Forex Summer Project
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Overview On FOREX Management
A PROJECT REPORT Submitted by Chirag Shah Batch 2009-2011 in partial fulfillment for the award of the degree
POST GRADUATE DIPLOMA IN MANAGEMENT
Under the Guidance of
Prof Aditi Mahajan THAKUR INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH KANDIVILI MUMBAI
Thakur Institute Of Management Studies And Research
ACKNOWLEDGEMENT Two months of summer training at Anugrah Stock & Broking Pvt Ltd. has been a great value addition to my career that would not have been possible without continuous guidance and administration of certain key people. I would like to place on record, my sincere gratitude to each of them. I am grateful to Dr. Mrinalini Kohojkar, Director, Thakur Institute Of Management Studies and Research for giving me this opportunity. I would like to express my appreciation towards Mr. Balkishan Sharma for giving me the opportunity to work on this project. I express my gratitude and indebtedness to him for guiding me in every aspect for making this effort a great success. I sincerely thank Prof. Aditi Mahajan, Thakur Institute Of Management Studies and Research for the valuable guidance extended by them during my entire course in the preparation of this dissertation and for letting me their valuable time when ever I was in need.
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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.
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Contents ...............................................................................................................................................................1 Contents................................................................................................................................................4 Foreign Exchange Market Overview....................................................................................................5 Forex Market: A Historical Perspective...............................................................................................8 Basic Concepts in Forex Trading.......................................................................................................12 :............................................................................................................................................................12 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.........................................................................................................................21 Foreign Exchange Market Structure...................................................................................................23 Fundamentals in Exchange Rate........................................................................................................24 Factors Affecting Exchange Rates.....................................................................................................25 Sources of Supply and Demand in the Foreign exchange.................................................................27 Corporate Hedging for Foreign Exchange Risk in India...................................................................31 Foreign Exchange Risk Management Framework.............................................................................37 Hedging Strategies/ Instruments.........................................................................................................39 Determinants of Hedging Decisions...................................................................................................42 An Overview of Corporate Hedging in India.....................................................................................44 Currency Risk Management...............................................................................................................49
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Foreign Exchange Market 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 Thakur Institute Of Management Studies And Research
In today’s 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 country’s 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, traveler’s 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 Thakur Institute Of Management Studies And Research
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/c’s 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 Thakur Institute Of Management Studies And Research
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 India’s 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
Forex Market: A Historical Perspective Early Stages: 1947-1977 The evolution of India’s foreign exchange market may be viewed in line with the shifts in India’s exchange rate policies over the last few decades from a par value system to a basket-peg and further to a managed float exchange rate system. During the period from 1947 to 1971, India Thakur Institute Of Management Studies And Research
followed the par value system of exchange rate. Initially the rupee’s external par value was fixed at 4.15 grains of fine gold. The Reserve Bank maintained the par value of the rupee within the permitted margin of ±1 per cent using pound sterling as the intervention currency. Since the sterling-dollar exchange rate was kept stable by the US monetary authority, the exchange rates of rupee in terms of gold as well as the dollar and other currencies were indirectly kept stable. The devaluation of rupee in September 1949 and June 1966 in terms of gold resulted in the reduction of the par value of rupee in terms of gold to 2.88 and 1.83 grains of fine gold, respectively. The exchange rate of the rupee remained unchanged between 1966 and 1971 (Chart VI.1). Given the fixed exchange regime during this period, the foreign exchange market for all practical purposes was defunct. Banks were required to undertake only cover operations and maintain a ‘square’ or ‘near square’ position at all times. The objective of exchange controls was primarily to regulate the demand for foreign exchange for various purposes, within the limit set by the available supply. The Foreign Exchange Regulation Act initially enacted in 1947 was placed on a permanent basisin 1957. In terms of the provisions of the Act, the Reserve Bank, and in certain cases, the Central Government controlled and regulated the dealings in foreign exchange payments outside India, export and import of currency notes and bullion, transfers of securities between residents and non-residents, acquisition of foreign securities, etc3 . With the breakdown of the Bretton Woods System in 1971 and the floatation of major currencies, the conduct of exchange rate policy posed a serious challenge to all central banks world wide as currency fluctuations opened up tremendous opportunities for market players to trade in currencies in a borderless market. In December 1971, the rupee was linked with pound sterling. Since sterling was fixed in terms of US dollar under the Smithsonian Agreement of 1971, the rupee also remained stable against dollar. In order to overcome the weaknesses associated with a single currency peg and to ensure stability of the exchange rate, the rupee, with effect from September 1975, was pegged to a basket of currencies. The currency selection and weights assigned were left to the discretion of the Reserve Bank. The currencies included in the basket as well as their relative weights were kept confidential in order to discourage speculation. It was around this time that banks in India became interested in trading in foreign exchange Formative Period: 1978-1992 The impetus to trading in the foreign exchange market in India came in 1978 when banks in India were allowed by the Reserve Bank to undertake intra-day trading in foreign exchange and were required to comply with the stipulation of maintaining ‘square’ or ‘near square’ position only at the close of business hours each day. The extent of position which could be left uncovered overnight (the open position) as well as the limits up to which dealers could trade during the day were to be decided by the management of banks. The exchange rate of the rupee during this period was officially determined by the Reserve Bank in terms of a weighted basket of currencies of India’s major trading partners and the exchange rate regime was characterised by daily announcement by the Reserve Bank of its buying and selling rates to the Authorised Dealers (ADs) Thakur Institute Of Management Studies And Research
for undertaking merchant transactions. The spread between the buying and the selling rates was 0.5 per cent and the market began to trade actively within this range. ADs were also permitted to trade in cross currencies (one convertible foreign currency versus another). However, no ‘position’ in this regard could originate in overseas markets. As opportunities to make profits began to emerge, major banks in India started quoting two way prices against the rupee as well as in cross currencies and, gradually, trading volumes began to increase. This led to the adoption of widely different practices (some of them being irregular) and the need was felt for a comprehensive set of guidelines for operation of banks engaged in foreign exchange business. Accordingly, the ‘Guidelines for Internal Control over Foreign Exchange Business’, were framed for adoption by the banks in 1981. The foreign exchange market in India till the early 1990s, however, remained highly regulated with restrictions on external transactions, barriers to entry, low liquidity and high transaction costs. The exchange rate during this period was managed mainly for facilitating India’s imports. The strict control on foreign exchange transactions through the Foreign Exchange Regulations Act (FERA) had resulted in one of the largest and most efficient parallel markets for foreign exchange in the world, i.e., the hawala (unofficial) market. By the late 1980s and the early 1990s, it was recognized that both macroeconomic policy and structural factors had contributed to balance of payments difficulties. Devaluations by India’s competitors had aggravated the situation. Although exports had recorded a higher growth during the second half of the 1980s (from about 4.3 per cent of GDP in 1987-88 to about 5.8 per cent of GDP in 1990-91), trade imbalances persisted at around 3 percent of GDP. This combined with a precipitous fall in invisible receipts in the form of private remittances, travel and tourism earnings in the year 1990-91 led to further widening of current account deficit. The weaknesses in the external sector were accentuated by the Gulf crisis of 1990-91. As a result, the current account deficit widened to 3.2 per cent of GDP in 1990-91 and the capital flows also dried up necessitating the adoption of exceptional corrective steps. It was against this backdrop that India embarked on stabilisation and structural reforms in the early 1990s. Post-Reform Period: 1992 onwards This phase was marked by wide ranging reform measures aimed at widening and deepening the foreign exchange market and liberalisation of exchange control regimes. A credible macroeconomic, structural and stabilization programme encompassing trade, industry, foreign investment, exchange rate, public finance and the financial sector was put in place creating an environment conducive for the expansion of trade and investment. It was recognised that trade policies, exchange rate policies and industrial policies should form part of an integrated policy framework to improve the overall productivity, competitiveness and efficiency of the economic system, in general, and the external sector, in particular. As a stabilsation measure, a two step downward exchange rate adjustment by 9 per cent and 11 per cent between July 1 and 3, 1991 was resorted to counter the massive drawdown in the foreign exchange reserves, to instill confidence Thakur Institute Of Management Studies And Research
among investors and to improve domestic competitiveness. A two-step adjustment of exchange rate in July 1991 effectively brought to close the regime of a pegged exchange rate. After the Gulf crisis in 1990-91, the broad framework for reforms in the external sector was laid out in the Report of the High Level Committee on Balance of Payments (Chairman: Dr. C. Rangarajan). Following the recommendations of the Committee to move towards the market-determined exchange rate, the Liberalised Exchange Rate Management System (LERMS) was put in place in March 1992 initially involving a dual exchange rate system. Under the LERMS, all foreign exchange receipts on current account transactions (exports, remittances, etc.) were required to be surrendered to the Authorised Dealers (ADs) in full. The rate of exchange for conversion of 60 per cent of the proceeds of these transactions was the market rate quoted by the ADs, while the remaining 40 percent of the proceeds were converted at the Reserve Bank’s official rate. The ADs, in turn, were required to surrender these 40 per cent of their purchase of foreign currencies to the Reserve Bank. They were free to retain the balance 60 per cent of foreign exchange for selling in the free market for permissible transactions. The LERMS was essentially a transitional mechanism and a downward adjustment in the official exchange rate took place in early December 1992 and ultimate convergence of the dual rates was made effective from March 1, 1993, leading to the introduction of a market-determined exchange rate regime. The dual exchange rate system was replaced by a unified exchange rate system in March 1993, whereby all foreign exchange receipts could be converted at market determined exchange rates. On unification of the exchange rates, the nominal exchange rate of the rupee against both the US dollar as also against a basket of currencies got adjusted lower, which almost nullified the impact of the previous inflation differential. The restrictions on a number of other current account transactions were relaxed. The unification of the exchange rate of the Indian rupee was an important step towards current account convertibility, which was finally achieved in August 1994, when India accepted obligations under Article VIII of the Articles of Agreement of the IMF. With the rupee becoming fully convertible on all current account transactions, the risk-bearing capacity of banks increased and foreign exchange trading volumes started rising. This was supplemented by wide-ranging reforms undertaken by the Reserve Bank in conjunction with the Government to remove market distortions and deepen the foreign exchange market. The process has been marked by ‘gradualism’ with measures being undertaken after extensive consultations with experts and market participants. The reform phase began with the Sodhani Committee (1994) which in its report submitted in 1995 made several recommendations to relax the regulations with a view to vitalising the foreign exchange market. In addition, several initiatives aimed at dismantling controls and providing an enabling environment to all entities engaged in foreign exchange transactions have been undertaken since the mid-1990s. The focus has been on developing the institutional framework and increasing the instruments for effective functioning, enhancing transparency and liberalising the conduct of Thakur Institute Of Management Studies And Research
foreign exchange business so as to move away from micro management of foreign exchange transactions to macro management of foreign exchange flows (Box VI.3). An Internal Technical Group on the Foreign Exchange Markets (2005) set up by the Reserve Bank made various recommendations for further liberalisation of the extant regulations. Some of the recommendations such as freedom to cancel and rebook forward contracts of any tenor, delegation of powers to ADs for grant of permission to corporates to hedge their exposure to commodity price risk in the international commodity exchanges/markets and extension of the trading hours of the inter-bank foreign exchange market have since been implemented. Along with these specific measures aimed at developing the foreign exchange market, measures towards liberalising the capital account were also implemented during the last decade, guided to a large extent since 1997 by the Report of the Committee on Capital Account Convertibility (Chairman: Shri S.S. Tarapore). Various reform measures since the early 1990s have had a profound effect on the market structure, depth, liquidity and efficiency of the Indian foreign exchange market.
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: Thakur Institute Of Management Studies And Research
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.
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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
Currency Exchanges in India: 1. MCX Stock Exchange (MCX – SX)
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2. National Stock Exchange (NSE) 3. United Stock Exchange (USE)
The daily turnover of NSE and MCX – SX together is around 30,000 cr.
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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. Thakur Institute Of Management Studies And Research
Foreign Exchange Management Act, 1999 The change in the entire approach towards exchange control regulation has been the result of the replacement of the Foreign Exchange Regulation Act, 1973, by the Foreign Exchange Management Act, 1999. The latter came into effect from June 1, 2000. The change in the preamble itself signifies the dramatic change in approach -- from "for the conservation of the foreign exchange resources" in FERA 1973, to "facilitate external trade and payments" under FEMA 1999. Any FEMA violations are civil, not criminal, offences, attracting monetary penalties, and not arrests or imprisonment. The scheme of FEMA and the notifications issued thereunder take into the account the convertibility of the rupee for all current account transactions. Indeed, there is now general freedom to authorised dealers to sell currency for most current account transactions. One old limitation continues. All transactions in foreign exchange have to be with authorised dealers, i.e. banks authorised to act as dealers in foreign exchange by the Reserve Bank. The original rules, regulations, notifications, etc., under FEMA are contained in the A.D. (M.A. series) Circular No. 11 of May 16, 2000. Subsequent circulars have been issued under the A.P. (DIR series) nomenclature. It is obviously impossible to incorporate all the current regulations in a book of this type, particularly since the regulations keep changing. An outline of the basic framework of exchange control under FEMA is in Annexure 5.3. But its contents should not be considered as either definitive or current and those interested need to keep up with the various circulars and other communications on the subject.
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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
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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: Thakur Institute Of Management Studies And Research
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. Corporation’s 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 Thakur Institute Of Management Studies And Research
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 Thakur Institute Of Management Studies And Research
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.
Foreign Exchange Market Structure Market Segments Foreign exchange market activity in most EMEs takes place onshore with many countries prohibiting onshore entities from undertaking the operations in offshore markets for their currencies. Spot market is the predominant form of foreign exchange market segment in Thakur Institute Of Management Studies And Research
developing and emerging market countries. A common feature is the tendency of importers/exporters and other end-users to look at exchange rate movements as a source of return without adopting appropriate risk management practices. This, at times, creates uneven supplydem and conditions, often based on ‘‘news and views’’. The lack of forward market development reflects many factors, including limited exchange rate flexibility, the de facto exchange rate insurance provided by the central bank through interventions, absence of a yield curve on which to base the forward prices and shallow money markets, in which market-making banks can hedge the maturity risks implicit in forward positions (Canales-Kriljenko, 2004). Most foreign exchange markets in developing countries are either pure dealer markets or a combination of dealer and auction markets. In the dealer markets, some dealers become market makers and play a central role in the determination of exchange rates in flexible exchange rate regimes. The bidoffer spread reflects many factors, including the level of competition among market makers. In most of the EMEs, a code of conduct establishes the principles that guide the operations of the dealers in the foreign exchange markets. It is the central bank, or professional dealers association, which normally issues the code of conduct (Canales-Kriljenko, 2004). In auction markets, an auctioneer or auction mechanism allocates foreign exchange by matching supply and demand orders. In pure auction markets, order imbalances are cleared only by exchange rate adjustments. Pure auction market structures are, however, now rare and they generally prevail in combination with dealer markets. The Indian foreign exchange market is a decentralised multiple dealership market comprising two segments – the spot and the derivatives market. In the spot market, currencies are traded at the prevailing rates and the settlement or value date is two business days ahead. The two-day period gives adequate time for the parties to send instructions to debit and credit the appropriate bank accounts at home and abroad. The derivatives market encompasses forwards, swaps and options. Though forward contracts exist for maturities up to one year, majority of forward contracts are for one month, three months, or six months. Forward contracts for longer periods are not as common because of the uncertainties involved and related pricing issues. A swap transaction in the foreign exchange market is a combination of a spot and a forward in the opposite direction. As in the case of other EMEs, the spot market is the dominant segment of the Indian foreign exchange market. The derivative segment of the foreign exchange market is assuming significance and the activity in this segment is gradually rising.
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 Thakur Institute Of Management Studies And Research
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 two–way 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: Thakur Institute Of Management Studies And Research
• 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 today’s environment, the only ‘trustworthy’ method of predicting exchange rates by gut feel. Bob Eveling, vice president of financial markets at SG, is corporate finance’s top foreign exchange forecaster for 1999. eveling’s 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 eveling’s 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 currency’s 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 Thakur Institute Of Management Studies And Research
Speculation Technical factors
Sources of Supply and Demand in the Foreign exchange Exchange Market The major sources of supply of foreign exchange in the Indian foreign exchange market are receipts on account of exports and invisibles in the current account and inflows in the capital account such as foreign direct investment (FDI), portfolio investment, external commercial borrowings (ECB) and non-resident deposits. On the other hand, the demand for foreign exchange Thakur Institute Of Management Studies And Research
emanates from imports and invisible payments in the current account, amortization of ECB (including short-term trade credits) and external aid, redemption of NRI deposits and outflows on account of direct and portfolio investment. In India, the Government has no foreign currency account, and thus the external aid received by the Government comes directly to the reserves and the Reserve Bank releases the required rupee funds. Hence, this particular source of supply of foreign exchange is not routed through the market and as such does not impact the exchange rate. During last five years, sources of supply and demand have changed significantly, with large transactions emanating from the capital account, unlike in the 1980s and the 1990s when current account transactions dominated the foreign exchange market. The behavior as well as the incentive structure of the participants who use the market for current account transactions differs significantly from those who use the foreign exchange market for capital account transactions. Besides, the change in these traditional determinants has also reflected itself in enhanced volatility in currency markets. It now appears that expectations and even momentary reactions to the news are often more important in determining fluctuations in capital flows and hence it serves to amplify exchange rate volatility (Mohan, 2006a). On many occasions, the pressure on exchange rate through increase in demand emanates from “expectations based on certain news”. Sometimes, such expectations are destabilizing and often give rise to self-fulfilling speculative activities. Recognizing this, increased emphasis is being placed on the management of capital account through management of foreign direct investment, portfolio investment, external commercial borrowings, nonresident deposits and capital outflows. However, there are occasions when large capital inflows as also large lumpiness in demand do take place, in spite of adhering to all the tools of management of capital account. The role of the Reserve Bank comes into focus during such times when it has to prevent the emergence of such destabilising expectations. In such cases, recourse is undertaken to direct purchase and sale of foreign currencies, sterilisation through open market operations, management of liquidity under liquidity adjustment facility (LAF), changes in reserve requirements and signaling through interest rate changes. In the last few years, despite large capital inflows, the rupee has shown two - way movements. Besides, the demand/supply situation is also affected by hedging activities through various instruments that have been made available to market participants to hedge their risks.
Derivative Market Instruments Derivatives play a crucial role in developing the foreign exchange market as they enable market players to hedge against underlying exposures and shape the overall risk profile of participants in the market. Banks in India have been increasingly using derivatives for managing risks and have also been offering these products to corporates. In India, various informal forms of derivatives contracts have existed for a long time though the formal introduction of a variety of instruments in the foreign exchange derivatives market started only in the post-reform period, especially since the mid-1990s. Cross-currency derivatives with the rupee as one leg were introduced with some restrictions in April 1997. Rupee-foreign exchange options were allowed in July 2003. The foreign Thakur Institute Of Management Studies And Research
exchange derivative products that are now available in Indian financial markets can be grouped into three broad segments, viz., forwards, options (foreign currency rupee options and cross currency options) and currency swaps (foreign currency rupee swaps and cross currency swaps) Available data indicate that the most widely used derivative instruments are the forwards and foreign exchange swaps (rupee-dollar). Options have also been in use in the market for the last four years. However, their volumes are not significant and bid offer spreads are quite wide, indicating that the market is relatively illiquid. Another major factor hindering the development of the options market is that corporates are not permitted to write/sell options. If corporates with underlying exposures are permitted to write/sell covered options, this would lead to increase in market volume and liquidity. Further, very few banks are market makers in this product and many deals are done on a back to back basis. For the product to reachthe farther segment of corporates such as small and medium enterprises (SME) sector, it is imperative that public sector banks develop the necessary infrastructure and expertise to transact in options. In view of the growing complexity, diversity and volume of derivatives used by banks, an Internal Group was constituted by the Reserve Bank to review the existing guidelines on derivatives and formulate comprehensive guidelines on derivatives for banks With regard to forward contracts and swaps, which are relatively more popular instruments in the Indian derivatives market, cancellation and rebooking of forward contracts and swaps in India have beenregulated. Gradually, however, the Reserve Bank has been taking measures towards eliminating such regulations. The objective has been to ensure that excessive cancellation and rebooking do not add to the volatility of the rupee. At present, exposures arising on account of swaps, enabling a corporate to move from rupee to foreign currency liability (derived exposures), are not permitted to be hedged. While the market participants have preferred such a hedging facility, it is generally believed that equating derivedexposure in foreign currency with actual borrowing in foreign currency would tantamount to violation of the basic premise for accessing the forward foreign exchange market in India, i.e., having an underlying foreign exchange exposure. This feature (i.e., ‘the role of an underlying transaction in the booking of a forward contract’) is unique to the Indian derivatives market. The insistence on this requirement of underlying exposure has to be viewed against the backdrop of the then prevailing conditions when it was imposed. Corporates in India have been permitted increasing access to foreign currency funds since 1992. They were also accorded greater freedom to undertake active hedging. However, recognising the relatively nascent stage of the foreign exchange market initially with the lack of capabilities to handle massive speculation, the ‘underlying exposure’ criterion was imposed as a prerequisite. Exporters and importers were permitted to book forward contracts on the basis of a declaration of an exposure and on the basis of past performance. Eligible limits were gradually raised to enable corporates greater flexibility. The limits are computed separately for export and import contracts. Documents are required to be furnished at the time of maturity of the contract. Contracts booked in excess of 25 per cent of the eligible limit had Thakur Institute Of Management Studies And Research
to be on a deliverable basis and could not be cancelled. This relaxation has proved very useful to exporters of software and other services since their projects are executed on the basis of master agreements with overseas buyers, which usually do not indicate the volumes and tenor of the exports (Report of Internal Group on Foreign Exchange Markets, 2005). In order to provide greater flexibility to exporters and importers, as announced in the Mid-term review of the Annual Policy 2006-07, this limit has been enhanced to 50 per cent. Notwithstanding the initiatives that have been taken to enhance the flexibility for the corporates, the need is felt to review the underlying exposure criteria for booking a forward contract. The underlying exposure criteria enable corporates to hedge only a part of their exposures that arise on the basis of the physical volume of goods (exports/imports) to be delivered4. With the Indian economy getting increasingly globalised, corporates are also exposed to a variety of ‘economic exposures’ associated with the types of foreign exchange/commodity risks/ exposures arising out of exchange rate fluctuations. At present, the domestic prices of commodities such as ferrous and non-ferrous metals, basic chemicals, petro-chemicals, etc. are observed to exhibit world import parity. Given the two-way movement of the rupee against the US dollar and other currencies in recent years, it is necessary for the producer/ consumer of such products to hedge their economic exposures to exchange rate fluctuation. Besides, price-fix hedges are also available for traders globally. They enable importers/exporters to lock into a future price for a commodity that they plan to import/export without actually having a crystallised physical exposure to the commodity. Traders may also be affected not only because of changes in rupee-dollar exchange rates but also because of changes in cross currency exchange rates. The requirement of ‘underlying criteria’ is also often cited as one of the reasons for the lack of liquidity in some of the derivative products in India. Hence, a fixation on the ‘underlying criteria’ as India globalises may hinder the full development of the forward market. The requirement of past performance/underlying exposures should be eliminated in a phased manner. This has also been the recommendation of both the committees on capital account convertibility. It is cited that this pre-requisite has been one of the factors contributing to the shift over time towards the non deliverable forward (NDF) market at offshore locations to hedge such exposures since such requirement is not stipulated while booking a NDF contract. An attempt has been made recently provide importers the facility to partly hedge their economic exposure by permitting them to book forward contracts for their customs duty component. The Annual Policy Statement for 2007-08, released on April 24, 2007 announced a host of measures to expand the range of hedging tools available to market participants as also facilitate dynamic hedging by residents. To hedge economic exposures, it has been proposed that ADs (Category- I) may permit (a) domestic producers/users to hedge their price risk on aluminium, copper, lead, nickel and zinc in international commodity exchanges, based on their underlying economic exposures; and (b) actual users of aviation turbine fuel (ATF) to hedge their economic exposures in the international commodity exchanges based on their domestic purchases. Thakur Institute Of Management Studies And Research
Authorised dealer banks may approach the Reserve Bank for permission on behalf of customers who are exposed to systemic international price risk, not covered otherwise. In order to facilitate dynamic hedging of foreign exchange exposures of exporters and importers of goods and services, it has been proposed that forward contracts booked in excess of 75 per cent of the eligible limits have to be on a deliverable basis and cannot be cancelled as against the existing limit of 50 per cent. With a view to giving greater flexibility to corporates with overseas direct investments, the forward contracts entered into for hedging overseas direct investments have been allowed to be cancelled and rebooked. In order to enable small and medium enterprises to hedge their foreign exchange exposures, it has been proposed to permit them to book forward contracts without underlying exposures or past records of exports and imports. Such contracts may be booked through ADs with whom the SMEs have credit facilities. They have also been allowed to freely cancel and rebook these contracts. In order to enable resident individuals to manage/hedge their foreign exchange exposures, it has been proposed to permit resident individuals to book forward contracts without production of underlying documents up to an annual limit of US $ 100,000, which can be freely cancelled and rebooked.
Corporate Hedging for Foreign Exchange Risk in India Introduction In 1971, the Bretton Woods system of administering fixed foreign exchange rates was abolished in favour of market-determination of foreign exchange rates; a regime of fluctuating exchange rates was introduced. Besides market-determined fluctuations, there was a lot of volatility in other markets around the world owing to increased inflation and the oil shock. Corporates struggled to cope with the uncertainty in profits, cash flows and future costs. It was then that financial derivatives – foreign currency, interest rate, and commodity derivatives emerged as means of managing risks facing corporations. In India, exchange rates were deregulated and were allowed to be determined by markets in 1993. The economic liberalization of the early nineties facilitated the introduction of derivatives based on interest rates and foreign exchange. However derivative use is still a highly regulated area due to the partial convertibility of the rupee. Currently forwards, swaps and options are available in India and the use of foreign currency derivatives is permitted for hedging purposes only. Thakur Institute Of Management Studies And Research
The aim is to provide a perspective on managing the risk that firm’s face due to fluctuating exchange rates. It investigates the prudence in investing resources towards the purpose of hedging and then introduces the tools for risk management. These are then applied in the Indian context. The motivation of this study came from the recent rise in volatility in the money markets of the world and particularly in the US Dollar, due to which Indian exports are fast gaining a cost disadvantage. Hedging with derivative instruments is a feasible solution to this situation. This report is organised in 6 sections. The next section presents the necessity of foreign exchange risk management and outlines the process of managing this risk. Section 3 discusses the various determinants of hedging decisions by firms, followed by an overview of corporate hedging in India in Section 4. Evidence from major Indian firms from different sectors is summarized here and Section 5 concludes. Foreign Exchange Risk Management: Process & Necessity Firms dealing in multiple currencies face a risk (an unanticipated gain/loss) on account of sudden/unanticipated changes in exchange rates, quantified in terms of exposures. Exposure is defined as a contracted, projected or contingent cash flow whose magnitude is not certain at the moment and depends on the value of the foreign exchange rates. The process of identifying risks faced by the firm and implementing the process of protection from these risks by financial or operational hedging is defined as foreign exchange risk management. This paper limits its scope to hedging only the foreign exchange risks faced by firms. Kinds of Foreign Exchange Exposure Risk management techniques vary with the type of exposure (accounting or economic) and term of exposure. Accounting exposure, also called translation exposure, results from the need to restate foreign subsidiaries’ financial statements into the parent’s reporting currency and is the sensitivity of net income to the variation in the exchange rate between a foreign subsidiary and its parent. Economic exposure is the extent to which a firm's market value, in any particular currency, is sensitive to unexpected changes in foreign currency. Currency fluctuations affect the value of the firm’s operating cash flows, income statement, and competitive position, hence market share and stock price. Currency fluctuations also affect a firm's balance sheet by changing the value of the firm's assets and liabilities, accounts payable, accounts receivables, inventory, loans in foreign currency, investments (CDs) in foreign banks; this type of economic exposure is called balance sheet exposure. Transaction Exposure is a form of short term economic exposure due to fixed price contracting in an atmosphere of exchange-rate volatility. The most common definition of the measure of exchange-rate exposure is the sensitivity of the value of the firm, proxied by the firm’s stock return, to an unanticipated change in an exchange rate. This is calculated by using the partial derivative function where the dependant variable is the firm’s value and the independent variable is the exchange rate (Adler and Dumas, 1984). Thakur Institute Of Management Studies And Research
Necessity of managing foreign exchange risk A key assumption in the concept of foreign exchange risk is that exchange rate changes are not predictable and that this is determined by how efficient the markets for foreign exchange are. Research in the area of efficiency of foreign exchange markets has thus far been able to establish only a weak form of the efficient market hypothesis conclusively which implies that successive changes in exchange rates cannot be predicted by analyzing the historical sequence of exchange rates.(Soenen, 1979). However, when the efficient markets theory is applied to the foreign exchange market under floating exchange rates there is some evidence to suggest that the present prices properly reflect all available information.(Giddy and Dufey, 1992). This implies that exchange rates react to new information in an immediate and unbiased fashion, so that no one party can make a profit by this information and in any case, information on direction of the rates arrives randomly so exchange rates also fluctuate randomly. It implies that foreign exchange risk management cannot be done away with by employing resources to predict exchange rate changes. Hedging as a tool to manage foreign exchange risk: There is a spectrum of opinions regarding foreign exchange hedging. Some firms feel hedging techniques are speculative or do not fall in their area of expertise and hence do not venture into hedging practices. Other firms are unaware of being exposed to foreign exchange risks. There are a set of firms who only hedge some of their risks, while others are aware of the various risks they face, but are unaware of the methods to guard the firm against the risk. There is yet another set of companies who believe shareholder value cannot be increased by hedging the firm’s foreign exchange risks as shareholders can themselves individually hedge themselves against the same using instruments like forward contracts available in the market or diversify such risks out by manipulating their portfolio. (Giddy and Dufey, 1992). There are some explanations backed by theory about the irrelevance of managing the risk of change in exchange rates. For example, the International Fisher effect states that exchange rates changes are balanced out by interest rate changes, the Purchasing Power Parity theory suggests that exchange rate changes will be offset by changes in relative price indices/inflation since the Law of One Price should hold. Both these theories suggest that exchange rate changes are evened out in some form or the other. Also, the Unbiased Forward Rate theory suggests that locking in the forward exchange rate offers the same expected return and is an unbiased indicator of the future spot rate. But these theories are perfectly played out in perfect markets under homogeneous tax regimes. Also, exchange ratelinked changes in factors like inflation and interest rates take time to adjust and in the meanwhile firms stand to lose out on adverse movements in the exchange rates. The existence of different kinds of market imperfections, such as incomplete financial markets, positive transaction and information costs, probability of financial distress and agency costs and restrictions on free trade make foreign exchange management an appropriate concern for corporate Thakur Institute Of Management Studies And Research
management. (Giddy and Dufey, 1992) It has also been argued that a hedged firm, being less risky can secure debt more easily and this enjoy a tax advantage (interest is excluded from tax while dividends are taxed). This would negate the Modigliani-Miller proposition as shareholders cannot duplicate such tax advantages. The MM argument that shareholders can hedge on their own is also not valid on account of high transaction costs and lack of knowledge about financial manipulations on the part of shareholders. There is also a vast pool of research that proves the efficacy of managing foreign exchange risks and a significant amount of evidence showing the reduction of exposure with the use of tools for managing these exposures. In one of the more recent studies, Allayanis and Ofek (2001) use a multivariate analysis on a sample of S&P 500 non-financial firms and calculate a firms exchangerate exposure using the ratio of foreign sales to total sales as a proxy and isolate the impact of use of foreign currency derivatives (part of foreign exchange risk management) on a firm’s foreign exchange exposures. They find a statistically significant association between the absolute value of the exposures and the (absolute value) of the percentage use of foreign currency derivatives and prove that the use of derivatives in fact reduce exposure. Risk Management and Settlement of Transactions in the Foreign Exchange Market The foreign exchange market is characterized by constant changes and rapid innovations in trading methods and products. While the innovative products and ways of trading create new possibilities for profit, they also pose various kinds of risks to the market. Central banks all over the world, therefore, have become increasingly concerned of the scale of foreign exchange settlement risk and the importance of risk mitigation measures. Behind this growing awareness are several events in the past in which foreign exchange settlement risk might have resulted in systemic risk in global financial markets, including the failure of Bankhaus Herstatt in 1974 and the closure of BCCI SA in 1991. The foreign exchange settlement risk arises because the delivery of the two currencies involved in a trade usually occurs in two different countries, which, in many cases are located in different time zones. This risk is of particular concern to the central banks given the large values involved in settling foreign exchange transactions and the resulting potential for systemic risk. Most of the banks in the EMEs use some form of methodology for measuring the foreign exchange settlement exposure. Many of these banks use the single day method, in which the exposure is measured as being equal to all foreign exchange receipts that are due on the day. Some institutions use a multiple day approach for measuring risk. Most of the banks in EMEs use some form of individual counterparty limit to manage their exposures. These limits are often applied to the global operations of the institution. These limits are sometimes monitored by banks on a regular basis. In certain cases, there are separate limits for foreign exchange settlement exposures, while in other cases, limits for aggregate settlement exposures are created through a range of instruments. Bilateral obligation netting, in jurisdictions where it is legally certain, is an important way for trade counterparties to mitigate the foreign exchange settlement risk. This process allows trade Thakur Institute Of Management Studies And Research
counterparties to offset their gross settlement obligations to each other in the currencies they have traded and settle these obligations with the payment of a single net amount in each currency. Several emerging markets in recent years have implemented domestic real time gross settlement (RTGS) systems for the settlement of high value and time critical payments to settle the domestic leg of foreign exchange transactions. Apart from risk reduction, these initiatives enable participants to actively manage the time at which they irrevocably pay away when selling the domestic currency, and reconcile final receipt when purchasing the domestic currency. Participants, therefore, are able to reduce the duration of the foreign exchange settlement risk. Recognising the systemic impact of foreign exchange settlement risk, an important element in the infrastructure for the efficient functioning of the Indian foreign exchange market has been the clearing and settlement of inter-bank USD-INR transactions. In pursuance of the recommendations of the Sodhani Committee, the Reserve Bank had set up the Clearing Corporation of India Ltd. (CCIL) in 2001 to mitigate risks in the Indian financial markets. The CCIL commenced settlement of foreign exchange operations for inter-bank USD-INR spot and forward trades from November 8, 2002 and for inter-bank USD-INR cash and tom trades from February 5, 2004. The CCIL undertakes settlement of foreign exchange trades on a multilateral net basis through a process of novation and all spot, cash and tom transactions are guaranteed for settlement from the trade date. Every eligible foreign exchange contract entered between members gets novated or replaced by two new contracts – between the CCIL and each of the two parties, respectively. Following the multilateral netting procedure, the net amount payable to, or receivable from, the CCIL in each currency is arrived at, member-wise. The Rupee leg is settled through the members’ current accounts with the Reserve Bank and the USD leg through CCIL’s account with the settlement bank at New York. The CCIL sets limits for each member bank on the basis of certain parameters such as member’s credit rating, net worth, asset value and management quality. The CCIL settled over 900,000 deals for a gross volume of US $ 1,180 billion in 2005-06. The CCIL has consistently endeavoured to add value to the services and has gradually brought the entire gamut of foreign exchange transactions under its purview. Intermediation, by the CCIL thus, provides its members the benefits of risk mitigation, improved efficiency, lower operational cost and easier reconciliation of accounts with correspondents. An issue related to the guaranteed settlement of transactions by the CCIL has been the extension of this facility to all forward trades as well. Member banks currently encounter problems in terms of huge outstanding foreign exchange exposures in their books and this comes in the way of their doing more trades in the market. Risks on such huge outstanding trades were found to be very high and so were the capital requirements for supporting such trades. Hence, many member banks have expressed their desire in several fora that the CCIL should extend its guarantee to these forward trades from the trade date itself which could lead to significant increase in the liquidity and depth in the forward market. The risks that banks today carry in their books on account of large Thakur Institute Of Management Studies And Research
outstanding forward positions will also be significantly reduced (Gopinath, 2005). This has also been one of the recommendations of the Committee on Fuller Capital Account Convertibility. 6.55 Apart from managing the foreign exchange settlement risk, participants also need to manage market risk, liquidity risk, credit risk and operational risk efficiently to avoid future losses. As per the guidelines framed by the Reserve Bank for banks to manage risk in the inter-bank foreign exchange dealings and exposure in derivative markets as market makers, the boards of directors of ADs (category-I) are required to frame an appropriate policy and fix suitable limits for operations in the foreign exchange market. The net overnight open exchange position and the aggregate gap limits need to be approved by the Reserve Bank. The open position is generally measured separately for each foreign currency consisting of the net spot position, the net forward position, and the net options position. Various limits for exposure, viz., overnight, daylight, stop loss, gap limit, credit limit, value at risk (VaR), etc., for foreign exchange transactions by banks are fixed. Within the contour of these limits, front office of the treasury of ADs transacts in the foreign exchange market for customers and own proprietary requirements. These exposures are accounted, confirmed and settled by back office, while mid-office evaluates the profit and monitors adherence to risk limits on a continuous basis. In the case of market risk, most banks use a combination of measurement techniques including VaR models. The credit risk is generally measured and managed by most banks on an aggregate counter-party basis so as to include all exposures in the underlying spot and derivative markets. Some banks also monitor country risk through crossborder country risk exposure limits. Liquidity risk is generally estimated by monitoring asset liability profile in various currencies in various buckets and monitoring currency-wise gaps in various buckets. Banks also track balances to be maintained on a daily basis in Nostro accounts, remittances and committed foreign currency term loans while monitoring liquidity risk. To sum up, the foreign exchange market structure in India has undergone substantial transformation from the early 1990s. The market participants have become diversified and there are several instruments available to manage their risks. Sources of supply and demand in the foreign exchange market have also changed in line with the shifts in the relative importance in balance of payments from current to capital account. There has also been considerable improvement in the market infrastructure in terms of trading platforms and settlement mechanisms. Trading in Indian foreign exchange market is largely concentrated in the spot segment even as volumes in the derivatives segment are on the rise. Some of the issues that need attention to further improve the activity in the derivatives segment include flexibility in the use of various instruments, enhancing the knowledge and understanding the nature of risk involved in transacting the derivative products, reviewing the role of underlying in booking forward contracts and guaranteed settlements of forwards. Besides, market players would need to acquire the necessary expertise to use different kinds of instruments and manage the risks involved.
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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 market-specific 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
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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-à-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.
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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 can’t 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 Thakur Institute Of Management Studies And Research
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 today’s 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.
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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.
Choice of hedging instruments The literature on the choice of hedging instruments is very scant. Among the available studies, Géczy et al. (1997) argues that currency swaps are more cost-effective for hedging foreign debt risk, while forward contracts are more cost-effective for hedging foreign operations risk. This is because foreign currency debt payments are long-term and predictable, which fits the long-term nature of currency swap contracts. Foreign currency revenues, on the other hand, are short-term and unpredictable, in line with the short-term nature of forward contracts. A survey done by Marshall (2000) also points out that currency swaps are better for hedging against translation risk, while forwards are better for hedging against transaction risk. This study also provides anecdotal evidence that pricing policy is the most popular means of hedging economic exposures. These results however can differ for different currencies depending in the sensitivity of that currency to various market factors. Regulation in the foreign exchange markets of various countries may also skew such results.
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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 firm’s 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 Thakur Institute Of Management Studies And Research
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 Thakur Institute Of Management Studies And Research
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.
An Overview of Corporate Hedging in India The move from a fixed exchange rate system to a market determined one as well as the development of derivatives markets in India have followed with the liberalization of the economy since 1992. In this context, the market for hedging instruments is still in its developing stages. In order to understand the alternative hedging strategies that Indian firms can adopt, it is important to understand the regulatory framework for the use of derivatives here. Development of Derivative Markets in India The economic liberalization of the early nineties facilitated the introduction of derivatives based on interest rates and foreign exchange. Exchange rates were deregulated and market determined in 1993. By 1994, the rupee was made fully convertible on current account. The ban on futures trading of many commodities was lifted starting in the early 2000s. As of October 2007, even corporates have been allowed to write options in the atmosphere of high volatility.9 Derivatives on stock indexes and individual stocks have grown rapidly since inception. In particular, single stock futures have become hugely popular. Institutional investors prefer to trade in the Over-TheCounter(OTC) markets to interest rate futures, where instruments such as interest rate swaps and forward rate agreements are thriving. Foreign exchange derivatives are less active than interest rate derivatives in \ India, even though they have been around for longer. OTC instruments in currency forwards and swaps are the most popular. Importers, exporters and banks use the rupee forward market to hedge their foreign currency exposure. Turnover and liquidity in this market has been increasing, although trading is mainly in shorter maturity contracts of one year or less. The typical forward contract is for one month, three months, or six months, with three months being the most common. The Indian rupee, which is being traded on the Dubai Gold and Commodities Exchange (DGCX), crossed a turnover of $23.24 million in June 2007. Regulatory Guidelines for the use of Foreign Exchange Derivatives With respect to foreign exchange derivatives involving rupee, residents have access to foreign exchange forward contracts, foreign currency-rupee swap instruments and currency options – both cross currency as well as foreign currency-rupee. In the case of derivatives involving only foreign Thakur Institute Of Management Studies And Research
currency, a range of products such as Interest Rate Swaps, Forward Contracts and Options are allowed. While these products can be used for a variety of purposes, the fundamental requirement is the existence of an underlying exposure to foreign exchange risk i.e. derivatives can be used for hedging purposes only. The RBI has also formulated guidelines to simplify procedural/documentation requirements for Small and Medium Enterprises (SME) sector. In order to ensure that SMEs understand the risks of these products, only banks with which they have credit relationship are allowed to offer such facilities. These facilities should also have some relationship with the turnover of the entity. Similarly, individuals have been permitted to hedge upto USD 100,000 on self declaration basis. Authorised Dealer(AD) banks may also enter into forward contracts with residents in respect of transactions denominated in foreign currency but settled in Indian Rupees including hedging the currency indexed exposure of importers in respect of customs duty payable on imports and price risks on commodities with a few exceptions. Domestic producers/users are allowed to hedge their price risk on aluminium, copper, lead, nickel and zinc as well as aviation turbine fuel in international commodity exchanges based on their underlying economic exposures. Authorised dealers are permitted to use innovative products like cross-currency options; interest rate swaps (IRS) and currency swaps, caps/collars and forward rate agreements (FRAs) in the international foreign exchange market. Foreign Institutional Investors (FII), persons resident outside India having Foreign Direct Investment (FDI) in India and Nonresident Indians (NRI) are allowed access to the forwards market to the extent of their exposure in the cash market. Hedging Instruments for Indian Firms The recent period has witnessed amplified volatility in the INR-US exchange rates in the backdrop of the sub-prime crisis in the US and increased dollar-inflows into the Indian stock markets. In this context, the paper has attempted to study the choice of instruments adopted by prominent firms to stem their foreign exchange exposures. All the data for this has been compiled from the 2006-2007 Annual Reports of the respective companies. A summary of the foreign exchange risk hedging behaviour of select Indian firms is given in the table. Instruments Reliance Industries Currency Swaps Options Contracts
Maruti Udyog Forward Contracts Currency swaps
Nature of exposure Earnings in all businesses are linked to USD. The key input, crude oil is purchased in USD. All export revenues are in foreign currency and local prices are based on import parity prices as well .
6411 (INRJPY) 70 ($-INR) 124.70(USD
Import/Royalty payable in Yen and Exports Receivables in dollars. Interest rate and forex risk.
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-INR) . Mahindra Mahindra Forward Contracts
Currency Swaps Arvind Mills Forward Contracts
Option Contracts Infosys Forward Contracts Options Contracts Range barrier options
TCS Forward Contracts Options Contracts
and 350 (INR-JPY) 2(INR-EUR) 27.3($-INR) 5390 INR)
Interest rate and foreign exchange risk.
152.98 ($-INR) 703.67 2.25 (GBPINR) 5 (INR-$) 21.88 1 2 2.5 ($-INR)
119 ($-INR) 4 ($-INR) 8 (INR-$) 2 ($-INR) 3 (Eur-INR)
529 18 36 971
15 (Eur-INR) 21 (GBP-INR)
8 3 0 ($-INR) 4057 47.5 (Eur-INR) 76.5 (GBPINR)
Ranbaxy Forward Contracts
Dr. Reddy’s Labs Forward Contracts
Trade payables in Yen and Euro and export receivables in dollars.
398 ($-INR) 11(Eur $) 30 (EUR-$)
Most of the revenue is either in dollars or linked to dollars due to export.
Revenues denominated in these currencies.
Revenues largely denominated in foreign currency, predominantly US$, GBP, and Euro. Other currencie include Australian $, Canadian $, South African Rand, and Swiss Franc
Exposed on accounts receivable and loans payable. Exposure in USD and Jap Yen
Foreign currency earnings through export, currency requirements for settlement of liability for import of goods.
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Discussion on Hedging by Indian Firms From the Table above, 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 earlier, forwards contracts can be tailored to the exact needs of the firm and this could be the reason for their popularity. The tailor ability 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 India11. 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 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.
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Conclusion Derivative use for hedging is only to increase due to the increased global linkages and volatile exchange rates. Firms need to look at instituting a sound risk management system and also need to formulate their hedging strategy that suits their specific firm characteristics and exposures. In India, regulation has been steadily eased and turnover and liquidity in the foreign currency derivative markets has increased, although the use is mainly in shorter maturity contracts of one year or less. Forward and option contracts are the more popular instruments. Regulators had initially only allowed certain banks to deal in this market however now corporates can also write option contracts. There are many variants of these derivatives which investment banks across the world specialize in, and as the awareness and demand for these variants increases, RBI would have to revise regulations. For now, Indian companies are actively hedging their foreign exchanges risks with forwards, currency and interest rate swaps and different types of options such as call, put, cross currency and range-barrier options. The high use of forward contracts by Indian firms also highlights the absence of a rupee futures exchange in India. However, the Dubai Gold and Commodities Exchange in June, 2007 introduced Rupee- Dollar futures that could be traded on its exchanges and had provided another route for firms to hedge on a transparent basis. There are fears that RBI’s ability to control the partially convertible currency will be subdued by this introduction but this issue is beyond the scope of this study. The partial convertibility of the Rupee will be difficult to control if many exchanges offer such instruments and that will be factor to consider for the RBI.
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Currency Risk Management Introduction The management of currency risk by corporations has come a longway in the last three decades. Before the break-up of BrettonWoods currency riskwas not a major consideration for corporate executives, nor did it have to be. Exchange rates were allowed to fluctuate, but only within reasonably tight bands, while the US dollar itselfwas pegged to that most solid of commodities, gold. The responsibility for managing currency risk, or rather maintaining currency stability, was largely that of governments. Needless to say, that burden, that responsibility has now passed from the public to the private sector. The way the corporation has dealt with currency risk has changed substantially over time. Corporations, many of which were reluctant to touch anything but the most vanilla of hedging structures, have now greatly increased the sophistication of their currency risk management and hedging strategies, particularly over the last decade. In this regard, two developments have helped greatly – the centralizing of Treasury operations, particularly within large multinationals, and the focus put on hiring specifically experienced and qualified personnel to manage the day-to-day operations of risk management. Currency Risk So, what precisely is currency risk? There is no point in focusing on an issue if one cannot first define it. Although definitions vary within the academic community, a practical description of currency risk would be: The impact that unexpected exchange rate changes have on the value of the corporation Currency risk is very important to a corporation as it can have a major impact on its cash flows, assets and liabilities, net profit and ultimately its stock market value. Assuming the corporation has accepted that currency risk needs to be managed specifically and separately, it has three initial priorities: 1. Define what kinds of currency risk the corporation is exposed to 2. Define a corporate Treasury strategy to deal with these currency risks 3. Define what financial instruments it allows itself to use for this purpose Currency risk is simple in concept, but complex in reality. At its most basic, it is the possible gain or loss resulting from an exchange rate move. It can affect the value of a corporation directly as a result of an unhedged exposure or more indirectly. Different types of currency risk can also offset each other. For instance, take a US citizen who owns stock in a German auto manufacturer and exporter to the US. If the Euro falls against the US dollar, the US dollar value of the Euro-denominated stock falls and therefore on the face of it the Thakur Institute Of Management Studies And Research
individual sees the US dollar value of their holding decline. However, the German auto exporter should in fact benefit from a weaker Euro as this makes the company’s exports to the US cheaper, allowing them the choice of either maintaining US prices to maintain margin or cutting them further to boost market share. Sooner or later, the stock market will realize this and mark up the stock price of the auto exporter. Thus, the stock owner may lose on the currency translation, but gain on the higher stock price. This is of course a very simple example and life unfortunately is rarely that simple. For just as a weaker Euro makes exports from the Euro-zone cheaper, so it makes imports more expensive. Thus, an exporter may not in fact feel the benefit of the currency translation through to market share because higher import prices force it to raise export prices from where they would otherwise would be according to the exchange rate. The first step in successfully managing currency risk is to acknowledge that such risk actually exists and that it has to be managed in the general interest of the corporation and the corporation’s shareholders. For some, this is of itself a difficult hurdle as there is still major reluctance within corporate management to undertake what they see as straying from their core, underlying business into the speculative world of currency markets. The truth however is that the corporation is a participant in the currency market whether it likes it or not; if it has foreign currency-denominated exposure, that exposure should be managed. To do anything else is irresponsible. The general trend within the corporate world has however been in favour of recognizing the existence of and the need to manage currency risk. That recognition does not of itself entail speculation. Indeed, at its best, prudent currency hedging can be defined as the elimination of speculation: The real speculation is in fact not managing currency risk The next step, however, is slightly more complex and that is to identify the nature and extent of the currency risk or exposure. It should be noted that the emphasis here is for the most part on nonfinancial corporations, on manufacturers and service providers rather than on banks or other types of financial institutions. Non-financial corporations generally have only a small amount of their total assets in the form of receivables and other types of transaction. Most of their assets are made up of inventory, buildings, equipment and other forms of tangible “real” assets. In order to measure the effect of exchange rate moves on a corporation, one first has to define the type and then the amount of risk involved, or the “value at risk” (VaR). There are three main types of currency risk that a multinational corporation is exposed to and has to manage. Types of Currency Risk 1. Transaction risk (receivables, dividends, etc.) 2. Translation risk (balance sheet) 3. Economic risk (present value of future operating cash flows) Transaction Risk Thakur Institute Of Management Studies And Research
Transaction currency risk is essentially cash flow risk and relates to any transaction, such as receivables, payables or dividends. The most common type of transaction risk relates to export or import contracts. When there is an exchange rate move involving the currencies of such a contract, this represents a direct transactional currency risk to the corporation. This is the most basic type of currency risk that a corporation faces. Translation Risk Translation risk is slightly more complex and is the result of the consolidation of parent company and foreign subsidiary financial statements. This consolidation means that exchange rate impact on the balance sheet of the foreign subsidiaries is transmitted or translated to the parent company’s balance. Translation risk is thus balance sheet currency risk. While most large multinational corporations actively manage their transaction currency risk, many are less aware of the potential dangers of translation risk. The actual translation process in consolidating financial statements is done either at the average exchange rate of the period or at the exchange rate at the period end, depending on the specific accounting regulations affecting the parent company. As a direct result, the consolidated results will vary as either the average or the end-of-period exchange rate varies. Thus, all foreign currency-denominated profit is exposed to translation currency risk as exchange rates vary. In addition, the foreign currency value of foreign subsidiaries is also consolidated on the parent company’s balance sheet, and that value will vary accordingly. Translation risk for a foreign subsidiary is usually measured by the net assets (assets less liabilities) that are exposed to potential exchange rate moves. Problems can occur with regard to translation risk if a corporation has subsidiaries whose accounting books are local currency-denominated. For consolidation purposes, these books must of course be translated into the currency of the parent company, but at what exchange rate? Income statements are usually translated at the average exchange rate over the period. However, deciding at what exchange rate to translate the balance sheet is slightly trickier. There are generally three methods used by major multinational corporations for translating balance sheet risk, varying in how they separate assets and liabilities between those that need to be translated at the “current” exchange rate at the time of consolidation and those that are translated at the historical exchange rate: _ The all current (closing rate) method _ The monetary/non-monetary method _ The temporal method As the name might suggest, the all current (closing rate) method translates all foreign currency exposures at the closing exchange rate of the period concerned. Under this method, translation risk Thakur Institute Of Management Studies And Research
relates to net assets or shareholder funds. This has become the most popular method of translating balance exposure of foreign subsidiaries, both in the US and worldwide On the other hand, the monetary/non-monetary method translates monetary items such as assets, liabilities and capital at the closing rate and non-monetary items at the historical rate. Finally, the temporal method breaks balance sheet items down in terms of whether they are firstly stated at replacement cost, realizable value, market value or expected future value, or secondly stated at historic cost. For the first group, these are translated at the closing exchange rate of the period concerned, for the second, at the historical exchange rate. The US accounting standard FAS 52 and the UK’s SSAP 20 apply to translation risk. Under FAS 52, the translation of foreign currency revenues and costs is made at the average exchange rate of the period. FAS 52 generally uses the all current method for translation purposes, though it does have several important provisions, notably regarding the treatment of currency hedging contracts. Under SSAP 20, the corporation can use either the current or average rate. Generally, there has been a shift among multinational corporations towards using the average rather than the closing rate because this is seen as a truer reflection of the translation risk faced by the corporation during the period. Translation risk is a crucial issue for corporations. Later in this chapter, we will look at methods of hedging it. For now, it is important to get an idea of how it can affect the company’s overall value. Example Take an example of a Euro-based manufacturer, which has bought a factory in Poland. Needless to say, the cost base in Poland is substantially below that of the parent company, one of several major reasons why the acquisition was made in the first place. From 1999 to 2001, the Euro was on a major downtrend, not just against its major currency counterparts but also against most currencies of the Central and East European area, such as the Polish zloty. Thus we get the following simple model: EUR–USD ↓= EUR–PLN ↓ where: EUR–USD = The Euro–US dollar exchange rate EUR–PLN = The Euro–Polish zloty exchange rate This is an over-simplification to be sure. For one thing, the Polish zloty was pegged to a basket of Euro (55%) and US dollar (45%) with a crawl and trading bands up until 2000, and thus was unable to appreciate despite the ongoing decline in the value of the Euro across the board. For another, it does not take account of EUR–PLN volatility. That said, general Euro weakness has clearly been an important factor in the depreciation of the Euro–zloty exchange rate. Note however that as the Euro–zloty exchange rate has depreciated for this and other reasons so the value of the original investment in the Polish factory has increased in Euro terms. Thus: EUR–PLN ↓= EURtranslation value of Polish subsidiary ↑
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Whatever our Euro-based manufacturer may think of Euro weakness, it is entirely beneficial for the manufacturer’s translation value of the Polish factory/subsidiary when the financial statements are consolidated at the end of the accounting period. The translation benefit to the balance sheet will depend on the accounting method of translation. Conversely, were the Euro ever to rally on a sustained basis, this might cause the Euro–zloty exchange rate to rally, thus in turn reducing the translation value of the corporation’s Polish subsidiary. The consolidation of financial statements would mean that this not only has an impact on the Euro value of the Polish subsidiary but also on the balance sheet of the parent, Euro-based manufacturer. The risk of a sudden balance sheet deterioration of this kind is not negligible where corporations have a broad range of foreign subsidiaries, with accompanying transactional and translational currency risk. Economic Risk The translation of foreign subsidiaries concerns the consolidated group balance sheet. However, this does not affect the real “economic” value or exposure of the subsidiary. Economic risk focuses on how exchange rate moves change the real economic value of the corporation, focusing on the present value of future operating cash flows and how this changes in line with exchange rate changes. More specifically, the economic risk of a corporation reflects the effect of exchange rate changes on items such as export and domestic sales, and the cost of domestic and imported inputs. As with translation risk, calculating economic risk is complex, but clearly necessary to be able to assess how exchange rate changes can affect the present value of foreign subsidiaries. Economic risk is usually applied to the present value of future operating cash flows of a corporation’s foreign subsidiaries. However, it can also be applied to the parent company’s operations and how the present value of those change in line with exchange rate changes. Summarizing this part, transaction risk deals with the effect of exchange rate moves on transactional exposure such as accounts receivable/payable or dividends. Translation risk focuses on how exchange rate moves can affect foreign subsidiary valuation and therefore the valuation of the consolidated group balance sheet. Finally, economic risk deals with the effect of exchange rate changes to the present value of future operating cash flows, focusing on the “currency of determination” of revenues and operating expenses. Here it is important to differentiate between the currency in which cash flows are denominated and the currency that may determine the nature and size of those cash flows. The two are not necessarily the same. To complicate the issue further, there is the small matter of the parent company’s currency, which is used to consolidate the financial statements. If a parent company has foreign currency-denominated debt, this is recorded in the parent company’s currency, but the value of its legal obligation remains in the currency denomination of the debt. In sum, transaction risk is just the tip of the iceberg! Of necessity, the reality of currency risk is very case-specific. That said, there has been an attempt by the academic and economic communities to apply the traditional exchange rate models to the corporate world for the purpose of demonstrating how exchange rates impact a corporation. Thakur Institute Of Management Studies And Research
PPP (or the law of one price) suggests that price differentials of the same good in different countries require an exchange rate adjustment to offset them. The international Fisher effect suggests that the expected change in the exchange rate is equal to the interest rate differential. The unbiased forward rate theory suggests that the forward exchange rate is equal to the expected exchange rate. Generally, these theories are grounded in the efficient market hypothesis and therefore flawed at best. Over the long term, these traditional “rules” of exchange rate theory suggest that competition and arbitrage should neutralize the effect of exchange rate changes on returns and on the valuation of the corporation. Equally, locking into the forward rate should, according to the unbiased forward rate theory, offer the same return as remaining exposed to currency risk, as this theory suggests that the distribution of probability should be equal on either side of the forward rate. The unfortunate thing about such models, however worthy the attempt, is that they do not and cannot deal with the practical realities of managing currency risk. What academics regard as “temporary deviations” from where the model suggests the exchange rate should be can be sufficient and substantial enough to cause painful and intolerable deterioration to both the P&L and the balance sheet? To conclude this part, a corporation should define and seek to quantify the types of currency risk to which it is exposed in order then to be able to go about creating a strategy for managing that currency risk. Core Principles for Managing Currency Risk 1. Determine the types of currency risk to which the corporation is exposed – Break these down into transaction, translation and economic risk, making specific reference to what currencies are related to each type of currency risk. 2. Establish a strategic currency risk management policy – Once currency risk types have been agreed on, corporate Treasury should establish and document a strategic currency risk `management policy to deal with these types of risks. This policy should include the corporation’s general approach to currency risk, whether it wants to hedge or trade that risk and its core hedging objectives. 3. Create a mission statement for Treasury – It is crucial to create a set of values and principles which embody the specific approach taken by the Treasury towards managing currency risk, agreed upon by senior management at the time of establishing and documenting the risk management policy. 4. Detail currency hedging approach – Having established the overall currency risk management policy, the corporation should detail how that policy is to be executed in practice, including the types of financial instruments that could be used for hedging, the process by which currency Thakur Institute Of Management Studies And Research
hedging would be executed and monitored and procedures for monitoring and reviewing existing currency hedges. 5. Centralizing Treasury operations as a single centre of excellence – Treasury operations can be more effectively and efficiently managed if they are centralized. This makes it easier to ensure all personnel are clear about the Treasury’s mission statement and hedging approach. Thus, the Treasury can be run as a single centre of excellence within the corporation, ensuring the quality of individual members. Large multinational corporations should consider creating a position of chief dealer to manage the dealing team, as the demands of a Treasurer often exceed the ability to manage all positions and exposures on a real-time basis. The currency dealing team must have the same level of expertise as their counterparty banks. 6. Adopt uniform standards for accounting for currency risk – In line with the centralizing of Treasury operations, uniform accounting procedures with regard to currency risk should be adopted, creating and ensuring transparency of risk. Create benchmarks for measuring the performance of currency hedging. 7. Have in-house modelling and forecasting capacity – Currency forecasting is as important as execution. While Treasury may rely on its core banks for forecasting exchange rates relative to its needs, it should also have its own forecasting ability, linked in with its operational observations which are frequently more real time than any bank is capable of. Treasury should also be able to model all its hedging positions using VaR and other sophisticated modelling systems. 8. Create a risk oversight committee – In addition to the safeguard of a chief dealer position for larger multinational corporations, a risk oversight committee should be established to approve position taking above established thresholds and review the risk management policy on a regular basis.
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