85609969 55190814 forex exposure management

7/29/2019 85609969 55190814 Forex Exposure Management

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NMIMS FOREX EXPOSURE MANAGEMENT

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TABLE OF CONTENTS

RUDIMENTS OF FOREIGN EXCHANGE......................................................... ............................... 4

1.1 FOREIGN EXCHANGE-INTRODUCTION ................................................................. ...................... 5

1.2 THE NEED FORFOREIGN EXCHANGE .......................................................... ............................... 51.3 CAN THE TRANSACTION BETWEEN TWO COUNTRIES BE SETTLED IN A 3RD COUNTRY? ............... 51.4 FOREIGN EXCHANGE MARKET ................................................................... ............................... 61.5 PARTICIPANT OF FOREIGN EXCHANGE MARKETS.............................................................. ........ 61.6 TYPES OF DEALING IN THE LOCAL FOREIGN EXCHANGE MARKETS ........................................... 81.7 FACTORS THAT CONTRIBUTE TO THE GROWTH OF INDIAN FOREX MARKETS ............................. 9

OVERVIEW OF FOREIGN TRADE ................................ ................................................................ 13

ORGANISATIONAL SET UP OF M/S CIBA SPECIALTY CHEMICALS INDIA LTD ............ 15

1.8 INTRODUCTION........................................................................................................................ 15

1.9 BACKGROUND......................................................................................................................... 17

FOREX MANAGEMENT POLICY................................................................................. .................. 18

1.10 PREQUISITES............................................................................................................................ 181.11 ANALYSIS................................................................................................................................ 181.12 CONCEPT OF GROSS EXPOSURE ANDNET EXPOSURE .............................................................. 191.13 FRAMING A POLICY ................................................................................................................. 191.14 PERFORMANCE EVALUATION CRITERIA ................................................................ .................. 211.15 FOREIGN EXCHANGE RISKMANAGEMENT POLICY OF M/S CSCIL ......................................... 211.16 RISKMEASUREMENT APPROACH ............................................................... ............................. 221.17 TYPES OF FOREIGN EXCHANGE RISKS ................................................................. .................... 231.18 RECOGNITION OF EXCHANGE RISKS ........................................................... ............................. 24

1.19 FOURSTEPS IN RISKMANAGEMENT .......................................................... ............................. 251.20 POSSIBLE PERFORMANCE EVALUATION CRITERIA AT M/S CSCIL: ................................. ......... 291.21 CONCEPT TRANSFERPRICING.................................................................................................. 311.22 PERIOD OF MEASUREMENT...................................................................................................... 321.23 NET POSITION.......................................................................................................................... 321.24 EXHIBIT-1: FOREXRATES&EXPOSURES .............................................................. ...... 321.25 MATURITYMISMATCHORGAPS ................................................................ .................... 33

STRUCTURE OF LIMITS..................................................................................... ............................. 36

1.26 OVERALL LIMITS ..................................................................................................................... 361.27 INDIVIDUAL DEALERLIMITS ................................................................................................... 36

GUIDELINES FOR RISK MANAGEMENT ................................................................ .................... 38

1.28 HEDGING ................................................................ .............................................................. 381.29 PASSIVERISKMANAGEMENT ............................................................ ............................. 381.30 ACTIVERISKMANAGEMENT .......................................................................................... 39

VALUATIONS OF FOREIGN EXCHANGE EXPOSURES ........................................................... 40

INTERNAL CONTROLS ................................................................ .................................................... 41

1.31 BALANCEOFPAYMENT ...................................................................... ............................. 421.31.1 SOME BASIC CONCEPTS ................................................................ ............................. 42

1.32 COMPONENTS OF BALANCE OF PAYMENTS: ............................................................................ 431.32.1 Current account ..................................................................................................... ......... 43


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1.32.2 Trade flows ............................................................................ ......................................... 431.32.3 Invisibles ........................................................... .............................................................. 431.32.4 Deficit & Surplus ................................................................... ......................................... 431.32.5 Capital Account ................................................................................. ............................. 45

THE MANAGEMENT OF FOREIGN EXCHANGE RISK ............................................................ 47

1.33 OVERVIEW ............................................................. .............................................................. 471.34 SHOULDFIRMSMANAGEFOREIGNEXCHANGERISK-HOW? .................................. 481.35 ECONOMIC EXPOSURE,PURCHASING POWERPARITY &THE INTERNATIONAL FISHEREFFECT501.36 FOREIGN EXCHANGE FORECASTING........................................................... ............................. 501.37 HISTORICAL PERSPECTIVE ON EXCHANGE RATE,GOLD STANDARD ......................................... 51

1.37.1 Gold standard ............................................................................................... .................. 511.37.2 Definition of Arbitrage ............................................................................................. ...... 521.37.3 Bretton Woods System ................................................................................................... 52

1.38 FEATURES OF EXCHANGE RATE SYSTEM .............................................................. .................. 521.38.1 Collapse of Bretton Woods System (1944 to 1971)......................................................... 53

1.39 FLOATING EXCHANGE RATE SYSTEM......................................................... ............................. 531.40 OBJECTIVES OF LIMITED FLEXIBILITY SYSTEM ................................................................ ....... 54

1.41 CRAWLING PEG (GLIDING PARITIES) ............................................................................... ......... 541.42 MIXED SYSTEM ....................................................................................................................... 541.43 EXCHANGE RATE ARRANGEMENTS ............................................................ ............................. 541.44 MARKET SIZE.......................................................................................................................... 551.45 MECHANICS OF EXCHANGE RATE.............................................................. ............................. 551.46 IDENTIFYING EXPOSURE.......................................................................................................... 571.47 METHOD FOLLOWED BY USCOMPANIES.............................................................. .................. 591.48 EXPOSURE-TYPESANDDESCRIPTION ...................................................... .................. 641.49 MANAGINGECONOMICEXPOSURE ............................................................. .................. 651.50 STEPSINMANAGINGECONOMICEXPOSURE ........................................... .................. 651.51 GUIDELINES FORCORPORATE FORECASTING OF EXCHANGE RATES ...................................... 681.52 TOOLS AND TECHNIQUES FORTHE MANAGEMENT OF FOREIGN EXCHANGE RISK................. 71

FOREIGN EXCHANGE MARKET..................................................................... ............................. 71

1.53 STRUCTURE OF THE FOREX MARKET:......................................................... ............................. 711.54 MARKET PLAYERS: ................................................................................................................. 721.55 MECHANICS OF CURRENCY TRADING: ....................................................... ............................. 721.56 TYPES OF TRANSACTIONS AND SETTLEMENT DATES: ........................................... .................. 721.57 ARBITRAGE BETWEEN BANKS: ................................................................................................ 731.58 INVERSE QUOTES AND 2-POINT ARBITRAGE ........................................................... .................. 731.59 OUTRIGHT FORWARD QUOTATIONS ........................................................... ............................. 741.60 DISCOUNTS AND PREMIA IN THE FORWARD MARKET.............................................................. 741.61 ANNUALIZED PREMIUM /DISCOUNT: .................................................................. .................... 751.62 MARGIN REQUIREMENT: ....................................................................................... .................. 751.63 FORWARDCONTRACTS,FUTURES&CURRENCYOPTIONS .............................. ...... 75

1.63.1 Forward Contract .................................................................. ......................................... 751.63.2 Currency Futures ............................................................................................................ 761.63.3 Debt instead of forwards or futures .............................................................. .................. 771.63.4 Currency Options ........................................................................................................... 781.63.5 Swap ............................................................................................................................... 791.63.6 Cross Rates ........................................................................................ ............................. 801.63.7 Controlling Corporate Treasury Trading Risks ............................................................. 80

1.64 MARKET FORECASTS ............................................................................................................... 811.65 MARKET PARTICIPANTS .......................................................................................................... 821.66 MARKET PARTICIPANTS -4CATEGORIES .............................................................. .................. 821.67 HEDGE FUNDS ......................................................................................................................... 821.68 DEALING ROOMS..................................................................................................................... 821.69 INFORMATION SYSTEMS .......................................................................................................... 831.70 PAYMENT AND COMMUNICATION SYSTEM............................................................ .................. 831.71 RISKAPPRAISAL ....................................................................................................................... 83


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1.72 BENCHMARKING....................................................................................................................... 841.73 HEDGING................................................................................................................................. 851.74 STOPLOSS................................................................................................................................ 861.75 REPORTING ANDREVIEW.......................................................................................................... 871.76 CONCLUSION............................................................................................................................ 89

LATEST IN FOREIGN EXCHANGE - TECHNOLOGY ADVANTAGE..................................... 89

RESREVE BANK OF INDIA REGULATIONS & DEFINITIONS ................................................ 93

1.77 SHORT TITLE & COMMENCEMENT .............................................................. ............................. 931.78 DEFINITIONS............................................................................................................................ 931.79 SUMMARY OF EXCHANGE RATE REGIME IN INDIA ............................................................ ...... 941.80 EXCHANGE RATE CALCULATIONS.............................................................. ............................. 941.81 MULTI CURRENCY OPTION...................................................................................................... 95

FROM THE ILLUSTRATION - LESSONS TO BE LEARNT ....................................................... 96

INFORMATION ON EURO ............................................................................................. .................. 97

1.82 EVOLUTION OF EURO MARKET ................................................................... ............................. 971.83 WHAT ARE EURO MARKETS? ................................................................................................... 97

FOREX MARKET IN INDIA .......................................................... ................................................... 99

BIBLIOGRAPHY & LIST OF REFERENCES .............................................................. ................ 101

RUDIMENTS OF FOREIGN EXCHANGE


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1.1 Foreign Exchange-Introduction

Foreign Exchange, simply stated, means foreign money. Thus, foreignexchange and near money instruments denominated in foreign currency,are called foreign exchange. In other words, all claims to foreign currency

payable abroad, whether consisting of funds held abroad in foreigncurrency or bill or cheques in foreign currency etc., fall in the category offoreign exchange.In India, foreign exchange has been given a statutory definition:

Def: Sec 2(b) of Foreign Exchange Regulation Act, 1973 states:

Foreign Exchange means foreign currency and includes:

1. all deposits, credits and balances payable in any foreign currency andany drafts, travelers cheques, letter of credit and bills of exchange,

expressed or drawn in Indian currency but payable in any foreigncurrency

2. any instruments payable, at the option of drawee or holder thereof orany other party thereto, either in Indian currency or in foreign currencyor partly in one and partly in the other.

1.2 The need for Foreign Exchange

An example in this aspect would be apt to understand the need of ForeignExchange.

A Japanese company exports electronic goods to USA and invoices thegoods in US Dollars. The American importer will pay the amount in USdollars, as the same is his home currency. However, the Japanese exporterrequires Yen i.e. his home currency for procuring raw material locally andmaking payments for the labour charges incurred for the purpose etc.

Thus, he would need exchanging US dollars for Yen. If the Japaneseexporter invoices his goods in Yen, then importer in USA will get his dollarsconverted in Yen and pay the exporter. And therefore, it can be inferred thatin case goods are bought or sold outside the country, exchange ofcurrencies becomes necessary.

1.3 Can the transaction between two countries be settled in a 3

rd

Country?


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Yes, it is also possible that the transactions between two countries might besettled in the currency of third country.

Ex:An Indian exporter, exporting goods to Singapore may raise an invoice for

the goods sold in US dollars and as the importer in Singapore has to makepayment in US dollars and as the importer in Singapore has to makepayments in US dollars, he will have to exchange his Singapore dollars intoUS dollars. The Indian exporter on receipt of US dollars will exchange theminto Indian Rupees. Thus, as in this case, the transaction may give rise toexchange of currencies in the exporters country as well as the importerscountry. Such transaction may give rise to conversion of currencies at twostages.

1.4 Foreign Exchange Market

Foreign Exchange market is in fact misnomer or misleading in as much asthere is no market place as such which can be called foreign exchangemarket. However, it is a facilitating mechanism through which one countryscurrency can be exchanged i., e bought or sold for the currency of anothercountry. It does not have any geographic location. The foreign exchangemarket comprises of all the foreign exchange traders who are connected toeach other throughout the world through telecommunication network. Theydeal with each other through telephones, telexes, and electronic systems.With advent of advanced technology like Reuters Money 2000-2, it is possibleto access any trader in any corner of the world within a few seconds. In factnow deal can be done through electronic dealing systems that allow bid andoffer rates to be matched automatically through central computers and thustransaction take place in jiffy.

1.5 Participant of Foreign Exchange Markets

Any one who exchanges the currency of one country for currency ofanother country or needs such services is said to participate in foreignexchange markets. The main players in the foreign exchange markets are:

a. Customers

The customers who are engaged in foreign trade participate inforeign exchange markets by availing of the services of banks, likean exporter or importer. Also services may be required for settlingany International obligations i.e., payment of technical know-howfees or repayment of foreign debt etc.

b. Commercial Banks


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Commercial banks dealing with international transactions offerservices for conversion of one currency into another. They are themost active players in forex market.

c. Central Banks

The central banks, in most of the countries, have been chargedwith the responsibility of maintaining the external value of thecurrency of the country. If the country is following a fixed exchangerage system then the central bank has to take necessary steps tomaintain the parity i.e., the rate so fixed. Even under the floatingexchange system the central bank has to ensure orderliness in themovement of exchange rates. This is achieved by central banksintervention in the forex market. Apart from intervention the Centralbank deal in the foreign exchange markets for the purpose of:

Exchange rate Management

Sometimes it is achieved thru the intervention yet where a CentralBank is required to maintain external rate of the domestic currencyat a level or in a band so fixed, they deal in the market to achievethe desired objective.

Reserve Management

Central Bank is predominantly concerned with investment ofcountries foreign exchange reserves in fairly stable proportions inrange of currencies, and in a range of assets in each currency.These proportions are, inter-alia, influenced by the structure ofofficial external assets/liabilities. The process of reservemanagement inevitably involves a certain amount of switchingbetween currencies.

d. Exchange Brokers

In India dealing is done in inter bank market through forex brokers.Similarly, in London, New York and Paris inter bank transactions

are put through forex brokers. However, in India the A Ds are freeto deal directly among themselves without going through brokers.The forex brokers are not allowed to deal in their own account allover the world and also in India.

e. Speculators

Major chunk of the foreign exchange dealings in the forex market ison account of speculators and speculative activities.

Banks do the same in view to make profit on account of favorablemovement in exchange rates, take positions, i.e. if they feel that


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rate of a particular currency is likely to go up in short term then theybuy currency and sell it as soon as they are able to make quickprofits.

Corporations-MNCs & TNCs having business operations beyond

their national frontiers and on account of their cash flows beinglarge and in multi currencies get into foreign exchange exposures.With a view to take advantage of the exchange rate movements intheir favor they either delay covering exposures or do not coveruntil cash flows materialize. Sometimes they take positions so as totake advantage of the exchange rate movement in their favor andfor undertaking this activity they have state of art dealing rooms.

As the exchange controls have been loosened, in India also some of thebig corporates are booking and canceling forward contracts and at timesthe same borders on speculative activity.

1.6 Types of dealing in the local Foreign Exchange Markets

Merchant TransactionWhen authorized dealers buy/sell foreign exchange from/toexporter/importers and other customers then its called a merchanttransaction. This transaction can be undertaken only on account ofgenuine exposure of the customers and speculation is prohibited.These merchant can book, re-book, cancel forward contracts withAuthorised Dealers with respect to their genuine foreign exchangeexposure. This facility was available to residents only. However, RBIhas loosened the grip further and allowed NRIs/FIIs also to bookforward contract for certain accounts/investments by them in India.

Inter-Bank TransactionWhen one bank deals with another bank i.e. buys/sells foreignexchange, it is known as inter bank dealing. The banks in India areallowed to deal freely amongst themselves. Most of the banks are notmarket makers and rather they are market users. Thus, there is notmuch liquidity and depth in the foreign exchange market in India and

the market notices even the small demand or supply. After Rupee hasjoined the freely floating currencies there are days when exchangerates in inter bank markets have been very volatile and RBI has beenforced to intervene in the market almost on regular basis, particularlyduring such periods.

Overseas Transaction

When a bank in India buys/sells foreign exchange in the overseasforeign markets then it is called an overseas transaction. The banks inIndia can cover its positions arising out of merchant transactions or

inter bank dealings freely in overseas exchange market. RBI has alsopermitted banks on a selective basis to initiate positions overseas.


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Transaction between Banks and RBI

After introduction of Modified Liberalized Exchange Rate ManagementSystem (Modified LERMS) and on account of amendment to Section

40 of RBI Act, 1934, RBI is not obliged to sell foreign exchange butbuys foreign exchange offered to it buy A Ds at market related rates.Therefore, RBI has discontinued, w.e. f Oct 4 th 1995, the practice ofannouncing its two way exchange rates. However, the RBI has beeninvested with the right to intervene in the market as and whennecessary and it intervenes in its wisdom it deems fit. In fact RBI hasbeen buying foreign exchange when there was excess supply in themarket. RBI has also been intervening in the market through Spot,Forward & Swaps quite often after the Rupee started floating, socalled, freely.

1.7 Factors that contribute to the growth of Indian Forex Markets

Global Forex market has taken quantum jump and the Indian market hasfollowed suit.

Better communication network like telephones, telexes, SWIFT,Reuters/Telerate system etc., have been made available to the forexdealers and these have contributed to the speed and efficiency of themarket. Thus, they are able to generate larger turnover.

Rigid and tight exchange controls have been relaxed and the banks arecompletely free to deal in the inter bank market as also, to some extent, inthe overseas market.

With opening up of the banking sector to private sector more players havebeen added to the market. Also, many more foreign banks have set upshops in India and those, which were already operating, have establishedmore branches. This has contributed to higher foreign exchange turnover.

Banks have been allowed to have, albeit to a small extent, an access to theforeign currency assets and liabilities. With limited integration of Indian andoverseas forex markets, banks have access to the inter bank markets forconversion of forex funds into Indian rupees and re-conversion of the sameon a continuous basis has given the fillip in the market.

The Liberalised Exchange Rate Management System and freedom given tothe corporates to book, re-book and cancel forwardcontracts so long they have the genuine exposure, have also contributed tothe increased inter-bank dealings and consequently increase in the tradingvolume in the foreign exchange markets.

Types of currencies traded in Indian Market


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The major currencies being traded in the Indian Forex market are US dollar,Pound Sterling(GBP), Deutsche Mark(DEM), Japanese Yen(YEN), FrenchFranc(FRF), Swiss Franc(CHF), Italian Lira(ITL) etc. The market also tradesin exotic currencies like Middle East currencies. The EURO is a new singlecurrency used by most of the nations of the Western Europe. It will

gradually replace national currencies such as German Mark or the FrenchFrank etc. Thus, Euro will also play a major role as far trading in India inconcerned.

Growth of forex market over the years

The forex market is the world's largest financial market, with $1.4-trillion intransactions daily. The turnover in the Indian forex market has also beenincreasing over the years. The average daily gross turnover in the dollar-rupee segment of the Indian forex market (merchant plus inter-bank) was in

the vicinity of US$ 3 billion during 1998-99. The daily turnover in themerchant segment of the dollar-rupee segment of foreign exchange marketwas US$ 0.7 billion, while turnover in the inter-bank segment was US$ 2.3billion. The average daily turnover in the spot market was around US$ 1.2billion and in the forward and swap market, the daily turnover was US$ 1.8billion during 1998-99.

FEDAI's role in the forex market

Foreign Exchange Dealers Association of India (FEDAI) sets the groundrules for fixation of commissions and other charges, and also involves itselfin matters of mutual interest of the Authorised Dealers. FEDAI alsoaccredits brokers through whom the banks put through deals.

Authorised dealers in foreign exchange

RBI may, on an application made to it in this behalf, authorise any person todeal in foreign exchange or in foreign securities, as an authorised dealer,money-changer or off-shore banking unit, or in any other manner as itdeems fit.

Generally, authorisations, in the form of licenses, to deal in foreignexchange, are granted to banks, which are well equipped to undertakeforeign exchange transactions in India. Authorisations have been given tocertain financial institutions to undertake specific types of foreign exchangetransactions incidental to their main business, which are also called

`restricted authorised dealers'.


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Rupee quoted against Dollar

In India, we follow a direct exchange rate quote which gives the homecurrency price of a certain amount of the foreign currency quoted, i.e. theamount of foreign currency is fixed and the amount of home currency keepsvarying with the change in exchange rate. This, however, is not the onlymethod of quoting the exchange rate; banks in Great Britain quote the valueof the pound Sterling in terms of the foreign currency, which is called the`indirect exchange rate quote'. The form of quoting Pound sterling, Euroand Australian Dollar is called indirect quote because GBP has alwaysbeen stronger than USD, even Euro started as a stronger currency thanUSD and Australian Dollar is the commonwealth currency so it has to followthe path of GBP.

Activities that can possibly carry foreign exchange exposure

Foreign exchange exposures arise from many different activities. A travelergoing to visit another country has the risk that if that country's currencyappreciates against their own, their trip will be more expensive.

Similarly, an exporter who sells his/her product in a foreign currency facesthe risk that if the value of the Indian rupee appreciates vis--vis dollar, hisrevenue in terms of the Indian rupee, nose-dives.

An importer, who buys goods priced in foreign currency, faces the risk thatthe rupee might depreciate against the dollar, thereby making the local-currency cost of the imports greater than expected.

Authorised money-changers and the powers they are they vested with

The Reserve Bank of India has empowered certain people, i.e. shops,emporia, travel agents, etc., to deal in foreign currency, subject to certainrestrictions. They are not allowed to deal in foreign exchange; rather theyare supposed to play the role of facilitators for undertaking the function ofmoney changing. They are required to provide facilities for encashment offoreign currency to visitors from abroad, especially foreign tourists.

They can be classified into two categories, i.e., full-fledged money-changerswho can undertake both purchase and sale transactions with the public,and restricted money-changers who are authorised only to purchase foreign

currency notes, coins and travelers cheques, subject to the condition that all


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such collections are surrendered by them in turn to an authorised dealer inforeign exchange/ full-fledged money-changer.

Has the Reserve Bank permitted exchange brokers to operate in theforeign exchange market?

Yes, the Reserve Bank of India has stated that there is no objection toemployment of brokers, but in all cases, their principal as well as thebrokers must comply with the requirement of the exchange control.Exchange brokers are, however, not authorised to deal in foreign exchangeon their own account, hence, they should not purchase or sell foreignexchange from/to the public.

Does a customer, i.e. an importer, exporter or any other person, havethe liberty to enter into a trade contract in whichever currency he or shedesires?

The Reserve Bank of India has not placed any restrictions on any foreigncurrency being chosen for trade purposes, but the EXIM policy stipulates thatall export contracts and invoices shall be denominated in permitted currenciesonly, i.e. freely convertible foreign currency.


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OVERVIEW OF FOREIGN TRADE

Any business is open to risks from movements in competitors' prices, rawmaterial prices, competitors' cost of capital, foreign exchange rates andinterest rates, all of which need to be (ideally) managed.

These Risk Management Guidelines are primarily an enunciation of somegood and prudent practices in exposure management. They have to beunderstood, and slowly internalised and customised so that they yieldpositive benefits to the company over time. It is imperative and advisable forthe Apex Management to both be aware of these practices and approvethem as a policy. Once that is done, it becomes easier for the ExposureManagers to get along efficiently with their task.

The efforts of globalization of Indian economy have set a new pace to

foreign trade. Further, the advent of economic reforms, liberalisation,deregulation & the process of opening up the economy to global playershad a far-reaching impact on foreign trade. Capital flows across nationshave registered a quantum leap with the removal of rigid exchange controlsby many nations and the consequent increase in cross-border trade. Theimpact of these developments is visibly obvious in the developing nations.

It can be observed that foreign trade constituting exports and imports wereUSD 46391 Mio in the year 1990-91 which increased to USD 73872 Mio in1995-96 and subsequently to 107456 Mio in 1999-00. It is also encouragingthat the exports now finance over 78 percent of imports compared to only

about 60 percent in the latter half of the eighties. Indias export performancegrew by 11.5 PA; almost double that of world exports which grew by 5.6percent. Similarly, the quantified export growth was 20 percent in 1996-97,18 percent in 1997-98 & 21 percent in 1998-99. Measured by all standardsIndias foreign trade definitely entered as fast track in the new globaltrajectory. Therefore, the demands on Public Sector Banks (PSBs) tooincreased in the area of handling international trade and related services.

While the expansion in economic activities in various other sectors could behandled by emerging new financial institutions and non-banking financialinstitutions, the requirements of foreign trade, international settlement of

transactions, global funds transfer and other exotic services related toForeign Exchange (FX) transactions need to be routed through theauthorised dealers. Therefore, the pressure for service centers more on theselected authorised branches of PSBs and EXIM bank.

But, on the other hand, the infrastructure to handle foreign trade in PublicSector Banks is growing at a lesser pace than the pace of growth of foreigntrade, which often creates a vacuum impinging the quality of services. Theattempt of PSBs to cope with growing demand is transparent.

The opening of specialised FX desk in branches, the proliferation of

dedicated overseas business branches, mechanisation of operations,introduction of new range of products/services etc. are certainly the


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manifestation of PSBs to meet the needs of increasing foreign tradeentrepreneurs.

These large increases in foreign trade by India are having its effects directlyor indirectly on every organisations. The reduction of import duty tariffs is

exposing domestic organisations to the global environment. Domesticorganisations are now restructuring their business to take advantage oflower imports in order to produce more competitive finished goods.

Similarly, reduced costs and incentives provided by the Government topromote exports attracts the domestic organisations to export trade.

This new environment has forced the organisations to participate in foreigntrade, which in turn has led them to face new foreign currency exposure. Inthe succeeding sections, we shall see more of M/s CSCIL, its policies forhandling its Foreign Trade Exposures and other related matters of Foreign

Trade, and managing of foreign exchange exposures.


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IMPORTS OF CSCIL IN THE LAST 5 YEARS

Year 95-96 96-97 97-98 98-99 99-00Rs.Crores 15.23 20.48 36.76 62.40 83.96

EXPORTS OF CSCIL IN THE LAST 5 YEARS

Year 95-96 96-97 97-98 98-99 99-00Rs.Crores 22.97 63.52 89.13 64.49 164.95

Year

95-96

96-9

7

97-98

98-99

99-00

0

50

1 2RS.

CRORES

YEAR

CSCIL IMPORT- LAST 5 YEARS

Year

95-96

96-97

97-98

98-99

99-00

22.97

63.52

89.13

64.49

164.95

CSCIL EXPORTS- LAST 5 YEARS

95-96

96-97

97-9898-99

99-00


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1.9 Background

Liberalisation of Indian Economy coupled with lowering of import tariffs onone hand and thrust on exports on other hand has resulted into significantlyhigher transactions denominated in foreign currency for many Corporates.

Up to 1992, for a long time, Indian Rupee was continuously but steadilydepreciating against major foreign currencies. Forex Management wasrelatively easier, as steady decline of Indian Rupee was more or lessmatched by the forward cover premiums.

The year 1992 saw Indian Rupee being officially devalued by more than10% in 8 days time. This was followed by huge inflow of foreign currency inthe country. The huge inflows were not only due to increase in exports, butalso due to Foreign Direct Investments (FDI) and Portfolio investments byForeign Institutional investors. As a result, the USD vis--vis Rupee ratewas rock steady at about Rs.31.40 - 45 for more than 30 months. However,

during this period also, USD suffered a setback of more than 20% betweenMay 1994 to August 1994 against European currencies and Yen. IndianRupee is linked to other currencies through USD. Therefore, it alsodepreciated by 20% against European currencies and Yen.

Thus, during a period of unprecedented steady Rupee against USD facedsubstantial volatility. Also Corporates having exposure to other foreigncurrencies had to face the same.

In the recent past alone, Indian Rupee first depreciated against USD bymore than 20% and then recovered by about 7%. USD has appreciated bya range of 10 - 15% against European currencies and Yen.

All this brings about the importance of active Forex management byCorporates. This paper attempts to explain all the important parameters ofactive Forex management. It is broadly divided into five major sections viz:

Forex Management Policy Treasury Performance Evaluation Criteria Policy and Performance evaluation of derivative products Managing External Commercial borrowings

Concept of Transfer Pricing


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FOREX MANAGEMENT POLICY

1.10 Pre-requisites

It is said that whatever gets measured gets managed better.

The first step in this direction is having a clear forex management policy. Adetailed and well laid down policy should determine authority andresponsibility of various people involved in the process. Ideally, CorporateFinance should be responsible for Forex Management, as finance peopleare more aware of forex risk and closer to bankers who offer forex hedgingproducts as well as settle all forex transactions. The process is followedsequentially as shown below:

DEPT/ACTIVITY DEPT/ACTIVITY EXPOSURE RESULT1 Purchase Dept/Import Order

Finance Dept/ForexPolicy (Norms)

Forward Contractcover Full/Part

Executionof Order

2 Sales Dept/ ExporterOrder

Finance Dept/ForexPolicy (Norms)

Keep part or fullexposure open

SalesRealisation

It is absolutely essential that the import and export order should clearlystate the currency, shipment schedule, payment terms etc. Itsrecommended that the exposure should be recognised with only onreceipt of a complete import or export order.

The following cash flows/ transactions are considered for the purpose ofexposure management.

Variable / Cash Flows Transaction TypeContracted Foreign Currency Cash FlowsForeign Interest Rates, whether Floating or FixedCash Flows from Hedge TransactionsProjected/ Contingent Cash Flows

Both Capital and Revenue in natureAll Interest Payments/ ReceiptsAll Open hedge transactionsBoth Capital and Revenue in nature

Cash Flows above $100,000/- in value will be brought to the notice of theExposure Manager, as soon as they are projected.

It is the responsibility of the Exposure Manager to ensure that he receivesthe requisite information on exposures from various sections of thecompany in time.

1.11 Analysis

These exposures will be analysed and the following aspects will be studied:

Foreign Currency Cash Flows/ Schedules


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Variability of Cash flows - how certain are the amounts and/ orvalue dates

Inflow-Outflow Mismatches / Gaps Time Mismatches / Gaps Currency Portfolio Mix

Floating / Fixed Interest Rate ratio

1.12 Concept of Gross Exposure and Net Exposure

Some managements look at imports and exports separately and,therefore, treat the exposures separately. Some are more particular wheresome imports are made towards export order & therefore, net forex inflowagainst forex outflow.

There are certain limitations of looking at Net Exposures:

The period of inflow and outflow may not match; The currency of inflow and outflow may be different; Cancellation or postponement of an import or export order may result

into substantial change in risk profile.

This is the reason why exposure of imports and exports should bemanaged separately.

1.13 Framing a Policy

Forex policy will reflect the management philosophy to the risk. It shouldclearly state the risk the management is willing to take and the delegationof authority, to various people.

The policies have been discussed followed by many Corporates andrecommendations of leading forex consultants. Practically, all of themrecommend a range between 25% to 75% for forward covers.

It means that the values covered should never be below 25% of theexposure & not beyond 75% of the exposures.

A slightly different but more practical approach to this is shown below:

a) Operational or Treasury Department Level:


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COVER(MINIMUM)

COVER(MAXIMUM)

1 For professionally managedand/or some what aggressiveOrganisation

35% 65%

2 For Organisations who do nothave proper set up or thosewho are risk averse

45% 55%

b) Top management level(Owner/Managing Director/ Head of Finance)

COVER(MINIMUM)

COVER(MAXIMUM)

1 For professionally managedand/or somewhat aggressiveOrganisation

25% - 35% 65%-75%

2 For organisation who do not havea proper set up or those who arerisk averse

25%-45% 55%-75%

Top Mangements decision should always be based upon input andrecommendations of either the operations level management or Banks orConsultants. It should always be recorded in writing.

We will observe that the arithmetic mean of minimum cover and maximumcover is 50%. This is same as the probability of getting head or tail whenwe toss a coin. Here there is a question. Is there any logic in keeping themean at 50%?

The answer is Yes. We will see this in our next section.


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1.14 Performance Evaluation Criteria

Very few organisations have an elaborate forex policy. Even among those,very few have performance evaluation criteria. Why?

One major problem is that of a having reasonable and rationalperformance evaluation criteria.

The second problem could be the efforts required to evaluate theperformance. A major factor could also be the fear of a bad performance.This issue is attacked first as it helps prepare ground for ourrecommendations towards the end of this section.

Consider following factors:

1. Forex business exceeds USD 1000 billion every day. There are manylarge players trying to outperform each other.

2. Forex market has rarely responded to basic fundamental factors in shortto medium terms. Short to medium term refers to a period of1 week to 6 months. Most of the corporate exposures will be for thisperiod.

3. When USD started depreciating against Yen and European currencies in1994-95, even intervention by 12 central banks of most powerful nations inthe world could not arrest the dollar fall.

4. Like any other market, forex is a zero sum game. Rewards normallydepend upon the risk one is taking.

In view of the above, its recommended that any performance, which iseven slightly above average, should be acceptable. Its advised not to setvery ambitious performance criteria, as this may result into total failure ofthe system or taking up of undue risk by the Treasury Manager.

1.15 Foreign Exchange Risk Management Policy of M/s CSCIL

Importance:

Any institution exposed to risk on account of foreign exchange exposureshould maintain written policies and procedures that clearly outline its riskmanagement strategy. These policies will help the institution in managingthe impact of exchange rate/ interest rate fluctuations on its profit and lossaccount and its balance sheet. The foreign exchange policy is also basedon and in consistency with the organizations broader business strategies,capitalization and loss bearing capacity, management expertise andcorporate philosophy on risk taking in this area. This policy seeks toestablish a sound and appropriate risk management process.

The primary components of the risk management process are:


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A comprehensive risk management approach A details structure of limits Guidelines and other parameters used to govern risk management A strong management information system for controlling, monitoring

and reporting risk.

In the light of the above, we shall study, in detail the primary componentsof risk management process at CSCIL.

The Board of Directors has approved the Foreign exchange riskmanagement guidelines. The senior management is responsible forensuring that procedures exist is followed strictly for conductingtransactions on a day-to-day basis. Also, the reporting and measurementin terms of exposure for risk management is adhered to.

Responsibility for daily currency risk management activities isconcentrated in a central Treasury Function. The Corporate Treasurer isresponsible for defining and managing the net currency exposure andgaps or maturity mismatches of the company from the exposures andgaps of the various individual units of the company. Responsibility forreporting risk exposures to senior management is with a unit independentof the treasury function to ensure that control and policy complianceobjectives are met.

1.16 Risk Measurement Approach

A sound risk measurement should identify

the various types of foreign exchange risks that the institution isexposed to (which has been listed in the earlier pages)

the point of recognition of these risks

the period of measurement.

Using these, the Corporate Treasurer defines the net position andgaps/maturity of the company.


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1.17 Types of Foreign Exchange Risks

A foreign exchange risk can be defined as the net effect of ratefluctuations on the Profit & Loss Account (P&L) and on the Balance Sheetposition.

In this context a foreign exchange risk impacting the P&L Account wouldarise on account of:

1 Imports of raw materials/exports of goods2 Availment of buyers/suppliers credits3 Sundry remittances of royalty/traveling expenses etc4 Principal amount of foreign exchange loan repayment5 Interest payments on outstanding foreign exchange loans6 Translation of financial statements of offshore

branches/subsidiaries incorporated overseas7 Depreciation on fixed assets financed through foreignexchange loans

A foreign exchange risk impacting the Balance Sheet (B/S) would be:

Imports of fixed assets financed though foreign exchange loans Approvals for foreign exchange loans (loans pending draw-down)

Also important to note is the risk on account of interest rate fluctuations in the

case of loans/borrowings/lendings etc. These also need to be addressed byan institution as they can be optimally managed with the use of derivativessuch as Interest Rate Swaps, Forward Rate Agreements etc.

Volumes of foreign exchange exposures at CSCIL as at 31/03/01 are listedbelow:

Nature of Exposures Amount PA(Rest in Mio)

Imports 1719Exports 1631Royalty 3Technical Know How Fees 0Indent Commission 2.3Dividend @ 50% p.a. 24Income from Research andDevelopment

0


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1.18 Recognition of Exchange risks

There are theoretically a number of alternatives when a company shouldrecognise the existence of a foreign exchange exposure.

I. At the time of BudgetingII. At the time of raising import orders/receiving export orders/approvals of

foreign exchange loansIII. At the time of shipment of goods/draw down of loansIV. On due date of payment

In order to be proactive in managing foreign exchange exposures, recognisea foreign exchange risk from the time of budgeting as this would be theearliest point in time where an exposure can be recognised. However, thevariations in the estimation of budgets may have a serious impact on theprofitability of a company and, therefore, M/s CSCIL recognises its exportsand covers the same only on raising of import order in the case of importsand on receipt of a confirmed export order in the case of exports or onapproval for foreign exchange loans.

Secondly, the company should also factor in that all budgeted items will not

necessarily fructify. As regards its other exposures, the same are recognisedas and when they arise/on due dates. It is important to note here that certainforeign exchange remittances may not really involve risk to to the remitter.

For example, M/s CSCIL remits dividends, royalty and technical know-howfees to its parent company, M/s CSC Inc., Basle, in Switzerland based oncertain factors like dividend is paid at the rate declared on equity of thecompany and equivalent USD or CHF (Swiss Francs) is remitted. Similar isthe case of technical know how fees and royalty remittances as the same arepaid as a percentage on sales.

Nature of Exposure Imports

Exports

Royalty

Technical KnowHow Fees

IndentCommission


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Step 1 Understanding Risks

Risks can be classified into five categories:

1. Price or Market Risk2. Counter party or Credit Risk

3. Dealing Risk

4. Settlement Risk

5. Operating Risks

1. Price Risks or Market Risk

This is the risk of loss due to change in market prices. Price risk can increasefurther due to Market Liquidity Risk, which arises when large positions inindividual instruments or exposures reach more than a certain percentage ofthe market, instrument or issue. Such a large position could be potentiallyilliquid and not be capable of being replaced or hedged out at the currentmarket value and as a result may be assumed to carry extra risk.

2. Counter party Risk or Credit Risk

This is the risk of loss due to a default of the Counterpart in honouring itscommitment in a transaction (Credit Risk). If the Counterparty is situated in

another country, this also involves Country Risk, which is the risk of theCounter party not honouring its commitment because of the restrictionsimposed by the government though counter party itself is capable to do so.

3. Dealing Risk

Dealing Risk is the sum total of all unsettled transactions due for all dates infuture. If the Counter party goes bankrupt on any day, all unsettledtransactions would have to be redone in the market at the current rates. Theloss would be the difference between the original contract rate and the currentrates. Dealing risk is therefore limited to only the movement in the prices andis measured as a percentage of the total exposure.

4. Settlement Risk

Settlement risk is the risk of Counterparty defaulting on the day of thesettlement. The risk in this case would be 100% of the exposure if thecorporate gives value before receiving value from the Counterparty. Inaddition the transaction would have to be redone at the current market rates.


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5. Operating Risks

Operational risk is the risk that the organization may be exposed to financialloss either through human error, misjudgment, negligence and malfeasance,or through uncertainty, misunderstanding and confusion as to responsibility

and authority.

Further operating risks could be classified as under:

Legal

Regulatory

Errors & Omissions

Frauds

Custodial

Systems

Legal

Legal risk is the risk that the organisation will suffer financial loss eitherbecause contracts or individual provisions thereof are unenforceable orinadequately documented, or because the precise relationship with thecounter party is unclear.

Regulatory

Regulatory risk is the risk of doing a transaction, which is not as per theprevailing rules and laws of the country.

Errors & Omissions

Errors and omissionsare not uncommon in financial operations. These mayrelate to price, amount, value date, currency, and buy/sell side or settlementinstructions.

Frauds

Some examples of frauds are:

Front running

Circular trading

Undisclosed Personal trading

Insider trading

Routing deals to select brokers

Custodial


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Custodial riskis the loss of prime documents due to theft, fire, water, termitesetc. This risk is enhanced when the documents are in transit.

Systems

Systems risk is due to significant deficiencies in the design or operation ofsupporting systems; or inability of systems to develop quickly enough to meetrapidly evolving user requirements; or establishment of a great many diverse,incompatible system configurations, which cannot be effectively linked by theautomated transmission of data and which require considerable manualintervention.

Step 2 - Define Risk Policy

Decide the basic risk policy that the organisation wants to have. This mayvary from taking no risk (cover all) to taking high risks (open all). Mostorganisations would fall somewhere in between the two extremes. Risk andreward go hand in hand.

Cost Center Vs. Profit Center

A cost center approach looks at exposure management as insurance againstadverse movements. One is not looking for optimisation of cost or realisationbut meeting certain budgeted or targeted rates. In a profit center approach,the business is taking deliberate risks to make money out of pricemovements.

Step 3- Risk Measurement

There are a number of different measures of price or market risk which aremainly based on historical and current market values Examples are Value atRisk (VAR), Revaluation, Modeling, Simulation, Stress Testing, Back Testing,etc.

Step 4- Risk Control

Control of Price Risk

Position limits are established to control the level of price or market risk takenby the organization.

Diversification is used to reduce systematic risk in a given portfolio.

Control of Credit Risk

Credit limits are established for each counter party for both Dealing Risk and

Settlement Risk separatelydepending upon the risk perception of the counterparty.


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Control of Operating Risk

Establishment of an effective and efficient internal control structure over the

trading and settlement activities, as well as implementing a timely andaccurate Management Information System (MIS).

Tools to control operating risks

Comprehensive Systems and Operations Manuals Proper Organizations structure and adequate personnel Separation of trading function from settlement, accounting and risk control

functions.

Strict enforcement of authority and limits Written confirmation of all verbal dealings Voice recording Legally binding agreements with counter parties ensuring proposed

transactions are not ultra vires. Contingency Planning Internal Audits Daily reconciliations Ethical standards and codes of conduct Dealing discipline

1.20 Possible performance evaluation criteria at M/s CSCIL:

1. Spot rate on settlement date

Actual rate of remittance is compared against spot rate on settlementdate. As a result, performance of uncovered transactions is Average or0 in mathematical terms. Thus, only performance of coveredtransactions gets reflected in this type of evaluation. Moreover,throughout the exposure period, there is no target for the Treasury

Manager.

2. Forward rate on date of exposure

In this method, Forward Rate quoted for the expected date of settlementis taken as standard for evaluation of performance. Since this rate isknown from day one, there is certainly a target for the Treasury Manager.However, in this case, performance of covered transactions will be 0 oraverage. Thus, only performance of uncovered transactions gets judged.Therefore, this method is also not desirable.

Both the above methods suffer from one major limitation. They have noreference to the forex policy of the organisation. To elaborate, in case of


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1st method, if the rupee is not expected to depreciate to the extent ofpremium, the Treasury Manager would like to keep all the importtransactions uncovered and cover all the export transactions.

Similarly, when he expects rupee to depreciate beyond the premium

levels, he would like to cover all the import transactions and keep open allthe export transactions. What one must find out is whether the policypermits taking such steps? Can a policy afford to be so flexible? If not,then a Treasury Manager has no authority to take such extreme positions.And when he cannot take position as per his views, can he be maderesponsible for that position?

To take a concrete example, if we are following:

Method 1: Treasury Manager will incur loss on covered transaction forimports (and uncovered export transactions), if rupee is steady

vs. premium. Since the policy requires certain minimumcover, Treasury Manager will attribute the losses to the policy.

Method 2: Similarly, if we are following this method and say Rupeedepreciates beyond premium, the Treasury Manager will incurloss on uncovered import and covered exports. Again he willattribute it to policy. In short, f the Treasury Manager cannottake a decision to keep uncovered 100% transactions or cover100% transactions; he cannot be expected to perform as pereither Method 1 or Method 2. Therefore, a more practicalmethod is recommended.

Method 3: 50% at forward rate on date of exposure and 50% at settlementdate rate, for each transaction. This method has followingadvantages:

I) For 50% of the amount of each transaction, there is a clear target,while for remaining 50%, the Treasury Manager will have to bereally alert, watchful and use his knowledge and experience ofmarket.

II) In method 1, performance of uncovered items does not getevaluated, while in method 2, performance of covered item doesnot get evaluated. However, in method 3, performance of bothcovered and uncovered transactions gets evaluated (though only tothe extent of 50%).

III) Normally any policy will allow taking cover up to 50% and keeping50% open. Therefore, Treasury Manager will have full authority toreach a position, which is in line with performance measurementcriteria. Therefore, he cannot attribute anything to rigid forex policy.


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In view of the above, I am of the opinion that method III is most balancedand acceptable way of performance evaluation.

An imaginary but realistic situations have been taken and the performanceis calculated under various methods. The results of the same are given in

the annexure. I am sure that the example clearly brings out limitation ofthe first two methods and advantages of method III.

1.21 Concept Transfer Pricing

Some companys follow the concept of transfers pricing for forextransactions viz. imports and exports. In this concept, the operatingdivisions and Finance agree on a budget rate of exchange at thebeginning of a period, generally a financial year. During the whole year,the transactions are passed on to the divisions at the agreed transfer price

rate. The difference between actual rate and transfer price is borne byFinance Department. According to advocates of this concept, it helpsoperating divisions to meet the budgeted targets, as they are assured of acertain rate for forex. However, there is a major practical difficulty in thisconcept.

Suppose for 1997-98, we have agreed on a transfer price @ 1 USD =Rs.37/-. Let us assume that some divisions are importing finished goodscosting USD 10 per kg. The product is sold in the market at Rs.400/- perkg. Now, suppose the USD/Rupee rate goes to Rs.41/- by June 1997. Ifthe division still continues to import the material (as it can get USD atRs.37/- being agreed rate with Finance), the division will make a profit ofRs.30/- per kg. Finance losses will be Rs.40/- per kg. The Company as awhole will lose Rs.10/- per kg. Is this situation acceptable? The reality isthat operating or business divisions must accept that there could bechanges in cost of inputs or sales realisation due to changes in exchangerate. As a matter of fact, can some one guarantee purchase or sale priceeven for local materials? Just because there is an added element ofexchange rate fluctuation, business divisions cannot pass it on entirely tofinance.

The best way to handle this kind of situation is to have a continuouscommunication between Finance and business divisions. Depending onlevel of forex business, Finance Division should send weekly or fortnightlyinformation about spot and forward rates for major currencies to businessdivisions. Based on this, business divisions should take their decisionsand inform the exposure to Finance as early as possible. In exceptionalcases, if there is any large import or export order with a very small margin,business division may insist on 100% cover specifically. Such requestsshould be accepted by Finance. However, in such cases, there should beno performance evaluation of such transactions, as the forward cover wasbusiness decision and not a finance decision.


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In summary, its recommended that:

I) there should be well laid down forex policy, separately for imports

and exports. The policy should be reviewed every year.

II) There has to be performance measurement criteria, givingweightage to both forward rate on date of exposure and spot rateon settlement date.

III) Transfer pricing concept should be avoided as far as possible.However, specific covers for large transactions may be taken as abusiness decision.

1.22 Period of Measurement

An institution would also need to define the time period over whichexposure must be managed. For example, exposure up to 1 year or till thefinancial year-end. However, as recommended that an exposure should berecognised at the time of budgeting. The period of measurement shouldcoincide with the budgeting period. In case of CSCIL, the FOREX risks aremeasured to a period of 1 year.

1.23 Net Position

Using these above criteria the Corporate Treasurer defines the new positionif the Company. For this purpose, the company distinguishes between theUSD/INR and the cross currency exposure for every item independently asthe local market in India determines the USD/NSR rate only and the coveron any other currency is possible through its cross with USD/INR. Thisdifferentiation is important as it enables the company to match or offsetexposures effectively and the hedging strategy for the crosses would bedifferent as compared to that of the USD/INR.

The General Manager Finance to the Managing Director reports the netposition on a weekly basis. Statistically, its shown in the exhibit below:

1.24 EXHIBIT-1: FOREX RATES & EXPOSURES

23-Oct-2001 0915 hrs


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25-Oct-01

Currency Inter Spot 1 month 1 month 2 month 3 month 3 month 6 month

Bank TT buy TT Sell TT buy TT Sell%

premia TT buy TT Sell TT buy TT Sell%

premia TT Buy

U.S. Dollar 47.99 47.79 48.19 47.99 48.39 0.05 48.22 48.62 48.44 48.84 0.05 49.15

Euro 0.89 42.26 43.33 42.41 43.49 0.04 42.58 43.66 42.76 43.84 0.05 43.32

Deutsche Mark 2.19 21.61 22.16 21.69 22.24 0.04 21.77 22.32 21.86 22.42 0.05 22.15

Jap. Yen (100) 122.52 38.78 39.55 39.07 39.85 0.09 39.36 40.15 39.66 40.45 0.09 40.58

Swiss Franc 1.66 28.73 29.45 28.87 29.39 0.02 29.01 29.54 29.16 29.69 0.05 29.63

Pound Sterling 1.43 67.74 69.03 67.96 69.25 0.04 68.21 69.50 68.45 69.75 0.04 69.22

Belgian Franc 45.23 1.05 1.07 1.05 1.08 0.04 1.06 1.08 1.06 1.09 0.05 1.07

French Franc 7.36 6.44 6.61 6.47 6.63 0.04 6.49 6.66 6.52 6.68 0.05 6.60

Italian Lira (100) 2,171.19 2.18 2.24 2.19 2.25 0.04 2.20 2.25 2.21 2.26 0.05 2.2

Dutch Guilder 2.47 19.18 19.66 19.25 19.74 0.04 19.32 19.81 19.40 19.89 0.05 19.66

Canadian Dollar 1.58 30.13 30.65 30.24 30.77 0.05 30.37 30.90 30.50 31.02 0.05 30.91

Austrian Schilling 15.43 3.07 3.15 3.08 3.16 0.04 3.09 3.17 3.11 3.19 0.05 3.15

Danish Kroner 8.34 5.70 5.81 5.72 5.83 0.04 5.74 5.85 5.76 5.87 0.04 5.83

Singapore Dollar 1.83 26.06 26.48 26.20 26.63 0.06 26.36 26.78 26.51 26.93 0.07 26.98

Swedish Kroner 10.67 4.46 4.54 4.47 4.55 0.04 4.49 4.57 4.51 4.59 0.05 4.57

Australian dollar 0.51 24.13 24.81 24.20 24.89 0.04 24.29 24.97 24.37 25.06 0.04 24.6

1.25 MATURITY MISMATCH OR GAPS

By using the above criteria, the Corporate Treasurer defines the gaps of theCompany in USD/INR and the crosses. A gap reflects a mismatch betweenthe maturity dates and inflows and outflows thereby creating an interestrate differential risk. For e.g., an import payment for USD 100,000 may bedue on the 1st of the month and an export payment for the same amountwould be receivable of the 15th of the same month. In this case, though the


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company does not have any net foreign exchange position, it has a maturitymismatch.

This gap can be closed out by doing a Swap where the Institution buysUSD 100,000 for value 1st and sells USD 100,000 for the value 15 th through

the money market or through Foreign Exchange forward markets.

We shall see now how the exposures are reported to the General ManagerFinance in case of exports and imports.

Exhibit No.2 represents the reporting system of exports. When a confirmedexport order is received the same is entered in Exhibit No.2 and therelevant data is completed from information available from the export order.

Like wise when an import order is issued in favour of some supplier, thesame is entered in Exhibit No.3. The specimen of these formats is listed

below. Exhibit 2 & 3 are sorted on due dates to find out MaturityMismatches or Gaps and the same are covered separately.

FOREXEXPOSURE

EXHIBIT- 2: EXPORT OPEN ORDER-(AS ON DD\MM\YY)

PYMNT TYPE PO NO PO DATE SHIPMENT BANK STATUS FC C/X FC AMT BUG SET BUDGTD BUDGTD

TERM DATE RATE AMT

21B 121120.12.98 21.02.99 BNP EX/1111 USD C 4414021.03.99 36.24 1599633

21B 121221.12.98 22.02.99 BNP EX/1112 USD X 6375021.03.99 36.46 2324325

21B 121322.12.98 23.02.99 BNP EX/1113 USD X 4318321.03.99 36.22 1564088

21B 121423.12.98 24.02.99 BNP EX/1114 USD C 4200021.03.99 36.92 1550640

21B 121524.12.98 25.02.99 BNP EX/1115 USD C 8400021.03.99 37.14 3119760

EXHIBIT-3 : IMPORT OPEN ORDER(AS ON DD\MM\YY)

PYMT TYPE PO NO PO DATE SHIPMENT BANK STATUS FC C/X FC AMT BUG SET BUDGTD BUDGTD

TERM DATE RATE AMT

21B I-1211 20.12.98 21.02.99 BNP DR/UR CHF X 2478021.03.99 22.33 553337

60B I-1212 21.12.98 22.02.99 BNP DR/UR CHF X 165000021.03.99 26.32 43428000

90B I-1213 22.12.98 23.02.99 ANZ DR/UR CHF H 15450321.03.99 26.49 4092784

90B I-1214 23.12.98 24.02.99 ANZ DR/UR CHF H 304021.03.99 27.65 84056

90B I-1215 24.12.98 25.02.99 ANZ DR/UR CHF X 1189521.03.99 27.71 329610


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NOTE:

Pymnt terms: Payment term of the order

Type: B-Basle, O-Others, G-group CompaniesPO No: Purchase Order NoPO Date: Purchase Order NumberPO Recd: Date of which the order reaches the TreasuryShipment: Shipment DateBank: Thru which Order was settledStatus: DR-document received, UR-under retirement

FC: Foreign CurrencyC/X: C-covered, E-Exposed, H-HedgedFC: Invoice in Foreign Currency AmtBUD SETT DT: Forecasted Settlement SateBUD RATE: The forward rate for that duration as quoted in the

PO recd date

BUD AMT: (FC Amt X Budgeted Rate)ACUTAL RATE: Actual RateACUTAL AMT: (FC Amt X Actual Rate)

PERFORMANCE : Difference between Budgeted & Actual


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STRUCTURE OF LIMITS

The Foreign Exchange Policy should clearly outline the limits of all foreignexchange positions and gaps of the country. These limits on risk takingmust be decided bearing in mind the risk profile of the company and thequantum of capital the company is willing to put a risk on account ofmovements of exchange rates. The foreign exchange policy as approved bythe Board of Directors should define the following limits:

1.26 Overall Limits

1. Total open position limit for the company either as a percentage of netposition or as a fixed limit based on capital adequacy.

2. Total open gap position limit for the Company.

The policy should not only define the personnel authorised to engage inforeign exchange business but also outline who will be authorised to deal inwhat type of foreign exchange products .

For example the dealers may only be allowed to engage in outright purchasesor sales of foreign exchange but all foreign exchange option transactions aredone by the Corporate Treasurer and Interest Rate or Currency Swaps maybe done subject to senior management approval.

The overall limits in the case of M/s Ciba Specialty Chemicals India Limitedare fixed at 80% to 120% of total exposure. The Direct Hedge PLUS InternalHedge should at no point of time of time exceed 120% of total exposure.

Hence a cascading structure of limits for all type of foreign exchange productsis to be outlined for:

Senior Management (Managing Director/Vice President)

Corporate Treasurer

Dealers

1.27 Individual Dealer Limits

Type of foreign exchange products that can be dealt.

Position and gap limit of each authorised dealer. Each dealer can have adifferent limit based on his experience and expertise.

Deal size limit. Each dealer should have a limit on the size of any individualdeal. Different dealers may have different deal size limits.


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The policy also defines the hierarchy for approval of temporaryincreases/changes in limits. The Board of Directors approves an Increase inthe total open position or open gap position of the company. Similarly, thepolicy also outlines the reporting and approval hierarchy for all types of limit

excesses by the dealers or Corporate Treasurer based on the quantum ofexcess.


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GUIDELINES FOR RISK MANAGEMENT

One of the following strategies may be adopted for the management ofcurrency exposures:

1.28 HEDGING

The company may cover all exposures for forward maturities as they arise,i.e. when import orders are placed or export orders are received or foreigncurrency loans are availed of. The company should as far as possiblematch offsetting exposures prior to taking cover. However, when thecompany matches offsetting exposures, this may result in a gap or amaturity mismatch. Hence the company would need to close out thesegaps by doing Swaps.

The company may also follow a policy of keeping a certain pre-definedpercentage of their exposures covered. For example, the company maycover only 50% of net import exposures in USD/INR, whereas netUSD/FCY could continue to be covered 100%. This strategy could, in somecircumstances, save the company the cost of USD/INR discounts.

CSCIL has its import exposures in CHF and export exposures in USD.However, in imports, it covers only USD / Rest and covers CHF/USD eithersubsequently or on spot depending on circumstances/market rates.

1.29 PASSIVE RISK MANAGEMENT

The company can choose to cover selectively and progressively based onits view of individual currency movements. Hence, the company may leavesome portions of their foreign exchange exposure or gaps open with theaim of capitalising on certain anticipated market movements.

However, the company could stand to lose should the market not move inthe anticipated direction. This would result in increased cost of imports orlower realisation of exports. In order that this negative effect is containedthe company should define Stop-Loss limits for all open positions. The

stop-loss limit should be defined based on the quantum of money thecompany is willing to risk on its open position. Conversely, Take-Profitlimits should also be defined to enable the company to crystallise gains onprofitable open positions.

Secondly, the company should decide the extent of total foreign exchangeexposures and gaps that the Central Treasury may keep open either as apercentage of its total exposure, or as a fixed limit, for e.g., USD 5 million.

CSCIL has not yet defined its stop-loss or take-profit limits and its policyis purely based on the overall limits. However in the long run it proposes to

fix such limits on the budgeted rate on the day the exposure arises.


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1.30 ACTIVE RISK MANAGEMENT

In addition to the above mentioned risk management strategies, thecompany may also decide to trade in the currencies in which it hasunderlying exposures and hence an existing need to manage exchange

risk. This activity should then be viewed as an additional product line orprofit center.

However, this activity should be carried out after adequate internal approval(Boardapproved). Risk Management Policy is obtained and with anappropriate degree of internal control. This includes:

Persons authorised to create risk positions and the spot position limitand gap limit of each trader so authorised.

Stop-Loss Limits for all open positions, either as a percentage varianceof the exchange rate, or as a quantum of money at risk per trader perday/month.

Total open position limits and gap limits for the company at any givenpoint in time, or total money at risk limit across these activities.

It should also be noted that, due to Exchange Control restrictions ActiveRisk Management is curtailed to the extent possible within documentationconstraints and against underlying open exposure.

The objective of the Corporate Treasurer is managing forex exposure andminimising losses due to fluctuations at CSCIL. Even though realisedGains/Losses are accounted as a separate profit center the objective is notprofit making, but to cover risks. Therefore, CSCIL is in no way in favor ofActive Risk Management.


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VALUATIONS OF FOREIGN EXCHANGE EXPOSURES

The company makes an analysis of the performance of its foreign exchangeportfolio in order to value at current market rates the cost of its imports,exports, loans, etc., and thus measure the impact of exchange/interestmovements on its Balance Sheet and Profit & Loss Account on a monthlybasis.

In order to achieve this, the company also assigns a budget rate or targetrate to its exposures as and when they arise. This rate can be the forwardvalue of the exposure on the day the exposure is recognised, which iscalculated by adding the premium amount to the spot value of thatcurrency.

The performance or the portfolio is then to be measured against these

budgeted rates by comparing the market rates prevailing at which theexposure can be covered against the budgeted rate.

In the case of passive & active risk management, there may be tradingpositions where the budgeted rate would be the rate at which the positionwas initiated as this would also be valued at prevailing market rates (alsoknown as Market-to-Market).

Accounting for the effects of changes in foreign exchange rates may bedone in accordance with the Accounting Standards 11(revised) issued bythe Institute of Chartered Accountants of India.

Exchange Gains or Losses at M/s CSCIL are classified under thefollowing account heads:

1. Realised Gains/Losses - Inter Company2. Realised Gains/Losses - Third Party3. Realised Gains/Losses - Forward Covers4. Realised Gains/Losses - Cancellations


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INTERNAL CONTROLS

The Institution needs to monitor open positions and stop loss limits on acontinuous basis and evaluate periodically the performance of the foreignexchange portfolio.

The Central Treasury reports, on a weekly basis, the open positions andopen gaps to Senior Management as represented in Exhibit 1 . This iscounter checked by an Independent Settlements Departments. TheSettlements Department monitors positions of the dealers and anyexcesses of any limits are to be reported directly to the senior management.

The foreign exchange portfolio is marked to market at least once a weekand a valuation report (cross checked by Settlements) is sent by theCorporate Treasurer to Management . The Board of Directors also reviews

the portfolio performance periodically.

Internal Audits addresses the functioning of the Central Treasury,adherence to policy & operational risks.

ORGANOGRAM of M/s Ciba Specialty Chemicals India Limited


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1.31 BALANCE OF PAYMENT

1.31.1 SOME BASIC CONCEPTS

The fundamental reason why foreign trade benefits an economy is the

so-called principle of comparative advantage. If different countriesconcentrate on providing products and services in which they havecomparative advantages arising out of differences in resources, costs ortechnology, then international trade can be beneficial to all the countries.Remember, we are referring to relative, and not absolute, efficiency ofproducing goods and services in other words, even if a country is themost efficient producer of all the goods and services it needs it will stillbenefit by engaging in international trade, as the relative efficiencies wouldsurely differ in practice.

1. Balance of Payments of a country is systematic records of all receiptsand payments between residents of the country with non-residents ofthe country over a period of time, say one year. These receipts andpayments could be of account on account of import and export of goodsand the difference on this account is known as balance of trade.

2. If receipt and payments on account of import and export of services liketourism, banking, insurance etc are also added to that of goods then thedifference on this account is known as balance on current account.

3.The 3rd component of balance of payment is grants, aids, foreign

investment etc falls under Capital Account.

Thus, receipt and payments on account of all the three components makethe Balance of Payments of the country.

Incidentally the BOP of a country is always balanced. If the receipt underthe 3 components i., e goods, services and capital account are less thanthe payments then the BOP of the country is said to be negative oradverse. Since BOP is always balanced the balancing is done thruForeign Exchange Reserve of the country.

The principle of comparative advantage is easy to understand. Theclassic textbook example is that of a person who happens to be both thebest lawyer as well as the best stenographer in the city.

Let us assume that as a lawyer he can earn Rest. 5000/- Per Hour whilehe can hire a stenographer[who may not be as good as himself] at sayRest. 50/- Per Hour. It obviously makes economic sense for the lawyer tohire a stenographer and devote all his time to working as a lawyer as hiscomparative advantage, given the earnings and expenses, obviously liesin working as a lawyer. It is a known factor that international trade benefits

an economy, the question of external receipts and payments has to beconsidered. It is customary to classify a countrys external receipts and


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payments under two broad headings- Current Account and CapitalAccount. The third category falling under BOP is the Reserve Account.

1.32 Components of Balance Of Payments:

1.32.1 Current account

The Current Account in turn, is split under two heads -

1. Trade flows &2. Invisibles

Of the two trade flows comprising exports and imports of goods is easier tounderstand. The difference between the two is commonly referred to as thesurplus or deficit trade balance. It is customary to report imports on CIFbasis and exports on FOB basis for calculating the trade balance.

1.32.2 Trade flows

Strong economic growth of economy in 1995-96 resulted in widening ofthe trade deficit to USD 8.9 bn. However, high interest rates and an overallliquidity squeeze in the corporate sector through second half of 1996 sawgrowth taper off rapidly. This was reflected in non-pol [petroleum, oil,lubricants] imports decline by 4 percent during April November 1996 asagainst an increase of 36 percent last years, whereas imports till

November were up by 4.66 percent, exports showed slightly higher growthat 7.81 percent, resulting in narrowing of the trade deficit. It is expectedthat the trade for 1996-97 would be between 7.5 to 8 bn. Conventionally,trade in physical goods is distinguished from trade-in services. Invisiblescomprise current international payments for items other than merchandiseexports or imports. Some of the more important items under the head[invisibles] comprising travel, transportation and insurance, interest,indentingcommission, export commissions, research income, dividend paymentsand other miscellaneous income and expenditure.

1.32.3 Invisibles

Invisibles have maintained a rising trend in recent years, on account ofsteady increase in private transfer receipts. It is expected that this trendwould continue as a moderate rate at the rate of [20] percent in 1996-97.Trade flows and invisibles together comprise the current account of acountry and the difference give the current account surplus deficit.

1.32.4 Deficit & Surplus

Meaning of Deficit and Surplus in BOP


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1. BOP is a double entry accounting record and hence must balance exceptfor errors and omissions.

2. As such deficit or surplus refer to subsets of accounts included in BOP.

These are imbalances or economic disequilibria.

3. Need to optimally group various accounts within BOP statement so as togive proper signals to the authorities to correct disequilibrium.

4. Division of entire BOP into set of accountsa. Above the line (if the net balance is positive, then there is BOP

surplus and if negative, there is a BOP deficit).b. Below the line (this net balance should be equal in magnitude but

opposite in sign of the balance above the line).

5. The items below the line are "compensatory" in nature. They "finance orsettle" the imbalance above the line.

6. The transactions above the line are "autonomous transactions". Thismeans a transaction undertaken for its own sake, in response to givenconfiguration of price, exchange rate, interest rate, etc. and usually torealize profit / reduce cost. It does not take into account situationelsewhere in the BOP.

7. An accommodating transaction (below the line) is undertaken with a viewto settle the imbalance arising out of other transactions. For e.g. financingthe deficits arising out of autonomous transactions.

8. BOP deficit or surplus is understood to mean deficit

85609969 55190814 forex exposure management

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