggest that
firms with larger size, R&D expenditure and exposure to exchange rates through foreign
sales and foreign trade are more likely to use derivatives. (Allayanis and Ofek, 2001)
First, the following section describes the factors that affect the decision to hedge and
then the factors affecting the degree of hedging are considered.

Firm size
Firm size acts as a proxy for the cost of hedging or economies of scale. Risk
management involves fixed costs of setting up of computer systems and
training/hiring of personnel in foreign exchange management. Moreover, large firms
might be considered as more creditworthy counterparties for forward or swap
transactions, thus further reducing their cost of hedging. The book value of assets is
used as a measure of firm size.

Leverage

According to the risk management literature, firms with high leverage have greater
incentive to engage in hedging because doing so reduces the probability, and thus
the expected cost of financial distress. Highly levered firms avoid foreign debt as a
means to hedge and use derivatives.

Liquidity and profitability:

Firms with highly liquid assets or high profitability have less incentive to engage in
hedging because they are exposed to a lower probability of financial distress.
Liquidity is measured by the quick ratio, i.e. quick assets divided by current
liabilities). Profitability is measured as EBIT divided by book assets.

Sales growth
Sales growth is a factor determining decision to hedge as opportunities are more
likely to be affected by the underinvestment problem. For these firms, hedging will
reduce the probability of having to rely on external financing, which is costly for
information asymmetry reasons, and thus enable them to enjoy uninterrupted high
growth. The measure of sales growth is obtained using the 3-year geometric
average of yearly sales growth rates.

As regards the degree of hedging Allayanis and Ofek (2001) conclude that the sole
determinants of the degree of hedging are exposure factors (foreign sales and trade). In
other words, given that a firm decides to hedge, the decision of how much to hedge is
affected solely by its exposure to foreign currency movements.
This discussion highlights how risk management systems have to be altered according
to characteristics of the firm, hedging costs, nature of operations, tax considerations,
regulatory requirements etc. The next section discusses these issues in the Indian
context and regulatory environment.

BIBLIOGRAPHY
o www.google.com GOOGLE SEARCH ENGINE
o Dr. G. KOTRESHWAR, RISK MANAGEMENT, HIMALAYA PUBLISHING
HOUSE, MUMBAI.
o A.K.SETH, INTERNATIONAL FINANCIAL MANAGEMENT.
o LEVY, INTERNATIONAL FINANCIAL MANAGEMENT.
o V.K.BHALLA, INTERNATIONAL FINANCIAL MANAGEMENT.
o SHAPIRO, INTERNATIONAL FINANCIAL MANAGEMENT.