“foreign exchange risk management” at rolex rings pvt. ltd., rajkot

Shri Sunshine Group of Education

Page1

Declaration

I hereby declare that I had a good learning experience in doing this project titled

“Foreign Exchange Risk Management” at Rolex Rings Pvt. Ltd., Rajkot submitted in

partial fulfillment of the requirements for the degree of MBA program of Gujarat

University.

I hereby declare that the project done by me is true to knowledge. The project

duration was of weeks. The content of this report is based on the information

collected from different sources and the company itself.

I further declare that this project report has not been submitted to any other

university or institute for the award of any degree or diploma.

Date: Vishal Sitapara

Place: Rajkot


Page2

Acknowledgement:

I take this opportunity to express my heartfelt gratitude to all the people who

have extended their assistance and provided me the information during the

tenure of the project. I am greatly indebted to them for their guidance and

support throughout the project and for sparing their valuable time with me.

I earnestly express to Mr. Manish Madeka for giving me this opportunity to work

with Rolex Rings Pvt. Ltd. and also to Mr. HirenDoshi and other staff members of

the firm for their invaluable guidance, cooperation and support during my

internship tenure.

I would also like to thank the Director of my college, Dr. SarlaAchuthan and

project guide Dr. PrateekKanchan for giving the opportunity to carry out the

project in the real world.

Thanking You,

Vishal Sitapara


Page3

Table of Contents:

1) Executive Summary

2) Objectives and Scope

a) Objectives

b) Scope

3) Company Profile

a) Introduction

b) History

c) Management Team

d) Product Profile

e) Quality Policy

f) Environment

g) Bank Affiliation

4) Research Methodology

a) Type of Study

b) Secondary Data

c) Limitations

5) Introduction to FOREX Market

a) Introduction

b) Foreign Exchange Meaning

c) Requisites for FOREX Deals

d) Need for FOREX


Page4

e) What does Foreign Exchange provide?

6) Foreign Exchange Market in India

a) Introduction

b) History

c) Modified LERMS

d) Exchange Rate Systems

e) Exchange Rate Systems in India

f) Factors affecting Exchange Rate

g) Factors affecting Indian Rupee

7) Foreign Exchange Exposure and Risk

a) Foreign Exchange Exposure

b) Foreign Exchange Risk

c) Differentiation of Exposure with Risk

8) FOREX Risk Management & Hedging Tools

a) FOREX Risk Management

b) Foreign Exchange Risk Management Framework

c) Determinants of Hedging Decisions

d) Hedging Tools

e) Risk Management Tools Available in India

f) Other Hedging Instruments

9) FOREX Risk Management at ROLEX RINGS

10) Findings & Conclusion

11) Bibliography


Page5

Executive Summary

This project is based on the study of Foreign Exchange Risk Management at Rolex

Rings Pvt. Ltd.

Foreign Exchange, in common parlance, is the exchange of one currency for

another. This exchange is done at a particular rate called the exchange rate or the

FX rate. The FX rate is the price of one currency in terms of another. As is true

with rates, FX rate too is for a pre-determined settlement date i.e. the date on

which the actual exchange of the currencies involved would take place.

The Liberalized Exchange Rate Management System (LERMS) was introduced in

March 1992, and as a result, the foreign exchange market in India effectively

became a two-tier one, with a dual exchange rate system in force. One rate was

the administered one at which specified type or proportion was determined by

demand and supply in the market and applied to the remaining transactions. In

March 1993, this system was abolished and now a single market determined rate

is applicable for all transactions.

The volatility of exchange rates can’t be traced to a single reason and

consequently, it becomes very difficult to precisely define the factors that affect

exchange rates. The foreign exchange risk is related to the variability of the

domestic currency, values of assets, liabilities or operating income due to

unanticipated changes in exchange rates, whereas foreign exchange exposure is

what is at risk. FOREX risk is the variability in the profit due to change in foreign

exchange rate.

Business firms/companies like Rolex Rings have internationalized their activities

considerably. This trend has manifested itself not only in increased involvement in

international trade and foreign operations, but also in the fact that even firms

without explicit international transactions have become subject to the direct and

indirect effects of foreign competition to a much larger extent than in the past.


Page6

Thus, the impact of exchange rate changes on business operations tends to be

pervasive; the concern is not limited to specific financial functions such as

corporate treasury.


Page7

Objectives and Scope Objectives of the Study:

Main objectives of the study are as under:

1. To ascertain the FERM practices and product usage of Rolex Rings.

2. To know the attitudes, perceptions and concerns of the firm towards FERM.

3. To understand the level of awareness of derivatives and their uses, with Rolex

Rings.

4. To ascertain the organization structure, policymaking and control process

adopted by the firm, which use derivatives, in managing foreign exchange

exposure.

Scope:

The scope of this study is limited to the Foreign Exchange Risk Management and

the way Rolex Rings manages it. It has nothing to do with any kind of forecasts

about the currency movements.


Page8

Company Profile


Page9

Introduction:

Established in 1980, Rolex Rings is the single largest manufacturer of hot forged

rolled rings in India and an emerging strong contender in the automotive

components space, catering to an array of multi-national companies across

countries such as Italy, France, Poland, Germany, Spain, USA, Mexico, China and

India. Rooted in the fertile grounds of hard beginnings and humble origins, Rolex

Rings, have survived and surpassed competitors and have become the leading

manufacturer of hot forged rolled rings along-with finished machining through

CNC route.

Today the company stands for engineering capability, customized solutions and

consolidated growth orientation. Its values of commitment to hard work and their

innate sense of responsibility towards providing the society with superior

products is the moving force behind their success saga.


Page10

History:

The history of Rolex Rings since the day of its inception has been described as

under:

Management Team:


Page11


Page12

Product Profile:


Page13


Page14

Quality Policy:

Pushing ahead with grueling schedules, punishing deadlines and a raging desire to

be beyond competition roles sets the bar high for quality standards at the

company.

Each stage of manufacturing at Rolex Rings reflects a profound presence of

excellence in quality. To meet the most exacting requirements of the most

demanding client, we have an array of sophisticated technology to ensure the

best of quality. High precision measuring instruments such as spectrometer,

electronic microscope, CMM, Contour measuring, Machine Profile Projector,

surface roughness tester etc. lay down the foundation for the quality of our

products.

Quality assurance activities for the manufacture of all the products of our plants

are closely coordinated at the following stages.

1. Raw Material

2. Statistical process control at the will press/machining

3. Acceptance test of forgings

4. Process and product quality audits

5. Packing

6. Transportation

Our employees contribute to the zero defect strategy.

Environment:

For any company in order to carry out its operations in the society, it becomes

very important on part of the company to take certain steps that protects the

environment and the society as a whole.

At Rolex Rings, we follow the following principles:


Page15

Healthy working environment for the employees.

Continuous control of the raw material and energy consumption to save

resources.

Continuously trying to reducing the waste.

Installation of precautionary steps against accidents that may have negative

effects for the environment.

Our environmental policy targets to a continuous improvement of the companies

environmental pollution control.

Rolex Rings has green power technology of 8.75 MW, which helps us to save the

environment and also be more competitive.

At Rolex, we believe that our responsibilities to the environment do not end with

developing Green power technology. As our global footprint grows and we

become more a part of the world around us, we are taking every step necessary

to ensure that our activities, processes & services ensure minimal adverse

impact on the environment. We are committed to pollution control and use every

opportunity to conserve energy.

Bank Affiliation:

Rolex Rings Pvt. Ltd. has its accounts in the following banks:

1) Corporation Bank

2) Oriental Bank of Commerce

3) Union Bank of India

4) Bank of Baroda

5) Indian Overseas Bank


Page16

Research Methodology


Page17

Introduction

This study aims to delineate the methodology, employed to undertake this study.

Research is a common parlance, which refers to a search for knowledge. One can

define research as scientific and systematic search for pertinent.

Research is of a great importance to find out the nature, extent and cause of the

research issue under study. Research methodology is the process in which various

steps generally adopted by a researcher are outlined.

Type of the study:

This is a descriptive study; analysis is made on the basis of the secondary data.

Secondary Data:

1) Publications

2) Articles

3) Websites

In this report, I have used the secondary data, most of which was obtained

from the internal records of the company. Data has also been gathered

from websites of RBI, X-Rates, NSE, FEDAI and Rolex Rings.

Limitations:

1) Lack of practical exposure in the area of Risk Management

2) Lack of formal sources of data


Page18

Introduction to Foreign

Exchange Market


Page19

Introduction:

The international currency market – the foreign exchange, is a special kind of the

world financial market. The Foreign exchange, also referred to as the “FOREX” or

“Spot FX” market, is the largest financial market in the world, with over $3.5

trillion changing hands every single day.

What is traded on the Foreign Exchange? The answer is money. FOREX trading is

where the currency of one nation is traded for that of another. A trader’s purpose

on this market is to get profit as the result of foreign currencies purchase and

sale in accordance with a known principle ‘Buy cheaper – Sell higher” and to

convert profits made in foreign currencies, buy or sell products or services in a

foreign country, into their domestic currency.FOREX trading is always traded in

pairs. The most commonly traded currency pairs are traded againstthe US Dollar

(USD). They are called ‘the majors’. The major currency pairs are the Euro Dollar

(EUR/USD), the British Pound (GBP/USD), the Japanese Yen (USD/JPY) and the

Swiss Franc (USD/CHF). As there is no central exchange for the FOREX market,

these pairs and their crosses are traded over the telephone and online through a

global network of banks, multinational corporations, importers and exporters,

brokers and currency traders, i.e. the FX market is considered as an Over The

Counter or ‘inter-bank’ market.

FOREX is different compared to all other sectors of the world financial system,

thanks to its heightened sensibility to a large and continuously changing number

of factors, accessibility to all individual and corporate traders, exclusively high

trade turnover which creates an ensured liquidity of traded currencies and the

round the clock business hours which enable traders to deal after normal hours or

during national holidays in their country finding markets abroad open. Also, just

as on any other market, the trading on FOREX along with an exclusively high

potential profitability, is essentially a risk bearing one.

Foreign Exchange – Meaning:


Page20

Foreign Exchange is the purchase or sale of a currency against the sale or

purchase of another, i.e. the exchange of one currency for another. This exchange

is done at a particular rate called the exchange rate or the FX rate. The FX rate is

the price of one currency in terms of another. As is true for rates, FX rate too is a

pre-determined settlement date, i.e. the date on which the actual exchange of

currencies involved would take place.

Requisites for Foreign Exchange Deals:

Exchange of two currencies

At an agreed exchange rate

For a specified settlement date

Settlement instructions for receipt and payment

Confidence that the terms of the trade will be adhered to

Need for Foreign Exchange:

In this global village, which has almost as many currencies as countries, business

activity would come to near standstill if each country insisted on dealing on its

own currency and none other. With the growing importance of international

trade and maturity in financial markets, the major international trade participants

have come to accept certain currencies as the “traded currencies” or “major

currencies”. These currencies are termed as such based on the strength of their

economies and their financial markets, the political backing of the countries,

international acceptability, liquidity and depth of their markets, economic and

political stability. The World Bank, leading international agencies and world

bodies have given a further boost to these currencies, using in their dealings too.

A country’s external reserves are denominated in these currencies. This is what

necessitates the Foreign Exchange.


Page21

What does Foreign Exchange provide?

The method or mechanism to conduct and settle the proceeds of

International Trade

The means to obtain/provide technology, expertise and the sharing of

information

The means to minimize the risks of currency fluctuations - primarily

through the use of various tools and financial instruments

Trading opportunities to generate incremental income


Page22

Foreign Exchange

Market in India


Page23

Introduction:

The Foreign Exchange business in India is regulated closely by the RBI. With

Exchange Control Regulations, the RBI ensures that involvement in the Foreign

Exchange business is restricted to certain sections of the business community

only.

Main Participants:

Corporate: Importers, Exporters and Customers for genuine trades or

merchant transactions

Banks: Banks in India are permitted to buy and sell currencies abroad in

cover of customer requirements. They have also been permitted to initiate

positions abroad too. Overseas banks call banks in India to cover their

Indian rupee requirements.

Overseas Traders: One authorized dealer dealing with another to generate

profit or cover its open exposure

Authorized Dealers v/s RBI: This occurs only when the RBI intervenes in the

market and not in the normal course

RBI restrictions in terms of participation in foreign currencies are as under:

Corporate:

Individuals as per the Exchange Control Manual (Retail)

Importers, Exporters and Borrowers of Foreign Currencies (Wholesale)

Banks/Others:

Money Changers (RMC’s and FFMC’s) licensed by the RBI to buy/sell

Foreign Currency Notes and Travelers Cheques from individuals (Retail)

Banks licensed by the RBI to carry out foreign exchange business on a

commercial wholesale level, called the Authorized Dealers


Page24

Brokers: Brokers are permitted to bring together buyers and sellers but cannot

trade for their own account. This means they have to strike thedeal with the

buyers and sellers simultaneously.

History of FOREX Market in India:

Until the early seventies, given the fixed rate regime, the foreign exchange market

was perceived as a mechanism merely to put through merchant transactions.

With the collapse of the Bretton Woods agreement and the floatation of major

currencies, the conduct of exchange rate policy posed a great challenge to central

banks as currency fluctuations opened up tremendous opportunities for market

players to trade in currency volatilities in a borderless market.

The market in India, however, remained insulated as exchange rate controls

inhibited capital movements and the banks were required to undertake cover

operations and maintain a square position at all times.

Slowly a demand began to build up that banks in India be permitted to trade in

FOREX. In response to this demand the RBI, as a first step, permitted banks to

undertake intraday trade in FOREX in 1978. As a consequence, the stipulation of

maintaining square or near square position was to be complied with only at the

close of business each day.

As the opportunities to make profit began to emerge, the major banks started

quoting two-way prices against the Rupee as well as in cross currencies (Non-

Rupee) and gradually, trading volumes began to increase. This was enabled by a

major change in the exchange rate regime in 1975 whereby the Rupee was

delinked from the Pound Sterling ad under a managed floating arrangement, the

external value of the Rupee was determined by the RBI in terms of weighted

basket of currencies of India’s major trading partners. Given the RBI’s obligation

to buy and sell unlimited amounts of Pound Sterling (the intervention currency),

arising from the bank’s merchant trades, and its quotes for buying/selling

effectively became the fulcrum around which the market moved.


Page25

As the volumes increased, the appetite for profits was found to lead the

observance of widely different practices dictated largely by the size of the players,

their location, expertise of the dealing staff and availability of communications

facilities, it was thought necessary to draw up a comprehensive set of guidelines

covering the entire gamut of dealing operations to be observed by banks engaged

in FOREX business. Accordingly, in 1981 the “Guidelines for Internal Control over

Foreign Exchange Business” was framed for adoption by banks.

During the eighties, deterioration in the macro-economic situation set in,

ultimately warranting a structural change in the exchange rate regime, which in

turn had an impact on the FOREX market. Large and persistent external

imbalances were reflected in rising level of internal indebtedness. The graduated

depreciation of the Rupee could not compensate for the widening inflation

differentials between India and the rest of the world and the exchange rate of the

Rupee was getting increasingly overvalued. The Gulf problems of August 1990,

given the fragile state of the economy, triggered off an unprecedented crisis of

liquidity and confidence. This unprecedented crisis called for the adoption of

exceptional corrective steps. The country simultaneously embarked upon the

measures of adjustment to stabilize the economy and got in motion structural

reforms to generate renewed impetus for stable growth.

As a first step in this direction, the RBI effected a two-step downward adjustment

of the Rupee in July 1991. Simultaneously, in order to provide a closer alignment

between exports and imports, the EXIM scrip scheme was introduced. The

scheme provided a boost to exports and with the experience gained in the

working of the scheme, it was thought prudent to institutionalize the incentive

component and convey it through the price mechanism, while simultaneously

insulating essential imports from currency fluctuations. Therefore, with effect

from March 1, 1992, RBI instituted a system of dual exchange rates under the

Liberalized Exchange Rate Management System (LERMS). Under this, 40% of the

exchange earnings had to be surrendered at a rate determined by the RBI and the

RBI was obliged to sell foreign exchange only for imports of essential commodities

such as oil, fertilizers, life-saving drugs etc., besides the government’s debt


Page26

servicing. The balance could be converted at rates determined by the market. The

scheme worked satisfactorily preparing the market for its emerging role and the

Rupee remained fairly stable with the spread between the official and the market

rate hovering around 17%.

Even though the dual exchange rate system worked well, it however, implied an

implicit tax on exporters and remittances. Moreover, it distorted the efficient

allocation of resources. The LERMS was essentially a transitional mechanism and

in March 1993, the two legs of the exchange rates were unified and christened

Modified LERMS. It stipulated that from March 2, 1993, all FOREX receipts could

be converted at market determined rates of exchange. Over the next eighteen

months, restrictions on a number of other current account transactions were

relaxed and on August 20, 1994, the Rupee was made fully convertible for all

current account transactions and the country formally accepted the obligations

under Article VIII of the IMF’s article of agreement.

Changes that took place:

1966 – The rupee was devalued by 57.5% on June 6

1967 – Rupee-Sterling parity change as a result of devaluation of the

Sterling

1971 – Bretton Woods system broke down in August. Rupee briefly pegged

to the USD @ Rs. 7.5 before reneging to Sterling at Rs. 18.87 with a 2.25%

margin on either side

1972 – Sterling floated on June 23. Rupee-Sterling parity revalued to Rs.

18.95 and then in October to Rs. 18.80

1975 – Rupee pegged to an undisclosed basket with a margin of 2.25% on

either side. Sterling, the intervention currency with a central bank rate of

Rs. 18.31

1979 – Margins around basket parity widened to 5% on each side in January

1991 – Rupee devalued by 19.5% in July 1s t and Rupee-Dollar rates

depreciated from Rs. 21.20 to Rs. 25.80. A version of dual exchange rate


Page27

introduced through EXIM scrip scheme, given exporters freely tradable

import entitlements equivalent to 30-40% of export earnings.

1992 – LERMS introduced with a 40-60 dual rate converting export

proceeds, market determined rates or all but specified imports and market

rate for approved capital transaction. US Dollar became the intervention

currency from March 4th. EXIM scrip abolished.

1993 – Unified market determined exchange rate introduced for all

transactions. RBI would buy/sell US Dollars for specified purposes. It will

not buy/sell Dollar Forwards though it will enter into Dollar Swaps.

1994 – Rupee made fully convertible on current account from August 20th

1998 – Foreign Exchange Management Act – FEM Bill 1998 which was

placed in the Parliament to replace FERA

1999 – Implication of FEMA starts

Modified Liberalized Exchange Rate Management System:

The process of liberalization continued further and it was decided to make the

Rupee fully floating with effect from March 1, 1993. This new arrangement is

called Modified LERMS. Its salient features are as under:

Effective from March 1, 1993, all foreign exchange transactions, receipts and

payments, both under current and capital accounts of Balance of Payments are

being put through by authorized dealers at market determined exchange rates.

Foreign exchange receipts and payments, however, continued to be governed by

the Exchange Control Regulations. Foreign exchange receipts are to be

surrendered to the authorized dealers except in cases where the residents have

been permitted by the RBI to retain them either with the banks in India or abroad.

Authorized dealers are free to retain the entire foreign exchange surrendered to

them for being sold for permissible transactions and are not required to surrender

to the Reserve Bank any portion of such receipts.


Page28

Reserve Bank of India, under section 40 of RBI Act 1934, was obliged to buy and

sell foreign exchange to authorized dealers. Reserve Bank is now required to sell

any authorized person at its offices/branches US Dollars for meeting foreign

exchange payments at its exchange rates based on the market rate only for such

purposes as are approved by the Central Government. The RBI buys spot US

Dollars from authorized dealers at its exchange rate. Reserve Bank does not

ordinarily buy spot Pound Sterling, Deutsche Mark and Japanese Yen. It does not

buy any forward currency. The exchange rate at which the RBI buys and sells

foreign exchange is in the +5/-5% band of the market rate. Also, the RBI

announces the reference rate at 12:00 hours which is the rate at which

transactions with IMF, IBRD etc. are undertaken.

Advantages of the New System:

The system seeks to ensure equilibrium between demand and supply with

respect to a fairly large subset of external transactions.

It has facilitated removal of several trade restrictions and granted

relaxation in exchange control (under current account transactions).

It is a step towards full convertibility of current account transactions in

order to achieve the full benefits of integrating the Indian economy with

the world economic system.

The incentives to exporters will be higher and more particularly to those

whose exports are not highly import intensive. Exporters of agricultural

products will find exports attractive.

A large number of expatriates, who are hitherto denied any advantages on

their remittances to India in line with the earnings of the exporters, are

now eligible for market rate for the full amount of remittances being in

nature of capital inflows.

This system, coupled with the Exchange Control Relaxation in certain areas,

and the abolition of travel tax is expected to make the havala route less

tempting. In this context, it needs to be remembered that smaller the gap

between the average rate received by the exporters and other earners of


Page29

foreign exchange and the market rate, the lesser will be the temptation to

continue using illegal channels for remittances.

In the fiscal area, customs revenue is likely to be higher, other things being

the same, to the extent the valuation of imports would be based on the

market exchange rate. It is, however, necessary to ensure that the tariff

rates together with higher input values do not result in a sharp increase in

import costs.

Exchange Rate System:

Countries of the world have been exchanging goods and services amongst

themselves. This has been going on since 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.

Different countries have adopted different exchange rate systems at different

times. Following are the exchange rate systems followed by various countries:

The Gold Standard, 1816-1933:

The 'gold standard' used the physical weight of gold as the standard value

for the money and making it directly exchangeable in the form of the

precious metal. In 1816 for instance, the pound sterling was defined as

123.27 grains of gold on its way to becoming the foremost reserve currency

and was the principal component of the international capital market. This

led to the expression 'as good as gold' when applied to the Sterling, as the

Bank of England at the time gained stability and prestige as the premier

monetary authority. Before the First World War, most Central banks

supported their currencies with convertibility to gold. Paper money could

always be exchanged for gold. For this type of gold exchange, a central

bank coverage backing up the government’s currency reserves was not


Page30

necessarily needed. When a group mindset fostered a disastrous notion of

converting back to gold in mass, panic resulted in so-called "Run on banks”.

The US dollar adopted the gold standard late in 1879 and became the

standard-bearer replacing the British Pound when Britain and the other

European countries came off the system with the outbreak of World War I

in 1914. Eventually, though, the worsening international depression lead

even the dollar off the gold standard by 1933 marking the period of

collapse in international trade and financial flows prior to World War II.

Purchasing Power Parity:

Professor Gustav Cassel, a Swedish Economist, introduced this system. The

theory to put in simple terms states that the currencies are valued for what

they can buy. Thus if 135 JPY buy a fountain pen and the same fountain pen

can be bought for USD 1, it can be inferred that since 1 USD or 135 JPY can

buy the same fountain pen, therefore, 1 USD = 135 JPY.

For example, if country A had a higher rate of inflation as compared to

country B, then the goods produced in country A would become costlier as

compared to goods produced in country B. This would induce imports into

country A and also the goods produced in country A being costlier, would

lose in international competition to goods produced in country B. This

decrease in exports of country A as compared to exports from country B

would lead to demand for the currency of country B and excess supply of

currency of country A. This in turn, causes currency of country A to

depreciate in comparison of country B which is having relatively higher

exports.

The Bretton Woods System, 1944-73:

The Gold Standard partly, fixing the USD at $35.00 per ounce of Gold and

fixing the other main currencies to the dollar, initially intended to be on a

permanent basis. The Bretton Woods system formalized the role of the US

dollar as the new 'global' reserve currency with its value fixed into gold and

the US assuming the responsibility of ensuring convertibility while other

currencies were pegged to the dollar.


Page31

In Asia, the lack of sustainability of fixed foreign exchange rates has gained

new relevance with the events in the latter part of 1997, where currencies

were forced to float. Currency after currency was devalued against the US

dollar. The devaluation of currencies continued to plague the currency

trading markets, and confidence in the open market of FOREX trading was

not sustained. Leaving other fixed exchange rates in particular in South

America also looking very vulnerable. While commercial companies have

had to face a much more volatile currency environment in recent years,

investors and financial institutions have discovered a new playground. The

size of the FOREX market now dwarfs any other investment market.

The last few decades have seen foreign exchange trading develop into the

world’s largest global market. Restrictions on capital flows have been

removed in most countries, leaving the market forces free to adjust foreign

exchange rates according to their perceived values. In the 1980s, cross-

border capital movements accelerated with the advent of computers and

technology, extending market continuum through Asian, European and

American time zones. Transactions in foreign exchange rocketed from

about $70 billion a day in the 1980s, to more than $1.5 trillion a day two

decades later.

The collapse of PPP System brought the Bretton Woods System, and after

its collapse, the Smithsonian Agreement. At present, the Floating Rate

System is used in almost all the countries.


Page32

Exchange Rate System in India:

The Rupee was historically linked i.e. pegged to the Pound Sterling. Earlier, during

the British regime and till late sixties, most of India’s trade transactions were

dominated by Pound Sterling. Under Bretton Woods System, as a member of IMF,

India declared its par value of Rupee in terms of gold. The corresponding Rupee -

Sterling rate was fixed at 1 GBP = Rs. 18.

When Bretton Woods System bore down in August 1971, the Rupee was delinked

from US Dollar and the exchange rate was fixed at 1 USD = Rs. 7.5. Reserve Bank

of India, however, kept the Pound Sterling as the currency of intervention. The

USD and Rupee pegging was used to arrive at Rupee-Sterling parity. After

Smithsonian Agreement in December 1971, the Rupee was delinked from USD

and again linked to Pound Sterling. This parity was maintained with a band of

2.25%. Due to poor fundamentals, Pound got depreciated by 20% which in turn

caused the Rupee to depreciate.

To be not dependent on a single currency, Pound Sterling, on September 25,

1975, Rupee was delinked from it and was linked to the basket of currencies with

their relative weights kept as a secret so that the speculators didn’t get the wind

of the direction of the movement of exchange rate of Rupee.

From January 1, 1984 the Sterling rate schedule was abolished. The interest

element which was hitherto in building the exchange rate was also delinked. The

interest rate was to be recovered from the customers separately. This not only

allowed transparency in the exchange rate quotations but also was in tune with

international practice in this regard. FEDAI issued guidelines for calculation of

merchant rates.

The liquidity crunch in 1990 and 1991 on FOREX front only hastened the process.

On March 1, 1992, Reserve Bank of India announced a new system of exchange

rates known as the Liberalized Exchange Rate Management System.

LERMS was to make balance of payments sustainable on ongoing basis allowing

the market force to play a greater role in determining the exchange rate of Rupee.

Under LERMS, the Rupee became convertible for all approved external

transactions. The exporters of goods and services and those who received

remittances from abroad were allowed to sell bulk of their FOREX receipts.


Page33

Similarly, those who needed foreign exchange to import and travel abroad were

to buy foreign exchange from market determined rate.

From March 1, 1993 Modified LERMS under which all the FOREX transactions,

under current and capital account, are being put through by Authorized Dealers at

market determined exchange rate.

Factors Affecting Exchange Rates: Various economic variables impact the movement in exchange rates. Interest

rates, inflation figures, GDP are the main variables; however other economic

indicators that provide direction regarding the state of the economy also have

a significant impact on the movement of a currency. These would include

employment reports, balance of payment figures, manufacturing indices,

consumer prices and retail sales amongst others. Indicators which suggest that

the economy is strengthening are positively correlated with a strong currency

and would result in the currency strengthening and vice versa.

Currency trader should be aware of government policies and the central bank

stance as indicated by them from time to time, either by policy action or

market intervention. Government structures its policies in a manner such that

its long term objectives on employment and growth are met. In trying to

achieve these objectives, it sometimes has to work around the economic

variables and hence policy directives and the economic variables are entwined

and have an impact on exchange rate movements.

Factors Affecting Indian Rupee:

As we know that FOREX market for Indian currency is highly volatile where one

cannot forecast the exchange rates easily as there is a mechanism which works

behind the determination of exchange rate. One of the most important factors

which affect the exchange rate is the demand and supply of the domestic and


Page34

foreign currency. There are some other factors also which are having major

impact on the exchange rate determination. These are:

Market Situation:

India follows the “Floating Rate System” for determining the exchange rate.

In this system, market situation also is pivot for determining exchange rate.

As we know that 90% of the FOREX market is between the banks and so

how the banks are taking the decision for settling out their different

exposures in the domestic or foreign currency is impacting the exchange

rate. Apart from the banks, transactions of exporters and importers are

having impact on this market. So in the day-to-day FOREX market, on the

basis of the bank and trader’s transactions, the demand and supply of the

currencies increase or decrease and that is deciding the exchange rate.

Economic Factors:

In the FOREX market, economic factors of the country play an important

role. The growth and development of any country depends on how stable

its economy is. Herein, there are two types of economic factors which

affect the exchange rate:

1. Internal Factors:

(a) Fiscal Deficit of the country

(b) GDP and GNP of the country

(c) Inflation Rate

(d) Agricultural Growth and Production

(e) Infrastructure

(f) Policies like EXIM policy, Credit Policy as well as the reforms

undertaken in the yearly budget

(g) Foreign Exchange Reserves

2. External Factors:

(a) Export – Import trade with foreign countries

(b) Relationship with foreign countries

(c) International Oil and Gold prices

(d) Foreign Direct Investment, Portfolio investment

(e) Loan sanction by World Bank and IMF


Page35

Political Factors:

Political factors also play an important role in determining the exchange

rate. The party forming the Government after winning the elections held

every five years also play a pivot role. Political stability helps improving the

exchange rates whereas on the other hand, political uncertainty leads to

the depreciation of the currency. The instability in the year 1999 led to the

depreciation of Rupee by 30 paise in April.


Page36

Foreign Exchange

Exposure and Risk:


Page37

Foreign Exchange Exposure:

Description:

Foreign exchange risk is related to the variability of the domestic currency values

of assets, liabilities or operating income due to unanticipated changes in

exchange rates, whereas foreign exchange exposure is what is at risk.

Foreign currency exposures and the attendant risk arise whenever a company has

an income or expenditure or an asset or liability in a currency other than that of

the balance-sheet currency. Indeed exposures can arise even for companies with

no income, expenditure, asset or liability in a currency different from the balance-

sheet currency.

When there is a condition prevalent where the exchange rates become extremely

volatile, the exchange rate movements destabilize the cash flows of a business

significantly. Such destabilization of cash flows that affects the profitability of the

business is the risk from foreign currency exposures.

Classification of Exposures:

Financial economists distinguish between three types of currency exposures –

Transaction Exposures, Translation Exposures and Economic Exposures. All three

affect the bottom-line of the business.

Transaction Exposure:

The transaction exposure component of the foreign exchange rates is also

referred to as a short-term economic exposure. This relates to the risk

attached to specific contracts in which the company has already entered

that result in foreign exchange exposures. A company may have a

transaction exposure if it is either on the buy side or sell side of a business

transaction. Any transaction that leads to an inflow or outflow of a foreign

currency results in a transaction exposure.

For example, Company A located in the United States has a contract for

purchasing raw material from Company B located in the United Kingdom

for the next two years at a product price fixed today. In this case, Company


Page38

A is the foreign exchange payer and is exposed to a transaction risk from

movements in the pound rate relative to dollar. If the pound sterling

depreciates, Company A has to make a smaller payment in dollar terms, but

if the pound appreciates, Company A has to pay a larger amount in dollar

terms leading to foreign currency exposure.

Transaction exposure arises from:

Purchasing or selling on credit goods or services whose prices are stated in

foreign currencies.

Borrowing or lending funds when repayment is to be made in a foreign

currency.

Being a party to an unperformed foreign exchange forward contract.

Otherwise acquiring assets or incurring liabilities denominated in foreign

currencies.

Strategy to manage Transaction Exposure:

Hedging through invoice currency:

The firm can shift, share or diversify exchange risk by appropriately

choosing the currency of invoice. Firms can avoid exchange rate risk by

invoicing in domestic currency, thereby shifting the exchange rate risk on

buyer.

As a practical matter, however, the firm may not be able to use risk shifting

or sharing as much as it wishes to for fear of losing sales to competitors.

Only an exporter with substantial market power can use this approach.

Also, if the currencies of both the importer and exporter are not suitable

for settling international trade, neither party can resort to risk shifting to

deal with exchange exposure.

Hedging via lead and lag:

To “lead” means to pay or collect early, whereas “lag” means to pay or

collect late. The firm would like to lead soft currency receivables and lag

hard currency receivables to avoid the loss from depreciation of the soft

currency and benefit from the appreciation of the hard currency. For the


Page39

same reason, the firm will attempt to lead the hard currency payables and

lag soft currency payables. To the extent that the firm can effectively

implement the lead/lag strategy, the transaction exposure the firm faces

can be reduced.

Translation Exposure:

Translation exposure of foreign exchange is of an accounting nature and is

related to a gain or loss arising from the conversion or translation of the

financial statements of a subsidiary located in another country.

A company such as General Motors may sell cars in about 200 countries

and manufacture those cars in as many as 50 different countries. Such a

company owns subsidiaries or operations in foreign countries and is

exposed to translation risk. At the end of the financial year the company is

required to report all its combined operations in the domestic currency

terms leading to a loss or gain resulting from the movement in various

foreign currencies.

Economic Exposure:

Economic exposure is a rather long-term effect of the transaction exposure.

If a firm is continuously affected by an unavoidable exposure to foreign

exchange over the long-term, it is said to have an economic exposure. Such

exposure to foreign exchange results in an impact on the market value of

the company as the risk is inherent to the company and impacts its

profitability over the years.

A beer manufacturer in Argentina that has its market concentration in the

United States is continuously exposed to the movements in the dollar rate

and is said to have an economic foreign exchange exposure.

Economic exposure consists of mainly two types of exposures. They are:

1) Asset Exposure

2) Operating Exposure

Economic risk is difficult to quantify but a favored strategy to manage it is

to diversify internationally, in terms of sales, location of production


Page40

facilities, raw materials and financing. Such diversification is likely to

significantly reduce the impact of economic exposure relative to a purely

domestic company, and provide much greater flexibility to react to real

exchange rate changes.

Foreign Exchange Risk:

Nature of Foreign Exchange Risk:

Foreign Exchange dealing is a business that one get involved in, primarily to

obtain protection against adverse rate movements on their core international

business. Foreign Exchange dealing is essentially a risk-reward business where

profit potential is substantial but it is extremely risky too.

Foreign exchange business has the certain peculiarities that make it a very risky

business. These would include:

FOREX deals are across country borders and therefore, often foreign

currency prices are subject to controls and restrictions imposed by foreign

authorities. Needless to say, these controls and restrictions are invariably

dictated by their own domestic factors and economy.

FOREX deals involve two currencies and therefore, rates are influenced by

domestic as well as international factors.

The FOREX market is a 24-hour global market and overseas developments

can affect rates significantly.

The FOREX market has great depth and numerous players shifting vast

sums of money. FOREX rates therefore, can move considerably, especially

when speculation against a currency rises.

FOREX markets are characterized by advanced technology, communications

and speed. Decision-making has to be instantaneous.

Description of Foreign Exchange Risk

In simple word FOREX risk is the variability in the profit due to change in foreign

exchange rate. Suppose the company is exporting goods to foreign company then


Page41

it gets the payment after month or so then change in exchange rate may effect in

the inflows of the fund. If rupee value depreciated he may lose some money.

Similarly if rupees value appreciated against foreign currency then it may gain

more rupees. Hence there is risk involved in it.

Classification of Foreign Exchange Risk

Position Risk

Gap or Maturity or Mismatch Risk

Translation Risk

Operational Risk

Credit Risk

1. Position Risk

The exchange risk on the net open FOREXposition is called the position risk. The

position can be a long/overbought position or it could be a short/oversold

position. The excess of foreign currency assets over liabilities is called a net long

position whereas the excess of foreign currency liabilities over assets is called a

net short position. Since all purchases and sales are at a rate, the net position too

is at a net/average rate. Any adverse movement in market rates would result in a

loss on the net currency position.

For example, where a net long position is in a currency whose value is

depreciating, the conversion of the currency will result in a lower amount of the

corresponding currency resulting in a loss, whereas a net long position in an

appreciating currency would result in a profit. Given the volatility

in FOREX markets and external factors that affect FX rates, it is prudent to have

controls and limits that can minimize losses and ensure a reasonable profit.

The most popular controls/limits on open position risks are:

Daylight Limit: Refers to the maximum net open position that can be built up a

trader during the course of the working day. This limit is set currency-wise and

the overall position of all currencies as well.

Overnight Limit: Refers to the net open position that a trader can leave

overnight – to be carried forward for the next working day. This limit too is set


Page42

currency-wise and the overall overnight limit for all currencies. Generally,

overnight limits are about 15% of the daylight limits.

2. Mismatch Risk/Gap Risk

Where a foreign currency is bought and sold for different value dates, it creates

no net position i.e. there is no FX risk. But due to the different value dates

involved there is a “mismatch” i.e. the purchase/sale dates do not match. These

mismatches, or gaps as they are often called, result in an uneven cash flow. If the

forward rates move adversely, such mismatches would result in losses.

Mismatches expose one to risks of exchange losses that arise out of adverse

movement in the forward points and therefore, controls need to be initiated.

The limits on Gap risks are:

Individual Gap Limit: This determines the maximum mismatch for any

calendar month; currency-wise.

Aggregate Gap Limit: Is the limit fixed for all gaps, for a currency, irrespective

of their being long or short. This is worked out by adding the absolute values of

all overbought and all oversold positions for the various months, i.e. the total

of the individual gaps, ignoring the signs. This limit, too, is fixed currency-wise.

Total Aggregate Gap Limit: Is the limit fixed for all aggregate gap limits in all

currencies.

3. Translation Risk

Translation risk refers to the risk of adverse rate movement on foreign currency

assets and liabilities funded out of domestic currency.

There cannot be a limit on translation risk but it can be managed by:

1. Funding of Foreign Currency Assets/Liabilities through money markets i.e.

borrowing or lending of foreign currencies

2. Funding through FX swaps

3. Hedging the risk by means of Currency Options

4. Funding through Multi Currency Interest Rate Swaps

4. Operational Risk


Page43

The operational risks refer to risks associated with systems, procedures, frauds

and human errors. It is necessary to recognize these risks and put adequate

controls in place, in advance. It is important to remember that in most of these

cases corrective action needs to be taken post-event too. The following areas

need to be addressed and controls need to be initiated.

Segregation of trading and accounting functions: The execution of deals is a

function quite distinct from the dealing function. The two have to be kept

separate to ensure a proper check on trading activities, to ensure all deals are

accounted for, that no positions are hidden and no delay occurs.

Follow-up and Confirmation: Quite often deals are transacted over the phone

directly or through brokers. Every oral deal has to be followed up immediately by

written confirmations; both by the dealing departments and by back-office or

support staff. This would ensure that errors are detected and rectified

immediately.

Settlement of funds: Timely settlement of funds is necessary not only to avoid

delayed payment interest penalty but also to avoid embarrassment and loss of

credibility.

Overdue contracts: Care should be taken to monitor outstanding contracts and to

ensure proper settlements. This will avoid unnecessary swap costs, excessive

credit balances and overdrawn Nostro accounts.

Float transactions: Often retail departments and other areas are authorized to

create exposures. Proper measures should be taken to make sure that such

departments and areas inform the authorized persons/departments of these

exposures, in time. A proper system of maximum amount trading authorities

should be installed. Any amount in excess of such maximum should be transacted

only after proper approvals and rate.

5. Credit Risk

Credit risk refers to risks dealing with counter parties. The credit is contingent

upon the performance of its part of the contract by the counter party. The risk is

not only due to non-performance but also at times, the inability to perform by the

counter party.


Page44

The credit risk can be:

Contract risk: Where the counter party fails prior to the value date. In such

a case, the FOREX deal would have to be replaced in the market, to

liquidate the FOREX exposure. If there has been an adverse rate movement,

this would result in an exchange loss. A contract limit is set counter party-

wise to manage this risk.

Clean risk: Where the counter party fails on the value date i.e. it fails to

deliver the currency, while you have already paid up. Here the risk is of the

capital amount and the loss can be substantial. Fixing a daily settlement

limit as well as a total outstanding limit, counter party-wise can control

such a risk.

Sovereign Risk: refers to risks associated with dealing into another country.

These risks would be an account of exchange control regulations, political

instability etc. Country limits are set to counter this risk.

Differentiation of Exposure with Risk

Even though foreign exchange risk and exposure have been the central issues of

International Financial Management for many years, a considerable degree of

confusion remains about their nature and measurement.

For instance, it is not uncommon to hear the term “Foreign Exchange Exposure”

used interchangeably with the term ‘Foreign Exchange Risk” when in fact they

conceptually completely different. Foreign Exchange Risk is related to the

variability of domestic currency of assets, liabilities or operating incomes due to

unanticipated changes in exchange rates whereas Foreign Exchange Exposure is

what is at risk.


Page45

Foreign Exchange Risk

Management and Hedging

Tools


Page46

FOREX Risk Management:

Description:

As a business engaged in the buying and selling of goods/services overseas, a

company is exposed to foreign exchange risks. These risks arise from the

fluctuations in the currency market, which will impact outgoing payments for

imports or incoming funds from exports. Changes in the exchange rate between

two currencies will translate into additional profits or losses to the payables or

receivables. The amount of risk depends on factors such as the volatilities of the

currencies involved and the value of the contract.

Objectives of Risk Management:

To minimize costs

To maximize revenue

To stabilize margins in the future

Understanding the Risk:

Identify your exposure:

Risk is not just limited to imports and exports. It can exist for any area of a

business that has an international component and requires foreign funds.

For example, these can include:

i) Goods and services for import/export

ii) Company assets that are purchased from a supplier abroad

iii) Operational costs for overseas offices or factories (such as rent,

equipment, payroll etc.)

iv) Staff’s global travel expenses

Calculate your exposure:

Figure out the sum value of all the components of business that are

exposed to foreign exchange risk. Then calculate as to what would happen

if one currency falls or rises by a certain amount against another currency.

Also consider the timeframe for payables or receivables, and the

corresponding profits or losses over 30-60-90 days.

Confirm your company’s foreign exchange objectives:


Page47

Each company will have a different approach to foreign exchange that is

based upon their industry, trade volumes, geographical markets etc. To

develop one’s own company’s strategy, it is important to understand

whether or not a company is risk-adverse, the level of risks for the

currencies you deal with and how sophisticated your knowledge is

regarding financial services.

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.

1. 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.

2. 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 problems 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.

3. Benchmarking: Given the exposures and the risk estimates, the firm has to set

its limits for handling foreign exchange exposure. The firm also has to decide

whether to manage its exposures on a cost center or profit center basis. A cost

center 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 center approach on the


Page48

other hand is a more aggressive approach where the firm decides to generate a

net profit on its exposure over time.

4. Hedging: Based on the limits a firm set for itself to manage exposure, the firms

then decides an appropriate hedging strategy. There are various financial

instruments available for the firm to choose from: futures, forwards, options and

swaps and issue of foreign debt.

Hedging strategies and instruments are explored in a section.

5. 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.

6. 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.

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.

I. 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


Page49

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.

II. Cost of Hedging

Hedging can be done through the derivatives market or through money markets

(foreign debt). In either case the cost of hedging should be the difference

between value received from a hedged position and the value received if the firm

did not hedge. In the presence of efficient markets, the cost of hedging in the

forward market is the difference between the future spot rate and current

forward rate plus any transactions cost associated with the forward contract.

Similarly, the expected costs of hedging in the money market are the transactions

cost plus the difference between the interest rate differential and the expected

value of the difference between the current and future spot rates. In efficient

markets, both types of hedging should produce similar results at the same costs,

because interest rates and forward and spot exchange rates are determined

simultaneously. The costs of hedging, assuming efficiency in foreign exchange

markets result in pure transaction costs. The three main elements of these

transaction costs are brokerage or service fees charged by dealers, information

costs such as subscription to Reuter reports and news channels and

administrative costs of exposure management.

III. 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)


Page50

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 valueof 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. quickassets divided by current liabilities). Profitability is

measured as EBIT divided bybook 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 isobtained using the 3-year geometric average of

yearly sales growth rates.


Page51

Hedging Tools:

Hedging means reducing or controlling risk. This is done by taking a position in the

futures market that is opposite to the one in the physical market with the

objective of reducing or limiting risks associated with price changes.

It is a two-step process. A gain or loss in the cash position due to changes in price

levels will be countered by changes in the value of a futures position.

To Hedge or Not To Hedge?

Hedging has come into existence because of the prevalence of risks in every

business. These risks could be physical, operating and investment and credit risks.

Some of the risks such as the movements in commodity markets may be beyond

our control.

Hedging provides a means of managing such risks. The need to manage external

risk is thus one pillar of the derivative market. Parties wishing to manage their

risks are called hedgers.

Some people and businesses are in the business of taking risks to make money i.e.

the possibility of a reward. These parties represent another pillar of derivative

market and are known as speculators.

Some derivative market participants look for pricing differences and market’s

mistakes and takes advantage of these. These mistakes thus eventually disappear

and never become too large. Such participants are known as arbitrageurs.

By covering the currency commitment by derivative contracts, exporter/importer

needs no longer worry about the exchange risk element in the foreign

transactions.

Numerous studies have found that managing this risk can successfully reduce

your company’s foreign exchange exposure. Managing foreign exchange risk

provides the following benefits to many Canadian companies:

minimize the effects of exchange rate movements on profit margins

increase the predictability of future cash flows

eliminate the need to accurately forecast the future direction of exchange

rates

facilitate the pricing of products sold on export markets


Page52

protect, temporarily, a company’s competitiveness if the value of the

Rupee rises (thereby buying time for the company to improve productivity)

Hedging Tools (Derivatives)

Introduction

The gradual liberalization of Indian economy has resulted in substantial inflow of

foreign capital into India. Simultaneously dismantling of trade barriers has also

facilitated the integration of domestic economy with world economy. With the

globalization of trade and relatively free movement of financial assets, risk

management through derivatives products has become a necessity in India also,

like in other developed and developing countries. As Indian businesses become

more global in their approach, evolution of a broad based, active and liquid

FOREX derivatives markets is required to provide them with a spectrum of

hedging products for effectively managing their foreign exchange exposures.

The global market for derivatives has grown substantially in the recent past. The

Foreign Exchange and Derivatives Market Activity survey conducted by Bank for

International Settlements (BIS) points to this increased activity. The total

estimated notional amount of outstanding OTC contracts increasing to $150

trillion at end−December 2009 from $94 trillion at end−June 2000. This growth in

the derivatives segment is even more substantial when viewed in the light of

declining activity in the spot foreign exchange markets. The turnover in traditional

foreign exchange markets declined substantially between 1998 and 2009. In April

2001, average daily turnover was $1,200 billion,compared to $1,490 billion in

April 1998, a 14% decline when volumes are measured at constant exchange

rates. Whereas the global daily turnover during the same period in foreign

exchange and interest rate derivative contracts, including what are considered to

be "traditional" foreign exchange derivative instruments, increased by an

estimated 10% to $1.4 trillion.

Evolution of the FOREX derivatives market in India:

This tremendous growth in global derivative markets can be attributed to a

number of factors. They reallocate risk among financial market participants, help


Page53

to make financial markets more complete, and provide valuable information to

investors about economic fundamentals. Derivatives also provide an important

function of efficient price discovery and make unbundling of risk easier. In India,

the economic liberalization in the early nineties provided the economic rationale

for the introduction of FX derivatives. Business houses started actively

approaching foreign markets not only with their products but also as a source of

capital and direct investment opportunities. With limited convertibility on the

trade account being introduced in 1993, the environment became even more

conducive for the introduction of these hedge products.

Hence, the development in the Indian FOREX derivatives market should be seen

along with the steps taken to gradually reform the Indian financial markets. As

these steps were largely instrumental in the integration of the Indian financial

markets with the global markets, the Indian economy saw a sea change in the

year 1999 whereby it ceased to be a closed and protected economy, and adopted

the globalization route, to become a part of the world economy. In the pre-

liberalization era, marked by State dominated, tightly regulated foreign exchange

regime, the only risk management tool available for corporate enterprises was,

‘lobbying for government intervention’. With the advent of LERMS (Liberalized

Exchange Rate Mechanism System) in India, in 1992, the market forces started to

present a regime with steady price volatility as against the earlier trend of long

periods of constant prices followed by sudden, large price movements.

The unified exchange rate phase has witnessed improvement in informational and

operationalefficiency of the foreign exchange market, though at a halting pace. In

the corporate finance literature, research on risk management has focused on the

question of why firms should hedge a given risk.

The literature makes the important point that measuring risk exposures is an

essential component of a firm's risk management strategy. Without knowledge of

the primitive risk exposures of a firm, it is not possible to test whether firms are

altering their exposures in a manner consistent with theory. Recent product

innovations in the financial markets and the use of these products by the

corporate sector are also examined. In addition to the traditional "physical"

products, such as spot and forward exchange rates, the new "synthetic" or


Page54

derivative products, including options, futures and swaps, and their use by the

corporate sector is considered. These synthetic products have their market value

determined by the value of a specific, underlying, physical product. The spurts in

foreign investments in India have led to substantial increase in the quantum of

inflows and outflows in different currencies, with varying maturities. Corporate

enterprises have had to face the challenges of the shift from low risk to high risk

operations involving foreign exchange. There was increasing awareness of the

need for introduction of financial derivatives in order to enable hedging against

market risk in a cost effective way. Earlier, the Indian companies had been

entering into forward contracts with banks, which were the Authorized Dealers

(AD) in foreign exchange. But many firms preferred to keep their risk exposures

un-hedged as they found the forward contracts to be very costly. In the current

formative phase of the development of the foreign exchange market, it will be

worthwhile to take stock of the initiatives taken by corporate enterprises in

identifying and managing foreign exchange risk.

Risk Management Tools Available in India:

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. The FOREX

derivative products that are available in the Indian financial market are as follows:

Forwards: A forward is a made-to-measure agreement between two

parties to buy/sell aspecified amount of a currency at a specified rate on

a particular date in the future. Thedepreciation of the receivable

currency is hedged against by selling a currency forward. If therisk is that

of a currency appreciation (if the firm has to buy that currency in future

say forimport), it can hedge by buying the currency forward. E.g. if RIL


Page55

wants to buy crude oil in USdollars six months hence, it can enter into a

forward contract to pay INR and buy USD and lockin a fixed exchange

rate for INR-USD to be paid after 6 months regardless of the actual INR

Dollarrate at the time. In this example the downside is an appreciation

of Dollar which isprotected by a fixed forward contract. The main

advantage of a forward is that it can be tailoredto 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 longerrequired and are binding.

Generally there are two types of Forward Contracts:

Fixed Forward Contract:

The forward contract under which the delivery of foreign exchange

should take place on a specified future date is known as a fixed forward

contract.

It is further sub-divided into two:

1) Rupee Forward Contract

2) Cross Currency Forward Contract

Option Forward Contract:

With a view to eliminate the difficulty in fixing the exact date for

delivery of foreign exchange, the customer may be given a choice of

delivering the foreign exchange during a given period of days.

“An arrangement whereby the customer can sell/buy from the bank

foreign exchange on any day during a given period of time at a

predetermined rate of exchange is known as an Option Forward

Contract.”

Futures: A futures contract is similar to the forward contract but is more

liquid because it istraded in an organized exchange i.e. the futures

market. Depreciation of a currency can behedged by selling futures and

appreciation can be hedged by buying futures. Advantages offutures are


Page56

that there is a central market for futures which eliminates the problem

of doublecoincidence. Futures require a small initial outlay (a proportion

of the value of the future) withwhich significant amounts of money can

be gained or lost with the actual forwards pricefluctuations. This

provides a sort of leverage.The previous example for a forward contract

for RIL applies here also just that RIL will have togo to a USD futures

exchange to purchase standardized dollar futures equal to the amount

tobe hedged as the risk is that of appreciation of the dollar. As

mentioned earlier, the tailor abilityof the futures contract is limited i.e.

only standard denominations of money can be boughtinstead of the

exact amounts that are bought in forward contracts.In India, Currency

Futures in INR is not available otherwise in world FOREX market; all

major currency futures are available. Currency futures are traded on

futures exchange and the most popular exchanges are the ones where

the contracts are transferable freely. The Singapore International

Monetary Exchange (SIMEX) and the International Monetary Marker,

Chicago (IMM) are the most popular futures exchanges. The main

currencies traded on the exchanges are Japanese Yen, Pound Sterling,

Swiss Franc, Australian Dollar and Canadian Dollar.

Options: A Currency Option is a contract giving the right, not the

obligation, to buy or sell aspecific quantity of one foreign currency in

exchange for another at a fixed price; called theExercise Price or Strike

Price. The fixed nature of the exercise price reduces the uncertainty

ofexchange rate changes and limits the losses of open currency

positions. Options areparticularly suited as a hedging tool for contingent

cash flows, as is the case in biddingprocesses. Call Options are used if

the risk is an upward trend in price (of the currency), whilePut Options

are used if the risk is a downward trend. Again taking the example of RIL

whichneeds to purchase crude oil in USD in 6 months, if RIL buys a Call

option (as the risk is anupward trend in dollar rate), i.e. the right to buy

a specified amount of dollars at a fixed rate ona specified date, there are


Page57

two scenarios. If the exchange rate movement is favorable i.e. thedollar

depreciates, then RIL can buy them at the spot rate as they have

become cheaper. Inthe other case, if the dollar appreciates compared to

today’s spot rate, RIL can exercise theoption to purchase it at the agreed

strike price. In either case RIL benefits by paying the lowerprice to

purchase the dollar.

Generally, there are two types of Options:

(1) Cross Currency Options:

The RBI has permitted authorized dealers to offer cross currency options to

the corporate clients and other interbank counter parties to hedge their

foreign currency exposures. Before the introduction of these options, the

corporate were permitted to hedge their foreign currency exposures only

through forwards and swaps route. Forwards and swaps do remove the

uncertainty by hedging the exposure but they also result in the elimination

of potential extraordinary gains from the currency position. Currency

options provide a way of availing of the upside from any currency exposure

while being protected from the downside for the payment of an upfront

premium.

(2) Rupee Currency Options:

Introduction of USD-INR options would enable Indian FOREX market

participants manage their exposures better by hedging the Dollar-Rupee

risk. The advantages of currency options in Dollar-Rupee would be as

follows:

The nature of the instrument makes its use possible as a hedge

against uncertainty of cash flows. Option structures can be used to

hedge the volatility along-with the non-linear nature of pay-offs.

Hedge for currency exposures to protect the downside while

retaining the upside by laying a premium upfront. This would be a big

advantage for importers, exporters as well as businesses with

exposures to international prices.

Swaps: A swap is a foreign currency contract whereby the buyer and

seller exchange equalinitial principal amounts of two different


Page58

currencies at the spot rate. The buyer and seller exchange fixed or

floating rate interest payments in their respective swapped currencies

overthe term of the contract. At maturity, the principal amount is

effectively re-swapped at apredetermined exchange rate so that the

parties end up with their original currencies. Theadvantages of swaps

are that firms with limited appetite for exchange rate risk may move to

apartially 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

orientedcompany that has entered into a swap for a notional principal

of USD 1 million at an exchangerate of 42/dollar.The company pays US

6months LIBOR to the bank and receives 11.00% p.a. every 6 monthson

1st January & 1st July, till 5 years. Such a company would have earnings

in Dollars and canuse the same to pay interest for this kind of borrowing

(in dollars rather than in Rupee) thushedging its exposures.

Foreign Debt: Foreign debt can be used to hedge foreign exchange

exposure by takingadvantage of the International Fischer Effect

relationship. This is demonstrated with theexample of an exporter who

has to receive a fixed amount of dollars in a few months frompresent.

The exporter stands to lose if the domestic currency appreciates against

that currencyin the meanwhile so, to hedge this; he could take a loan in

the foreign currency for the sametime period and convert the same into

domestic currency at the current exchange rate. Thetheory assures that

the gain realized by investing the proceeds from the loan would match

theinterest rate payment (in the foreign currency) for the loan.


Page59

Other Hedging Instruments:

Hedging FX exposure is possible with a range of internal and external methods.

– Internal methods can be utilized to manage FX risk from within the company

or between related companies without the use of external market

instruments→ operating and financial hedges (also natural hedge).

Internal methods:

Invoice in home currency

One easy way is to insist that all foreign customers pay in your home

currency and that your company pays for all imports in your home

currency.

However the exchange-rate risk has not gone away, it has just been

passed onto the customer. Your customer may not be too happy with

your strategy and simply look for an alternative supplier.

Achievable if you are in a monopoly position, however in a competitive

environment this is an unrealistic approach.

Leading and lagging

If an importer (payment) expects that the currency it is due to pay will

depreciate, it may attempt to delay payment. This may be achieved by

agreement or by exceeding credit terms.

If an exporter (receipt) expects that the currency it is due to receive will

depreciate over the next three months it may try to obtain payment

immediately. This may be achieved by offering a discount for immediate

payment. The problem lies in guessing which way the exchange rate will

move.

Matching

When a company has receipts and payments in the same foreign

currency due at the same time, it can simply match them against each

other.

It is then only necessary to deal on the FOREX markets for the

unmatched portion of the total transactions. An extension of the

matching idea is setting up a foreign currency bank account.


Page60

Decide to do nothing?

The company would "win some, lose some". Theory suggests that, in the

long run, gains and losses net off to leave a similar result to that if

hedged.

In the short run, however, losses may be significant. One additional

advantage of this policy is the savings in transaction costs.

– External methods refer to hedging methods available to the company

externally (on the market) in the form of specialized hedging instruments→

contractual hedges.

External methods:

Short Term Borrowing

Debt-borrowing in the currency to which the firm is exposed or investing

in interest bearing assets to offset a foreign currency payment is a

widely used hedging tool that serves much the same purpose as forward

contracts. The cost of this money market hedge is the interest

differentials between the two countries. The money market hedge suits

many companies because they have to borrow anyway, so it is simply a

matter of denominating the company’s debt in the currency to which it

is exposed.

Discounting

Discounting can be used to cover only the export receivables. It cannot

be used to cover foreign currency payables or to hedge a translation

exposure. Where an export receivable is to be settled by bill of

exchange, the exporter can discount the bill any time and receive the

payment before the receivable settlement date. The bill may be

discounted either with the foreign bank in the customer’s country in

which case the foreign currency proceeds can be repatriated

immediately or with the exporter’s country bank at the currency spot

rate.

Factoring


Page61

Factoring can only be used as a means of covering export receivables.

When the export receivable is to be settled on open account, rather

than by bill of exchange, the receivables can be assigned as collateral for

selected bank financing. Under most circumstances, such service will

give protection against rate changes, though during unsettled periods in

the foreign exchange markets, appropriate variations may be made in

the factoring agreement.

Government Exchange Risk Guarantees

To encourage exports, government agencies in many countries offer

their exporters insurance against export, credit risk and special export

financing schemes.


Page62

Foreign Exchange Risk Management at Rolex:

Rolex Rings Pvt. Ltd. being the largest producer of hot forged rolled rings in India

along-with finished machining through CNC route is bound to have a good

amount of import-export of its own. According to the company sources, out of

the total sales of the company, 70% comprises that of the exports and the

remaining 30% is that of the domestic sales.

The company in order to carry out its production activity does import a part of its

raw materials from the foreign countries. It also has a set of huge imported

machineries purchased from countries like Japan, Germany etc. Some of the

specialized services too are being imported by the firm for its facilitation.

So in order to manage these kinds of transactions, a company like Rolex Rings is

bound to have a proper FOREX management system so as to generate profits. The

absence of this kind of a system will ultimately lead to losses which will affect the

company in many different ways.

At Rolex Rings, the firm uses the following techniques for the imports and

exports:

For Exports:

Discounting the Bill of Exchange:

A non-interest-bearing written order used primarily in international

trade that binds one party to pay a fixed sum of money to another party

at a predetermined future date.

Bills of exchange are similar to checks and promissory notes. They can

be drawn by individuals or banks and are generally transferable by

endorsements. The difference between a promissory note and a bill of

exchange is that this product is transferable and can bind one party to

pay a third party that was not involved in its creation. If these bills are

issued by a bank, they can be referred to as bank drafts. If they are

issued by individuals, they can be referred to as trade drafts.


Page63

As soon as the bill of exchange is accepted by the concerned party, the

bill is discounted by Rolex Rings from the bank. The bank is then liable to

pay the amount of export order to the firm based on the spot rate of the

currency in exchange market. After this, at the time of the maturity of

the bill, the bank will then collect the same amount of foreign currency

from the importer. However, though the amount of the foreign currency

will be the same, the rate of the same in INR at that point of time may

be different i.e. high or low.

Let us take an example to understand this in a better way.

Suppose on Jan 1, 2013 Rolex Rings received the bill of exchange of an

export order of amount 100000$ having a maturity period of 3 months.

Now for Rolex, it can wait till 3 months or else it can get it discounted.

So the firm goes with the discounting from the bank. On that particular

day, the spot rate of the USD/INR = Rs.50. thus, the bank will now pay

the firm with 100000*50= Rs.5000000.

Now on Mar 31, 2013 i.e. the maturity date, the bank will collect the

100000$ from the importer. Turns out that the USD/INR rate on that day

was Rs.52. As a result, the bank will be receiving 100000*52 =

Rs.5200000 from the importer. There can be altogether a completely

opposite situation too, whereby the bank might have to bear some loss

because of the reduced USD/INR rate.

Rolex Rings has its deals with two types of currencies in its export orders. They

are:

1) US Dollar

2) Euro

For Imports:

Import of Raw Materials and Components

Forward Contracts:


Page64

Forward exchange contract is a device which can afford adequate

protection to an importer or an exporter against exchange risk. Forward

currency contracts are most widely used tools for foreign exchange risk

management.

Rolex Rings uses the forward contracts in the import of its raw materials.

In this case, during the time of purchase a specific payment rate is fixed

which the firm will be liable to pay at time of final payment. This rate is

known as the forward rate. Generally they will be having a time period

of 1, 2 or 3 months. The rate fixed at present day will be the rate that

the firm will be paying at time of maturity. If at the time of maturity,

there arises a difference in the pre-determined value and the current

value, then also the firm will be giving the pre-determined rate only.

Thus, for an import order of 100000$ with a maturity date of 1 month

and the forward rate of Rs.52, even though at the time of maturity the

spot rate turns out to be Rs.53, Rolex Rings will be liable to pay

100000*52= Rs.5200000 only and not 100000*53 = Rs.5300000.

Import of Services

Spot Rates:

Now as far as the imports of services are concerned, the amount that

Rolex Rings is liable to pay is based on the spot rate and not the forward

rate. Herein, as soon as the bill is received by the firm, based on that

taking into accounts the current market rates, the payment is carried

out to the exporter.

Rolex Rings has its deals with the following currencies in the import orders:

1) US Dollar

2) Japanese Yen

3) Canadian Dollar


Page65

4) Swish Franc

Here is the table showing the details of the import, export and consumption of

Rolex Rings for years 2010-11, 2011-12 and 2012-13.

(Rs. In Million)

2010-11 2011-12 2012-13

Imports Purchase

Raw Materials 929.19 1263.84 1258.61

Spare Parts 23.57 27.02 3.22

Capital Goods 429.04 265.48 37.77

Consumption

Imported

Raw Materials 730.75 1599.15 1465.73

Components 27.79 28.6 25.39

Indigenous

Raw Materials 1233.92 980.13 1363.06

Components 199.56 411.41 301.06

Sales

Export 1679.99 2230.63 2481.31

Domestic 1456.96 1918.489 1691.06

Scrap 176.394 366.22 324.635

Year


Page66

Findings - Conclusion: With reference to the study undertaken with help of the secondary data, some of

the key findings and conclusion related to that of the Rolex Rings are as follows:

The firm is having an effective FOREX management system.

The firm is satisfied with the bill discounting it follows for the exports

and forward contracting for imports.

The firm being a medium scale industry, it faces transaction exposure.

There are no problems as such in the collection and payment of

amounts.

The firm is not interested in adapting any other technique for the

import-exports.

The firm is also flexible in different currency dealings in case of imports.

Also, the firm does not believe in speculation as it is the most risky

technique and least favored by others too.


Page67

Bibliography: Book:

Foreign Exchange and Risk Management, C.Jeevanandam – Sultan Chand &

Sons

Newspapers:

The Economic Times

Business Standard

Research Article:

Hedging of Foreign Exchange Risk by Corporate in India, Dr. HirenManiar

Websites:

www.rbi.org.in

www.fedai.org.in

www.x-rates.com

www.nseindia.com

www.rolexrings.com

http://www.rbi.org.in/

http://www.fedai.org.in/

http://www.x-rates.com/

http://www.nseindia.com/

http://www.rolexrings.com/

“foreign exchange risk management” at rolex rings pvt. ltd., rajkot

Education

foreign exchange market

actual exchange

exchange rateg factors

fx rate

project report

project guide

project duration

particular rate