Foreign Exchange Risk Management

March 23, 2019 | Author: Ashwin Rana | Category: Swap (Finance), Futures Contract, Option (Finance), Foreign Exchange Market, Exchange Rate
Share Embed Donate


Short Description

Download Foreign Exchange Risk Management...

Description

Prepared by: Sagathiya Sanjay

- 11072

Pathan Minhaz Khan -11029 Foreign Exchange Risk Management 

1

TABLE OF CONTENT SR. NO. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15.

PARTICULARS TITLE TABLE OF CONTENT PREFACE ACKNOWLEDGEMET EXECUTIVE SUMMARY RESEARCH METHODOLOGY TRENDS IN WORLD TRADE WHAT IS FOREIGN TRADE? FOREX RISK WHAT TO DO HAVE A SHIELD AGIANST AFORESAID EXPOSURE INDIAN MARKET CONCERNS USE OF VARIUOS INSTRUMENTS INTERNATINAL CONCERNS CONCLUSION BIBLIOGRAPHY

Foreign Exchange Risk Management 

PAGE NO. 1 2 3 4 5 6 7 9 10 12 18 20 22 25 26

2

PREFACE Whichever the industry is, it has effect of the other disciplines on it. No one can gauge it, however, everyone tries. Result remains the sa me. Unintelligible! The industry, we have taken or rather we are interested in, is Forex. It’s one of the most developing and dynamic market. We did not try to gauge its propensity. Because, it’s as difficult as trying to measure the amount of water in the Indian Ocean. This study has been done as a part of academic intention. In 3 rd semester, the students, who have opted for Core, have to do it. We have tried our best to first understand the market, then to explain it in this report. This study is focusing on the world market. It is obvious that forex appears if there is a foreign trade. We have used the currencies which are most popular, strong and most of the world trade is carried out through them. However, this does not purport to say that other currencies business is not as developed as that of stronger one. We have tried to take real world experience for the purpose of our study. The industry response was good enough. It has been as good as any industry would have provided. Moreover, we want to assure you that we have done elementary as well as the high level study of the subject (of course, in limit of our ability).

Foreign Exchange Risk Management 

3

 ACKNOWLEDGEMENT We are thankful to every person who came to help us in preparing this report, directly or indirectly. One such person is respected Dr. Sarla Achyuthan, Director of our beloved B.K. School of Business Management, who gave us opportunity to study in highly respected institute and inspired us to complete this report. We are also very grateful to Professor Dharmesh, who help ed us to choose our subject and taught us the basics as well as deeper elements of the subject. Without his guidance, this project would not have been completed. The other persons, to whom we are thankful, are the Western Union Money Transfer and Advances Travel Private Limited, who helped us to understand how the forex industry works.

Foreign Exchange Risk Management 

4

EXECUTIVE SUMMARY 

The knowledge of any field is very important, specially, if someone wants to do business in that field. As world became global village, the businesses started going global, so did the risk. To manage highly likely risks, intellectuals invented some tools. Those tools are sometimes savior and sometimes destroyer. This is an attempt to understand as well as elaborate the dynamics of risk of Forex Market of the world. To fulfill the need of data, primary and secondary data are taken. For secondary data, Internet came to rescue and for primary data, many officers and attendance of the Forex firms helped us. This is not highly researched and highly intelligent report, though. This may be identified as a raw study of the whole market.

Foreign Exchange Risk Management 

5

RESEARCH METHODOLOGY  Primary Research: 1) Western Union Money Transfer Sur Apartment, C G Road, Navrang Pura H O Ahedabad - 380009 2) Advance Travel Ltd. 105 Sahajanand Complex, Nr Swastik Char Rasta Bh My My Show Room, Navrangpura, Ahmedabad - 380009

Secondary Data : 1) International Finance - Choel S. Eun and Bruce G. Resnic 2) Derivatives and Risk Management  -Jhon C. Hull 3) International Finance Management  -Madhu Vij 4) Web sites of  -RBI, -BIS, -Ministry of Commerce, -Ministry of Finance

Foreign Exchange Risk Management 

6

We have seen the effect of the America and Europe on each other and on rest if the world. They are trying to take a ‘hedging’ against the problems they are facing. However, we are reading all the news in newspapers about where they are heading. That’s not  our topic of the project though. We have taken a tumbler of the tremendously shaking sea by this report. How the exchange market started, we will not answer that, but we shall dig into how it is working now. We will start with trade in the world.

TRENDS IN WORLD TRADE As the business started becoming global, the international trade also got the boost. The following chart shows that, though with some fluctuations, world trade is increasing.

SOME FACTS ABOUT INTERNATIONAL TRADE AND ITS INSTITUTIONS WORLD TRADE STATISTICS

Foreign Exchange Risk Management 

7

In above chart, it is shown that the percentages of the foreign trade of the total GDP of the world. Though it is sometimes declining and looks like roller coaster ride, it has shown tendency to increase. This has been the major reason why companies all around the world have started hedging seriously. India is also going in tandem with the world as the data shows the imports as well as exports are increasing like anything.

Exports (including re-exports) There is huge jump of Exports during October, 2011. They were val ued at US$ 19869.97 million (Rs.97875.32 crore) which was 10.82 per cent higher in Dollar terms (22.92 per cent higher in Rupee terms) than the level of US$ 17929.64 million (Rs. 79626.77) during October, 2010. It is just for one month. If we see the data of seven months, cumulative value of exports for the period April-October 2011 -12 was US$ 179777.23 million (Rs 820679.43 crore) as against US$ 123170.46 million (Rs.564313.87 crore) registering a growth of 45.96 per cent in Dollar terms and 45.43 per cent in Rupee terms over the same period last year. The graph also depicts the data and its upward slope. Imports Increment in exports is favorable for the country, but as we have to import crude oil to run our economy, we have to enhance our import. which during October, 2011 were valued at US$ 39513.73 million (Rs.194636.35 crore) representing a growth of 21.72 per cent in Dollar terms (35.01 per cent in Rupee terms) over the level of imports valued at US$ 32461.70 million ( Rs. 144164.69 crore) in October, 2010. Cumulative value of imports for the period April-October, 2011-12 was US$ 273467.77 million (Rs.1251948.19 crore) as against US$ 208821.75 million (Rs. 955937.28 crore) registering a growth of 30.96 per cent  in Dollar terms and 30.97 per cent in Rupee terms over the same period last year.

Foreign Exchange Risk Management 

8

Export & Import 300000 250000    D    S 200000    U    n    i    t 150000    n    u    o    m100000    A

273467.77 208821.75 179777.23 123170.46

export import

50000 0 April-October 2010 -11

April-October 2011 -12

Timeline

The global trade, Indian trade vis-à-vis the exchange market is so dynamic that if  President Obama sneezes, the market shows its concern. However, we cannot take sneezes of Obama as threats to the exchange market. There are plenty of other threats which can shake the market from head to toe. There are many other factors which make forex market risky. To know how those factors affect the exchange market, we should know what the types of risks are. And to understand risk  properly, we should know what the foreign exchange is. It is popularly known as forex.

WHAT IS FOREIGN EXCHANGE? Foreign Exchange rate is the rate on which two countries agree to exchange their goods and services. It is the largest financial market in the world by virtually any standard, and has been growing very fast during the recent years. It has some risk entailed. It is called foreign exchange risk. To be clearer, Foreign Exchange risk is linked to unexpected fluctuation in the value of currency. The stronger the currency, the riskier it is. That means, currency which is having more value has more to lose. This is because exchange rates are generally unanticipated. For example, Indian company has the business with one US firm and it is supposed to pay some amount for imports. Now, if the USD appreciates (read becomes costlier), Indian company will need more rupees to pay for the same amount of USD. Its situation will deteriorate. Risk is involved in its practices.

Foreign Exchange Risk Management 

9

Foreign exchange risk poses the greatest challenge to a multinational company, because MNCs operate in multiple countries and currencies. The unforgivable sins are to fail to consider the risks or fail to act on any decisions. First step is to consider the risk, second is to take decision for that and third is to how to minimize that risk. One such risk arises when a company, usually an MNC, indulge in foreign trade. The company has to hedge against that risk in a number of ways. One way is to do interbank transaction. In this company does nothing but the spot and forward transaction. Company will decide what would be the exchange rate in near future, in relation to present exchange rate. (Present exchange rate is also called ‘current rate’ or ‘spot rate’). If company wants to do standardized contracts, it can go to the Exchange Markets. Exchange Markets provide future contracts and option contracts. Generally MNCs have wide network of subsidiaries. Such subsidiaries can be in strong economies or in weak economies or in both. The subsidiaries that are in weak  economies should pay their international debts or other payments as soon as possible, because there is a greater chance of their currency being depreciated. For example, if t oday we have to pay 1 USD, it will cost us INR 51.76. But if INR is depreciating, we might have to pay INR 52 per 1 USD. This will stand contrary, for the strong economies.

FOREX RISK  Above mentioned risk is basic type of risk. Going further in this regime, we find three types of risks. 

Transaction exposure



Translation exposure and



Economic exposure.

To have a better idea, we will dig in them all. Transaction exposure To understand this exposure, we will start with an example. HCL, an Indian company, exports its computers to USA. To manufacture these computers, it imports raw materials from USA on regular basis. Let’s assume they are exporting computers worth 1 million USD. Assume further that today’s exchange rate is INR 51 per 1 USD. It will earn INR 51 millions. Now it, again, will import raw materials in Foreign Exchange Risk Management 

10

next month. Let’s say, in this next month the exchange rate is INR 52 per 1 USD. Then for same 1 million imports HCL will have to pay INR 52 millions.

HCL has to pay INR 1 million extra because of exchange rate fluctuation. It has a risk  of INR further depreciating. This risk is, in technical language, called Transaction risk. Translation exposure MNC head office and its subsidiaries may be writing their book of accounts in different currencies. Generally this is the case. All financial statements of foreign subsidiaries have to be translated into the home currency for the purpose of finalizing the account. Investors are interested in ‘their’ currency values. That’s why foreign accounts are restated in ‘their’ currency. For example, say, Indian MNC’s foreign affiliates are in France and Germany. They will restate their accounts from FFR and DEM to INR. This accounting process is called ‘translation’. At this time exchange rate will affect the valuation o f assets, capital structure ratios, profitability ratio, solvency ratios etc. This risk is the propensity to which the financial statements are affected by exchange rate changes. When the head office is consolidating the statements of assets and liabilities, it should consider the exchange rate which is prevailing at that time. But rate of the transaction date should be considered in case of translation of revenue and expenses. Sometimes weighted average is also taken when items are transacted more often than not. This is also called Accounting risk, for it is related to accounting practices.

Economic exposure A company can have an economic exposure. But what is economic exposure after all? As its name suggests, it is related with the changes in economy. We directly will refer to an example. Let’s say there are two car manufacturers, Maruti and TATA. Tatas are importing from Britain and Maruti are manufacturing it in India. Now, when Pound sterling depreciates, Tatas are in better position. Because they will pay less than they had to pay previously. In such way, Tatas are more competitive than Maruti. Maruti has lost its competitiveness. Economic exposure will have its affect in the long run. However, we cannot take protection against economic exposure. Financial engineers have devised many instruments to take care of aforesaid risks. Let’s have a look at them.

Foreign Exchange Risk Management 

11

WHAT TO DO TO HAVE A SHIELD AGAINST ALL AFORESAID EXPOSURES? Financial engineers have devised many techniques to hedge against risks. Most used of them are Forward exchange Contracts, Money Market Hedge and options & swaps. Explanation of them is given as under. Forward exchange contract  As its name suggests, it is a contract and it will take place on future date. This future date is usually later than two business days. This contract pertains to the exchange rates of  the two concerning currencies. As the main motto is to fix the exchange rate, the parties will decide it today. It is in the best interest of them as they know what the existing rate is. They will decide that whatever happens in future, they will transact at the decided rate. No change! As it is of today’s rate, it is called Spot Rate. It is decided by market mechanism of  Supply and Demand, so the parties don’t need to bother about it. Imagine you will need raw materials in future. This future will come in 12 months time. You will buy it from foreign exporter of Germany. The amount of purchase will be EURO 1, 00,000. Current exchange rate is, suppose, INR 70 for 1 EURO. So the supply of raw material is worth INR 70 lacs. However, if the exchange rate changes to INR 71 for 1 EURO, then the raw material will cost you 71 lacs. Now, let’s again imagine that you expects that  the euro will increase in future. So, you will agree to buy euro on t oday’s exchange rate of  70. There is one risk though. You will lose if the exchange rate becomes INR 69 for 1 EURO. This strategy works very well in extremely volatile market. And when the parties require large amount in foreign trade. What’s in there for India? An important segment of the forex derivatives market in India is the Rupee forward contracts market. This has been growing rapidly with increasing participation from corporate, exporters, importers, banks and FIIs. Till Derivatives Markets in India: 2003 209 February 1992, forward contracts were permitted only against trade related e xposures and these contracts could not be cancelled except where the underlying transactions failed to materialize. In March 1992, in order to provide operational freedom to corporate entities, unrestricted booking and cancellation of forward contracts for all genuine exposures, whether trade related or not, were permitted. Although due to the Asian crisis, freedom to re-book cancelled contracts was suspended, which has been since relaxed for the exporters but the restriction still remains for the importers. Foreign Exchange Risk Management 

12

 Advantages--1. You are protected against any adverse movement in the exchange rate. 2. You can set budgets because you know what will be the transaction costs as you know the exchange rate. Disadvantages--1. If you enter into such a contract, you have to perform your promise; otherwise, you will be prosecuted. If any adverse circumstances occur, you are grilled. 2. Because the rate is fixed, you cannot benefit by the favorable change in the exchange rate. One of the major issues that need to be addressed in the forward market relates to depth and liquidity. The forward market in our country was active only up to six months, where two-way quotes are available. As a result of the initiatives of the RBI, the maturity profile has elongated and now there are quotes available up to one year. Understandably, in most of markets where there are restrictions on capital movements, liquidity across the spectrum as seen in the developed markets, proves to be difficult at least in the early stages of development of the market. The question that we would need to address is within these constraints, how can the liquidity improve? Currency futures Indian forwards market is relatively illiquid for the standard maturity contracts as most of the contracts traded are for the month ends only. One of the reasons for the market  makers’ reluctance to offer these contracts could be the absence of well-developed term money market. It could be argued that given the future like nature of Indian forwards market, currency futures could be allowed. Some of the benefits provided by the futures are as follows: 1. Currency futures, since they are traded on organized exchanges, also confer benefits from concentrating order flow and providing a transparent venue for price discovery, while over-the-counter forward contracts rely on bilateral negotiations. 2. Two characteristics of futures contract- their minimal margin requirements and the low transactions costs relative to over-the-counter markets due to existence of a clearinghouse, also strengthen the case of their introduction.

Foreign Exchange Risk Management 

13

3. Credit risks are further mitigated by daily marking to market of all futures positions with gains and losses paid by each participant to the clearinghouse by the end of  trading session. 4. Moreover, futures contracts are standardized utilizing the same delivery dates and the same nominal amount of currency units to be traded. Hence, traders need only establish the number of contracts and their price. 5. Contract standardization and clearing house facilities mean that price discovery can proceed rapidly and transaction costs for participants are relatively low.

However, given the status of convertibility of Rupee whereby residents cannot freely transact in currency markets, the introduction of futures may have to wait for further liberalization on the convertibility.

Currency Options and Swaps A currency option is a contract that gives the owner the right, but not the obligation, to buy or sell a given quantity of a foreign currency for a specified amount of the domestic currency on or before a specified date in the future. A call currency option is an option to buy and a put currency option is an option to sell the foreign currency at the stated (exercise) price. Being rational, the option buyer would only exercise the option when it is to his advantage to do so; if not, he would let it expire. Since the option provides the buyer with a type of insurance, we would expect him to pay a price for it. This price is called the option premium. American options can be exercised at any time at or prior to the end of the contract, while European options can only be exercised at the expiration date of the contract. A currency swap involves the exchange of the principal and interest payments of a liability denominated in one currency for the principal and interest payments of a liability denominated in another currency. Currency swaps can be fixed-for-fixed, fixed-for-floating, or floating-for-floating rate debt service. Mechanics and Purposes of Currency Options and Swaps Both currency options and swaps are frequently used to hedge foreign exchange exposure, i.e., to protect the option buyer and the swap parties against adverse movements in foreign exchange rates. The difference between them is that currency options seldom have terms longer than a few years, while currency swaps can be used to hedge long-term foreign exchange risk. Let us look at some examples to illustrate the hedging purpose of currency options and swaps. Foreign Exchange Risk Management 

14

Suppose that Can, a Canadian company is due to pay Brit, a British company, $100,000 in three months to pay for raw materials. The current spot exchange rate is $2/$1. Can can hedge this transaction by buying call options for the delivery of $100,000 in three months at a specified rate, say, $2.1/$1. This approach guarantees that the cost of the $100,000 will not exceed $210,000 in any event, while simultaneously allows Can to benefit  should the pound depreciates. The cost of this flexibility is the premium that Can pays for the calls. An example of a currency swap is a bit more involving.2 Suppose that Can has a British subsidiary, BritSub, which needs $100,000 for its 3-year expansion project in the U.K. One option for Can is to buy $100,000 in the spot market at a price of $200,000, which can be raised in the Canadian capital market by issuing 3-year bonds at 5%. Then, during the next 3 years, it  will use BritSub's revenues to pay interests of $10,000 at each year-end and repay the $200,000 principal at the end of year 3. Revenues in pounds are translated using the spot rates at the times these payments are due. Therefore, if the pound depreciates dramatically against the dollar, BritSub may have to generate a substantial amount of revenues in pounds to be able to service the dollar-denominated debt. Alternatively, Can can raise the $100,000 directly in the international capital market or British capital market by issuing pound-denominated bonds. Suppose that Can is not well- known and thus can only borrow the money at a rate of 8%, whereas the current normal borrowing rate for a well-known firm of equivalent  creditworthiness is 7%. Suppose further that Brit and its Canadian subsidiary, CanSub, have mirror-image financing needs. CanSub needs $200,000 to finance its expansion project in Canada with a 3-year economic life. Brit can raise $100,000 in the British capital market at 7%, or alternatively, it can raise $200,000 in the international or Canadian capital market at a rate of 6%, higher than the 5% at which Can can borrow in these markets. A currency swap, normally arranged by a swap bank, will solve the double problem of Can and Brit. The swap bank would instruct Can to raise the $200,000 at 5% in the Canadian capital market and Brit to raise the $100,000 at 7% in the British capital market. The two firms would then exchange these principals through the swap bank. At the end of  each year, Can would use $7,000 generated by BritSub and Brit would use $10,000 generated by CanSub to make interest payments through the swap bank. At the end of year 3, the $100,000 and $200,000 are paid back through the swap bank. As can be seen, the swap helps Can and Sub avoids the foreign exchange risk by effectively locking them into a series of future exchange rates. The two firms also benefit from the cost savings as a result  of the comparative advantage of Can and Sub in their respective national capital markets. Besides serving as effective hedging mechanism, currency options and swaps are sometimes used for speculative purposes. It should be noted that using foreign exchange derivatives for speculative purposes is extremely risky. Foreign Exchange Risk Management 

15

Currency Options and Swaps Market Statistics Currency options are traded on both derivatives exchanges and OTC markets. In the U.S., foreign currency options have traded on the Philadelphia Stock Exchange since December 1982. Exchange-traded currency options are normally written for American dollars, with the euro and five other major currencies3 serving as the underlying currencies. OTC options are also written on the major seven and sometimes less actively traded currencies. OTC options can be tailor-made, but generally are written for large a mounts4 and typically European style. The volume of OTC currency options trading is much larger than that of organized-exchange option trading. According to the 2004 Bank of  International Settlements (BIS) Survey, the OTC currency option daily volume alone was approximately $117 billion, a 95% growth rate since 2001, while the total daily volume of  exchange-traded currency contracts was only $10 billion. Unlike currency options, currency swaps are only traded on OTC markets. According to the International Swaps and Derivatives Association, Inc., from 1991 to 2002, total outstanding currency swaps increased 400%, from $807 billion to over $4.5 trillion.5 Furthermore, the aforementioned 2004 BIS Survey reported that the increase in turnover from 2001 to 2004 was particularly large for currency swaps, up by 200%, although the size of this market remains relatively small compared to other currency derivative products. The five most common currencies used to denominate currency swaps are the U.S. dollar, euro, Japanese yen, British pound, and Swiss franc. The types of counterparties entering currency options and swaps are quite diverse, including local and cross-border reporting dealers, other financial institutions, and non-financial dealers. The 2004 BIS Survey reported expanded business for all types of counterparties during the 2001-04 periods. Galati and Melvin (2004) proposed several factors that may explain this surge in the currency derivatives market during the 2001-04 periods. Firstly, there existed clear, British pound, Australian dollar, Canadian dollar, Japanese yen and Swiss franc At least U.S. $1,000,000 of the currency serving as the underlying asset. Size of swap markets is measured by notional principal for interest rate swaps and principal for currency swaps. Secondly, higher volatility foreign exchange markets induced an increase in currency hedging activity. Thirdly, this period was also marked with interest differentials, which encouraged investors to borrow in low interest rate currencies to invest in high interest  rate currencies if the target currencies tended to appreciate against the funding currencies. All of these factors encouraged both speculative strategies and hedging activity in the foreign ex- change market.

Foreign Exchange Risk Management 

16

Valuation of Currency Options and Swaps A currency option can be valued using either the binomial (for American options) or the Black-Scholes (for European options) option pricing model. The formulae are quite complex and discussing them in detail is out of the scope of this paper. However, it should be noted that the value of a currency option at time t is a function of the following five variables: The spot exchange rate at time t, the exercise price, the domestic and foreign interest rates, and the term to maturity of the option. The value of a currency swap is the present value of the cash flows that a party is to pay and receive in the swap agreement  discounted at proper discount rates, with the cash flows in the foreign currency converted to the domestic currency at the spot rate. Alternatively, a currency swap can be thought of as a portfolio of forward contracts maturing at different dates and can be priced as such.

Example of swap A Foreign Exchange Swap transaction allows you to utilize the funds you have in one currency to fund obligations denominated in a different currency, without incurring foreign exchange risk. It is an effective and efficient cash management tool for companies that have assets and liabilities denominated in different currencies. On the near date, you swap one currency for another at an agreed foreign exchange rate a nd agree to swap the currencies back again on a future (far) date at a price agreed upon at the inception of the swap. In most cases, currencies are initially swapped at the spot rate and the future (far) rate is calculated by adjusting the spot price by the forward points for the length of time the swap transaction runs for. The SolutionIn the situation outlined above, you would agree to sell the EUR to the bank, at the spot rate of 0.90. A full exchange of funds takes place on the near date and you would deliver EUR 500,000 to the bank. In return the bank will deliver USD 450,000 to you on the near date (typically but not always the spot date). At the same time you would agree to buy back the EUR and send back the USD in three months time at a spot price of 0.90, adjusted for forward points of -. 0045, for a forward price of 0.8955. In this case, on the future (far) date the bank would return the EUR 500,000 and you would send the bank USD 447,750. The forward points adjustment is easily explained and calculated. In this case, assume the prevailing interest rate in Europe is 5% and in the United States are 3%. By entering into the foreign exchange swap with the bank you are giving them the use of a currency which they could invest at 5% and in return they are giving you the use of USD which you could only invest at 3%. The purpose of the forward point’s adjustment is to equalize this interest rate differential and compensate you for 'giving up' or 'receiving' the higher interest bearing currency.

Foreign Exchange Risk Management 

17

The forward points are easy to calculate and a simple method is outlined below: Near Date On the near date the Bank receives EUR 500k and pays you $450k. $450k divided by EUR 500k =Spot Exchange Rate of 0.9000 In the three month period the bank could earn 5% interest on the EUR 500k for three months = EUR 6,250 In the three month period you could earn 3% interest on the $450k for three months =$3,375 At the end of the period the bank would have EUR 506,250 At the end of the period you would have USD 453,375 Far Date $453,375 divided by EUR 506,250 = Exchange Rate of 0.8955 Bank returns the EUR 500k to you at the agreed upon rate of 0.8955 and you send the bank USD 447,750** ** The $2,250 “gain” you made on the transaction described above is simply the monetized difference between the interest rates in the two countries/currencies. 2% earnings on EUR500k for three months translated back to USD is $2,250. In cases where your surplus funds are in a currency with a low interest rate and your funding need is in a country with a higher interest rate environment, the forward points will be “against you” and the “gain” in the example above would be reversed.

INDIAN MARKET CONCERNS RUPEE CURRENCY OPTIONS Corporate in India can use instruments such as forwards, swaps a nd options for hedging cross-currency exposures. However, for hedging the USD-INR risk, corporate is restricted to the use of forwards and USDINR swaps. Introduction of USD-INR options would enable Indian forex market participants manage their exposures better by hedging the dollar-rupee risk. The advantages of currency options in dollar rupee would be as follows: 1. Hedge for currency exposures to protect the downside while retaining the upside, by paying a premium upfront. This would be a big advantage for impo rters, exporters (of both goods and services) as well as businesses with exposures to international prices. Currency options would enable Indian industry and businesses to compete better in the international markets by hedging currency risk.

Foreign Exchange Risk Management 

18

2. Non-linear payoff of the product enables its use as hedge for various special cases and possible exposures. e.g. If an Indian company is bidding for an international assignment where the bid quote would be in dollars but the costs would be in rupees, then the company runs a risk till the contract is awarded. Using forwards or currency swaps would create the reverse positions if the company is not allotted the contract, but the use of an option contract in this case would freeze the liability only to the option premium paid up front. 3. The nature of the instrument again makes its use possible as a hedge against  uncertainty of the cash flows. Option structures can be used to hedge the volatility along with the non-linear nature of payoffs. 4. Attract further forex investments due to the availability of another mechanism for hedging forex risk.

Hence, introduction of USD-INR options would complete the spectrum of derivative products available to hedge INR currency risk. FOREIGN CURRENCY – RUPEE SWAPS Another spin-off of the liberalization and financial reform was the development of a fledgling market in FC-RE swaps. A fledgling market in FC-RE swaps started with foreign banks and some financial institutions offering these products to corporate. Initially, the market was very small and two way quotes were quite wide, but the market started developing as more market players as well as business houses started understanding these products and using them to manage their exposures. Corporate started using FC-RE swaps mainly for the following purposes: 



Hedging their currency exposures (ECBs, forex trade, etc.) To reduce borrowing costs using the comparative advantage of borrowing in local markets (Alternative to ECBs – Borrow in INR and take the swap route to take exposure to the FC currency)

The market witnessed expanding volumes in the initial years with volumes up to US$ 800 million being experienced at the peak. Corporate were actively exploring the swap market in its various variants (such as principal only and coupon only swaps), and using the route not only to create but also to extinguish forex exposures. However, the regulator was worried about the impact of these transactions on the local forex markets, since the spot and forward markets were being used to hedge these swap transactions.

Foreign Exchange Risk Management 

19

So the RBI tried to regulate the spot impact by passing the below regulations: 





The authorized dealers offering swaps to corporate should try and match demand between the corporate The open position on the swap book and the access to the interbank spot market  because of swap transaction was restricted to US$ 10 million The contract if cancelled is not allowed to be re-booked or re-entered for the same underlying.

The above regulations led to a constriction in the market because of the one-sided nature of the market. However, with a liberalizing regime and a buildup in foreign exchange reserves, the spot access was initially increased to US$ 25 million and then to US$ 50 million. The authorized dealers were also allowed the use of currency swaps to hedge their asset liability portfolio. The above developments are expected to result in increased market activity with corporate being able to use the swap route in a more flexible manner to hedge their exposures. A necessary pre-condition to increased liquidity would be the further development and increase in participants in the rupee swap market (linked to MIFOR) thereby creating an efficient hedge market to hedge rupee interest rate risk. USE OF VARIOUS INSTRUMENTS The pie chart shows breakup of the whole market hedging done by major Indian companies. These companies include Reliance, Maruti-Suzuki, Mahindra & Mahindra, Arvind Mills, Infosys, Tata Consultancy Services, Dr. Reddy’s Lab and Ranbaxy.

Hedging by leading Companies (in Rs.)

8743.253 Options

12478.405

Currency swaps Forward

1625.64

Foreign Exchange Risk Management 

20

Forward contracts are most suitable for the companies. There is data to support this argument. As in the above showed pie chart, forward contracts have got the lion’s share, which is not less than 55% of the total market. Reason —it provides surety about the future price and, as seen recently, it has been increasing like hell. The pie consists of 38.53% part  of Options. Swaps are less popular as they obtain only 6.02% of the whole market. In recent  times the rupee has experienced the highest level of value erosion. In fact, it hit the lowest  point of its life, around INR 55 needed to buy just 1 USD. There were two reason mostly affected to rupee. First is the level of inflation in the country. It remained nearly double digit whole year. The higher the inflation, the lower the purchasing power of the currency and the lower the value of currency. Second, the plight of the Eurozone economy. As the Eurozone is performing below the expectations, people are losing faith in it. Due to that, USD is looking very attractive currency to invest. Because of this reason, the value of dollar is increasing. So does its price in other currency terms. From pie chart, it can be seen that earnings of all the firms are linked to either US dollar, Euro or Pound as firms transact primarily in these foreign currencies globally. Forward contracts are commonly used and among these firms, Ranbaxy and RIL depend heavily on these contracts for their hedging requirements. As discussed ea rlier, forwards contracts can be tailored to the exact needs of the firm and this could be the reason for their popularity. The tailorability is a consideration as it enables the firms to match their exposures in an exact manner compared to exchange traded derivatives like futures that  are standardized where exact matching is difficult. RIL, Maruti Udyog and Mahindra and Mahindra are the only firms using currency swaps. Swap usage is a long term strategy for hedging and suggests that the planning horizons for these companies are longer than those of other firms. These businesses, by nature involve longer gestation periods and higher initial capital outlays and this could explain their long planning horizons. Another observation is that TCS prefers to hedge its exposure to the US Dollar through options rather than forwards. This strategy has been observed among many firms recently in India. This has been adopted due to the marked high volatility of the US Dollar against the Rupee. Options are more profitable instruments in volatile conditions as they offer unlimited upside profitability while hedging the downside risk whereas there is a risk with forwards if the expectation of the exchange rate (the guess) is wrong as firms lose out on some profit. The use of Range barrier options by Infosys also suggests a strategy to tackle the high volatility of the dollar exchange rates. Software firms have a limited domestic market and rely on exports for the major part of their revenues and hence require additional flexibility in hedging when the volatility is high. Another implication of this is that their planning horizons are shorter compared to capital intensive firms. It is evident that most Indian firms use forwards and options to Foreign Exchange Risk Management 

21

hedge their foreign currency exposure. This implies that these firms chose short-term measures to hedge as opposed to foreign debt. This preference is possibly a consequence of  their costs being in Rupees, the absence of a Rupee futures exchange in India and curbs on foreign debt. It also follows that most of these firms behave like Net Exporters and are adversely affected by appreciation of the local currency. There are a few firms which have import liabilities which would be adversely affected by Rupee depreciation. However, it must be pointed out that the data set considered for this study does not  indicate how the use of foreign debt by these firms hedges their exposures to foreign exchange risk and whether such a strategy is used as a substitute or complement to hedging with derivatives. INTERNATIONAL CONCERNS Derivatives contracts are increasing to $111 trillion at end-December 2001 from $94 trillion at end-June 2000. This growth in the derivatives segment is even more substantial when viewed in the light of declining activity in the spot foreign exchange markets. The turnover in traditional foreign exchange markets declined substantially between 1998 and 2001. In April 2001, average daily turnover was $1,200 billion, compared to $1,490 billion in April 1998, 14 percent decline when volumes are measured at constant exchange rates. Whereas the global daily turnover during the same period in foreign exchange and interest rate derivative contracts, including what are considered to be “traditional” foreign exchange derivat ive instruments, increased by an estimated 10 percent to $1.4 trillion. One bank did the survey, as it does every year. The findings of the survey are presented in the table and the chart on the next page. Total forex instrument market is climbing though, not steadily. With it percentage changes are also shown.

YEAR FOREX INSTRUMENTS USUANCE % CHANGE

1998 1527

2001 1239

2004 1934

2007 3324

2010 3981

0

-18.86

56.09

71.87

19.76

Foreign Exchange Risk Management 

22

Global Forex Market T/O USD forex instruments 4500 4000     D3500     S     U3000    n2500     i    t    n2000    u    o1500    m     A1000 500 0

% change 80%

72%

60%

56%

40% 20% 20% 0%

0% -19%

-20% -40%

1998

2001

2004

2007

2010

Year

Only once it has declined! In span of just a decade, it has been become more than doubled. However, its rocketing is not steady. It has declined once during the year of 2001. Since then, just see at  the graph! Even the growth rate is increasing. That means it is increasing with increasing propensity. Tough it is growing, the Recession did not spare it from its spat. Its growth rate has been slowed down from 72% in 2007 to 20% in 2010. Some analysts even believe this market itself is the culprit for the recent downturn. How ironic! The saver itself is the hunter.

Situation of different instruments in 2010 (amount in USD) INSTRUMENT/YEAR SPOT TRANSACTION OUTRIGHT FORWARD FOREIGN EXCHANGE SWAPS CURRENCY SWAPS OPTIONS OTHER PRODUCTS

2010 1490 475 1765 43 207

Foreign Exchange Risk Management 

23

How is it in 2010 43 207 spot trancsation

1490

outright forward 1765

foreign exchange swaps 475

currency swaps options other products

In 2010, the picture seems to be a little rejoiced. However, if see overall, the market  is contracted by 20%. And by the size of the market, 20% is like a fortune. Currency swaps remained to be least used instrument. On the contrary, Foreign Exchange Contracts are as popular as before. The reasons remain the same as above stated. The inflation and the predicament of the Eurozone. To know what the situation of these instruments in previous year was, we will have to consult the past data and it is in the table. (Amount in USD) INSTRUMENT/YEAR SPOT TRANSACTION OUTRIGHT FORWARD FOREIGN EXCHANGE SWAPS CURRENCY SWAPS OPTIONS & OTHER PRODUCTS

1998 568 128 734

2001 386 130 656

2004 631 209 954

2007 1005 362 1714

2010 1490 475 1765

10 87

7 60

21 119

31 212

43 207

Each type of instrument has shown tendency to increase. But the last one named OPTIONS & OTHER PRODUCTS has managed to come as underdog. Due to traders’ trust  towards other instruments like Spot Transaction, Outright Forward etc. the market is growing. This shows that the dynamism is working and companies are very well aware and Foreign Exchange Risk Management 

24

armed to confront the situation. Spot Transaction is popular because of various money changers such as Western Union Money Transfer. CONCLUSION This is how the forex market in the world works. Such instrument provides an ozone layer against the exposure of forex market’s ‘ultra violet rays’. There are many national and international regulatory and agencies in the world which keeps hawk eye on such transactions. In India, SEBI and RBI work in tandem to curb malpractices of the market. On bigger and higher level, there is BIS (as well as WTO, to the some extent) to take care of the ‘bullies’ of the market. They have devised a very good mechanism to t ackle with the operations. The inspector is placed in every market. But, we don’t have any reason to believe that they are working properly, because, the brokers of the market has ‘christened’ them as Helen, after the dumb and deaf Helen Keller. That is the reason why though taking every type of protection companies have felt the heat of the global meltdown at their bottoms.

Foreign Exchange Risk Management 

25

BIBLIOGRAPHY  1. www.rbi.org.in 2. www.bis.com 3. www.finmin.nic.in 4. www.commerce.nic.in 5. www.imf.com 6.

Foreign Exchange Risk Management 

26

View more...

Comments

Copyright ©2017 KUPDF Inc.
SUPPORT KUPDF