Project Report

On

Analysis of Foreign Exchange Market

Submitted in partial fulfillment of requirement of Bachelor of Business Administration

(B.B.A) General

BBA VIth SEMESTER (B) (E)

BATCH 2012-2015

Name of guide: Dr. Ruchi Singhal Name of Student: Abhishek Dimri

Designation : Asst. Professor Enrollment no.:11624501712

JAGANNATH INTERNATIONAL MANAGEMENT SCHOOL

[1]

ACKNOWLEDGEMENT

Success is an effort bounded activity that involves co-operation of all.

I hereby take the opportunity to express our profound sense of gratitude and reverence to all

those who have helped and encouraged us towards successful completion of the Project

Report. I would like to thank our Project Guide Dr. Ruchi Singhal for her immense guidance,

valuable help and the opportunity provided to me to complete the project under her guidance. I

would like to convey my heartfelt to my faculty for the trust she showed in me in assigning me

an important and interesting project by sparing time for me from her busy schedule to discuss

and clarify various issue connected with this project, for her friendly advice and the motivation

she provided me in the completion of the project.

Last but not the least, my gratitude to great almighty and my parents without whose

concerned and devoted support this project would not have been possible.

Date:

Place: New Delhi

Submitted by: Abhishek Dimri

[2]

STUDENTS UNDERTAKING

I hereby declare that I have carried out project on the topic entitled “Analysis of Forex

Market” at Jagannath International Management School, New Delhi.

I further declare that this project work is based on my original work and no part of this

project has been published or submitted to anybody.

(Abhishek Dimri)

[3]

CERTIFICATE OF COMPLETION

This is to certify that the dissertation/project report entitled “Analysis of Forex Market”

carried out by Abhishek Dimri is an authentic work carried out by him at Jagannath

International Management School under my guidance. The matter embodied in this project

work has not been submitted earlier for the award of any degree to the best of my knowledge

and belief.

Date: Dr. Ruchi Singhal

(Assistant Professor)

[4]

CONTENTS

Description Page No.

Acknowledgement 2

Student Undertaking 3

Certificate of Completion 4

List of Tables 6

Executive Summary 7

Objectives 9

10

Research Methodology 64

Findings & Inferences 65

Results and Discussion 71

Conclusion 73

Bibliography 74

[5]

List of Tables

S.No. Description Page no.

1 Table 1.1 – Voluntary Retirement Scheme in Public Sector banks 17

2 Table 1.2 35

3 Table 1.3 47

4 Table 1.4 48

5 Table 1.5 68

6 Table 1.6 69

7 Table 1.7 70

8 Table 1.8 70

[6]

EXECUTIVE SUMMARY

The project work is pursued as a part of BBA (General) Curriculum at “Jagannath International

Management School, Delhi”.

The foreign exchange market (forex, FX, or currency market) is a global decentralized market

for the trading of currencies. In terms of volume of trading, it is by far the largest market in the

world. The main participants in this market are the larger international banks. Financial centres

around the world function as anchors of trading between a wide range of multiple types of

buyers and sellers around the clock, with the exception of weekends. The foreign exchange

market determines the relative values of different currencies. The foreign exchange market

works through financial institutions, and it operates on several levels. Behind the scenes banks

turn to a smaller number of financial firms known as “dealers,” who are actively involved in large

quantities of foreign exchange trading. Most foreign exchange dealers are banks, so this

behind-the-scenes market is sometimes called the “interbank market”, although a few insurance

companies and other kinds of financial firms are involved. Trades between foreign exchange

dealers can be very large, involving hundreds of millions of dollars. Because of the sovereignty

issue when involving two currencies, Forex has little (if any) supervisory entity regulating its

actions. The foreign exchange market assists international trade and investments by enabling

currency conversion. For example, it permits a business in the United States to import goods

from the European Union member states, especially Eurozone members, and pay Euros, even

though its income is in United States dollars. It also supports direct speculation and evaluation

relative to the value of currencies, and the carry trade, speculation based on the interest rate

differential between two currencies. In a typical foreign exchange transaction, a party purchases

some quantity of one currency by paying for some quantity of another currency. The modern

foreign exchange market began forming during the 1970s after three decades of government

restrictions on foreign exchange transactions (the Bretton Woods system of monetary

management established the rules for commercial and financial relations among the world's

major industrial states after World War II), when countries gradually switched to floating

exchange rates from the previous exchange rate regime, which remained fixed as per the

Bretton Woods system.

[7]

This project gives an in-depth analysis and understanding of Foreign Exchange Markets in

India. It helps to understand the History and the evolution of the foreign market in India.

It gives an overview of the conditions existing in the current global economy. It gives an

overview of the Foreign exchange market.

It talks about the foreign exchange management act applicable and also gives details

about the participants in the forex markets.

It also talks about what are the sources of demand and supply of foreign exchange in the

market all over the world.

The report also talks about the Foreign Exchange trading platform and how the efficiency

and the transparency is maintained.

The report focuses on corporate hedging for foreign exchange risk in India. The report

contains details about some companies Foreign Exposure and how they have maintained it.

It also talks about the determinants to be taken care of while taking corporate hedging

decisions. It gives insights about the Regulatory guidelines for the use of Foreign Exchange

derivatives, Development of Derivatives markets in India and also the Hedging instruments for

Indian firms.

Foreign exchange market is a market where foreign currencies are bought & sold.

Foreign exchange market is a system facilitating mechanism through which one

country’s currency can be exchanged for the currencies of another country.

The purpose of foreign exchange market is to permit transfers of purchasing power

denominated in one currency to another i.e. to trade one currency for another.

The report gives an in-depth analysis of the currency risk management by talking about what

currency risk is, the types of currency risk – Transaction risk, Translation risk and Economic

risk. It also contains details about the companies in the index Sensex and nifty showing their

transaction is foreign currency like the imports, exports, Loans, Interest payments and the other

expenses. It then shows the sensitivity analysis of how the currency rates impact the gains/

profits of the company.

The data used in this project has been collected from websites based on related topics and

various books of forex market. The information displayed may be limited, as each and every

aspect related with the project that is provided by the available sources might not be complete in

all respects.[8]

OBJECTIVES OF THE STUDY

MAIN OBJECTIVE

This project attempt to study the intricacies of the foreign exchange market. The main purpose

of this study is to get a better idea and the comprehensive details of foreign exchange market.

SUB OBJECTIVES

To know about the various concept and technicalities in foreign exchange.

To know the various functions of forex market.

To get the knowledge about the hedging tools used in foreign exchange.

To have a knowledge of different types of forex markets and various quotations in Forex

markets.

To study risk in the Forex market as well as volatility in Forex market.

To have a knowledge of how people trade in forex market.

To study the factors that force different types of people in different markets.

LIMITATIONS OF THE STUDY

Time constraint.

Resource constraint.

Bias on the part of interviewers.

DATA COLLECTION

The secondary data was collected from books, newspapers, other publications

and internet.

DATA ANALYSIS

The data analysis was done on the basis of the information available from various sources and

brainstorming.

[9]

CHAPTER I

THE FOREIGN EXCHANGE MARKET- AN

INTRODUCTION

Globally, operations in the foreign exchange market started in a major way after the

breakdown of the Bretton Woods system in 1971, which also marked the beginning of floating

exchange rate regimes in several countries. Over the years, the foreign exchange market has

emerged as the largest market in the world. The decade of the 1990s witnessed a perceptible

policy shift in many emerging markets towards reorientation of their financial markets in terms

of new products and instruments, development of institutional and market infrastructure and

realignment of regulatory structure consistent with the liberalized operational framework. The

changing contours were mirrored in a rapid expansion of foreign exchange market in terms of

participants, transaction volumes, decline in transaction costs and more efficient mechanisms

of risk transfer.

The origin of the foreign exchange market in India could be traced to the year 1978 when

banks in India were permitted to undertake intra-day trade in foreign exchange. However, it

was in the 1990s that the Indian foreign exchange market witnessed far reaching changes

along with the shifts in the currency regime in India. The exchange rate of the rupee, that was

pegged earlier was floated partially in March 1992 and fully in March 1993 following the

recommendations of the Report of the High Level Committee on Balance of Payments

(Chairman: Dr.C. Rangarajan). The unification of the exchange rate was instrumental in

developing a market-determined exchange rate of the rupee and an important step in the

progress towards current account convertibility, which was achieved in August 1994. 6.3 A

further impetus to the development of the foreign exchange market in India was provided with

the setting up of an Expert Group on Foreign Exchange Markets in India (Chairman: Shri O.P.

Sodhani), which submitted its report in June 1995. The Group made several recommendations

for deepening and widening of the Indian foreign exchange market. Consequently, beginning

from January 1996, wide-ranging reforms have been undertaken in the Indian foreign

[10]

exchange market. After almost a decade, an Internal Technical Group on the Foreign

Exchange Market (2005) was constituted to undertake a comprehensive review of the

measures initiated by the Reserve Bank and identify areas for further liberalization or

relaxation of restrictions in a medium-term framework.

The momentous developments over the past few years are reflected in the enhanced risk-

bearing capacity of banks along with rising foreign exchange trading volumes and finer

margins. The foreign exchange market has acquired depth (Reddy, 2005). The conditions in

the foreign exchange market have also generally remained orderly (Reddy, 2006c). While it is

not possible for any country to remain completely unaffected by developments in international

markets, India was able to keep the spillover effect of the Asian crisis to a minimum through

constant monitoring and timely action, including recourse to strong monetary measures, when

necessary, to prevent emergence of self-fulfilling speculative activities

In today’s world no economy is self-sufficient, so there is need for exchange of goods and

services amongst the different countries. So in this global village, unlike in the primitive age the

exchange of goods and services is no longer carried out on barter basis. Every sovereign

country in the world has a currency that is legal tender in its territory and this currency does not

act as money outside its boundaries. So whenever a country buys or sells goods and services

from or to another country, the residents of two countries have to exchange currencies. So we

can imagine that if all countries have the same currency then there is no need for foreign

exchange.

Need for Foreign Exchange:

Let us consider a case where Indian company exports cotton fabrics to USA and invoices the

goods in US dollar. The American importer will pay the amount in US dollar, as the same is his

home currency. However the Indian exporter requires rupees means his home currency for

procuring raw materials and for payment to the labor charges etc. Thus he would need

exchanging US dollar for rupee. If the Indian exporters invoice their goods in rupees, then

importer in USA will get his dollar converted in rupee and pay the exporter. From the above

[11]

example we can infer that in case goods are bought or sold outside the country, exchange of

currency is necessary. Sometimes it also happens that the transactions between two countries

will be settled in the currency of third country. In that case both the countries that are

transacting will require converting their respective currencies in the currency of third country.

For that also the foreign exchange is required.

About foreign exchange market:

Particularly for foreign exchange market there is no market place called the foreign exchange

market. It is mechanism through which one country’s currency can be exchange i.e. bought or

sold for the currency of another country. The foreign exchange market does not have any

geographic location. Foreign exchange market is described as an OTC (over the counter)

market as there is no physical place where the participant meets to execute the deals, as we

see in the case of stock exchange. The largest foreign exchange market is in London, followed

by the New York, Tokyo, Zurich and Frankfurt. The markets are situated throughout the

different time zone of the globe in such a way that one market is closing the other is beginning

its operation. Therefore it is stated that foreign exchange market is functioning throughout 24

hours a day. In most market US dollar is the vehicle currency, viz., the currency sued to

dominate international transaction. In India, foreign exchange has been given a statutory

definition. Section 2 (b) of foreign exchange regulation ACT, 1973 states: Foreign exchange

means foreign currency and includes:

All deposits, credits and balance payable in any foreign currency and any draft, traveler’s

cheques, letter of credit and bills of exchange. Expressed or drawn in India currency but

payable in any foreign currency.

Any instrument payable, at the option of drawee or holder thereof or any other party thereto,

either in Indian currency or in foreign currency or partly in one and partly in the other. In order

to provide facilities to members of the public and foreigners visiting India, for exchange of

foreign currency into Indian currency and vice-versa RBI has granted to various firms and

individuals, license to undertake money-changing business at seas/airport and tourism place of

tourist interest in India. Besides certain authorized dealers in foreign exchange (banks) have

also been permitted to open exchange bureaus.

[12]

Following are the major bifurcations:

Full fledge moneychangers – they are the firms and individuals who have been authorized to

take both, purchase and sale transaction with the public.

Restricted moneychanger – they are shops, emporia and hotels etc. that have been

authorized only to purchase foreign currency towards cost of goods supplied or services

rendered by them or for conversion into rupees.

Authorized dealers – they are one who can undertake all types of foreign exchange

transaction. Banks are only the authorized dealers. The only exceptions are Thomas cook,

western union, UAE exchange which though, and not a bank is an AD. Even among the

banks RBI has categorized them as follows:

Branch A – They are the branches that have Nostro and Vostro account.

Branch B – The branch that can deal in all other transaction but do not maintain Nostro and

Vostro a/c’s fall under this category. For Indian we can conclude that foreign exchange refers

to foreign money, which includes notes, cheques, bills of exchange, bank balance and

deposits in foreign currencies.

Foreign Exchange Market: An Assessment

The continuous improvement in market infrastructure has had its impact in terms of enhanced

depth, liquidity and efficiency of the foreign exchange market. The turnover in the Indian

foreign exchange market has grown significantly in both the spot and derivatives segments in

the recent past. Along with the increase in onshore turnover, activity in the offshore market has

also assumed importance. With the gradual opening up of the capital account, the process of

price discovery in the Indian foreign exchange market has improved as reflected in the bid-ask

spread and forward premia behaviour.

Foreign Exchange Market Turnover

As per the Triennial Central Bank Survey by the Bank for International Settlements (BIS) on

[13]

“Foreign Exchange and Derivatives Market Activity”, global foreign exchange market activity

rose markedly between 2001 and 2004. The strong growth in turnover may be attributed to two

related factors. First, the presence of clear trends and higher volatility in foreign exchange

markets between 2001 and 2004 led to trading momentum, where investors took large

positions in currencies that followed persistent appreciating trends. Second, positive interest

rate differentials encouraged the so-called “carry trading”, i.e., investments in high interest rate

currencies financed by positions in low interest rate currencies. The growth in outright forwards

between 2001 and 2004 reflects heightened interest in hedging. Within the EM countries,

traditional foreign exchange trading in Asian currencies generally recorded much faster growth

than the global total between 2001 and 2004. Growth rates in turnover for Chinese renminbi,

Indian rupee, Indonesian rupiah, Korean won and new Taiwanese dollar exceeded 100 per

cent between April 2001 and April 2004. Despite significant growth in the foreign exchange

market turnover, the share of most of the EMEs in total global turnover, however, continued to

remain low.

The Indian foreign exchange market has grown manifold over the last several years. The daily

average turnover impressed a substantial pick up from about US $ 5 billion during 1997-98 to

US $ 18 billion during 2005-06. The turnover has risen considerably to US $ 23 billion during

2006-07 (up to February 2007) with the daily turnover crossing US $ 35 billion on certain days

during October and November 2006. The inter-bank to merchant turnover ratio has halved

from 5.2 during 1997-98 to 2.6 during 2005-06, reflecting the growing participation in the

merchant segment of the foreign exchange market (Table 6.6 and Chart VI.2). Mumbai alone

accounts for almost 80 per cent of the foreign exchange turnover. 6.60 Turnover in the foreign

exchange market was 6.6 times of the size of India’s balance of payments during 2005-06 as

compared with 5.4 times in 2000-01 (Table 6.7). With the deepening of the foreign exchange

market and increased turnover, income of commercial banks through treasury operations has

increased considerably. Profit from foreign exchange transactions accounted for more than 20

per cent of total profits of the scheduled commercial banks during 2004-05 and 2005-06

[14]

Participants in foreign exchange market

The main players in foreign exchange market are as follows:

CUSTOMERS

The customers who are engaged in foreign trade participate in foreign exchange market by

availing of the services of banks. Exporters require converting the dollars in to rupee and

importers require converting rupee in to the dollars, as they have to pay in dollars for the

goods/services they have imported.

COMMERCIAL BANK

They are most active players in the forex market. Commercial bank dealing with international

transaction offer services for conversion of one currency in to another. They have wide network

of branches. Typically banks buy foreign exchange from exporters and sells foreign exchange to

the importers of goods. As every time the foreign exchange bought or oversold position. The

balance amount is sold or bought from the market.

CENTRAL BANK

In all countries Central bank have been charged with the responsibility of maintaining the

external value of the domestic currency. Generally this is achieved by the intervention of the

bank.

EXCHANGE BROKERS

Forex brokers play very important role in the foreign exchange market. However the extent to

which services of foreign brokers are utilized depends on the tradition and practice prevailing at

a particular forex market center. In India as per FEDAI guideline the Ads are free to deal directly

[15]

among themselves without going through brokers. The brokers are not among to allowed to deal

in their own account all over the world and also in India.

OVERSEAS FOREX MARKET

Today the daily global turnover is estimated to be more than US$1.5 trillion a day. The

international trade however constitutes hardly 5 to 7 % of this total turnover. The rest of trading

in world forex market is constituted of financial transaction and speculation. As we know that the

forex market is 24-hour market, the day begins with Tokyo and thereafter Singapore opens,

thereafter India, followed by Bahrain, Frankfurt, Paris, London, New York, Sydney, and back to

Tokyo.

SPECULATORS

The speculators are the major players in the forex market.

Bank dealing are the major speculators in the forex market with a view to make profit on

account of favorable movement in exchange rate, take position i.e. if they feel that rate of

particular currency is likely to go up in short term. They buy that currency and sell it as soon

as they are able to make quick profit.

Corporation’s particularly multinational corporation and transnational corporation having

business operation beyond their national frontiers and on account of their cash flows being

large and in multi currencies get in to foreign exchange exposures. With a view to make

advantage of exchange rate movement in their favor they either delay covering exposures or

do not cover until cash flow materialize.

Individual like share dealing also undertake the activity of buying and selling of foreign

exchange for booking short term profits. They also buy foreign currency stocks, bonds and

other assets without covering the foreign exchange exposure risk. This also result in

speculations.

[16]

Basic Concepts in Forex Trading

Bid and Ask Rate:

The bid/ask spread is the difference between the price at which a bank or market maker will

sell ("ask", or "offer") and the price at which a market taker will buy ("bid") from a wholesale or

retail customer. The customer will buy from the market-maker at the higher "ask" price, and will

sell at the lower "bid" price, thus giving up the "spread" as the cost of completing the trade.

Margin Trading:

Foreign exchange is normally traded on margin. A relatively small deposit can control much

larger positions in the market. For trading the main currencies, Saxo Bank requires a 1%

margin deposit. This means that in order to trade one million dollars, you need to place just

USD 10,000 by way of security.

In other words, you will have obtained a gearing of up to 100 times. This means that a change

of, say 2%, in the underlying value of your trade will result in a 200% profit or loss on your

deposit.

Stop-loss discipline:

There are significant opportunities and risks in foreign exchange markets. Aggressive traders

might experience profit/loss swings of 20-30% daily. This calls for strict stop-loss policies in

positions that are moving against you.

Fortunately, there are no daily limits on foreign exchange trading and no restrictions on trading

hours other than the weekend. This means that there will nearly always be an opportunity to

react to moves in the main currency markets and a low risk of getting caught without the

opportunity of getting out. Of course, the market can move very fast and a stop-loss order is by

no means a guarantee of getting out at the desired level. For speculative trading, it is

recommended to place protective stop-loss orders.

[17]

Spot and forward trading:

When you trade foreign exchange you are normally quoted a spot price. This means that if you

take no further steps, your trade will be settled after two business days. This ensures that your

trades are undertaken subject to supervision by regulatory authorities for your own protection

and security. If you are a commercial customer, you may need to convert the currencies for

international payments. If you are an investor, you will normally want to swap your trade

forward to a later date. This can be undertaken on a daily basis or for a longer period at a time.

Often investors will swap their trades forward anywhere from a week or two up to several

months depending on the time frame of the investment.

Although a forward trade is for a future date, the position can be closed out at any time - the

closing part of the position is then swapped forward to the same future value date.

Currency Traded Across Globe & India

The FOUR major currency pairs

EUR/USD

USD/JPY

[18]

USD/CHF

GBP/USD

Currency Crosses

EUR/CHF

EUR/JPY

GBP/JPY

EUR/GBP

Currencies traded in India:

USD/INR

EUR/INR

GBP/INR

JPY/INR

Currency Exchanges in India:

1. MCX Stock Exchange (MCX – SX)

2. National Stock Exchange (NSE)

3. United Stock Exchange (USE)

The daily turnover of NSE and MCX – SX together is around 30,000 cr.

Forex Symbol Currency Pairs Trading Terminologies

EUR/USD Euro / U.S. Dollar Euro

GBP/USD British Pound / U.S. Dollar Cable or Sterling

USD/JPY U.S. Dollar / Japanese Yen Dollar Yen

USD/CHF U.S. Dollar / Swiss Franc Dollar Swiss

USD/CAD U.S. Dollar / Canadian Dollar Dollar Canada

AUD/USD Australian Dollar / U.S. Dollar Aussie Dollar or Aussie

EUR/GBP Euro / British Pound Euro Sterling

[19]

EUR/JPY Euro / Japanese Yen Euro Yen

EUR/CHF Euro / Swiss Franc Euro Swiss

GBP/JPY British Pound / Japanese Yen Sterling Yen

Trading Platforms

Indian Perspective

o Trade Station

It is the premier brokerage trading platform for rule-based trading. And we have the awards to

prove it.

Whether you trade stocks, options, futures or forex, Trade Station offers uniquely powerful

strategy creation and testing tools, customizable analytics and fully automated trading

technology in a single trading platform.

Features

1. Create an unlimited number of trading strategies

2. Back test and optimize the strategies

3. Monitor multiple markets

Systematic

1. Fully automated portfolio solution

2. Web-based easy-to-use trading

3. Low cost trading 

4. Transparent trade results

5. Diversification and risk management options

6. Comprehensive online video tutorials and FAQ 

7. One account, two platforms - works in parallel with MetaTrader 4

8. Choice of over 70 independent trading strategies and 20 predefined portfolios

9. No subscription or maintenance fees

10.USD 500 minimum deposit

11.Minimum trade size 0.1 lot 

[20]

12.29 currency pairs

13.Unlimited access to Alpari Academy and Alpari Research

14.Fully automated trading

15.Trade notifications by e-mail for opened/closed trades

16.Available in 9 languages

o Alpari Direct Pro

Alpari Direct Pro is an institutional-level platform that offers the most direct route to optimum

liquidity and institutional-level prices from the world’s leading banks, and highly competitive

spreads on major currencies.

Designed for institutions, money managers and individuals, Alpari Direct Pro caters for those

who want to trade high volumes with the fastest execution speeds, full market depth and

sophisticated order management options.

o Features

Fast-track to liquidity

Alpari Direct Pro is an advanced institutional-level platform designed for money managers,

institutional traders and investors wanting to trade high volumes with the fastest execution

speeds (market execution), full market depth and sophisticated order management.

Non-Dealing Desk execution

Fully automated processing without any manual intervention cuts out any obstacles between

your trade and the market. Going direct, with trades executed at the highest speed and with

minimum latency means you can react instantly to opportunities as they arise.

Know the depth of the market in full

View the most comprehensive picture of the market with current orders displayed by price and

volume. This provides a more transparent picture of the Forex market and the best opportunity

to make the most informed trading decisions possible.

Manage more orders more effectively

[21]

A comprehensive suite of orders and order management options allow you to execute

sophisticated strategies based on precise timing and multiple order types enabling better

control of order timing and execution.

Factors Affecting Foreign Exchange

There are various factors affecting the exchange rate of a currency. They can be classified as

fundamental factors, technical factors, political factors and speculative factors.

Fundamental factors:

The fundamental factors are basic economic policies followed by the government in relation to

inflation, balance of payment position, unemployment, capacity utilization, trends in import and

export, etc. Normally, other things remaining constant the currencies of the countries that

follow sound economic policies will always be stronger. Similarly, countries having balance of

payment surplus will enjoy a favorable exchange rate. Conversely, for countries facing balance

of payment deficit, the exchange rate will be adverse.

Technical factors:

Interest rates: Rising interest rates in a country may lead to inflow of hot money in the country,

thereby raising demand for the domestic currency. This in turn causes appreciation in the

value of the domestic currency.

Inflation rate: High inflation rate in a country reduces the relative competitiveness of the

export sector of that country. Lower exports result in a reduction in demand of the domestic

currency and therefore the currency depreciates.

Exchange rate policy and Central Bank interventions: Exchange rate policy of the country is

the most important factor influencing determination of exchange rates. For example, a country [22]

may decide to follow a fixed or flexible exchange rate regime, and based on this, exchange

rate movements may be less/more frequent. Further, governments sometimes participate in

foreign exchange market through its Central bank in order to control the demand or supply of

domestic currency.

Political factors:

Political stability also influences the exchange rates. Exchange rates are susceptible to political

instability and can be very volatile during times of political crises.

Speculation:

Speculative activities by traders worldwide also affect exchange rate movements. For

example, if speculators think that the currency of a country is overvalued and will devalue in

near future, they will pull out their money from that country resulting in reduced demand for

that currency and depreciating its value.

Foreign Exchange Management Act, 1999

The change in the entire approach towards exchange control regulation has been the result of

the replacement of the Foreign Exchange Regulation Act, 1973, by the Foreign Exchange

Management Act, 1999. The latter came into effect from June 1, 2000. The change in the

preamble itself signifies the dramatic change in approach -- from "for the conservation of the

foreign exchange resources" in FERA 1973, to "facilitate external trade and payments" under

FEMA 1999. Any FEMA violations are civil, not criminal, offences, attracting monetary

penalties, and not arrests or imprisonment.

The scheme of FEMA and the notifications issued thereunder take into the account the

convertibility of the rupee for all current account transactions. Indeed, there is now general

freedom to authorised dealers to sell currency for most current account transactions. One old

[23]

limitation continues. All transactions in foreign exchange have to be with authorised dealers,

i.e. banks authorised to act as dealers in foreign exchange by the Reserve Bank. The original

rules, regulations, notifications, etc., under FEMA are contained in the A.D. (M.A. series)

Circular No. 11 of May 16, 2000. Subsequent circulars have been issued under the A.P. (DIR

series) nomenclature. It is obviously impossible to incorporate all the current regulations in a

book of this type, particularly since the regulations keep changing. An outline of the basic

framework of exchange control under FEMA is in Annexure 5.3. But its contents should not be

considered as either definitive or current and those interested need to keep up with the various

circulars and other communications on the subject.

Foreign Exchange Market Structure

Market Segments

Foreign exchange market activity in most EMEs takes place onshore with many countries

prohibiting onshore entities from undertaking the operations in offshore markets for their

currencies. Spot market is the predominant form of foreign exchange market segment in

developing and emerging market countries. A common feature is the tendency of

importers/exporters and other end-users to look at exchange rate movements as a source of

return without adopting appropriate risk management practices. This, at times, creates uneven

supplydem and conditions, often based on ‘‘news and views’’. The lack of forward market

development reflects many factors, including limited exchange rate flexibility, the de facto

exchange rate insurance provided by the central bank through interventions, absence of a

yield curve on which to base the forward prices and shallow money markets, in which market-

making banks can hedge the maturity risks implicit in forward positions (Canales-Kriljenko,

2004).

Most foreign exchange markets in developing countries are either pure dealer markets or a

combination of dealer and auction markets. In the dealer markets, some dealers become

market makers and play a central role in the determination of exchange rates in flexible

exchange rate regimes. The bid offer spread reflects many factors, including the level of

[24]

competition among market makers. In most of the EMEs, a code of conduct establishes the

principles that guide the operations of the dealers in the foreign exchange markets. It is the

central bank, or professional dealers association, which normally issues the code of conduct

(Canales-Kriljenko, 2004). In auction markets, an auctioneer or auction mechanism allocates

foreign exchange by matching supply and demand orders. In pure auction markets, order

imbalances are cleared only by exchange rate adjustments. Pure auction market structures

are, however, now rare and they generally prevail in combination with dealer markets.

The Indian foreign exchange market is a decentralised multiple dealership market comprising

two segments – the spot and the derivatives market. In the spot market, currencies are traded

at the prevailing rates and the settlement or value date is two business days ahead. The two-

day period gives adequate time for the parties to send instructions to debit and credit the

appropriate bank accounts at home and abroad. The derivatives market encompasses

forwards, swaps and options. Though forward contracts exist for maturities up to one year,

majority of forward contracts are for one month, three months, or six months. Forward

contracts for longer periods are not as common because of the uncertainties involved and

related pricing issues. A swap transaction in the foreign exchange market is a combination of a

spot and a forward in the opposite direction. As in the case of other EMEs, the spot market is

the dominant segment of the Indian foreign exchange market. The derivative segment of the

foreign exchange market is assuming significance and the activity in this segment is gradually

rising.

EXCHANGE RATE SYSTEM

Countries of the world have been exchanging goods and services amongst themselves. This

has been going on from time immemorial. The world has come a long way from the days of

barter trade. With the invention of money the figures and problems of barter trade have

disappeared. The barter trade has given way ton exchanged of goods and services for

currencies instead of goods and services.

The rupee was historically linked with pound sterling. India was a founder member of the IMF.

During the existence of the fixed exchange rate system, the intervention currency of the

[25]

Reserve Bank of India (RBI) was the British pound, the RBI ensured maintenance of the

exchange rate by selling and buying pound against rupees at fixed rates. The interbank rate

therefore ruled the RBI band. During the fixed exchange rate era, there was only one major

change in the parity of the rupee- devaluation in June 1966.

Different countries have adopted different exchange rate system at different time. The

following are some of the exchange rate system followed by various countries.

THE GOLD STANDARD

Many countries have adopted gold standard as their monetary system during the last two

decades of the 19th century. This system was in vogue till the outbreak of world war 1. under

this system the parties of currencies were fixed in term of gold. There were two main types of

gold standard:

Gold specie standard

Gold was recognized as means of international settlement for receipts and payments amongst

countries. Gold coins were an accepted mode of payment and medium of exchange in

domestic market also. A country was stated to be on gold standard if the following condition

were satisfied:

Monetary authority, generally the central bank of the country, guaranteed to buy and sell gold

in unrestricted amounts at the fixed price.

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

Import and export of gold was freely allowed.

The total money supply in the country was determined by the quantum of gold available for

monetary purpose.

Gold Bullion Standard

Under this system, the money in circulation was either partly of entirely paper and gold served

as reserve asset for the money supply.. However, paper money could be exchanged for gold

at any time. The exchange rate varied depending upon the gold content of currencies. This

was also known as “Mint Parity Theory “ of exchange rates.

The gold bullion standard prevailed from about 1870 until 1914, and intermittently thereafter

until 1944. World War I brought an end to the gold standard.[26]

BRETTON WOODS SYSTEM

During the world wars, economies of almost all the countries suffered. In ordere to correct the

balance of payments disequilibrium, many countries devalued their currencies. Consequently,

the international trade suffered a deathblow. In 1944, following World War II, the United States

and most of its allies ratified the Bretton Woods Agreement, which set up an adjustable parity

exchange-rate system under which exchange rates were fixed (Pegged) within narrow

intervention limits (pegs) by the United States and foreign central banks buying and selling

foreign currencies. This agreement, fostered by a new spirit of international cooperation, was

in response to financial chaos that had reigned before and during the war.

In addition to setting up fixed exchange parities ( par values ) of currencies in relationship to

gold, the agreement established the International Monetary Fund (IMF) to act as the

“custodian” of the system.

Under this system there were uncontrollable capital flows, which lead to major countries

suspending their obligation to intervene in the market and the Bretton Wood System, with its

fixed parities, was effectively buried. Thus, the world economy has been living through an era

of floating exchange rates since the early 1970.

FLOATING RATE SYSTEM

In a truly floating exchange rate regime, the relative prices of currencies are decided entirely

by the market forces of demand and supply. There is no attempt by the authorities to influence

exchange rate. Where government interferes’ directly or through various monetary and fiscal

measures in determining the exchange rate, it is known as managed of dirty float.

PURCHASING POWER PARITY (PPP)

Professor Gustav Cassel, a Swedish economist, introduced this system. The theory, to put in

simple terms states that currencies are valued for what they can buy and the currencies have

no intrinsic value attached to it. Therefore, under this theory the exchange rate was to be [27]

determined and the sole criterion being the purchasing power of the countries. As per this

theory if there were no trade controls, then the balance of payments equilibrium would always

be maintained. Thus if 150 INR buy a fountain pen and the samen fountain pen can be bought

for USD 2, it can be inferred that since 2 USD or 150 INR can buy the same fountain pen,

therefore USD 2 = INR 150.

For example India has a higher rate of inflation as compaed to country US then goods

produced in India would become costlier as compared to goods produced in US. This would

induce imports in India and also the goods produced in India being costlier would lose in

international competition to goods produced in US. This decrease in exports of India as

compared to exports from US would lead to demand for the currency of US and excess supply

of currency of India. This in turn, cause currency of India to depreciate in comparison of

currency of Us that is having relatively more exports.

Fundamentals in Exchange Rate

Exchange rate is a rate at which one currency can be exchange in to another currency, say

USD = Rs.48. This rate is the rate of conversion of US dollar in to Indian rupee and vice versa.

Methods of Quoting Rate

There are two methods of quoting exchange rates.

1) Direct method:

Foreign currency is kept constant and home currency is kept variable. In direct quotation, the

principle adopted by bank is to buy at a lower price and sell at higher price.

2) Indirect method:

Home currency is kept constant and foreign currency is kept variable. Here the strategy used

by bank is to buy high and sell low. In India with effect from august 2, 1993, all the exchange

rates are quoted in direct method. It is customary in foreign exchange market to always quote

two rates means one for buying and another rate for selling. This helps in eliminating the risk of

[28]

being given bad rates i.e. if a party comes to know what the other party intends to do i.e. buy

or sell, the former can take the letter for a ride. There are two parties in an exchange deal of

currencies. To initiate the deal one party asks for quote from another party and other party

quotes a rate. The party asking for a quote is known as’ asking party and the party giving a

quotes is known as quoting party. The advantage of two–way quote is as under

The market continuously makes available price for buyers or sellers

Two way prices limit the profit margin of the quoting bank and comparison of one quote

with another quote can be done instantaneously.

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

sale foreign currency, this ensures that the quoting bank cannot take advantage by

manipulating the prices.

It automatically insures that alignment of rates with market rates.

Two way quotes lend depth and liquidity to the market, which is so very essential for

efficient market. In two way quotes the first rate is the rate for buying and another for

selling.

We should understand here that, in India the banks, which are authorized dealer, always,

quote rates. So the rates quoted- buying and selling is for banks point of view only. It means

that if exporters want to sell the dollars then the bank will buy the dollars from him so while

calculation the first rate will be used which is buying rate, as the bank is buying the dollars from

exporter. The same case will happen inversely with importer as he will buy dollars from the

bank and bank will sell dollars to importer.

Factors Affecting Exchange Rates

In free market, it is the demand and supply of the currency which should determine the

exchange rates but demand and supply is the dependent on many factors, which are ultimately

the cause of the exchange rate fluctuation, sometimes wild. The volatility of exchange rates

cannot be traced to the single reason and consequently, it becomes difficult to precisely define

the factors that affect exchange rates. However, the more important among them are as

follows:

[29]

• Strength of Economy

Economic factors affecting exchange rates include hedging activities, interest rates, inflationary

pressures, trade imbalance, and euro market activities. Irving fisher, an American economist,

developed a theory relating exchange rates to interest rates. This proposition, known as the

fisher effect, states that interest rate differentials tend to reflect exchange rate expectation. On

the other hand, the purchasing- power parity theory relates exchange rates to inflationary

pressures. In its absolute version, this theory states that the equilibrium exchange rate equals

the ratio of domestic to foreign prices. The relative version of the theory relates changes in the

exchange rate to changes in price ratios.

• Political Factor

The political factor influencing exchange rates include the established monetary policy along

with government action on items such as the money supply, inflation, taxes, and deficit

financing. Active government intervention or manipulations, such as central bank activity in the

foreign currency market, also have an impact. Other political factors influencing exchange

rates include the political stability of a country and its relative economic exposure (the

perceived need for certain levels and types of imports). Finally, there is also the influence of

the international monetary fund.

• Expectation of the Foreign Exchange Market

Psychological factors also influence exchange rates. These factors include market anticipation,

speculative pressures, and future expectations. A few financial experts are of the opinion that

in today’s environment, the only ‘trustworthy’ method of predicting exchange rates by gut feel.

Bob Eveling, vice president of financial markets at SG, is corporate finance’s top foreign

exchange forecaster for 1999. eveling’s gut feeling has, defined convention, and his method

proved uncannily accurate in foreign exchange forecasting in 1998.SG ended the corporate

finance forecasting year with a 2.66% error overall, the most accurate among 19 banks. The

secret to eveling’s intuition on any currency is keeping abreast of world events. Any event,

from a declaration of war to a fainting political leader, can take its toll on a currency’s value.

[30]

Today, instead of formal modals, most forecasters rely on an amalgam that is part economic

fundamentals, part model and part judgment.

Fiscal policy

Interest rates

Monetary policy

Balance of payment

Exchange control

Central bank intervention

Speculation

Technical factors

Sources of Supply and Demand in the Foreign exchange

Exchange Market

The major sources of supply of foreign exchange in the Indian foreign exchange market are

receipts on account of exports and invisibles in the current account and inflows in the capital

account such as foreign direct investment (FDI), portfolio investment, external commercial

borrowings (ECB) and non-resident deposits. On the other hand, the demand for foreign

exchange emanates from imports and invisible payments in the current account, amortization

of ECB (including short-term trade credits) and external aid, redemption of NRI deposits and

outflows on account of direct and portfolio investment. In India, the Government has no foreign

currency account, and thus the external aid received by the Government comes directly to the

reserves and the Reserve Bank releases the required rupee funds. Hence, this particular

source of supply of foreign exchange is not routed through the market and as such does not

impact the exchange rate.

During last five years, sources of supply and demand have changed significantly, with large

transactions emanating from the capital account, unlike in the 1980s and the 1990s when

current account transactions dominated the foreign exchange market. The behavior as well as

the incentive structure of the participants who use the market for current account transactions

[31]

differs significantly from those who use the foreign exchange market for capital account

transactions. Besides, the change in these traditional determinants has also reflected itself in

enhanced volatility in currency markets. It now appears that expectations and even momentary

reactions to the news are often more important in determining fluctuations in capital flows and

hence it serves to amplify exchange rate volatility (Mohan, 2006a). On many occasions, the

pressure on exchange rate through increase in demand emanates from “expectations based

on certain news”. Sometimes, such expectations are destabilizing and often give rise to self-

fulfilling speculative activities. Recognizing this, increased emphasis is being placed on the

management of capital account through management of foreign direct investment, portfolio

investment, external commercial borrowings, nonresident deposits and capital outflows.

However, there are occasions when large capital inflows as also large lumpiness in demand do

take place, in spite of adhering to all the tools of management of capital account. The role of

the Reserve Bank comes into focus during such times when it has to prevent the emergence of

such destabilising expectations. In such cases, recourse is undertaken to direct purchase and

sale of foreign currencies, sterilisation through open market operations, management of

liquidity under liquidity adjustment facility (LAF), changes in reserve requirements and

signaling through interest rate changes. In the last few years, despite large capital inflows, the

rupee has shown two - way movements. Besides, the demand/supply situation is also affected

by hedging activities through various instruments that have been made available to market

participants to hedge their risks.

Derivative Market Instruments

Derivatives play a crucial role in developing the foreign exchange market as they enable

market players to hedge against underlying exposures and shape the overall risk profile of

participants in the market. Banks in India have been increasingly using derivatives for

managing risks and have also been offering these products to corporates. In India, various

informal forms of derivatives contracts have existed for a long time though the formal

introduction of a variety of instruments in the foreign exchange derivatives market started only

in the post-reform period, especially since the mid-1990s. Cross-currency derivatives with the

rupee as one leg were introduced with some restrictions in April 1997. Rupee-foreign

exchange options were allowed in July 2003. The foreign exchange derivative products that [32]

are now available in Indian financial markets can be grouped into three broad segments, viz.,

forwards, options (foreign currency rupee options and cross currency options) and currency

swaps (foreign currency rupee swaps and cross currency swaps)

Available data indicate that the most widely used derivative instruments are the forwards and

foreign exchange swaps (rupee-dollar). Options have also been in use in the market for the

last four years. However, their volumes are not significant and bid offer spreads are quite wide,

indicating that the market is relatively illiquid. Another major factor hindering the development

of the options market is that corporates are not permitted to write/sell options. If corporates

with underlying exposures are permitted to write/sell covered options, this would lead to

increase in market volume and liquidity. Further, very few banks are market makers in this

product and many deals are done on a back to back basis. For the product to reachthe farther

segment of corporates such as small and medium enterprises (SME) sector, it is imperative

that public sector banks develop the necessary infrastructure and expertise to transact in

options. In view of the growing complexity, diversity and volume of derivatives used by banks,

an Internal Group was constituted by the Reserve Bank to review the existing guidelines on

derivatives and formulate comprehensive guidelines on derivatives for banks

With regard to forward contracts and swaps, which are relatively more popular instruments in

the Indian derivatives market, cancellation and rebooking of forward contracts and swaps in

India have been regulated. Gradually, however, the Reserve Bank has been taking measures

towards eliminating such regulations. The objective has been to ensure that excessive

cancellation and rebooking do not add to the volatility of the rupee. At present, exposures

arising on account of swaps, enabling a corporate to move from rupee to foreign currency

liability (derived exposures), are not permitted to be hedged. While the market participants

have preferred such a hedging facility, it is generally believed that equating derived exposure

in foreign currency with actual borrowing in foreign currency would tantamount to violation of

the basic premise for accessing the forward foreign exchange market in India, i.e., having an

underlying foreign exchange exposure.

This feature (i.e., ‘the role of an underlying transaction in the booking of a forward contract’) is

unique to the Indian derivatives market. The insistence on this requirement of underlying [33]

exposure has to be viewed against the backdrop of the then prevailing conditions when it was

imposed. Corporates in India have been permitted increasing access to foreign currency funds

since 1992. They were also accorded greater freedom to undertake active hedging.

However, recognising the relatively nascent stage of the foreign exchange market initially with

the lack of capabilities to handle massive speculation, the ‘underlying exposure’ criterion was

imposed as a prerequisite. Exporters and importers were permitted to book forward contracts

on the basis of a declaration of an exposure and on the basis of past performance

Eligible limits were gradually raised to enable corporates greater flexibility. The limits are

computed separately for export and import contracts. Documents are required to be furnished

at the time of maturity of the contract. Contracts booked in excess of 25 per cent of the eligible

limit had to be on a deliverable basis and could not be cancelled. This relaxation has proved

very useful to exporters of software and other services since their projects are executed on the

basis of master agreements with overseas buyers, which usually do not indicate the volumes

and tenor of the exports (Report of Internal Group on Foreign Exchange Markets, 2005). In

order to provide greater flexibility to exporters and importers, as announced in the Mid-term

review of the Annual Policy 2006-07, this limit has been enhanced to 50 per cent.

Notwithstanding the initiatives that have been taken to enhance the flexibility for the

corporates, the need is felt to review the underlying exposure criteria for booking a forward

contract. The underlying exposure criteria enable corporates to hedge only a part of their

exposures that arise on the basis of the physical volume of goods (exports/imports) to be

delivered4. With the Indian economy getting increasingly globalised, corporates are also

exposed to a variety of ‘economic exposures’ associated with the types of foreign

exchange/commodity risks/ exposures arising out of exchange rate fluctuations.

At present, the domestic prices of commodities such as ferrous and non-ferrous metals, basic

chemicals, petro-chemicals, etc. are observed to exhibit world import parity. Given the two-way

movement of the rupee against the US dollar and other currencies in recent years, it is

necessary for the producer/ consumer of such products to hedge their economic exposures to

exchange rate fluctuation. Besides, price-fix hedges are also available for traders globally.

They enable importers/exporters to lock into a future price for a commodity that they plan to [34]

import/export without actually having a crystallised physical exposure to the commodity.

Traders may also be affected not only because of changes in rupee-dollar exchange rates but

also because of changes in cross currency exchange rates. The requirement of ‘underlying

criteria’ is also often cited as one of the reasons for the lack of liquidity in some of the

derivative products in India. Hence, a fixation on the ‘underlying criteria’ as India globalises

may hinder the full development of the forward market. The requirement of past

performance/underlying exposures should be eliminated in a phased manner. This has also

been the recommendation of both the committees on capital account convertibility. It is cited

that this pre-requisite has been one of the factors contributing to the shift over time towards the

non-deliverable forward (NDF) market at offshore locations to hedge such exposures since

such requirement is not stipulated while booking a NDF contract. An attempt has been made

recently provide importers the facility to partly hedge their economic exposure by permitting

them to book forward contracts for their customs duty component.

The Annual Policy Statement for 2007-08, released on April 24, 2007 announced a host of

measures to expand the range of hedging tools available to market participants as also

facilitate dynamic hedging by residents. To hedge economic exposures, it has been proposed

that ADs (Category- I) may permit (a) domestic producers/users to hedge their price risk on

aluminium, copper, lead, nickel and zinc in international commodity exchanges, based on their

underlying economic exposures; and (b) actual users of aviation turbine fuel (ATF) to hedge

their economic exposures in the international commodity exchanges based on their domestic

purchases. Authorised dealer banks may approach the Reserve Bank for permission on behalf

of customers who are exposed to systemic international price risk, not covered otherwise. In

order to facilitate dynamic hedging of foreign exchange exposures of exporters and importers

of goods and services, it has been proposed that forward contracts booked in excess of 75 per

cent of the eligible limits have to be on a deliverable basis and cannot be cancelled as against

the existing limit of 50 per cent. With a view to giving greater flexibility to corporates with

overseas direct investments, the forward contracts entered into for hedging overseas direct

investments have been allowed to be cancelled and rebooked. In order to enable small and

medium enterprises to hedge their foreign exchange exposures, it has been proposed to

permit them to book forward contracts without underlying exposures or past records of exports [35]

and imports. Such contracts may be booked through ADs with whom the SMEs have credit

facilities. They have also been allowed to freely cancel and rebook these contracts. In order to

enable resident individuals to manage/hedge their foreign exchange exposures, it has been

proposed to permit resident individuals to book forward contracts without production of

underlying documents up to an annual limit of US $ 100,000, which can be freely cancelled

and rebooked.

Corporate Hedging for Foreign Exchange Risk in India

Introduction

In 1971, the Bretton Woods system of administering fixed foreign exchange rates was

abolished in favour of market-determination of foreign exchange rates; a regime of fluctuating

exchange rates was introduced. Besides market-determined fluctuations, there was a lot of

volatility in other markets around the world owing to increased inflation and the oil shock.

Corporates struggled to cope with the uncertainty in profits, cash flows and future costs. It was

then that financial derivatives – foreign currency, interest rate, and commodity derivatives

emerged as means of managing risks facing corporations.

In India, exchange rates were deregulated and were allowed to be determined by markets in

1993. The economic liberalization of the early nineties facilitated the introduction of derivatives

based on interest rates and foreign exchange. However derivative use is still a highly regulated

area due to the partial convertibility of the rupee. Currently forwards, swaps and options are

available in India and the use of foreign currency derivatives is permitted for hedging purposes

only.

The aim is to provide a perspective on managing the risk that firm’s face due to fluctuating

exchange rates. It investigates the prudence in investing resources towards the purpose of

hedging and then introduces the tools for risk management. These are then applied in the

Indian context. The motivation of this study came from the recent rise in volatility in the money

markets of the world and particularly in the US Dollar, due to which Indian exports are fast

[36]

gaining a cost disadvantage. Hedging with derivative instruments is a feasible solution to this

situation.

This report is organised in 6 sections. The next section presents the necessity of foreign

exchange risk management and outlines the process of managing this risk. Section 3

discusses the various determinants of hedging decisions by firms, followed by an overview of

corporate hedging in India in Section 4. Evidence from major Indian firms from different sectors

is summarized here and Section 5 concludes.

Foreign Exchange Risk Management: Process & Necessity

Firms dealing in multiple currencies face a risk (an unanticipated gain/loss) on account of

sudden/unanticipated changes in exchange rates, quantified in terms of exposures. Exposure

is defined as a contracted, projected or contingent cash flow whose magnitude is not certain at

the moment and depends on the value of the foreign exchange rates. The process of

identifying risks faced by the firm and implementing the process of protection from these risks

by financial or operational hedging is defined as foreign exchange risk management. This

paper limits its scope to hedging only the foreign exchange risks faced by firms.

Kinds of Foreign Exchange Exposure

Risk management techniques vary with the type of exposure (accounting or economic) and

term of exposure. Accounting exposure, also called translation exposure, results from the need

to restate foreign subsidiaries’ financial statements into the parent’s reporting currency and is

the sensitivity of net income to the variation in the exchange rate between a foreign subsidiary

and its parent. Economic exposure is the extent to which a firm's market value, in any

particular currency, is sensitive to unexpected changes in foreign currency. Currency

fluctuations affect the value of the firm’s operating cash flows, income statement, and

competitive position, hence market share and stock price. Currency fluctuations also affect a

firm's balance sheet by changing the value of the firm's assets and liabilities, accounts

payable, accounts receivables, inventory, loans in foreign currency, investments (CDs) in

foreign banks; this type of economic exposure is called balance sheet exposure. Transaction

Exposure is a form of short term economic exposure due to fixed price contracting in an [37]

atmosphere of exchange-rate volatility. The most common definition of the measure of

exchange-rate exposure is the sensitivity of the value of the firm, proxied by the firm’s stock

return, to an unanticipated change in an exchange rate. This is calculated by using the partial

derivative function where the dependant variable is the firm’s value and the independent

variable is the exchange rate (Adler and Dumas, 1984).

Necessity of managing foreign exchange risk

A key assumption in the concept of foreign exchange risk is that exchange rate changes are

not predictable and that this is determined by how efficient the markets for foreign exchange

are. Research in the area of efficiency of foreign exchange markets has thus far been able to

establish only a weak form of the efficient market hypothesis conclusively which implies that

successive changes in exchange rates cannot be predicted by analyzing the historical

sequence of exchange rates.(Soenen, 1979). However, when the efficient markets theory is

applied to the foreign exchange market under floating exchange rates there is some evidence

to suggest that the present prices properly reflect all available information.(Giddy and Dufey,

1992). This implies that exchange rates react to new information in an immediate and

unbiased fashion, so that no one party can make a profit by this information and in any case,

information on direction of the rates arrives randomly so exchange rates also fluctuate

randomly. It implies that foreign exchange risk management cannot be done away with by

employing resources to predict exchange rate changes.

Hedging as a tool to manage foreign exchange risk:

There is a spectrum of opinions regarding foreign exchange hedging. Some firms feel hedging

techniques are speculative or do not fall in their area of expertise and hence do not venture

into hedging practices. Other firms are unaware of being exposed to foreign exchange risks.

There are a set of firms who only hedge some of their risks, while others are aware of the

various risks they face, but are unaware of the methods to guard the firm against the risk.

There is yet another set of companies who believe shareholder value cannot be increased by

hedging the firm’s foreign exchange risks as shareholders can themselves individually hedge

themselves against the same using instruments like forward contracts available in the market

or diversify such risks out by manipulating their portfolio. (Giddy and Dufey, 1992).[38]

There are some explanations backed by theory about the irrelevance of managing the risk of

change in exchange rates. For example, the International Fisher effect states that exchange

rates changes are balanced out by interest rate changes, the Purchasing Power Parity theory

suggests that exchange rate changes will be offset by changes in relative price indices/inflation

since the Law of One Price should hold. Both these theories suggest that exchange rate

changes are evened out in some form or the other.

Also, the Unbiased Forward Rate theory suggests that locking in the forward exchange rate

offers the same expected return and is an unbiased indicator of the future spot rate. But these

theories are perfectly played out in perfect markets under homogeneous tax regimes. Also,

exchange rate-linked changes in factors like inflation and interest rates take time to adjust and

in the meanwhile firms stand to lose out on adverse movements in the exchange rates.

The existence of different kinds of market imperfections, such as incomplete financial markets,

positive transaction and information costs, probability of financial distress and agency costs

and restrictions on free trade make foreign exchange management an appropriate concern for

corporate management. (Giddy and Dufey, 1992) It has also been argued that a hedged firm,

being less risky can secure debt more easily and this enjoy a tax advantage (interest is

excluded from tax while dividends are taxed). This would negate the Modigliani-Miller

proposition as shareholders cannot duplicate such tax advantages. The MM argument that

shareholders can hedge on their own is also not valid on account of high transaction costs and

lack of knowledge about financial manipulations on the part of shareholders.

There is also a vast pool of research that proves the efficacy of managing foreign exchange

risks and a significant amount of evidence showing the reduction of exposure with the use of

tools for managing these exposures. In one of the more recent studies, Allayanis and Ofek

(2001) use a multivariate analysis on a sample of S&P 500 non-financial firms and calculate a

firms exchange-rate exposure using the ratio of foreign sales to total sales as a proxy and

isolate the impact of use of foreign currency derivatives (part of foreign exchange risk

management) on a firm’s foreign exchange exposures. They find a statistically significant

association between the absolute value of the exposures and the (absolute value) of the [39]

percentage use of foreign currency derivatives and prove that the use of derivatives in fact

reduce exposure.

Risk Management and Settlement of Transactions in the Foreign Exchange Market

The foreign exchange market is characterized by constant changes and rapid innovations in

trading methods and products. While the innovative products and ways of trading create new

possibilities for profit, they also pose various kinds of risks to the market. Central banks all over

the world, therefore, have become increasingly concerned of the scale of foreign exchange

settlement risk and the importance of risk mitigation measures. Behind this growing awareness

are several events in the past in which foreign exchange settlement risk might have resulted in

systemic risk in global financial markets, including the failure of Bankhaus Herstatt in 1974 and

the closure of BCCI SA in 1991.

The foreign exchange settlement risk arises because the delivery of the two currencies

involved in a trade usually occurs in two different countries, which, in many cases are located

in different time zones. This risk is of particular concern to the central banks given the large

values involved in settling foreign exchange transactions and the resulting potential for

systemic risk. Most of the banks in the EMEs use some form of methodology for measuring the

foreign exchange settlement exposure. Many of these banks use the single day method, in

which the exposure is measured as being equal to all foreign exchange receipts that are due

on the day. Some institutions use a multiple day approach for measuring risk. Most of the

banks in EMEs use some form of individual counterparty limit to manage their exposures.

These limits are often applied to the global operations of the institution. These limits are

sometimes monitored by banks on a regular basis. In certain cases, there are separate limits

for foreign exchange settlement exposures, while in other cases, limits for aggregate

settlement exposures are created through a range of instruments. Bilateral obligation netting,

in jurisdictions where it is legally certain, is an important way for trade counterparties to

mitigate the foreign exchange settlement risk. This process allows trade counterparties to

[40]

offset their gross settlement obligations to each other in the currencies they have traded and

settle these obligations with the payment of a single net amount in each currency.

Several emerging markets in recent years have implemented domestic real time gross

settlement (RTGS) systems for the settlement of high value and time critical payments to settle

the domestic leg of foreign exchange transactions. Apart from risk reduction, these initiatives

enable participants to actively manage the time at which they irrevocably pay away when

selling the domestic currency, and reconcile final receipt when purchasing the domestic

currency. Participants, therefore, are able to reduce the duration of the foreign exchange

settlement risk.

Recognising the systemic impact of foreign exchange settlement risk, an important element in

the infrastructure for the efficient functioning of the Indian foreign exchange market has been

the clearing and settlement of inter-bank USD-INR transactions. In pursuance of the

recommendations of the Sodhani Committee, the Reserve Bank had set up the Clearing

Corporation of India Ltd. (CCIL) in 2001 to mitigate risks in the Indian financial markets. The

CCIL commenced settlement of foreign exchange operations for inter-bank USD-INR spot and

forward trades from November 8, 2002 and for inter-bank USD-INR cash and tom trades from

February 5, 2004. The CCIL undertakes settlement of foreign exchange trades on a

multilateral net basis through a process of novation and all spot, cash and tom transactions are

guaranteed for settlement from the trade date.

Every eligible foreign exchange contract entered between members gets novated or replaced

by two new contracts – between the CCIL and each of the two parties, respectively. Following

the multilateral netting procedure, the net amount payable to, or receivable from, the CCIL in

each currency is arrived at, member-wise. The Rupee leg is settled through the members’

current accounts with the Reserve Bank and the USD leg through CCIL’s account with the

settlement bank at New York. The CCIL sets limits for each member bank on the basis of

certain parameters such as member’s credit rating, net worth, asset value and management

quality. The CCIL settled over 900,000 deals for a gross volume of US $ 1,180 billion in 2005-

06. The CCIL has consistently endeavoured to add value to the services and has gradually [41]

brought the entire gamut of foreign exchange transactions under its purview. Intermediation, by

the CCIL thus, provides its members the benefits of risk mitigation, improved efficiency, lower

operational cost and easier reconciliation of accounts with correspondents.

An issue related to the guaranteed settlement of transactions by the CCIL has been the

extension of this facility to all forward trades as well. Member banks currently encounter

problems in terms of huge outstanding foreign exchange exposures in their books and this

comes in the way of their doing more trades in the market. Risks on such huge outstanding

trades were found to be very high and so were the capital requirements for supporting such

trades. Hence, many member banks have expressed their desire in several fora that the CCIL

should extend its guarantee to these forward trades from the trade date itself which could lead

to significant increase in the liquidity and depth in the forward market. The risks that banks

today carry in their books on account of large outstanding forward positions will also be

significantly reduced (Gopinath, 2005). This has also been one of the recommendations of the

Committee on Fuller Capital Account Convertibility. 6.55 Apart from managing the foreign

exchange settlement risk, participants also need to manage market risk, liquidity risk, credit

risk and operational risk efficiently to avoid future losses. As per the guidelines framed by the

Reserve Bank for banks to manage risk in the inter-bank foreign exchange dealings and

exposure in derivative markets as market makers, the boards of directors of ADs (category-I)

are required to frame an appropriate policy and fix suitable limits for operations in the foreign

exchange market. The net overnight open exchange position and the aggregate gap limits

need to be approved by the Reserve Bank. The open position is generally measured

separately for each foreign currency consisting of the net spot position, the net forward

position, and the net options position. Various limits for exposure, viz., overnight, daylight, stop

loss, gap limit, credit limit, value at risk (VaR), etc., for foreign exchange transactions by banks

are fixed. Within the contour of these limits, front office of the treasury of ADs transacts in the

foreign exchange market for customers and own proprietary requirements. These exposures

are accounted, confirmed and settled by back office, while mid-office evaluates the profit and

monitors adherence to risk limits on a continuous basis. In the case of market risk, most banks

use a combination of measurement techniques including VaR models. The credit risk is [42]

generally measured and managed by most banks on an aggregate counter-party basis so as

to include all exposures in the underlying spot and derivative markets. Some banks also

monitor country risk through cross-border country risk exposure limits. Liquidity risk is

generally estimated by monitoring asset liability profile in various currencies in various buckets

and monitoring currency-wise gaps in various buckets. Banks also track balances to be

maintained on a daily basis in Nostro accounts, remittances and committed foreign currency

term loans while monitoring liquidity risk.

To sum up, the foreign exchange market structure in India has undergone substantial

transformation from the early 1990s. The market participants have become diversified and

there are several instruments available to manage their risks. Sources of supply and demand

in the foreign exchange market have also changed in line with the shifts in the relative

importance in balance of payments from current to capital account. There has also been

considerable improvement in the market infrastructure in terms of trading platforms and

settlement mechanisms. Trading in Indian foreign exchange market is largely concentrated in

the spot segment even as volumes in the derivatives segment are on the rise. Some of the

issues that need attention to further improve the activity in the derivatives segment include

flexibility in the use of various instruments, enhancing the knowledge and understanding the

nature of risk involved in transacting the derivative products, reviewing the role of underlying in

booking forward contracts and guaranteed settlements of forwards. Besides, market players

would need to acquire the necessary expertise to use different kinds of instruments and

manage the risks involved.

Foreign Exchange Risk Management Framework

Once a firm recognizes its exposure, it then has to deploy resources in managing it. A heuristic

for firms to manage this risk effectively is presented below which can be modified to suit firm-

specific needs i.e. some or all the following tools could be used.

Forecasts: After determining its exposure, the first step for a firm is to develop a forecast

on the market trends and what the main direction/trend is going to be on the foreign

[43]

exchange rates. The period for forecasts is typically 6 months. It is important to base the

forecasts on valid assumptions. Along with identifying trends, a probability should be

estimated for the forecast coming true as well as how much the change would be.

Risk Estimation: Based on the forecast, a measure of the Value at Risk (the actual profit or

loss for a move in rates according to the forecast) and the probability of this risk should be

ascertained. The risk that a transaction would fail due to market-specific problems4 should

be taken into account. Finally, the Systems Risk that can arise due to inadequacies such as

reporting gaps and implementation gaps in the firms’ exposure management system should

be estimated.

Benchmarking: Given the exposures and the risk estimates, the firm has to set its limit for

handling foreign exchange exposure. The firm also has to decide whether to manage its

exposures on a cost centre or profit centre basis. A cost centre approach is a defensive one

and the main aim is ensure that cash flows of a firm are not adversely affected beyond a

point. A profit centre approach on the other hand is a more aggressive approach where the

firm decides to generate a net profit on its exposure over time.

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

decides an appropriate hedging strategy. There are various financial instruments available

for the firm to choose from: futures, forwards, options and swaps and issue of foreign debt.

Hedging strategies and instruments are explored in a section.

Stop Loss: The firms risk management decisions are based on forecasts which are but

estimates of reasonably unpredictable trends. It is imperative to have stop loss

arrangements in order to rescue the firm if the forecasts turn out wrong. For this, there

should be certain monitoring systems in place to detect critical levels in the foreign

exchange rates for appropriate measure to be taken.

Reporting and Review: Risk management policies are typically subjected to review based

on periodic reporting. The reports mainly include profit/ loss status on open contracts after [44]

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.

Hedging Strategies/ Instruments

A derivative is a financial contract whose value is derived from the value of some other

financial asset, such as a stock price, a commodity price, an exchange rate, an interest rate, or

even an index of prices. The main role of derivatives is that they reallocate risk among financial

market participants, help to make financial markets more complete. This section outlines the

hedging strategies using derivatives with foreign exchange being the only risk assumed.

Forwards

A forward is a made-to-measure agreement between two parties to buy/sell a specified amount

of a currency at a specified rate on a particular date in the future. The depreciation of the

receivable currency is hedged against by selling a currency forward. If the risk is that of a

currency appreciation (if the firm has to buy that currency in future say for import), it can hedge

by buying the currency forward. E.g. if RIL wants to buy crude oil in US dollars six months

hence, it can enter into a forward contract to pay INR and buy USD and lock in a fixed

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

at the time. In this example the downside is an appreciation of Dollar which is protected by a

fixed forward contract. The main advantage of a forward is that it can be tailored to the specific

needs of the firm and an exact hedge can be obtained. On the downside, these contracts are

not marketable, they can’t be sold to another party when they are no longer required and are

binding.

Futures

[45]

A futures contract is similar to the forward contract but is more liquid because it is traded in an

organized exchange i.e. the futures market. Depreciation of a currency can be hedged by

selling futures and appreciation can be hedged by buying futures. Advantages of futures are

that there is a central market for futures which eliminates the problem of double coincidence.

Futures require a small initial outlay (a proportion of the value of the future) with which

significant amounts of money can be gained or lost with the actual forwards price fluctuations.

This provides a sort of leverage.

The previous example for a forward contract for RIL applies here also just that RIL will have to

go to a USD futures exchange to purchase standardised dollar futures equal to the amount to

be hedged as the risk is that of appreciation of the dollar. As mentioned earlier, the tailorability

of the futures contract is limited i.e. only standard denominations of money can be bought

instead of the exact amounts that are bought in forward contracts.

Options

A currency Option is a contract giving the right, not the obligation, to buy or sell a specific

quantity of one foreign currency in exchange for another at a fixed price; called the Exercise

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

exchange rate changes and limits the losses of open currency positions. Options are

particularly suited as a hedging tool for contingent cash flows, as is the case in bidding

processes. Call Options are used if the risk is an upward trend in price (of the currency), while

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

needs to purchase crude oil in USD in 6 months, if RIL buys a Call option (as the risk is an

upward trend in dollar rate), i.e. the right to buy a specified amount of dollars at a fixed rate on

a specified date, there are two scenarios. If the exchange rate movement is favourable i.e the

dollar depreciates, then RIL can buy them at the spot rate as they have become cheaper. In

the other case, if the dollar appreciates compared to today’s spot rate, RIL can exercise the

option to purchase it at the agreed strike price. In either case RIL benefits by paying the lower

price to purchase the dollar

Swaps[46]

A swap is a foreign currency contract whereby the buyer and seller exchange equal initial

principal amounts of two different currencies at the spot rate. The buyer and seller exchange

fixed or floating rate interest payments in their respective swapped currencies over the term of

the contract. At maturity, the principal amount is effectively re-swapped at a predetermined

exchange rate so that the parties end up with their original currencies. The advantages of

swaps are that firms with limited appetite for exchange rate risk may move to a partially or

completely hedged position through the mechanism of foreign currency swaps, while leaving

the underlying borrowing intact. Apart from covering the exchange rate risk, swaps also allow

firms to hedge the floating interest rate risk. Consider an export oriented company that has

entered into a swap for a notional principal of USD 1 mn at an exchange rate of 42/dollar.

The company pays US 6months LIBOR to the bank and receives 11.00% p.a. every 6 months

on 1st January & 1st July, till 5 years. Such a company would have earnings in Dollars and can

use the same to pay interest for this kind of borrowing (in dollars rather than in Rupee) thus

hedging its exposures.

Foreign Debt

Foreign debt can be used to hedge foreign exchange exposure by taking advantage of the

International Fischer Effect relationship. This is demonstrated with the example of an exporter

who has to receive a fixed amount of dollars in a few months from present. The exporter

stands to lose if the domestic currency appreciates against that currency in the meanwhile so,

to hedge this, he could take a loan in the foreign currency for the same time period and convert

the same into domestic currency at the current exchange rate. The theory assures that the

gain realised by investing the proceeds from the loan would match the interest rate payment

(in the foreign currency) for the loan.

Choice of hedging instruments

The literature on the choice of hedging instruments is very scant. Among the available studies,

Géczy et al. (1997) argues that currency swaps are more cost-effective for hedging foreign

debt risk, while forward contracts are more cost-effective for hedging foreign operations risk.

This is because foreign currency debt payments are long-term and predictable, which fits the

[47]

long-term nature of currency swap contracts. Foreign currency revenues, on the other hand,

are short-term and unpredictable, in line with the short-term nature of forward contracts. A

survey done by Marshall (2000) also points out that currency swaps are better for hedging

against translation risk, while forwards are better for hedging against transaction risk. This

study also provides anecdotal evidence that pricing policy is the most popular means of

hedging economic exposures.

These results however can differ for different currencies depending in the sensitivity of that

currency to various market factors. Regulation in the foreign exchange markets of various

countries may also skew such results.

Determinants of Hedging Decisions

The management of foreign exchange risk, as has been established so far, is a fairly

complicated process. A firm, exposed to foreign exchange risk, needs to formulate a strategy

to manage it, choosing from multiple alternatives. This section explores what factors firms take

into consideration when formulating these strategies.

Production and Trade vs. Hedging Decisions

An important issue for multinational firms is the allocation of capital among different countries

production and sales and at the same time hedging their exposure to the varying exchange

rates. Research in this area suggests that the elements of exchange rate uncertainty and the

attitude toward risk are irrelevant to the multinational firm's sales and production decisions

(Broll,1993). Only the revenue function and cost of production are to be assessed, and, the

production and trade decisions in multiple countries are independent of the hedging decision.

The implication of this independence is that the presence of markets for hedging instruments

greatly reduces the complexity involved in a firm’s decision making as it can separate

production and sales functions from the finance function. The firm avoids the need to form

expectations about future exchange rates and formulation of risk preferences which entails

high information costs.

Cost of Hedging[48]

Hedging can be done through the derivatives market or through money markets (foreign debt).

In either case the cost of hedging should be the difference between value received from a

hedged position and the value received if the firm did not hedge. In the presence of efficient

markets, the cost of hedging in the forward market is the difference between the future spot

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

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

difference between the interest rate differential and the expected value of the difference

between the current and future spot rates. In efficient markets, both types of hedging should

produce similar results at the same costs, because interest rates and forward and spot

exchange rates are determined simultaneously. The costs of hedging, assuming efficiency in

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

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

subscription to Reuter reports and news channels and administrative costs of exposure

management.

Factors affecting the decision to hedge foreign currency risk

Research in the area of determinants of hedging separates the decision of a firm to hedge

from that of how much to hedge. There is conclusive evidence to suggest that firms with larger

size, R&D expenditure and exposure to exchange rates through foreign sales and foreign

trade are more likely to use derivatives. (Allayanis and Ofek, 2001) First, the following section

describes the factors that affect the decision to hedge and then the factors affecting the degree

of hedging are considered.

Firm size

Firm size acts as a proxy for the cost of hedging or economies of scale. Risk management

involves fixed costs of setting up of computer systems and training/hiring of personnel in

foreign exchange management. Moreover, large firms might be considered as more

creditworthy counterparties for forward or swap transactions, thus further reducing their cost of

hedging. The book value of assets is used as a measure of firm size.

Leverage[49]

According to the risk management literature, firms with high leverage have greater incentive to

engage in hedging because doing so reduces the probability, and thus the expected cost of

financial distress. Highly levered firms avoid foreign debt as a means to hedge and use

derivatives

Liquidity and profitability:

Firms with highly liquid assets or high profitability have less incentive to engage in hedging

because they are exposed to a lower probability of financial distress. Liquidity is measured by

the quick ratio, i.e. quick assets divided by current liabilities). Profitability is measured as EBIT

divided by book assets.

Sales growth

Sales growth is a factor determining decision to hedge as opportunities are more likely to be

affected by the underinvestment problem. For these firms, hedging will reduce the probability

of having to rely on external financing, which is costly for information asymmetry reasons, and

thus enable them to enjoy uninterrupted high growth. The measure of sales growth is obtained

using the 3-year geometric average of yearly sales growth rates.

As regards the degree of hedging Allayanis and Ofek (2001) conclude that the sole

determinants of the degree of hedging are exposure factors (foreign sales and trade). In other

words, given that a firm decides to hedge, the decision of how much to hedge is affected solely

by its exposure to foreign currency movements.

This discussion highlights how risk management systems have to be altered according to

characteristics of the firm, hedging costs, nature of operations, tax considerations, regulatory

requirements etc. The next section discusses these issues in the Indian context and regulatory

environment.

An Overview of Corporate Hedging in India

The move from a fixed exchange rate system to a market determined one as well as the

development of derivatives markets in India have followed with the liberalization of the

economy since 1992. In this context, the market for hedging instruments is still in its [50]

developing stages. In order to understand the alternative hedging strategies that Indian firms

can adopt, it is important to understand the regulatory framework for the use of derivatives

here.

Development of Derivative Markets in India

The economic liberalization of the early nineties facilitated the introduction of derivatives based

on interest rates and foreign exchange. Exchange rates were deregulated and market

determined in 1993. By 1994, the rupee was made fully convertible on current account. The

ban on futures trading of many commodities was lifted starting in the early 2000s. As of

October 2007, even corporates have been allowed to write options in the atmosphere of high

volatility.9 Derivatives on stock indexes and individual stocks have grown rapidly since

inception. In particular, single stock futures have become hugely popular. Institutional investors

prefer to trade in the Over-The-Counter (OTC) markets to interest rate futures, where

instruments such as interest rate swaps and forward rate agreements are thriving. Foreign

exchange derivatives are less active than interest rate derivatives in

\ India, even though they have been around for longer. OTC instruments in currency forwards

and swaps are the most popular. Importers, exporters and banks use the rupee forward market

to hedge their foreign currency exposure. Turnover and liquidity in this market has been

increasing, although trading is mainly in shorter maturity contracts of one year or less. The

typical forward contract is for one month, three months, or six months, with three months being

the most common. The Indian rupee, which is being traded on the Dubai Gold and

Commodities Exchange (DGCX), crossed a turnover of $23.24 million in June 2007.

Regulatory Guidelines for the use of Foreign Exchange Derivatives

With respect to foreign exchange derivatives involving rupee, residents have access to foreign

exchange forward contracts, foreign currency-rupee swap instruments and currency options –

both cross currency as well as foreign currency-rupee. In the case of derivatives involving only

foreign currency, a range of products such as Interest Rate Swaps, Forward Contracts and

Options are allowed. While these products can be used for a variety of purposes, the

fundamental requirement is the existence of an underlying exposure to foreign exchange risk

i.e. derivatives can be used for hedging purposes only.[51]

The RBI has also formulated guidelines to simplify procedural/documentation requirements for

Small and Medium Enterprises (SME) sector. In order to ensure that SMEs understand the

risks of these products, only banks with which they have credit relationship are allowed to offer

such facilities. These facilities should also have some relationship with the turnover of the

entity. Similarly, individuals have been permitted to hedge upto USD 100,000 on self-

declaration basis. Authorised Dealer (AD) banks may also enter into forward contracts with

residents in respect of transactions denominated in foreign currency but settled in Indian

Rupees including hedging the currency indexed exposure of importers in respect of customs

duty payable on imports and price risks on commodities with a few exceptions. Domestic

producers/users are allowed to hedge their price risk on aluminium, copper, lead, nickel and

zinc as well as aviation turbine fuel in international commodity exchanges based on their

underlying economic exposures. Authorised dealers are permitted to use innovative products

like cross-currency options; interest rate swaps (IRS) and currency swaps, caps/collars and

forward rate agreements (FRAs) in the international foreign exchange market. Foreign

Institutional Investors (FII), person’s resident outside India having Foreign Direct Investment

(FDI) in India and Nonresident Indians (NRI) are allowed access to the forwards market to the

extent of their exposure in the cash market.

Hedging Instruments for Indian Firms

The recent period has witnessed amplified volatility in the INR-US exchange rates in the

backdrop of the sub-prime crisis in the US and increased dollar-inflows into the Indian stock

markets. In this context, the paper has attempted to study the choice of instruments adopted

by prominent firms to stem their foreign exchange exposures. All the data for this has been

compiled from the 2006-2007 Annual Reports of the respective companies. A summary of the

foreign exchange risk hedging behaviour of select Indian firms is given in the table.

[52]

InstrumentsCurrency(mn) Rs (Cr) Nature of exposure

Reliance Industries Earnings in all businesses are linked to USD.Currency Swaps 1064.49 The key input, crude oil is purchased in USD.

Options Contracts 2939.76All export revenues are in foreign currency and

Forward Contracts 5764.1local prices are based on import parity prices as well

Maruti Udyog .

Forward Contracts6411 (INR-JPY) Import/Royalty payable in Yen and70 ($-INR) Exports Receivables in dollars.

Currency swaps124.70(USD-INR) Interest rate and forex risk.

.

Mahindra and MahindraForward Contracts 350 (INR-JPY) Trade payables in Yen and Euro and

2(INR-EUR) export receivables in dollars.27.3($-INR)

Currency Swaps5390 (JPY-INR) Interest rate and foreign exchange risk.

Arvind MillsForward Contracts 152.98 ($-INR) 703.67

2.25 (GBP-INR)5 (INR-$) 21.88 Most of the revenue is either in dollars

or linked to dollars due to export.

[53]

Option Contracts 1 2 2.5 ($-INR) 547.16

InfosysForward Contracts 119 ($-INR) 529Options Contracts 4 ($-INR) 18 Revenues denominated in these

8 (INR-$) 36 currencies.Range barrier options 2 ($-INR) 971

3 (Eur-INR)

TCSForward Contracts 15 (Eur-INR) 265.75 Revenues largely denominated in

21 (GBP-INR) foreign currency, predominantly US$,GBP, and Euro. Other currencie include

Options Contracts 8 3 0 ($-INR) 4057 Australian $, Canadian $, South African47.5 (Eur-INR) Rand, and Swiss Franc76.5 (GBP-INR)

Ranbaxy

Forward Contracts2894.589 Exposed on accounts receivable and

loans payable. Exposure in USD andJap Yen

Dr. Reddy’s LabsForward Contracts 398 ($-INR) Foreign currency earnings through

11(Eur $) export, currency requirements forsettlement of liability for import of

Options Contracts 30 (EUR-$) goods.

Discussion on Hedging by Indian Firms

From the Table above, it can be seen that earnings of all the firms are linked to either US

dollar, Euro or Pound as firms transact primarily in these foreign currencies globally. Forward

contracts are commonly used and among these firms, Ranbaxy and RIL depend heavily on

these contracts for their hedging requirements. As discussed earlier, forwards contracts can be

[54]

tailored to the exact needs of the firm and this could be the reason for their popularity. The

tailor ability is a consideration as it enables the firms to match their exposures in an exact

manner compared to exchange traded derivatives like futures that are standardized where

exact matching is difficult. RIL, Maruti Udyog and Mahindra and Mahindra are the only firms

using currency swaps. Swap usage is a long term strategy for hedging and suggests that the

planning horizons for these companies are longer than those of other firms. These businesses,

by nature involve longer gestation periods and higher initial capital outlays and this could

explain their long planning horizons.

Another observation is that TCS prefers to hedge its exposure to the US Dollar through options

rather than forwards. This strategy has been observed among many firms recently in India11.

This has been adopted due to the marked high volatility of the US Dollar against the Rupee.

Options are more profitable instruments in volatile conditions as they offer unlimited upside

profitability while hedging the downside risk whereas there is a risk with forwards if the

expectation of the exchange rate (the guess) is wrong as firms lose out on some profit. The

use of Range barrier options by Infosys also suggests a strategy to tackle the high volatility of

the dollar exchange rates. Software firms have a limited domestic market and rely on exports

for the major part of their revenues and hence require additional flexibility in hedging when the

volatility is high. Another implication of this is that their planning horizons are shorter compared

to capital intensive firms.

It is evident that most Indian firms use forwards and options to hedge their foreign currency

exposure. This implies that these firms chose short-term measures to hedge as opposed to

foreign debt. This preference is possibly a consequence of their costs being in Rupees, the

absence of a Rupee futures exchange in India and curbs on foreign debt. It also follows that

most of these firms behave like Net Exporters and are adversely affected by appreciation of

the local currency. There are a few firms which have import liabilities which would be adversely

affected by Rupee depreciation.

However it must be pointed out that the data set considered for this study does not indicate

how the use of foreign debt by these firms hedges their exposures to foreign exchange risk

and whether such a strategy is used as a substitute or complement to hedging with derivatives.[55]

Conclusion

Derivative use for hedging is only to increase due to the increased global linkages and volatile

exchange rates. Firms need to look at instituting a sound risk management system and also

need to formulate their hedging strategy that suits their specific firm characteristics and

exposures.

In India, regulation has been steadily eased and turnover and liquidity in the foreign currency

derivative markets has increased, although the use is mainly in shorter maturity contracts of

one year or less. Forward and option contracts are the more popular instruments. Regulators

had initially only allowed certain banks to deal in this market however now corporates can also

write option contracts. There are many variants of these derivatives which investment banks

across the world specialize in, and as the awareness and demand for these variants increases,

RBI would have to revise regulations.

For now, Indian companies are actively hedging their foreign exchanges risks with forwards,

currency and interest rate swaps and different types of options such as call, put, cross

currency and range-barrier options. The high use of forward contracts by Indian firms also

highlights the absence of a rupee futures exchange in India.

However, the Dubai Gold and Commodities Exchange in June, 2007 introduced Rupee- Dollar

futures that could be traded on its exchanges and had provided another route for firms to

hedge on a transparent basis. There are fears that RBI’s ability to control the partially

convertible currency will be subdued by this introduction but this issue is beyond the scope of

this study. The partial convertibility of the Rupee will be difficult to control if many exchanges

offer such instruments and that will be factor to consider for the RBI.

[56]

Currency Risk Management

Introduction

The management of currency risk by corporations has come a longway in the last three

decades. Before the break-up of BrettonWoods currency riskwas not a major consideration for

corporate executives, nor did it have to be. Exchange rates were allowed to fluctuate, but only

within reasonably tight bands, while the US dollar itselfwas pegged to that most solid of

commodities, gold. The responsibility for managing currency risk, or rather maintaining

currency stability, was largely that of governments. Needless to say, that burden, that

responsibility has now passed from the public to the private sector.

The way the corporation has dealt with currency risk has changed substantially over time.

Corporations, many of which were reluctant to touch anything but the most vanilla of hedging

structures, have now greatly increased the sophistication of their currency risk management

and hedging strategies, particularly over the last decade. In this regard, two developments

have helped greatly – the centralizing of Treasury operations, particularly within large

multinationals, and the focus put on hiring specifically experienced and qualified personnel to

manage the day-to-day operations of risk management.

Currency Risk

So, what precisely is currency risk? There is no point in focusing on an issue if one cannot first

define it. Although definitions vary within the academic community, a practical description of

currency risk would be:

[57]

The impact that unexpected exchange rate changes have on the value of the corporation

Currency risk is very important to a corporation as it can have a major impact on its cash flows,

assets and liabilities, net profit and ultimately its stock market value. Assuming the corporation

has accepted that currency risk needs to be managed specifically and separately, it has three

initial priorities:

1. Define what kinds of currency risk the corporation is exposed to

2. Define a corporate Treasury strategy to deal with these currency risks

3. Define what financial instruments it allows itself to use for this purpose

Currency risk is simple in concept, but complex in reality. At its most basic, it is the possible

gain or loss resulting from an exchange rate move. It can affect the value of a corporation

directly as a result of an unhedged exposure or more indirectly.

Different types of currency risk can also offset each other. For instance, take a US citizen who

owns stock in a German auto manufacturer and exporter to the US. If the Euro falls against the

US dollar, the US dollar value of the Euro-denominated stock falls and therefore on the face of

it the individual sees the US dollar value of their holding decline. However, the German auto

exporter should in fact benefit from a weaker Euro as this makes the company’s exports to

the US cheaper, allowing them the choice of either maintaining US prices to maintain margin

or cutting them further to boost market share. Sooner or later, the stock market will realize this

and mark up the stock price of the auto exporter. Thus, the stock owner may lose on the

currency translation, but gain on the higher stock price. This is of course a very simple

example and life unfortunately is rarely that simple. For just as a weaker Euro makes exports

from the Euro-zone cheaper, so it makes imports more expensive. Thus, an exporter may not

in fact feel the benefit of the currency translation through to market share because higher

import prices force it to raise export prices from where they would otherwise would be

according to the exchange rate.

The first step in successfully managing currency risk is to acknowledge that such risk actually

exists and that it has to be managed in the general interest of the corporation and the

corporation’s shareholders. For some, this is of itself a difficult hurdle as there is still major [58]

reluctance within corporate management to undertake what they see as straying from their

core, underlying business into the speculative world of currency markets. The truth however is

that the corporation is a participant in the currency market whether it likes it or not; if it has

foreign currency-denominated exposure, that exposure should be managed. To do anything

else is irresponsible. The general trend within the corporate world has however been in favour

of recognizing the existence of and the need to manage currency risk. That recognition does

not of itself entail speculation. Indeed, at its best, prudent currency hedging can be defined as

the elimination of speculation:

The real speculation is in fact not managing currency risk

The next step, however, is slightly more complex and that is to identify the nature and extent of

the currency risk or exposure. It should be noted that the emphasis here is for the most part on

non-financial corporations, on manufacturers and service providers rather than on banks or

other types of financial institutions. Non-financial corporations generally have only a small

amount of their total assets in the form of receivables and other types of transaction. Most of

their assets are made up of inventory, buildings, equipment and other forms of tangible “real”

assets. In order to measure the effect of exchange rate moves on a corporation, one first has

to define the type and then the amount of risk involved, or the “value at risk” (VaR). There are

three main types of currency risk that a multinational corporation is exposed to and has to

manage.

Types of Currency Risk

1. Transaction risk (receivables, dividends, etc.)

2. Translation risk (balance sheet)

3. Economic risk (present value of future operating cash flows)

Transaction Risk

Transaction currency risk is essentially cash flow risk and relates to any transaction, such as

receivables, payables or dividends. The most common type of transaction risk relates to export [59]

or import contracts. When there is an exchange rate move involving the currencies of such a

contract, this represents a direct transactional currency risk to the corporation. This is the most

basic type of currency risk that a corporation faces.

Translation Risk

Translation risk is slightly more complex and is the result of the consolidation of parent

company and foreign subsidiary financial statements. This consolidation means that exchange

rate impact on the balance sheet of the foreign subsidiaries is transmitted or translated to the

parent company’s balance. Translation risk is thus balance sheet currency risk. While most

large multinational corporations actively manage their transaction currency risk, many are less

aware of the potential dangers of translation risk.

The actual translation process in consolidating financial statements is done either at the

average exchange rate of the period or at the exchange rate at the period end, depending on

the specific accounting regulations affecting the parent company. As a direct result, the

consolidated results will vary as either the average or the end-of-period exchange rate varies.

Thus, all foreign currency-denominated profit is exposed to translation currency risk as

exchange rates vary. In addition, the foreign currency value of foreign subsidiaries is also

consolidated on the parent company’s balance sheet, and that value will vary accordingly.

Translation risk for a foreign subsidiary is usually measured by the net assets (assets less

liabilities) that are exposed to potential exchange rate moves.

Problems can occur with regard to translation risk if a corporation has subsidiaries whose

accounting books are local currency-denominated. For consolidation purposes, these books

must of course be translated into the currency of the parent company, but at what exchange

rate? Income statements are usually translated at the average exchange rate over the period.

However, deciding at what exchange rate to translate the balance sheet is slightly trickier.

There are generally three methods used by major multinational corporations for translating

balance sheet risk, varying in how they separate assets and liabilities between those that need [60]

to be translated at the “current” exchange rate at the time of consolidation and those that are

translated at the historical exchange rate:

_ the all current (closing rate) method

_ the monetary/non-monetary method

_ the temporal method

As the name might suggest, the all current (closing rate) method translates all foreign currency

exposures at the closing exchange rate of the period concerned. Under this method,

translation risk relates to net assets or shareholder funds. This has become the most popular

method of translating balance exposure of foreign subsidiaries, both in the US and worldwide

On the other hand, the monetary/non-monetary method translates monetary items such as

assets, liabilities and capital at the closing rate and non-monetary items at the historical rate.

Finally, the temporal method breaks balance sheet items down in terms of whether they are

firstly stated at replacement cost, realizable value, market value or expected future value, or

secondly stated at historic cost. For the first group, these are translated at the closing

exchange rate of the period concerned, for the second, at the historical exchange rate.

The US accounting standard FAS 52 and the UK’s SSAP 20 apply to translation risk. Under

FAS 52, the translation of foreign currency revenues and costs is made at the average

exchange rate of the period. FAS 52 generally uses the all current method for translation

purposes, though it does have several important provisions, notably regarding the treatment of

currency hedging contracts. Under SSAP 20, the corporation can use either the current or

average rate. Generally, there has been a shift among multinational corporations towards

using the average rather than the closing rate because this is seen as a truer reflection of the

translation risk faced by the corporation during the period. Translation risk is a crucial issue for

corporations. Later in this chapter, we will look at methods of hedging it. For now, it is

important to get an idea of how it can affect the company’s overall value.

Example

Take an example of a Euro-based manufacturer, which has bought a factory in Poland.

Needless to say, the cost base in Poland is substantially below that of the parent company,

one of several major reasons why the acquisition was made in the first place. From 1999 to [61]

2001, the Euro was on a major downtrend, not just against its major currency counterparts but

also against most currencies of the Central and East European area, such as the Polish zloty.

Thus we get the following simple model:

EUR–USD ↓= EUR–PLN ↓

Where:

EUR–USD = the Euro–US dollar exchange rate

EUR–PLN = The Euro–Polish zloty exchange rate

This is an over-simplification to be sure. For one thing, the Polish zloty was pegged to a basket

of Euro (55%) and US dollar (45%) with a crawl and trading bands up until 2000, and thus was

unable to appreciate despite the ongoing decline in the value of the Euro across the board. For

another, it does not take account of EUR–PLN volatility. That said, general Euro weakness has

clearly been an important factor in the depreciation of the Euro–zloty exchange rate. Note

however that as the Euro–zloty exchange rate has depreciated for this and other reasons so

the value of the original investment in the Polish factory has increased in Euro terms. Thus:

EUR–PLN ↓= EURtranslation value of Polish subsidiary ↑

Whatever our Euro-based manufacturer may think of Euro weakness, it is entirely beneficial for

the manufacturer’s translation value of the Polish factory/subsidiary when the financial

statements are consolidated at the end of the accounting period. The translation benefit to the

balance sheet will depend on the accounting method of translation. Conversely, were the Euro

ever to rally on a sustained basis, this might cause the Euro–zloty exchange rate to rally, thus

in turn reducing the translation value of the corporation’s Polish subsidiary. The consolidation

of financial statements would mean that this not only has an impact on the Euro value of the

Polish subsidiary but also on the balance sheet of the parent, Euro-based manufacturer. The

risk of a sudden balance sheet deterioration of this kind is not negligible where corporations

have a broad range of foreign subsidiaries, with accompanying transactional and translational

currency risk.

Economic Risk

The translation of foreign subsidiaries concerns the consolidated group balance sheet.

However, this does not affect the real “economic” value or exposure of the subsidiary. [62]

Economic risk focuses on how exchange rate moves change the real economic value of the

corporation, focusing on the present value of future operating cash flows and how this changes

in line with exchange rate changes. More specifically, the economic risk of a corporation

reflects the effect of exchange rate changes on items such as export and domestic sales, and

the cost of domestic and imported inputs. As with translation risk, calculating economic risk is

complex, but clearly necessary to be able to assess how exchange rate changes can affect the

present value of foreign subsidiaries. Economic risk is usually applied to the present value of

future operating cash flows of a corporation’s foreign subsidiaries. However, it can also be

applied to the parent company’s operations and how the present value of those change in line

with exchange rate changes.

Summarizing this part, transaction risk deals with the effect of exchange rate moves on

transactional exposure such as accounts receivable/payable or dividends. Translation risk

focuses on how exchange rate moves can affect foreign subsidiary valuation and therefore the

valuation of the consolidated group balance sheet. Finally, economic risk deals with the effect

of exchange rate changes to the present value of future operating cash flows, focusing on the

“currency of determination” of revenues and operating expenses. Here it is important to

differentiate between the currency in which cash flows are denominated and the currency that

may determine the nature and size of those cash flows. The two are not necessarily the same.

To complicate the issue further, there is the small matter of the parent company’s currency,

which is used to consolidate the financial statements. If a parent company has foreign

currency-denominated debt, this is recorded in the parent company’s currency, but the value of

its legal obligation remains in the currency denomination of the debt. In sum, transaction risk is

just the tip of the iceberg!

Of necessity, the reality of currency risk is very case-specific. That said, there has been an

attempt by the academic and economic communities to apply the traditional exchange rate

models to the corporate world for the purpose of demonstrating how exchange rates impact a

corporation.

PPP (or the law of one price) suggests that price differentials of the same good in different

countries require an exchange rate adjustment to offset them. The international Fisher effect [63]

suggests that the expected change in the exchange rate is equal to the interest rate

differential. The unbiased forward rate theory suggests that the forward exchange rate is equal

to the expected exchange rate.

Generally, these theories are grounded in the efficient market hypothesis and therefore flawed

at best. Over the long term, these traditional “rules” of exchange rate theory suggest that

competition and arbitrage should neutralize the effect of exchange rate changes on returns

and on the valuation of the corporation. Equally, locking into the forward rate should, according

to the unbiased forward rate theory, offer the same return as remaining exposed to currency

risk, as this theory suggests that the distribution of probability should be equal on either side of

the forward rate.

The unfortunate thing about such models, however worthy the attempt, is that they do not and

cannot deal with the practical realities of managing currency risk. What academics regard as

“temporary deviations” from where the model suggests the exchange rate should be can be

sufficient and substantial enough to cause painful and intolerable deterioration to both the P&L

and the balance sheet?

To conclude this part, a corporation should define and seek to quantify the types of currency

risk to which it is exposed in order then to be able to go about creating a strategy for managing

that currency risk.

Core Principles for Managing Currency Risk

1. Determine the types of currency risk to which the corporation is exposed – Break

these down into transaction, translation and economic risk, making specific reference to what

currencies are related to each type of currency risk.

2. Establish a strategic currency risk management policy – Once currency risk types have

been agreed on, corporate Treasury should establish and document a strategic currency risk

`management policy to deal with these types of risks. This policy should include the

corporation’s general approach to currency risk, whether it wants to hedge or trade that risk

and its core hedging objectives.[64]

3. Create a mission statement for Treasury – It is crucial to create a set of values and

principles which embody the specific approach taken by the Treasury towards managing

currency risk, agreed upon by senior management at the time of establishing and documenting

the risk management policy.

4. Detail currency hedging approach – Having established the overall currency risk

management policy, the corporation should detail how that policy is to be executed in practice,

including the types of financial instruments that could be used for hedging, the process by

which currency hedging would be executed and monitored and procedures for monitoring and

reviewing existing currency hedges.

5. Centralizing Treasury operations as a single centre of excellence – Treasury operations

can be more effectively and efficiently managed if they are centralized. This makes it easier to

ensure all personnel are clear about the Treasury’s mission statement and hedging approach.

Thus, the Treasury can be run as a single centre of excellence within the corporation, ensuring

the quality of individual members. Large multinational corporations should consider creating a

position of chief dealer to manage the dealing team, as the demands of a Treasurer often

exceed the ability to manage all positions and exposures on a real-time basis. The currency

dealing team must have the same level of expertise as their counterparty banks.

6. Adopt uniform standards for accounting for currency risk – In line with the centralizing

of Treasury operations, uniform accounting procedures with regard to currency risk should be

adopted, creating and ensuring transparency of risk. Create benchmarks for measuring the

performance of currency hedging.

7. Have in-house modelling and forecasting capacity – Currency forecasting is as

important as execution. While Treasury may rely on its core banks for forecasting exchange

rates relative to its needs, it should also have its own forecasting ability, linked in with its

operational observations which are frequently more real time than any bank is capable of.

[65]

Treasury should also be able to model all its hedging positions using VaR and other

sophisticated modelling systems.

8. Create a risk oversight committee – In addition to the safeguard of a chief dealer position

for larger multinational corporations, a risk oversight committee should be established to

approve position taking above established thresholds and review the risk management policy

on a regular basis.

Fundamental and technical analysis of Currency Market

Without the apparatus for making sense of the currency market, any trade represents a pure

gamble. There are two broad schools of analysis, which are not mutually exclusive.

Fundamental analysis is the application of micro and macroeconomic theory to markets, with

the aim of predicting future trends. So what fundamental forces drive currency markets?

(a). The balance of trade: Currencies that are associated with long term trade surpluses will

tend to strengthen against those associated with persistent deficits - simply because there is

net buying of surplus currencies corresponding to the excess of exports over imports.

Trends are important too. An improving balance of trade should cause the relevant currency to

appreciate relative to those associated with a deteriorating or stable balance of trade.

(b). Relative inflation rates: If country A is suffering a higher rate of price inflation than

country B, then A’s currency ought to weaken relative to B’s in order to restore “purchasing

powerparity”.

(c). Interest rates: International capital flows seek the highest inflation-adjusted returns,

creating additional demand for high real interest-rate currencies and pushing up their rates of

exchange.

[66]

(d). Expectations and speculation: Markets anticipate events. Speculation on, say, the future

rate of inflation may be enough to move the exchange rate - long before the actual trend

becomes apparent.

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

task, however, to establish where the sum of interacting economic forces will take the market.

The solution, some argue, lies in technical analysis.

Technical analysis

Technical analysis is concerned with predicting future price trends from historical price and

volume data. The underlying axiom of technical analysis is that all fundamentals (including

expectations) are factored into the market and are reflected in exchange rates.

The tools of technical analysis are now freely available to private investors in support of their

trading decisions. It cannot be stressed too heavily, however, that such tools are only

estimators and are not infallible.

The following is the briefest of introductions to the technical analytical tools used to identify

trends and recurring patterns in a volatile marketplace. Aspiring forex dealers are advised to

undergo proper training in technical analysis, although true proficiency comes with practice,

endurance and experience.

TREND CLASSIFICATIONS

[67]

DRAWING TRENDLINES

The basic trendline is one of the simplest technical tools employed by the trader, and is also

one of the most valuable in any type of technical trading.

For an up trendline to be drawn, there must be at least two low points in the graph where the

2nd low point is higher than the first.

A price low is the lowest price reached during a counter trend move.

BULLISH TREND LINES

[68]

TREND, ANALYSIS AND TIMING

Markets don't move straight up and down.  The direction of any market at any time is either

Bullish (Up), Bearish (Down), or Neutral (Sideways).  Within those trends, markets have

countertrend (backing & filling) movements.  In a general sense "Markets move in waves", and

in order to make money a trader must catch the wave at the right time.

[69]

 

DRAWING VARIOUS TRENDLINES

DRAWING TRENDLINES

[70]

TRENDLINES

Drawing Trendlines will help to determine when a trend is changing.

TREND

The direction of trend is absolutely essential to trading and analyzing the market.

[71]

In the Foreign Exchange (FX) Market it is possible to profit from UP and Down movements,

because of the buying of one currency and selling against the other currency e.g. Buy US

Dollar Sell German Mark.  ex. Up Trend chart.

RESEARCH METHODOLOGY

[72]

To define the research methodology, one has to go step by step. Any research methodology

involves following steps:

I. PROBLEM RECOGNITION

II. SURVEY OF LITERATURE

III. HYPOTHESIS FORMULATION

IV. RESEARCH DESIGN

V. SAMPLE DESIGN

VI. DATA COLLECTION

VII. ANALYSIS AND INTERPRETATION.

RESEARCH PROBLEM : A problem properly defined is half solved.

It is very necessary for any research that research problem should be recognized.

It is critical to any research.

Once problem is identified, it is to be formulated properly.

Initially the plan is stated in a broad and general way and then it is properly defined in specific

terms.

Problem formulation means defining a problem precisely.

In this study our research problem is: THE STUDY OF FOREX MARKET.

LITERATURE SURVEY : To do any research, we have to review/study previous literature.

For this we studied Journals, Magazines & Books of FOREX & RISK MANAGEMENT and

also the search engine www.google.com. To get good results in any research, it is very

[73]

essential that this review of literature should be carefully done. The review of literature survey

for this project includes the following:

Elliot Wave – This is considered by most experienced traders to be the purest form of

technical analysis, since Elliott Wave analysis measures investor psychology. The Wave

shows how the psychology of traders, en masse, moves from pessimism to optimism on a

stock. This shift occurs in a specific and measurable. Detecting where a stock is in the

pattern can help a trader estimate the future movements of the market.

K.B. Advisory Ltd. – This program offers you daily technical analysis and trading

recommendations that are based on sophisticated trading strategies developed by Keith

Black. It boasts a successful three-year track record.

TRL (Technical Research Limited) – TRL is a Specialist Foreign Exchange Forecasting

Service that can help you with forecasting and trading analysis in the global foreign exchange

markets. Technical Research Limited is rated the No. 1 FX Advisory Service by customers in

39 different countries around the world.

IFR (International Financing Review) – IFR Forex Watch has real-time technical analysis of

the FX spot and options markets. It connects you with analysts in London, New York, Boston,

San Francisco, Singapore and Sydney. IFR specializes in sifting through the vast array of

information that clutters up current market participants, and boiling it down to its bare

essentials.

GMR (Global Market Research) – Global Market Research provides price forecasting and

performance-based Trade Strategies for the FX market. You can check out their daily

newsletter, their FX Technicals and intraday updates and analysis through the Web. Or you

can have them E-mailed to you.

CHQREK.com – This is a resource created by a market professional that has been trading

and writing about markets for nearly 20 years. You can capitalize on of his experience and

his analysis, especially technical analysis, and get a real trader's take on current market

action.

4CASTWEB – 4CAST sends out key market information and analysis to market participants

worldwide, including central banks. It also has an on-line service that gives you fundamental,

political, strategic and technical analysis 24 hours a day

[74]

ForexTRM – ForexTRM is a forex charting service that pairs 18 world and regional currencies

and tracks them every day. This means ForexTRM lets you to trade any one of the 18

currencies against any of the other 17. It uses trademarked Sigma Bands and Hurst Cycle

Analysis to correctly identify overbought/sold FOREX markets, where trading risk is at its

lowest point in time, and which currency pairs are ready to trade.

HYPOTHESIS FORMULATION : Hypothesis is any assumption for the research effectively &

efficiently. The hypothesis of my research is that:

Forex market is very volatile in nature.

It is changing day by day showing a wide growth in economy.

Different factors like speculation, hedging forces different people to enter in different market.

Risk is there in Forex market and various risk management strategies are there to manage it.

RESEARCH DESIGN : Research design is a conceptual structure within which research is

conducted. “A Research design is the arrangement of conditions for collection and analysis of

data in a manner that aims to combine relevance to the research purpose with economy in

procedures.”

Research design can be of various types.

- Descriptive.

- Exploratory.

- Experimental.

- Analytical.

Research Design of my study is EXPLORATORY & ANALYTICAL.

[75]

DATA COLLECTION : The data is of two types: PRIMARY AND SECONDRY. Data are the facts

presented to the researcher from the study environment. The method of data collection in my

study is SECONDRY only. Because I have collected all the data from books and from websites.

SIGNIFICANCE OF THE STUDY

Forex market is changing day by day showing a wide growth in the economy.

Forex market is more volatile in nature.

There are different factors like speculation, hedging which force different people to enter in

different markets.

There is risk in Foreign market and various Risk management strategies are there to manage it.

Risk management is done in order to minimize the adverse effects of potential losses at the

least possible cost.

How a person manages risk in foreign market, it depends upon his needs and perception.

How a person trades in foreign market.

Due to all these factors, one can interpret that foreign market plays a significant role in economy

of any country and risk is managed by different strategies in foreign market to maximize profit in

the long run and that give a boost to the economy.

[76]

ANALYSIS AND INTERPRETATIONS

Understanding Strategy and Analysis

All successful traders have a carefully thought out system that they follow to make profitable

trades. This system is generally based on a strategy that allows them to find good trades. And

the strategy is based on some form of market analysis. Successful traders need some way to

interpret and even predict some of the movements of the market.

There are two basic approaches to analysing market movements, in both equity markets and

the FOREX market. These are technical analysis and fundamental analysis. However, technical

analysis is much more likely to be used by traders. Still, it’s good to have an understanding of

both types of analysis, so that you can decide which type would work best for your system.

Fundamental Analysis

In fundamental analysis, you are basically valuing either a business, for equity markets, or a

country, for FOREX. If you think it's hard enough to value one company, you should try valuing

a whole country. It can be quite difficult to do, but there are indicators that can be studied to give

insight into how the country works. A few indicators you might want to study are: Non-farm

payrolls, Purchasing Managers Index (PMI), Consumer Price Index (CPI), Retail Sales, and

Durable Goods.

Most traders in the FOREX market only use fundamental analysis to predict long-term trends.

However, some traders do trade short-term based on the reactions to different news releases.

There are also quite a variety of meetings where you can get quotes and commentary that can

affect markets just as much as any news release or indicator report. These meetings are often

discuss interest rates, inflation, and other issues that have the ability to affect currency values.

[77]

Even changes in how things are worded in statements addressing these types of issues, such

as the Federal Reserve chairman's comments on interest rates, can cause volatility in the

market. Two important meetings that you should watch for are the Federal Open Market

Committee and the Humphrey Hawkins Hearings.

Just by reading the reports and examining the commentary, a FOREX fundamental analyst can

get a better understanding of most long-term market trends. Keeping up on these developments

will also allow short-term traders to profit from extraordinary happenings. If you do decide to

follow a fundamental strategy, you will want to keep an economic calendar handy at all times so

you know when these reports are released. Your broker may also be able to provide you with

real-time access to this kind of information.

Technical Analysis

Just like their counterparts in the equity markets, technical analysts in the FOREX market

analyze price trends. The only real difference between technical analysis in FOREX and

technical analysis in equities is the time frame. FOREX markets are open 24 hours a day.

Because of this, some forms of technical analysis that factor in time have to be modified so that

they can work in the 24-hour FOREX market. Some of the most common forms of technical

analysis used in FOREX are: Elliott Waves, Fibonacci studies, Parabolic SAR, and Pivot points.

A lot of technical analysts combine technical indicators to make more accurate predictions. (The

most common tendency is to combine Fibonacci studies with Elliott Waves.) Others prefer to

create entire trading systems in an effort to repeatedly locate similar buying and selling

condition.

[78]

FINDINGS

Trading by Numbers – Eighteen Tips

You can never have too many tips or tricks up your sleeve when you are trading. Most of the

tips I’m including here are received wisdom, trading truisms that you should remember. They

apply to all markets, but are particularly useful in a volatile and technical market like the FOREX

1. Pay attention to the market. Exit and enter trades based on market information. Don’t

wait for a price you think the currency should hit when the market has changed direction on you.

2. There are times when, due to a lack of liquidity or excessive volatility, you should not

trade at all. On a similar note, never trade when you are sick. You can’t count on yourself to be

alert to the shifts of the markets, and make good decisions.

3. Trading systems that work in an up market may not work in a down market, and a

system that works for trending markets, or for range bound markets may not work in other

markets. Have a system for each type of market.

4. Up market and down market patterns are ALWAYS there, but you have to look for the

dominant trends. Always select trades that move with the trends

5. During the blowout stage of the market, either up or down, the risk managers are

usually issuing margin call position liquidation orders. They don't generally check the screen to

see what’s overbought or oversold; they just keep issuing liquidation orders. Make sure you stay

out of their way.

6. Trust your instincts. If something feels wrong about a trade, don’t make it. It’s better to

be superstitious than to loose money.

7. Rumour is king. Buy when you hear the rumour, sell when you hear the news.

8. The first and last ticks are always the most expensive. Get in the market late, and out

early. And never trade in the direction of a gap, either opening or closing.

[79]

9. When everyone else is in, it's time for you to get out. If a stock or currency is

overbought, it’s time to exit your position.

10. Don’t worry about missing out on an opportunity to trade. There will always be another

good one just around the corner. If the trade you are considering doesn’t meet all your entry

signals but it seems to good to pass up, remember, you’re never going to run out of trades you

can make.

11. Don’t get too confident. No one can predict the market with 100% accuracy. You need

to always expect the unexpected. If you become uneasy, or the market becomes choppy, exit

your trades.

12. Don't turn three losing trades in a row into six. When you’re off, turn off the screen, do

something else.  Often the best way to break a streak of consecutive loses is to not trade for a

day.

13. But, don't stop trading when you’re on a winning streak.

14. Measure your success by the profit made in a day, not on a trade. It’s even better to

measure it over two or three days. A successful trader’s goal is to make money, not to win on

every trade.

15. Scalpers reduce the number of variables affecting market risk by being in a position

only for a few seconds. Day traders reduce market risk by being in trades for minutes.  If you

convert a scalp or day trade into a position trade, you probably didn’t analyze the risks of the

trade properly.

16. There is no secret to understanding the market. You can spend much of your valuable

time and money looking for these kinds of secrets. It’s better to take the time to create a solid

trading system, and realize that the secret to success is hard work.

17. Never ask for someone else's opinion, they probably didn’t do as much homework as

you did anyways.

18. When the market is going up, say it out loud. When the market is going down, say that

out loud too. You’ll be amazed at how hard it is to say what is going on right in front of you when

you want it the market to be doing something else.

[80]

Bibliography

www.google.com GOOGLE SEARCH ENGINE

Dr. G. KOTRESHWAR, RISK MANAGEMENT, HIMALAYA PUBLISHING HOUSE,

MUMBAI.

A.K.SETH, INTERNATIONAL FINANCIAL MANAGEMENT.

LEVY, INTERNATIONAL FINANCIAL MANAGEMENT.

V.K.BHALLA, INTERNATIONAL FINANCIAL MANAGEMENT.

SHAPIRO, INTERNATIONAL FINANCIAL MANAGEMENT.

[81]