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Executive Summary

In light of the Globalizing world economy, the world is turning into a smaller place with foreign exchange playing a major role. The objective of this paper is to learn all about Foreign xchange ! "ates, #ar$ets "is$s and what not% The report is divided into five distinct parts. PART I: xchange "ate &etermination

The rate of exchange means the price of one currency in terms of another currency. This part deals with xchange rate systems and outlines the major changes in this xchange rates li$e the 'urchasing regard. Further, this section deals with the historical determinants of the xchange rates and gives various models and theories of 'ower 'arity Theory, The &orn (ush Theory and the #undell Fleming #odel. )astly it covers the techni*ues of forecasting the xchange rates and its importance to managers. PART II: Foreign xchange #ar$et The foreign exchange mar$et does not have a physical mar$et place called the foreign exchange mar$et. It is a mechanism through which one country+s currency can be exchange i.e. bought or sold for the currency of another country. The foreign exchange mar$et does not have any geographic location. The mar$et comprises of all foreign exchange traders who are connected to each other through out the world. They deal with each other through telephones, telexes and electronic systems. This section gives us an insight into the participants in the Foreign xchange mar$et for e.g. customers, commercial ban$s, central ban$, exchange bro$ers and speculators. ,lso this section discusses the fundamentals of exchange rates and also certain factors affecting exchange rates. PART III: Foreign xchange xposure and its #anagement Foreign exchange ris$ is related to the variability of the domestic currency values of assets, liabilities or operating income due to unanticipated changes in exchange rates, whereas foreign exchange exposure is what is at ris$.

FOREIGN EXCHANGE

Foreign currency exposures and the attendant ris$ arise whenever a business has an income or expenditure or an asset or liability in a currency other than that of the balance-sheet currency. Indeed exposures arise even for companies with no income, expenditure, asset or liability in a currency different from the balance-sheet currency. .hen there is a condition prevalent where the exchange rates become extremely volatile the exchange rate movements destabilize the cash flows of a business significantly. /uch destabilization of cash flows that affects the profitability of the business is the ris$ from foreign currency exposures. This section deals with exchange exposure, its types, identification and management. PART IV: #ethods and Techni*ues of "is$ 0overage - xchange &erivatives Trade and (usiness is no more confined to national boundaries and that is why foreign exchange ris$ management is becoming a necessary tool to prevent business form any foreign exchange ris$. , variety of foreign exchange derivatives provide a mean to hedge against any Foreign futures, options and swaps.2. PART V: "is$ #anagement The ris$ on account of exchange rate fluctuations, in international trade transactions increases if the time period needed for completion of transaction is longer. It is not uncommon in international trade, on account of logistics3 the time frame cannot be foretold with cloc$ precision. In international trade there is considerable time lag between entering in to a sales4purchase contract, shipment of goods, and payment. In the meantime, if exchange rate moves against the party who has to exchange his home currency in to foreign currency, he may end up in loss. 0onse*uently, buyers and sellers want to protect them against exchange rate ris$. The objectives of risk management #inimize 0osts #aximize "evenue xchange "is$. This section highlights some of xchange "is$ 1namely forwards, the ways in which one can hedge ones Foreign

FOREIGN EXCHANGE

/tabilize #argins in the Future

Exchange Rate - An Overview


What is Exchange Rate?
0ountries of the world have been exchanging goods and services amongst themselves from time immemorial. .ith the invention of money, the rigors and problems of barter trade have disappeared. The barter trade has given way to exchange of goods and services for currencies instead of exchange for goods and services. ,s every sovereign nation has a distinct national currency, international trade has necessitated exchange of currencies and this exchange of currencies necessitated exchange rate. )i$e any other commodity, the price of one unit of foreign currency can be stated in terms of domestic company. Thus, the rate of exchange means the price of one currency in terms of another country. For instance, the price of 5/ &ollar can be expressed in terms of Indian "upees. If 5/ &ollar 6 7 I8" 9:, it means the exchange rate of 5/ &ollars and Indian "upees is 6; 9:. xchange rates are normally *uoted in terms of a buying rate, a flat rate, and a selling rate. The buying rate is that which a ban$ will pay for a foreign currency. The selling rate is the rate a ban$ will charge for the currency, and the flat rate is an average of the buying and the selling rates. In other words, the exchange rate is said to be the rate at which a number of units of one currency can be exchanged for a number of units of another currency.

FOREIGN EXCHANGE

Some Important Terms


Fixed Exchange Rate System In a fixed exchange rate system foreign central ban$s stand ready to buy and sell their currencies at a fixed price in terms of dollars. Intervention Intervention is the buying or selling of foreign exchange by the central ban$. Foreign exchange mar$et intervention occurs when a government buys and sells foreign exchange in an attempt to influence the exchange rate. F exib e Exchange Rate System In a flexible exchange rate system, the central ban$s allow the exchange rate to adjust to e*uate the supply and demand for foreign currency. The terms flexible and floating rates are used interchangeably. In a system of 0lean Floating "ate, 0entral (an$s stand aside completely and allow exchange rates to be freely determined in the foreign exchange mar$ets. 5nder a #anaged or a &irty floating rate, 0entral ban$s intervene to buy and sell foreign currencies in attempts to influence exchange rates. !eva "ation &evaluation ta$es place when the price of foreign currencies under a fixed rate regime is increased by official action. The outfall of this is that the foreigners pay less for the devalued currency and the residents of the devaluing currency pay more for foreign currencies.

FOREIGN EXCHANGE

!e#reciation , change in price of foreign exchange under flexible exchange rates is referred to as currency depreciation or appreciation. , currency depreciates when, under floating rates, it becomes less expensive in terms of foreign currencies. The reverse results in appreciation. If the exchange rate falls, the domestic currency is worth more3 it costs fewer domestic currencies to buy a unit of foreign currency.

FOREIGN EXCHANGE

Exchange Rate Systems Over The Last Century


&ifferent countries have adopted different exchange rate systems at different times. The following are some of such systems in brief followed in the last century;

The Pre-Bretton Woods Era: (1900-19 !"


The Ear y $ears of E"ro#ean %anking ,t the beginning of the <=th century, one 5nited /tates &ollar was e*ual to 6 0anadian &ollar, < >apanese yen, : Indian rupees, 9.< German mar$s 1"eichsmar$s2 and ?.@ Italian lira. The (ritish 'ound and the French franc were much stronger fetching A9.B@ and A6C.< respectively. Those were the days of 'ax (ritannica i.e. (ritish hegemony. ,lmost literally, the sun never set on the (ritish mpire and the (ritish 'ound was the worldDs premier reserve currency. ,fter the 8apoleonic wars in 6B6?, )ondon had become the worldDs financial center, enriched by growing private fortunes and international trade, which increased with each stage of the industrial revolution. The expansion of trade also transformed the nature of ban$ing. )ondon was not only the richest city but it also made the most effective use of its money. Its ban$s were able to attract the savings of the whole country, lending them for the maximum profit, first within (ritain and then across the world. The supremacy of )ondon had attracted merchants from all over urope, li$e the (arings, "othschilds or Eambros who first used their connections with their home country to finance trade and lend money across frontiers, and later became part of the 0ityDs financial system. Eowever, new joint stoc$ ban$s li$e the .estminster, the 8ational, )loyds and (arclays had also begun ta$ing deposits from a growing number of small savers and lending the same cautiously but profitably. The enterprise of (ritish ban$s was underpinned by the maintenance of 'ax (ritannica by the (ritish ,rmy and 8avy.

FOREIGN EXCHANGE

Fther uropean ban$ers had also begun to move more boldly abroad as prosperity and savings increased. French ban$s had begun loo$ing towards astern urope, "ussia in particular G 8orth ,frica, which offered better opportunities than metropolitan France. German ban$s had also ventured abroad in ,merica, /outh ,frica, 0hina, #orocco, Tur$ey, Ira* and the #iddle ast. The ban$ersD confidence in lending money was almost always fortified by their $nowledge of a powerful imperial government behind them. Eowever, .orld .ar I that bro$e out in 6C69 and "ussiaDs 0ommunist revolution in 6C6@ dashed the hopes of a world united by capital. The confidence of German ban$ers was shattered as Germany was burdened with unplayable debts and rac$ed with inflation. French ban$s found that the "ussian bonds they held were valueless when "ussia refused to honor its debts. The (ritish were forced to sell much of their foreign investments to pay for the cost of the war. /uddenly, ,merican ban$s found themselves lending to urope and other parts of the world. The Ear y American Scene /ince independence, the subject of ban$ers in the 5nites /tates was explosive. #ost farmers did not trust ban$ers and paper money. Thomas >efferson regarded the expansion of credit as an evil. The extreme opposition to ban$ers, however, waned as ,merican commerce and prosperity increased. (y the beginning of the <=th century, (an$ of ,merica, 0itiban$, 0hase #anhattan (an$ and >.'.#organ were well established. ,ll these powerful ban$s had grown from their very different roots to become major financial operators during the boom of 6C<C. ,fter the stoc$ mar$et crash in Fctober 6C<C, the Governor of the Federal "eserve (an$ of 8ew Hor$ saved the day by underta$ing to buy huge amounts of Government bonds from the ban$s and provide ample li*uidity to the mar$et. The real ban$ing crisis however began a year later when the (an$ of 5nited /tates closed its doors following a run on its deposits and refusal of other fellow ban$ers to rescue it due to allegations of anti-/emitism. (etween 6C<C and 6C:: the number of ,merican ban$s had shrun$ from <?=== to 6B===%

FOREIGN EXCHANGE

,merican ban$ers lost much political support. The Glass-/teagall ,ct of 6C:: forced deposit ban$s to separate themselves from ban$s selling securities. #organ, 0iti and 0hase divested themselves of their securities affiliates. The &or d !e#ression The Great 0rash and the Great &epression that followed in ,merica had long repercussions on the rest of the world. The falling production and investment from ,merica disrupted the whole pattern of international trade. ,s ,merica put up tariffs on imports, many )atin ,merican countries, which had borrowed from the big 8ew Hor$ ban$s, defaulted as their exports were severely hit. The extension of the depression to urope eventually led to global catastrophe. The economic ruin of Germany, the post-revolutionary chaos in "ussia and the impoverishment of France and (ritain had already undermined the structure of uropean trade and ban$ing. In this dangerous condition, urope was hit by the Great &epression, which dried up ,merican orders and cut down employment. The first uropean ban$ to fall was the "othschildsD Ireditanstalt ban$ in Jienna. ,s the German ban$s tried to rescue it, they themselves faced a panic and one of the biggest German ban$s, the &armstadter, collapsed. The German ban$s then had to be granted a moratorium on their debts. This led to a crisis in (ritain as other uropean countries sold sterling to buy gold from )ondon. 0onse*uently, (ritain was forced to go off the gold standard. Fther countries followed suit. The German ban$s were however able to integrate themselves into the war economy after Eitler came to power in 6C::. Germany became increasingly self-sufficient and independent of the rest of urope. Eowever, the cosmopolitan world of the old German->ewish ban$s was shattered when Eitler invaded ,ustria in #arch 6C:B.

FOREIGN EXCHANGE

&or d &ar II Eitler invaded 'oland on /eptember 6, 6C:C. ,lmost immediately, (ritain and France declared war against Germany and thus began .orld .ar II. Germany swept through continental urope, occupying France in just K wee$s. Eowever, as we $now, (ritain held out till the end. In the summer of 6C96, "ussia was drawn into the war as Germany attac$ed it brea$ing the "usso-German peace treaty. Finally, in &ecember 6C96, ,merica was forced to join the war after the >apanese who had attac$ed the (ritish mpire in ast ,sia, bombed 'earl Earbor. ,merican-led ,llied troops liberated France in 6C99. The war ended in the first wee$ of #ay 6C9? after Eitler committed suicide and after ,merica had dropped atom bombs on Eiroshima and 8agasa$i. .hen the (ritish and French economies and later the ,merican economy were revived with full employment, the revival was ironically based on the preparation for war% Internationa 'onetary System ,t the commencement of the <=th century, a large number of countries were on the gold specie standard. This standard called for fixed exchange rates, with parities set for participating currencies in terms of gold, and provided that any paper currency could on demand be exchanged for gold specie at the central ban$ of issue. The system was designed to bring about automatic adjustment in case of external deficits or surpluses in transactions between countries. The underlying concept was that any deficit country would have to surrender gold to cover its deficit - this would force it to reduce its money supply leading to lower prices and improved export competitiveness. , trade surplus on the other hand would lead to an influx of gold, commensurate increase in money supply and higher prices.

FOREIGN EXCHANGE

5nder this gold standard, exchange rates could in principle fluctuate only within narrow limits determined by the costs of shipping and insuring gold. From 6BB= till the outbrea$ of .orld .ar I in 6C69, the Lmint parityL between the 5/ &ollar and (ritish 'ound was approximately A9.B@ based on the official gold prices of 5/&<=.K@ per troy ounce in the 5/ and G('9.<9 per troy ounce in the 5I. ,fter the start of .orld .ar I, one combatant country after another suspended gold convertibility and floating exchange rates prevailed. The 5nited /tates, which entered the war late, maintained gold convertibility, but the &ollar effectively floated against the other currencies, which were no longer convertible in to gold. #any currencies suffered substantial depreciation against the &ollar after ..-I, which ended in 6C6B. The burden of war reparations and the French invasion of the "uhr valley in 6C<: led to hyperinflation in Germany. The "eichsmar$ had collapsed completely to 9.< trillion per &ollar and was abandoned. It was replaced by the "entenmar$. Germany returned to the gold standard in 6C<9 in an attempt to stop hyperinflation. (ritain followed suit in 6C<? and France in 6C<K. (ritain reestablished gold convertibility but at the pre-war parity with the &ollar in a bid to save face and maintain worldwide confidence in the 'ound and in (ritish financial institutions. The return to the gold standard with unrealistic parities led to sudden and sharp monetary contraction. This led to the deflation of the 6C:=s and eventually the &epression. (ritain went off gold in 6C:63 ,merica followed in 6C:: but only to return to the gold standard in 6C:9 after devaluing the &ollar from 5/&<=.K@ to 5/& :? per troy ounce. France left in 6C:K. This was also the year of the Tripartite #onetary ,greement, which established a &ollar standard where the &ollar was the only currency, anchored to gold. ,ll other countries in this system $ept their currencies pegged to the &ollar. This system lasted till 6C@6.

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FOREIGN EXCHANGE

Eowever, the (retton .oods conference in 6C99 did not establish any new international monetary system. "ather, it created two new international institutions, the I#F and the .orld (an$ to manage international interdependence in the international financial system and provide a supranational veneer for the anchored &ollar standard. In summing up, all the concerned currencies were stable during the first decade of the <=th century. Eowever, the French franc lost nearly K?M of its value during the second decade as Tsarist "ussia accounted for a *uarter of all French foreign investments and these were left with practically no value after the communist revolution in "ussia. The French franc continued to suffer devaluation4depreciation from time to time and by the start of .orld .ar II, it had lost nearly C=M of its value against the &ollar. &uring the 8azi regime in Germany, the ,llied #ilitary #ar$ replaced the "entenmar$. It was only on >une <=, 6C9B i.e. after ..-II and the establishment of the Federal "epublic of Germany that the &eutsche #ar$ came into existence. The >apanese Hen was relatively stable against the &ollar till 6C:C but became practically worthless by the end of the 9=+s due to the devastation caused by the war. $ear 6C== 6C6= 6C<= 6C:= 6C9= 6C9K (%P 9.B@ 9.B@ :.KK 9.BK :.C9 9.=: !E' 9.<= 9.<= 9.<= 9.6C <.9C FRF =.=? =.=? =.69 =.<? =.9? )P$ <.=: <.=< <.=: <.=: 9.<@ 69.CC

/ource ; Federal "eserve

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FOREIGN EXCHANGE

The Bretton Woods Era: (19 ! T# 19$%"


*e+ Internationa Economic System The intellectual foundations for a new international economic system were laid at the height of .orld .ar II. /urrounded by the chaos and destruction of the war, politicians and economists were able to start again from scratch. The original concepts were put forward not by ban$ers, bureaucrats or politicians but by two brilliant academics ! >ohn #aynard Ieynes, the renowned (ritish economist and Earry &exter .hite, adviser to the 5nited /tates Treasury /ecretary. Ieynes wanted to avoid the chaos of exchange rates, which he had seen after the First .orld .ar and after 6C96, and he constructed a bold plan for LInternational 0learing 5nionL or a L.orld 0entral (an$L. .hite on the other hand was convinced of the need for a new international organization after the war to safeguard the monetary system, to restore foreign trade and to revive the nationsD economies. ,ccordingly, he drafted a plan for a L/tabilization FundL and a L(an$ for "econstruction and &evelopmentL. .hite proposed an international currency called the L5nitasL but the Fund would only be an agency for distributing money contributing by member nations rather than machinery for creating credit as Ieynes had proposed. The (an$ for "econstruction and &evelopment was to be a far-reaching international lending agency, which could provide long-term loans for reconstruction, for financing trade or stabilizing commodity prices and buy4sell gold and securities li$e a world central ban$. IeynesD and .hiteDs proposals were published in ,pril 6C9<. ,fter a lot of deliberations and discussions, delegates from 99 nations met in >uly 6C99 at the 8ew Eampshire resort of (retton .oods and thrashed out the post-war economic system over a period of 9 wee$s. The International #onetary Fund 1I#F2 and the International (an$ for "econstruction and &evelopment 1.orld (an$2 were thus born. The I#FDs role was eventually restricted to providing loans for offsetting shortterm exchange rate fluctuations and balance of payments crises while the .orld (an$ was restricted to lending for specific projects.

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FOREIGN EXCHANGE

The /oviet 5nion had already hardened its attitude after being refused an ,merican loan and it did not join the (retton .oods agreements. In the middle of 6C9@, the /oviets were preparing to establish their own economic bloc, 0F# 0F8. .orld .ar II mar$ed the end of 'ax (ritannica and the start of 'ax ,mericana. The 5nited /tates was assumed to remain the dominant partner in the new international economic system. The &ollar was expected to be the worldDs reserve currency, interchangeable into gold, with sterling in a secondary role. It was also expected that ,mericans would head both the I#F and the .orld (an$ but a last minute hitch saw a (elgian getting appointed as the #anaging &irector of the I#F. Thus started the tradition that the head of the I#F would always be a uropean while the head of the .orld (an$ would be an ,merican. 5nder the new exchange rate regime, all other member nations agreed to peg their respective currencies to the 5/ &ollar. #embers were expected to maintain their exchange rates to the &ollar within 6M on either side of the peg or the par value. Eowever, they were permitted to adjust the peg or par value in response to any fundamental dis-e*uilibrium, but with the approval of the I#F. Fn its part, the 5/ assured full &ollar convertibility into gold at a fixed price of 5/& :? per troy ounce. The &or d %ank ,fter the first few conservative years, the .orld (an$ underwent a decisive change from 6C9C under the presidency of ugene (lac$. ,lthough still officially called the I("&, #arshall ,id had ta$en over most of the reconstruction business and (lac$ saw that the critical need was to finance development in the third world. The .orld (an$ embar$ed on lending not only to safe countries li$e ,ustralia and 0anada but also to more doubtful developing countries li$e 0olombia and 'eru. Ff course, all loans had to be for specific projects such as ports, dams or roads and had to be guaranteed by the respective foreign governments.

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FOREIGN EXCHANGE

The .orld (an$ was strictly businessli$e demanding commercial interest rates and prompt repayment. Eowever, most of the new developing countries needed loans on softer terms i.e. concessional interest rates and long repayment periods. The 5/ 0ongress was pressing for more lenient loans to save the third world from communism. 0onse*uently, in 6CK= the .orld (an$ established a new agency called the International &evelopment ,gency 1I&,2 for granting soft loans up to ?= years N =.@?M p.a. The 'oney 'andarins The other pillar of (retton .oods, the International #onetary Fund, had only gradually become involved with the problems of the third world. Its charter included the development of the productive resources of all its members but it was at first preoccupied with France and (ritain. The I#F was constructed as a rich manDs club and it was mainly concerned with upholding financial discipline, coordinating national monetary policies and preventing economic warfare. 0ommercial ban$s were inclined to see the I#F as an extension of the discipline and safeguards of the central ban$s inside each nation. It was to be a Olender of last resortD, which could bail out a country in extreme difficulties but only on tough terms. The Fund has often been seen to be unrelentingly strict towards developing countries prescribing bitter, unpalatable medicine. Fn the other hand it is also believed that many of the developing countries in trouble have, for political reasons, wanted to implement austerity measures under the aegis of the I#F%

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FOREIGN EXCHANGE

(y the late sixties, the &ollarDs role as a reserve currency began to wea$en following ,mericaDs persistent trade deficits and other countries began to insist that the Fund brea$ away from its dependence on both the &ollar and the gold. ,t its annual meeting in 6CK@, the Fund finally approved a new $ind of currency called the /pecial &rawing "ight 1/&"2. Two years later, the Fund agreed to ma$e its first issue of /&"s totaling C.? billion &ollars, in proportion to each countryDs *uota. They fixed the value of /&" against gold at the same rate as the &ollar. Today, the /&" is assigned a value based on the average worth of the worldDs five major currencies and is worth about 5/& 6.:@. ,ondon and the E"rodo ars ,fter .orld .ar II, 8ew Hor$ was the financial capital of the world. The big 8ew Hor$ ban$s competed to attract deposits from customers and to lend the money with an aggressiveness and visibility that distressed the staid ban$s of urope. In the 6C?=s there was little indication that )ondon could again become a world financial center. )ondon ban$ers were much more defensive and somnolent than the ,mericans surveying their past more lovingly than their future. Eowever, )ondonDs fortunes changed with the birth and growth of the urodollar mar$et. ,ccording to one version, urodollars came into existence in 6C9C when the new

communist government in 0hina, wanting to protect its &ollar earnings from the ,mericans, placed them with a /oviet-owned ban$ in 'aris called the (an*ue 0ommerciale pour lD urope du 8ord. The word urodollar is supposed to have originated from the cable address of this ban$, which happened to be O uroban$D. ,fter the commencement of the 0old .ar, the "ussians also began to worry that their &ollars could be frozen in the 5/. Eence, they also began to $eep their &ollars outside ,merica ! both in the said 'aris ban$ and in the #oscow 8arodny (an$ in )ondon.

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FOREIGN EXCHANGE

,t start the .estern

urodollars crept into )ondon stealthily but soon they became an

expatriate currency providing world credit on an unprecedented scale. In 6C?B, most uropean countries ! though not (ritain ! made their currencies convertible into &ollars for the first time since .orld .ar II. This gave new freedom for cross-border dealings. In the same year, the 5nited /tates moved into a trade deficit. &ollars were flowing freely into urope, both companies and ban$s preferring to hold them in the form of urodollars ! &ollars held in ban$ accounts outside the 5/ ! to earn higher interest at a time when ,merican interest rates were strictly controlled. The urodollar mar$et multiplied rapidly. It roughly tripled in 6C?C and then uropean boom and the expansion of ,merican

doubled in 6CK= boosted by the

multinational corporations. .orried by the increasing &ollar outflows, 'resident Iennedy announced the Interest *ualization Tax in 6CK: designed to strengthen the &ollar by ma$ing foreign borrowing in ,merica more expensive. 8ot only did this measure fail to bolster the &ollar but it also encouraged international borrowers to turn to urope and urodollars for their loans. , further boost came with the escalating Jietnam .ar, which pushed up the ,merican deficit and the supply of &ollars abroad. -o a#se of %retton &oods Fixed Exchange Rate System The leadership of ,merican ban$s had already begun to wane by the end of the /ixties, as the balance of financial power had begun to shift. Fver time, the &ollar faced increasingly greater pressures, reflecting chronic 5/ budget deficits ! in part associated with the fiscal conse*uences of the Jietnam .ar and new domestic social programs in the 5/. The &ollarDs decline also related to the stronger competitive position of a restored urope and >apan. Faced with rapidly mounting demands from other nations to convert their &ollars into gold, 'resident 8ixon suspended gold convertibility of the &ollar on ,ugust 6?, 6C@6.

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FOREIGN EXCHANGE

In &ecember 6C@6, the G-6= countries ! (elgium, 0anada, France, Germany, Italy, >apan, the 8etherlands, /weden, the 5nited Iingdom and the 5nited /tates ! negotiated the /mithsonian ,greement to devalue the &ollarDs par value against the gold from A:? per troy ounce to A:B, a devaluation of @.CM. The 5/ agreed to the rate adjustments but did not restore gold convertibility of the &ollar. ,fter a few months, exchange mar$ets again became volatile. The &ollar was devalued a second time in less than 6? months by another 6=M to A9<.<< per troy ounce of gold. Eowever, foreign exchange mar$ets continued to be unstable and finally on #arch 66, 6C@:, the G-6= nations announced that they would allow their currencies to float. Foreign Exchange F "ct"ations d"ring the %retton &oods Era The table shows how the relevant exchange rates moved from the end of .orld .ar II till the collapse of the (retton .oods system of fixed exchange rates. It is evident that the &eutsche #ar$ and the Hen were the major beneficiaries during this period. $ear 6C9K 6C?= 6CK= 6C@= 6C@: (%P 9.=: <.B= <.B6 <.9= <.9? !E' 9.<= 9.6@ :.K? <.KK FRF :.9C 9.C= ?.?< 9.9? )P$ 69.CC :K6 :?C :?B <@<

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FOREIGN EXCHANGE

The Post-Bretton Woods Era:(19$%-1999"


Ro"nd.the.c ock Ro er coaster .ith the free floating of the major currencies, the international foreign exchange mar$et became and is till today, a round-the-cloc$ roller coaster from #onday morning in .ellington till Friday afternoon in /an Francisco. This was and is a constant temptation for speculators. 0urrency futures began to be traded in 0hicago in #ay 6C@<. Today, they are traded practically in all major financial centers of the world. Rise of /PE- and Sovereign ,ending The *uadrupling of the price of oil towards the end of 6C@: was a big shoc$ to the whole world. The change was so sudden that it too$ some time to comprehend. It was estimated that the F' 0 countries would earn an extra B= billion &ollars a year from their oil exports. The 5/ administration saw this as a $ind of treason and discouraged any plans to OrecycleD or lend the surplus funds to needy countries through the .orld (an$ or the I#F. The F' 0 leaders were e*ually bewildered by the sudden shift in wealth and dazed by their sudden success. The Iuwaitis, Iranians and /audis began buying into western companies and properties. /till, the F' 0 countries had a lot of these surplus OpetrodollarsD, which they placed as deposits in the western ban$s they $new best. The big ,merican and (ritish ban$s began to compete for more and more F' 0 money. The natural conse*uence was an unprecedented rush of ban$ lending to some very sha$y countries in the third world on the premise that countries never go ban$rupt. The list is big but you are familiar with the names; ,rgentina, (razil, #exico, Iran, Indonesia, 'oland, 8igeria, Paire, et al. The more populated F' 0 countries had grandiose plans for industrial and commercial development and they found they could, so to spea$, pledge their future oil earnings to raise huge loans, which they might have otherwise not got at all. The Finance #inisters of third world countries with large natural resources and significant development potential had become an enviable lot with the mar$eting officers of big ban$s chasing them to sell loans%

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FOREIGN EXCHANGE

The Iranian crisis of 6C@C ! the ta$ing of ,merican diplomats in Teheran as hostages on 8ovember 9 followed *uic$ly by the freezing of all Iranian deposits in ,merican ban$s whether held in the 5nited /tates or abroad ! was the eye-opener for the aggressive money lenders. This was followed by the )atin ,merican crisis of 6CB< when several )atin ,merican countries were almost on the verge of default as a conse*uence of the FedDs tight monetary policy and the second oil shoc$ in 6C@C. ,t the end of 6CB:, the military coup in 8igeria - an F' 0 country ! made even more *uestionable the soundness of these ban$ersD sovereign ris$ assessment procedures. In the late eighties, under the aegis of the (an$ for International /ettlements, (asle several central ban$s introduced the country ris$ matrix for more objective assessment thereof. Eowever, in the end, ban$ing was and is still a O people businessD. 8o matter how complex and mathematical the business has become, it still depends on the assessment of trust by individuals with very human failings. Age of P astic 'oney The style of a ban$ had changed since medieval moneylenders counted coins on a bench. It had become much harder to trace the money from the beginning to the end ! from the small saver leaving a few &ollars in his local ban$ to the billion-&ollar urodollar loans raised by a syndicate of say 6=-<= international ban$s to finance a country in any corner of the world. (ig ban$s were ma$ing new profits from relending the F' 0 billions but were still dependent on their retail home base of savers and borrowers. #any ban$ers began to pay more attention to this mar$et segment as global competition intensified. 0itiban$ was again setting the pace in this area. In 6C@9, it had already decided on a Oconsumer strategyD to compete for small savings and by 6C@@, it was beginning to install automated ban$ing centers across 8ew Hor$, which could ta$e deposits and give out cash all round the cloc$ without any tellers. The extraordinary development of the credit card had begun modestly in 6C?= with the establishment of the O&inersD 0lubD which provided select members with credit at << restaurants in 8ew Hor$ and collected a commission for paying the bills promptly.

19

FOREIGN EXCHANGE

Then in 6C?B, ,merican across the world.

xpress began selling their green-and-white card as a

prestigious open-sesame to hotels, restaurants, shops or airlines in ,merica and

In the meantime, many ban$s were moving into credit cards. They were not so much concerned with collecting commissions from shops. Instead, they saw and exploited a new opportunity of granting unsecured loans at high interest rates to credit-card holders who did not pay their bills promptly. The controllers of this empire of credit cards had given great benefit to those citizens who were inside the system of credit while automatically rejecting those who were not. The whole of concept of trust, which underlay credit, seemed to have been ta$en over by computers. %ankers &i A +ays be the same In the words of >ohn #aynard Ieynes, La sound ban$er is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.L #ost ambitious customers $now how to exploit the human wea$nesses of ambitious ban$ers ! greed, jealousy 1or one-upmanship2, arrogance and lust. The >apanese ban$ing crisis following the bursting of >apanDs asset mar$et bubble in the early nineties, the recent ast ,sian crisis and the collapse of (an$ of 0redit and 0ommerce International are in the ultimate analysis an example of ban$ers succumbing to one or more of the human wea$nesses. Indian ban$ers might of course li$e to thin$ that they are an exception. The top brass of the '/5 ban$s may not hesitate to say in anonymity that a large portion of their 8',Ds are due to government interference in some form or other. This may be true to some extent. (ut who was responsible for the 8',Ds abroad in rec$less financing of ambitious 8"I businessmenQ

20

FOREIGN EXCHANGE

The !o ar -risis The severance of the &ollarDs gold lin$ in 6C@6 and the shift to flexible exchange rates in 6C@: removed the constraint on monetary expansion. The price level of what had become the mainstream of the world economy was now in the hands of the 5/ Federal "eserve /ystem. The *uadrupling of oil prices had created deficits in urope, >apan and elsewhere which were funded by domestic money supply did not rise unduly. Eowever, the worldDs &ollar base had increased at a rapid pace via the urodollars and as the recent 8obel )aureate, "obert #undell had shown way bac$ in 6C@6, 5/ inflation was governed by the global &ollar supply. 5/ inflation had risen to double digits. From #arch 66, 6C@: till 8ovember 6, 6C@B when 'resident 0arter moved to support the &ollar, it had fallen from :.<= mar$s to 6.@< mar$s and from :=6 yen to 6@@ yen. Formation of the E"ro#ean 'onetary System The devastation of .orld .ar II created the desire for greater economic and political union in urope, in order that .orld .ar III would never be fought. The Treaty of "ome was signed in 6C?@ but it wasnDt until 6CK< that the proposed a single currency for urope. The .erner "eport, approved in 6C@6, proposed a single currency by 6CB=. The first step was to tie uropeDs currencies to each other through the Lsna$eL which ended up becoming more of a &eutsche #ar$ bloc than a single currency. #embership of this union was however fluid. France left in 6C@9, rejoined in 6C@? and pulled out again in 6C@K. /weden left in 6C@@ and 8orway left in 6C@B. uropean 0ommission urodollar credits, in turn fed by 5/ monetary expansion. The Fed argued that its policy was not inflationary because

21

FOREIGN EXCHANGE

Eowever, the persistent wea$ness of the &ollar in the seventies gave further impetus to uropean monetary integration. Following the (remen summit in 6C@B, French uropean #onetary /ystem 1 #/2, which came into 'resident, Giscard dD staing and German 0hancellor, Eelmut /chmidt made an agreement to create the existence in #arch 6C@C. The #/ created the uropean #onetary 0ooperation Fund and introduced a $ind of pre-money, the 05, defined as a bas$et of the currencies of the 0 countries, weighted by a formula that too$ account of both trade and G&'. The exchange rate mechanism 1 "#2 within the Linflation anchorL of the system. The #/ in theory was symmetrical

with respect to its member countries but in practice the &eutsche #ar$ became the "# gravitated to a mar$ standard in the 6CB=s. The (undesban$ had only one objective, that is, of controlling inflation in Germany and maintaining the internal purchasing power of the mar$. Fther member nations had to pursue policies to stabilize their exchange rates and preserve balance of payments e*uilibrium.

22

FOREIGN EXCHANGE

The Reagan&B'sh Era


'resident "onald "eagan came to power in 8ovember 6CB= when the &ollar was at 6.C? mar$s and <6< yen. Ee embar$ed on a very expansionary fiscal policy cutting taxes and hi$ing spending, particularly on defense. To chec$ inflation, the Fed under the chairmanship of 'aul Jolc$er followed a tight monetary policy. The &ollar rallied sharply thereafter under the combination of loose fiscal policy and tight monetary policy. The )atin ,merican crisis of 6CB< saw the Fed lower interest rates at the behest of the big ,merican ban$s. The 5/ bond mar$et soared and the &ollar continued to rise. (y #arch 6CB?, the &ollar had soared to :.9@ mar$s and over <K= yen. ,s for the Fed funds rate, it rose from around CM in >uly 6CB= to 6CM in >une 6CB6 but then fell bac$ to around BM by the end of 6CB<. In /eptember 6CB?, the G-@ countries reached the 'laza ,ccord, deciding to ta$e concerted action including currency mar$et intervention to help correct the &ollarDs overvaluation and reduce the rising 5/ current account deficit. (y then the &ollar had retreated to <.B? mar$s and <9= yen but its slide accelerated thereafter. The 5/ trade deficit continued to rise and the &ollar continued to fall. Finally, following the first (lac$ #onday on Fctober 6C, 6CB@ at .all /treet, the &ollar crashed to new record lows of 6.?K mar$s and 6<= yen by the end of 6CB@. The stoc$ mar$et had stabilized than$s to prompt monetary easing by the Fed under its new 0hairman, ,lan Greenspan. Eowever, after #arch 6CBB, the Fed began to tighten monetary policy to ward off inflationary pressures and in a yearDs time the Fed funds rate was up sharply from about K.?M to about 6=M. The &ollar recovered sharply and despite a cyclical hiccup ahead of the presidential election in 8ovember 6CBB, reached around <.=? #ar$s and 6?< Hen by mid->une 6CBC. The 5/ economy then slowed down sharply and went into a recession. The Fed began aggressive monetary easing and the Fed funds rate was down to :M by the time of the 6CC< presidential elections - which were won by (ill 0linton.

23

FOREIGN EXCHANGE

(erman Re"nification and the 0112 ER' -risis3 ,t the time of the German reunification in 6CC=, the (undesban$ had advised the German government that the ast German currency be replaced at a ratio of 6 & # to 9 ast #ar$s. In retrospect, it would seem that 0hancellor Iohl did not want to spoil the celebration of his Ldream come trueL with monetary stinginess. Ee decided on a magnanimous exchange of 6 & # for every ast #ar$. The conse*uent explosion of money supply in united Germany put pressure on the German price level and (undesban$ reacted in the only way that it could i.e. tighten monetary policy and jac$ up interest rates regardless of the conditions in other "# member countries. (ritain had joined the "# in 6CC= just around the time of the reunification. ,s

interest rates $ept going up in Germany, (ritain had to follow suit at a time when its economic position did not permit it to do so. The #aastricht Treaty was signed in 6CC< setting the timetable for the launch of a single currency by >anuary 6, 6CCC. The rejection of the #aastricht treaty by a &anish referendum in 6CC< however led to a speculative attac$ on the $now, became world famous. "# in /eptember 6CC<. This led to devaluations by "#. ,nd George /oros, as you (ritain and Italy and caused (ritain to leave the

24

FOREIGN EXCHANGE

!o ar4s Sec" ar !ec ine and T"rnaro"nd The &ollarDs secular decline, which began in #arch 6CB?, seems to have ended only in #arch4,pril 6CC? after the 5/ administration switched to a strong &ollar policy under the leadership of the mar$et savvy "obert "ubin. (y then the &ollar had already fallen as low as 6.:9 mar$s and B= yen. This 6=-year decline was, however, interspersed with : significant recovery periods against the mar$ - >anuary 6CBB to >une 6CBC, February 6CC6 to ,ugust 6CC6 and Fctober 6CC< to February 6CC9. ,gainst the Hen, the &ollar enjoyed only one significant recovery period lasting from >anuary 6CBB till ,pril 6CC=. The adoption of a strong &ollar policy by the 5/ administration together with the robust, non-inflationary growth enjoyed by the 5/ economy helped the &ollar to rise sharply as foreign capital flowed into &ollar-denominated assets. The &ollar rose to 6.BC mar$s by ,ugust 6CC@ but then fell to 6.?C mar$s by Fctober 6CCB due mainly to the .hite Eouse crisis, "ussian default4devaluation and euphoria in the run-up to the launch of the uro. The &ollar rose against the Hen too 1from B= Hen in ,pril 6CC? to about 69@ yen in ,ugust 6CCB2 but then fell to about 66< Hen by Fctober 6CCB before recovering to about 6<? Hen in #ay 6CCC. The &ollar again fell sharply and has come close to the magical 6== Hen level after nearly 9 years. .hile the reason cited is the nascent >apanese economic recovery and the rally in >apanese e*uities, the real reasons appear to be an extra-loose fiscal policy and an extra-tight monetary policy as in the 5/ during the early eighties and in Germany during the early nineties.

25

FOREIGN EXCHANGE

E'5 and the E"ro The uropean conomic and #onetary 5nion began on >anuary 6, 6CCC with the uro. Fut of the 6? uropean 5nion launch of the single currency called the

countries, Greece was dis*ualified under the #aastricht criteria while (ritain, &enmar$ and /weden did not join in the first round. The remaining 66 countries ,ustria, (elgium, Finland, France, Germany, Ireland, Italy, )uxembourg, the 8etherlands, 'ortugal and /pain joined the single currency. The main operating characteristics of the #5 are a common monetary policy and a single interest rate decided by the uropean 0entral (an$ and irrevocable, loc$ed-in conversion rates between the uro and the 66 national currencies. The early urophoria subsided very *uic$ly and for a host of economic and political reasons, the uro has been in a downtrend ever since its launch. It has so far fallen 6?M against the &ollar, <:M against the yen and 6<M against sterling. In all fairness, however, the external strength or wea$ness of the uro is not a measure of #5Ds success or failure - which will instead be decided by the extent to which the single interest rate, etc help maintain convergence between the 66 members. Initial signs are not *uite encouraging inasmuch as inflation in several countries has exceeded <M and is rising, essentially because *uite a few countries li$e Ireland and /pain had to cut interest rates sharply to the level of German repo rate, contrary to their own domestic needs. Het, in the absence of clairvoyance, it may be too early to say whether these are just teething troubles or a signal of the beginning of an early brea$down of the #5.

26

FOREIGN EXCHANGE

()oating Rate S*stem


.ith the exit of fixed parities system, different countries experimented with exchange rate systems. The brea$down of (retton .oods /ystem and the subse*uent adoption of generalized floating by major industrialized countries, the option left open to the developing countries was to choose their own exchange rate regime in line with national preferences. Today, exchange rate regimes and practices vary considerably across countries. The widespread adoption of flexible exchange rate system has made major contributions by offering many countries the easier use of an effective means of adjustment and by reducing the political biases against adjustments, which existed under the par value system.

27

FOREIGN EXCHANGE

Exchange Rate Systems In Different Countries


The member countries generally accept the I#F classification of exchange rate regime, which is based on the degree of exchange rate flexibility that a particular regime reflects. Eowever, it has been generally observed that there exists no strict relationship between a particular regime and the degree of exchange rate flexibility it faces, either at the nominal or real exchange rate levels. The exchange rate arrangements adopted by the developing countries cover a broad spectrum, which are as follows; Sing e -"rrency Peg The country pegs to a major currency, usually the 5. /. &ollar or the French franc 1 x-French colonies2 with infre*uent adjustment of the parity. #any of the developing countries have single currency pegs. -om#osite -"rrency Peg , currency composite is formed by ta$ing into account the currencies of major trading partners. The objective is to ma$e the home currency more stable than if a single peg was used. 0urrency weights are generally based on trade in goods ! exports, imports, or total trade. ,bout one fourth of the developing countries have composite currency pegs. F exib e ,imited vis.6.vis Sing e -"rrency The value of the home currency is maintained within margins of the peg. /ome of the #iddle astern countries have adopted this system. ,djusted to indicators The currency is adjusted more or less automatically to changes in selected macroeconomic indicators. , common indicator is the real effective exchange rate 1" "2

28

FOREIGN EXCHANGE

that reflects inflation adjusted change in the home currency vis-R-vis major trading partners. 'anaged f oating The 0entral (an$ sets the exchange rate, but adjusts it fre*uently according to certain pre-determined indicators such as the balance of payments position, foreign exchange reserves or parallel mar$et spreads and adjustments are not automatic. Inde#endent y f oating Free mar$et forces determine exchange rates. The system actually operates with different levels of intervention in foreign exchange mar$ets by the central ban$. It is important to note that these classifications do conceal several features of the developing country exchange rate regimes. , particular regime may be compatible with dual or multiple rates, separate exchange rates for capital and current account transactions, a combination of fixed-floating arrangement and tax-subsidy schemes for export ! import trade.

29

FOREIGN EXCHANGE

The Evolution Of India s Exchange Rate Regime


The "upee was historically lin$ed with 'ound /terling. India was a founder member of the I#F. &uring the existence of the fixed exchange rate system, the intervention currency of the "eserve (an$ of India 1"(I2 was the (ritish 'ound3 the "(I ensured maintenance of the exchange rate by selling and buying pounds against rupees at fixed rates. The inter-ban$ rate therefore ruled the "(I band. &uring the fixed exchange rate era, there was only one major change in the parity of the rupeedevaluation in >une 6CKK. ,ccording to >ohn . "ule, it is the views of participants in the foreign-exchange

mar$ets that result in the daily buying and selling pressures on currencies. The views of these participants, such as traders, ban$ers, and businessmen, are in turn influenced by political, economic and psychological factors. Po itica Factors The political factors influencing exchange rates include the established monetary policy along with government action or inaction on items such as the money supply, inflation, taxes, and deficit financing. ,ctive government intervention or manipulation, such as central ban$ activity in the foreign currency mar$ets, also have an impact. Fther political factors influencing exchange rates include the political stability of a country and its relative economic exposure 1the perceived need for certain levels and types of imports2. Finally, there is also the influence of the International #onetary Fund.

30

FOREIGN EXCHANGE

Economic Factors conomic factors affecting exchange rates include hedging activities, interest rates, inflationary pressures, trade imbalances, and This proposition, $nown as the Fisher tend to reflect exchange rate expectations. Fn the other hand, the purchasing-power-parity theory relates exchange rates to inflationary pressures. In its absolute version, this theory states that the e*uilibrium exchange rate e*uals the ratio of domestic to foreign prices. The relative version of the theory relates changes in the exchange rate to changes in price ratios. Fther economic factors influencing exchange rates are included in a theory proposed by &ombush, who presented both a long-run view and a short-run view of exchange rate determinants. ,ccording to &ombush, the long-run determinants of exchange rates are the nominal *uantities of monies, the real money demands and the relative price structure. ,mong the factors that exert an influence on real money demand are interest rates, expected inflation, and real income growth. In the short run, &ombush theorizes, exchange rates are determined by interest arbitrage together with speculation about future spot rates. uro mar$et activities. Irving Fisher, an ,merican economist, developed a theory relating exchange rates to interest rates. ffect, states that interest rate differentials

31

FOREIGN EXCHANGE

Psycho ogica Factors 'sychological factors also influence exchange rates. These factors include mar$et anticipation, speculative pressures, and future expectations. , few financial experts are of the opinion that in todayDs environment, the only OtrustworthyD method of predicting exchange rates is by gut feel. (ob forecaster for 6CCC. veling, vicepresident of financial mar$ets at /G, is 0orporate Finance+s top foreign exchange veling+s gut feeling has, defied convention, and his method proved uncannily accurate in foreign exchange forecasting in 6CCB. /G ended the 0orporate Finance forecasting year with a <.KKM error overall, the most accurate among 6C ban$s. The secret to veling+s intuition on any currency is $eeping abreast of world events. ,ny event, from a declaration of war to a fainting political leader, can ta$e its toll on a currency+s value. Today, instead of formal models, most forecasters rely on an amalgam that is part economic fundamentals, part model and part judgment.

32

FOREIGN EXCHANGE

!odels And Theories Of Exchange Rate


P'rchasing Po+er Parit* Theor* (PPP"
'urchasing 'ower 'arity Theory was pronounced by 'rof. Gustav 0assel. The theory argues that exchange rate movements primarily reflect differences in inflation rates between countries. It advocated that currencies are valued for what they can buy and the currencies had no intrinsic value attached to it. Therefore, under this theory the exchange rate was to be determined and the sole criterion being the purchasing power of the countries. ,s per this theory if there were no trade controls, then the balance of payments e*uilibrium would always be maintained. exchange rate, e'f 4', the theory maintains the following .hen 'f and 4or ' changes, e changes in such a way as to maintain e'f 4' constant. .here, ' is the domestic price, 'f is the foreign price level and e is the exchange rate. ''' is a plausible description of the trend behaviour of exchange rates, especially when inflation differentials between the countries are large. This theory does hold in the case of an increase in the money stoc$. Eowever, in this theory some factors li$e the methods of production, the consumer preferences, transportation costs and the existence of trade controls was overloo$ed Influence of non-monetary disturbances affecting exchange rates was totally ignored. xamining the real

33

FOREIGN EXCHANGE

The

,'nde))

()eming

,ode):

Per-ect

.apita)

,o/i)it*
"obert #undell and #arcus Fleming, extended the standard I/-)# model to the open economy under perfect capital mobility. It is advocated that under fixed exchange rates and perfect capital mobility, a country cannot pursue an independent monetary policy. Interest rates cannot move out of line with those prevailing in the world mar$et. ,ny attempt at independent monetary policy leads to capital flows and a need to intervene until interest rates are bac$ in line with those in the world mar$et. 5nder perfect capital mobility the slightest interest differential provo$es infinite capital flows. It follows that with perfect capital mobility, central ban$s cannot conduct an independent monetary policy under fixed exchange rate system. It tightens the monetary policy, and interest rates rise resulting in portfolio changes. ,s a result of huge capital inflow, the balance of payments shows huge surplus. The foreigners tend to buy domestic assets, appreciating the exchange rate and forcing the central ban$ to intervene to hold the exchange rate constant. This intervention results in increase in home currency stoc$s. ,s a result, the initial monetary contraction is reversed and the process ends when home interest rates have been pushed bac$ to the initial level. The following is represented by Figure 6 below.

34

FOREIGN EXCHANGE

'onetary Ex#ansion 5nder Fixed Rates And Perfect -a#ita 'obi ity xtending this model to flexible exchange rate system, the absence of central ban$ intervention implies a zero balance of payments. ,ny current account deficit must be financed by private capital inflows; a current account surplus is balanced by capital outflows. ,djustments in the exchange rate ensure that the sum of the current and capital accounts is zero.

35

FOREIGN EXCHANGE

0orn/'sh Theor* on ,onetar* Expansion: Short and 1ong Term E--ects


.ith given prices a monetary expansion under flexible rates and perfect mobility leads to depreciation and increased income. Eowever when adjustments in prices are ta$en into consideration, the output increase is transitory. In the long run a monetary expansion leads to an exchange depreciation and to higher prices with no change in competitiveness. The important feature of the adjustment process is that exchange rate and prices do not move at the same rate. .hen a monetary expansion pushes interest rates down, the exchange rate adjusts immediately but prices adjust only gradually. #onetary expansion therefore leads in the short run to an immediate and abrupt change in relative prices and competitiveness. Effects of 'onetary Ex#ansion

xchange "ate /hort run S )ong run S

'rice e'f 4' Futput = S S = S =

The exchange rate overshoots its new e*uilibrium level when, in response to a disturbance, it first moves beyond the e*uilibrium it ultimately will reach and then gradually returns to the long-run e*uilibrium position. Eere, overshooting means that changes in monetary policy produce large changes in exchange rates.

36

FOREIGN EXCHANGE

"orecasting Of Exchange Rates


Forecasting foreign exchange rates is important for treasury and Forex managers as it reduces the uncertainties associated with commitments to accept or to ma$e payments in foreign currencies with short-term and long-term investment decisions, with financing decisions and with income earned in foreign currencies. It is also important for a Forex manager to understand the intricacies and the limitations of forecasting foreign exchange rates as it helps them to utilize the alternate avenues to manage exchange rate ris$. Though an intra-day forecast of the exchange rate is not possible, but the direction and magnitude of change in longer term can be forecasted with a fair degree of accuracy. xchange rate forecasts also help to; # ,nalyze attractiveness of foreign borrowings3 # 'lan investments in foreign countries3 # 'lan long-term export-import strategy3 # #anage exchange rate ris$s and plan hedging strategies. 8ow, the exchange rate between two currencies could be either fluctuating or fixed. )ogically, forecast for fluctuating exchange rates only would be re*uired by treasury manager, as fixed rates are more or less $ept within a narrow band by intervention of the two governments.

37

FOREIGN EXCHANGE

Techni$ues of "orecasting Exchange Rate


There are several techni*ues available to forecast future rates. These can be classified under following categories; Forward rates as short-term forecasters Technical ,nalysis conomic #odels

(or+ard Rates as Short-term (orecasters


Forward rates are sometimes used to predict future spot rates. (an$s act as clearing houses for both forward and spot contracts. Firms generally anticipate future spot rate. The evaluation of any forecasts can be done based on two criteria; Acc"rate Forecast Indicator; If the future values are forecasted accurately every time with minor forecast errors, then it is an accurate forecast indicator. 5nbiased Forecast Indicator; ,n unbiased estimator is one, which can overestimate the value as much with the same probability as it can underestimate which implies that positive errors are as much probable as negative errors. If the forecasts are done accurately on an average they are called unbiased forecasts.

38

FOREIGN EXCHANGE

(oreign

Exchange

Rate

(orecasting

+ith

Technica) 2na)*sis
Forecasting future exchange rates with the use of past exchange rate movements is called technical analysis. The forecasters are called technicians. 'ure technicians ignore economic factors such as inflation rates, interest rates, balance of payments and political stability. The pure technicians believe that clues in the past movements lead them to the future. , technician believes that exchange rate movements are mechanistic and are not caused by economic and political changes. Technicians develop their own forecasts about future currency values and each technician has his individual method. There are many methods used by technicians such as sophisticated statistical models, charts of past exchange rate movements etc. /ome technicians use historical data from primary analysis and then recommend the client in an informal fashion by $eeping in view the economic and political factors.

39

FOREIGN EXCHANGE

Eva "ation of technica Forecasts conomists do not li$e technical analysis, as it does not obey the principles of economics. The logical explanation given by economists in support of their view is that according to efficient mar$et hypothesis, prices reflect all available information. In an efficient Forex mar$et, the impact of available information is already reflected in the present rates, therefore, forecasts based on historical data do not help develop accurate forecasts. conomic research indicates that Forex movements follow a pattern of random wal$, which implies that a specific present change is unrelated to past changes and therefore a forecast is not possible. The explanation given by economists is that current exchange rates change with the unforeseeable events. The unforeseeable events occur in random fashion and hence exchange rate changes follow a random pattern. Technical analysts assert that their approach wor$s and it is very difficult to disapprove their assertions. The evaluation of technical forecasts is difficult because it wor$s at times. To prove the efficiency of technical forecasts, it is necessary to prove them to be superior to other methods over a period of time. This is not possible as at a given time, the technical analysis has proved to be superior. Technical forecasts arte often used in conjunction with economic model based forecasts, but technical forecasts are widely used by speculators in the forex mar$ets to boo$ *uic$ profits since technical forecasts emphasize on short-term exchange rates.

40

FOREIGN EXCHANGE

*et Effective Exchange Rate 7*eer8 'erformance over the past five years 8 " is a good indicator of the exchange rate of the country. It is a multi-lateral measurement of the exchange rate of the "upee, which depends on the trade based weights of five countries. Trends in the movement of 8 " from 6CC: ,pril to February 6CCC are illustrated in " after the xchange "ate #anagement /ystem the table given below. This is in effect the performance of the 8 implementation of the #odified )iberalized 1#odified ! ) "#/2 with effect from 6st #arch 6CC:.

The performance of the 8

" ma$es a good study of the effect of the policies on the

exchange rate after ,pril 6CC:.

41

FOREIGN EXCHANGE

.e have made a forecast of the 8

", which is shown above, using various time-

series techni*ues. These time-series techni*ues are technical forecasts and their accuracy can be studied by sing #,' , #/ and ThielDs statistic. In the tables given below, the different techni*ues and their respective #,' , #/ and ThielDs statistics are given. ,"I#, =.:@@6? =.=6==< (rownDs #ethod EoltDs #ethod :.<?BC:@ 6.?<B6C? .interDs #ethod 9=B.B:C@ <<.:<K6C

#,' ThielDs 5 /imple #oving #/ #,' &ouble /ingle

#oving ,vg xponen

,vg 9.:<@6K9 9.?6:?C6 6.BB<?:C 6.C?=?96

/moothen :.?KKB<< <.C6<B:6 6.@=<<C< =.=6?=:@

42

FOREIGN EXCHANGE

Exchange ,ode)s

Rate

(orecasting

+ith

Economic

The difference between technical analysis and economic forecasting is that economic forecasting is based on established and verified economic relationships such as (o', inflation, interest rates, etc. The approach adopted is cause and effect approach. For example, in case of inflation rate, we $now that inflation rates affect future exchange rates. Future exchange rates can be forecasted by forecasting inflation rate. The statistical models wor$ by establishing a relationship between future exchange rates and the variables that affect future exchange rates. 5sually, as it involves more than two variables, a multiple regression analysis based on statistical models is done. In any forecasting model, the future exchange rate is a dependent variable as it depends on various economic indicators. These indicators such as (o', inflation, and interest rates are independent variables. The accuracy of the predicted changes in the independent variables and the gathering of accurate historical data on the variables such as inflation, G8' is difficult. In case of three or four variables gathering historical information for a specific period for all the variables is also difficult. There is a difference of opinion in inclusion and exclusion of variables. ,ny statistical model does not give fruitful results unless political factors and impact of news are *uantified. It also re*uires for a good forecast to predict the future direction and extent of government intervention. The superiority of a forecasting model depends on its accuracy over mar$et forecast. If some forecasts are superior to others its advantage is *uic$ly eliminated by the mar$et forces as they act favorably towards the forecasts and brings the price to the forecasted level if it is an efficient mar$et. If a firm develops a superior forecast it is not sufficient to gain from it. , firm should have enough capital to materialize the gains out of its forecast. /o, it will be advantageous to firms to $eep abreast of the

43

FOREIGN EXCHANGE

latest information regarding economic indicators such as (o', inflation rates, interest rates etc.

44

FOREIGN EXCHANGE

Suita%ility for &se in "oreign Currency Translation


In the final analysis, exchange rates are designed to facilitate the exchange of one currency for another. ,ccordingly, exchange rates represent reasonable mechanisms with which to translate foreign-currency transactions, particularly those that will be settled in the short term. There is a multiplicity of factors that affect the movement of exchange rates. /ince exchange rates are not strong proxies for purchasing power parity relationships, another tool such as purchasing-power-parity indexes should be found for use in the translation of foreign currency. Eowever, at present, an acceptable tool of this nature is not available. 5ntil such an index does become generally available, the use of exchange rates in the translation of foreign currency must suffice.

45

FOREIGN EXCHANGE

"oreign Exchange !ar'et


The foreign exchange mar$et does not have a physical mar$et place called the foreign exchange mar$et. It is a mechanism through which one country+s currency can be exchange i.e. bought or sold for the currency of another country. The foreign exchange mar$et does not have any geographic location. The mar$et comprises of all foreign exchange traders who are connected to each other through out the world. They deal with each other through telephones, telexes and electronic systems. The foreign exchange mar$et operates twenty four hours a day during the business wee$3 the only time it is silent is after the 8ew Hor$ mar$et closes on Friday afternoon and before the /ydney mar$et opens on #onday morning 1which would be /unday evening 8ew Hor$ time2.

46

FOREIGN EXCHANGE

The (artici)ants in "oreign Exchange !ar'ets


.'stomers
The customers who are engaged in foreign trade participate in foreign exchange mar$ets by availing of the services of ban$s. For example, xporters re*uire converting the dollars in to rupee and importers re*uire converting rupee in to the dollars, as they have to pay in dollars for the goods4services they have imported. -ommercia %anks They are most active players in the Forex mar$et. 0ommercial ban$s dealing with international transactions offer services for conversion of one currency in to another. They have wide networ$ of branches. Typically ban$s buy foreign exchange from exporters and sells foreign exchange to the importers of the goods. ,s every time the foreign exchange bought and sold may not be e*ual ban$s are left with the overbought or oversold position. The balance amount is sold or bought from the mar$et. 8owadays, in international foreign exchange mar$ets, the international trade turnover accounts for a fraction of huge amounts dealt, i.e. bought and sold. The balance amount is accounted for either by financial transactions or speculation. (an$s have enough financial strength and wide experience to speculate the mar$et and ban$s does so. This is popularly $nown as the trading in the Forex mar$et.

47

FOREIGN EXCHANGE

0ommercial ban$s have following objectives for being active in the foreign exchange mar$ets. # They render better service by offering competitive rates to their customers engaged in international trade3 # They are in a better position to manage ris$s arising out of exchange rate fluctuations3 # Foreign exchange business is a profitable activity and thus such ban$s are in a position to generate more profits for themselves3 # They can manage their integrated treasury in a more efficient manner. In India "eserve (an$ of India has given license to the commercial ban$s to deal in foreign exchange under section K Foreign called the ,uthorized &ealers 1, &s2. -entra %ank In all countries central ban$s have been charged with the responsibility of maintaining the external value of the domestic currency. Generally this is achieved by the intervention of the ban$. ,part from this central ban$s deal in the foreign exchange mar$et for the following purposes; Exchange rate management; It is achieved by the intervention though sometimes ban$s have to maintain external rate of the domestic currency at a level or in a band so fixed. Reserve management; 0entral ban$ of the country is mainly concerned with the investment of countries foreign exchange reserve in a stable proportions in range of currencies and in a range of assets in each currency. For this ban$ has to involve certain amount of switching between currencies. xchange "egulation ,ct, 6C@:, who are

48

FOREIGN EXCHANGE

Exchange %rokers Forex bro$ers play a very important role in the foreign exchange mar$ets. Eowever the extent to which services of Forex bro$ers are utilized depends on the tradition and practice prevailing at a particular Forex mar$et center. In India as per F &,I guidelines the ,&Ds are free to deal directly among themselves without going through bro$ers. The Forex bro$ers are not allowed to deal on their own account all over the world and also in India. 9o+ exchange brokers +ork: (an$s see$ing to trade display their bid and offer rates on their respective pages of "euters+s screen, but these prices are indicative only. Fn in*uiry from bro$ers they *uote firm prices on telephone. In this way, the bro$ers can locate the most competitive buying and selling prices, and these prices are immediately broadcast to a large number of ban$s by means of hotlines 4 loudspea$ers in the ban$s dealing room 4 contacts many dealing ban$s through calling assistants employed by the bro$ing firm. If any ban$ wants to respond to these prices thus made available, this is done by counterparty ban$ by clinching the deal. (ro$ers do not disclose counterparty ban$+s name until the buying and selling ban$s have concluded the deal. Fnce the deal is struc$ the bro$er exchange the names of the ban$ who has bought and who has sold. The bro$ers charge commission for the services rendered. In India bro$er+s commission bas been fixed by F &,I.

49

FOREIGN EXCHANGE

/verseas Forex 'arkets Today the daily global turnover is estimated to be more than 5/ A 6.? trillion a day. The international trade however constitutes hardly ? to @ M of this total turnover. The rest of trading in world Forex mar$ets is constituted of financial transactions and speculation. ,s we $now that the Forex mar$et is <9-hour mar$et, the day begins with To$yo and thereafter /ingapore opens, thereafter India, followed by (ahrain, Fran$furt, 'aris, )ondon, 8ew Hor$, /ydney, and bac$ to To$yo.

Spec')ators
The speculators are the major speculators in the Forex mar$et. (an$s dealing are the major speculators in the Forex mar$ets with a view to ma$e profit on account of favorable movement in exchange rate, ta$e position i.e. if they feel that rate of particular currency is li$ely to go up in short term. They buy that currency and sell it as soon as they are able to ma$e *uic$ profit. 0orporations+ particularly #ultinational 0orporation and transnational corporations having business operations beyond their national frontiers and on account of their cash flows being large and in multi currencies get in to foreign exchange exposures. .ith a view to ma$e advantage of exchange rate movement in their favor they either delay covering exposures or do not cover until cash flow materialize. /ometimes they ta$e positions so as to ta$e advantage of the exchange rate movement in their favor and for underta$ing this activity, they have state of the art dealing rooms. In India, some of the big corporate are as the exchange control have been loosened, boo$ing, and canceling forward contracts, and at times the same borders on speculative activity.

50

FOREIGN EXCHANGE

Governments borrow or invest in foreign securities and delay coverage of the exposure on account of such deals. Individuals li$e share dealings also underta$e the activity of buying and selling of foreign exchange for boo$ing short-term profits. They also buy foreign currency stoc$s, bonds and other assets without covering the foreign exchange exposure ris$. This also results in speculations. 0orporate entities ta$e positions in commodities whose price are expressed in foreign currency. This also adds to speculative activity.

51

FOREIGN EXCHANGE

"undamentals in Exchange Rate


xchange rate is a rate at which one currency can be exchange in to another currency, say 5/& 6 7 "s. 9<. This rate is the rate of conversion of 5/ dollar in to Indian rupee and vice versa.

,ethods o- 3'oting Exchange Rates


There are two methods of *uoting exchange rates. 6. !irect method; Foreign currency is $ept constant and home currency is $ept variable <. Indirect method; Eome currency is $ept constant and foreign currency is $ept variable In India, with effect from ,ugust <, 6CC:, all the exchange rates are *uoted in &irect method. 'ethod of ;"otation It is customary in foreign exchange mar$et to always *uote tow rates means one rate for buying and another rate for selling. This helps in eliminating the ris$ of being given bad rates i.e. if a party comes to $now what the other party intends to do i.e., buy or sell, the former can ta$e the latter for a ride. There are two parties in an exchange deal of currencies. To initiate the deal one party as$s for *uote from another party and the other party *uotes a rate. The party as$ing for a *uote is $nown as O,s$ing partyD and the party giving a *uote is $nown as OTuoting partyD.

52

FOREIGN EXCHANGE

The advantage of two-way *uote is as under; The mar$et continuously ma$es available price for buyers and sellers Two-way price limits the profit margin of the *uoting ban$ and comparison of one *uote with another *uote can be done instantaneously ,s it is not necessary any player in the mar$et to indicate whether he intends to buy or sell foreign currency, this ensures that the *uoting ban$ cannot ta$e advantage by manipulating the prices. It automatically insures alignment of rates with mar$et rates Two-way *uotes lend depth and li*uidity to the mar$et, which is so very essential for efficient mar$ets. In two-way *uotes the first rate is the rate for buying and another rate is for selling. .e should understand here that, in India the ban$s, which are authorized dealers, always *uote rates. /o the rates *uotedUbuying and selling is for ban$s point of view only. It means that if exporter want to sell the dollars then the ban$ will buy the dollars from him so while calculation the first rate will be used which is a buying rate, as the ban$ is buying the dollars from the exporter. The same case will happen inversely with the importer as he will buy the dollars from the ban$ and ban$ will sell dollars to importer.

53

FOREIGN EXCHANGE

"actors Affecting Exchange Rates


In a free mar$et, it is the demand and supply of the currency which should determine the exchange rates but demand and supply is the dependent on many factors, which are ultimately the cause of the exchange rate fluctuation, some times wild. The volatility of exchange rates can not be traced to the singe reason and conse*uently, it becomes difficult to precisely define the factors that affect exchange rates. Eow ever, the more important among them are as follows; (alance of payments /trength of economy Fiscal policy Interest rates #onetary policy 'olitical factor xchange control 0entral ban$ intervention /peculation Technical factors xpectations of the foreign exchange mar$et

.e can see that how these factors affect to the foreign exchange, from the daily reports of the Jadilal Industries )imited 1Forex division2 on Indian foreign exchange mar$et.

54

FOREIGN EXCHANGE

-ross Rates .e $now that 5/ dollar being the currency of intervention only 5/ dollar4rupee exchange rate is available in the Indian forex mar$et and exchange rates of rupee with all other foreign currencies are derived from this rate through crosses. If we want to remit french from India, exchange rate of French franc4rupee has to be arrived at. .hat we have to do is the first buy 5/ dollar against rupee and by selling 5/ dollar so bought, say in )ondon mar$et, we buy French franc. )et us understand by an exampleV If exchange rates in #umbai interban$ mar$et and )ondon mar$et are as follows; Interban$ mar$et #umbai 5/ A 6 7 "s. 96.<??=-96.<K?= )ondon #ar$et 5/ A 6 7 F"F K.=?==-K.=??= The transaction will proceed li$e, interban$ mar$et ta$es rupees 96.<K?= and gives 5/ A 6. This 5/ A is ta$en to the )ondon mar$et for conversion in the F"F. The )ondon mar$et ta$es 5/ A 6 and gives F"F K.=?==. o we can calculate the direct rate between F"F and I8". F"F K.=?== 7 5/ A6 ,nd 5/ A 6 7 "/. 96.<K?= Therefore, F"F K.=?== 7 5/ A 6 7 "/. 96.<K?= /o, F"F 6 7 "/.96.<K?=4K.=?== 7 "/. K.B<=K

In this way, ban$s can calculate exchange rate between any two currencies.

55

FOREIGN EXCHANGE

Va "e !ate In foreign exchange mar$et, it ta$es some times to process the transactions and send the instruction to the correspondent ban$4branch abroad. Therefore, it is customary to *uote the rate to do the deal exchange the currencies not on the same date but generally afterwards. Jalue date is the date on which the exchange of currencies actually ta$es place. This is irrespective of the date of deal. &ate of deal 0ash4"eady C-6-<=== Tom /pot Forward Friday C-6-<=== Friday C-6-<=== Friday C-6-<=== Friday Jalue date C-6-<=== Friday 6<-6-<=== #onday 6:-6-<=== Tuesday 69-6-<=== beyond spot date

Generally exchange rates are *uoted on spot basis i.e. the settlement ta$es place on the second wor$ing day after the date of transaction. The exchange rate for settlement on a day beyond spot date is naturally different and is called Oforward rateD

56

FOREIGN EXCHANGE

Forward rate has two components3 6. /pot rate <. Forward points Forward points, also called as forward differentials, reflect the interest differential between the pair of currencies provided capital flows are freely allowed. This is not true in case of 5/ A 4 "upee rate as there are exchange control regulations prohibiting free movement of capital from4into India. In case of 5/ A 4 "upee it is pure demand and supply which determines forward differentials. If forward price is higher than the spot price the currency is said to be at OpremiumD. ,nd if forward price is lower than spot price the currency is said to be at OdiscountD. Forward rates are *uoted by indicating spot rate and premium4discount. In direct rate; Forward rate 7 spot rate S 'remium 4 - &iscount In foreign exchange mar$et forward transaction are necessary for following reasons; Fne can hedge or cover an existing future financial, commercial or trade related exchange ris$. These types of deals, in combinations of spot deals, are used for money mar$et operations through Oswap transactionsD. Ta$ing a view of the mar$et, these can be used for speculation.

Premi'm
.hen a currency is costlier in future1forward2 as compared to spot, the currency is said to be at premium vis-R-vis another currency.

0isco'nt
.hen a currency is cheaper in future1forward2 as compared to spot, the currency is said to be at discount vis-R-vis another currency.

57

FOREIGN EXCHANGE

Factors Affecting Premi"m < !isco"nt Forward differentials are relatively but are not constant and therefore, vary from time to time. The following factors affect forward differentials; 6. /upply and demand for the currency for a settlement date. If for a currency for a particular settlement date, there are more buyers than sellers the forward differential will go up. /imilarly, if a currency for a particular settlement date, there are more sellers and buyers the forward differential will go down. This is all the more true when there is restriction of capital flows. <. #ar$et expectations. #ar$et expectations about the development in interest differentials and exchange rates of the currencies on account of various factors. :. Interest rate differentials Interest rate differentials between the currencies exchanged. In fact, this is the only factor, which affects the forward differentials provided capital flows are free from restrictions. .e can see from the daily report of the Jadilal Industries )imited 1Forex division2 that how premium 4 discount changes.

58

FOREIGN EXCHANGE

'erchant Rates The exchange rates *uoted by ,uthorized &ealers in India, for transactions with merchants are $nown as O#erchant "atesD. The rates *uoted by ban$s for dealing in inter-ban$ mar$et are $nown as OInter ban$ ratesD. There are four types of merchant rates are used in India; 6. TT 1(uying2 "ate <. TT 1/elling2 "ate :. (ill 1(uying2 "ate 9. (ill 1/elling2 "ate

59

FOREIGN EXCHANGE

"oreign Exchange Ex)osure


Foreign exchange ris$ is related to the variability of the domestic currency values of assets, liabilities or operating income due to unanticipated changes in exchange rates, whereas foreign exchange exposure is what is at ris$. Foreign currency exposures and the attendant ris$ arise whenever a business has an income or expenditure or an asset or liability in a currency other than that of the balance-sheet currency. Indeed exposures can arise even for companies with no income, expenditure, asset or liability in a currency different from the balance-sheet currency. .hen there is a condition prevalent where the exchange rates become extremely volatile the exchange rate movements destabilize the cash flows of a business significantly. /uch destabilization of cash flows that affects the profitability of the business is the ris$ from foreign currency exposures.

60

FOREIGN EXCHANGE

Identi-ication o- (oreign Exchange Expos'res


Foreign exchange exposures arise from many different activities. , traveler going to visit another country has the ris$ that if that country+s currency appreciates against their own their trip will be more expensive. ,n exporter who sells its product in foreign currency has the ris$ that if the value of that foreign currency falls then the revenues in the exporter+s home currency will be lower. ,n importer who buys goods priced in foreign currency has the ris$ that the foreign currency will appreciate thereby ma$ing the local currency cost greater than expected. Fund #anagers and companies who own foreign assets are exposed to falls in the currencies where they own the assets. This is because if they were to sell 1repatriate2 those assets their exchange rate would have a negative effect on the home currency value. Fther foreign exchange exposures are less obvious and relate to the exporting and importing in ones local currency but where the negotiated price is being affected by exchange rate movements. Generally the aim of foreign exchange ris$ management is to stabilize the cash flows and reduce uncertainty from financial forecasts. Fortunately there are a range of hedging instruments that achieve exactly that.

61

FOREIGN EXCHANGE

Ty)es of Ex)osures
Financial economists distinguish between three types of currency exposures transaction exposures, translation exposures, and economic exposures. ,ll three affect the bottom- line of the business.

Transaction Expos're
/uppose that a company is exporting deutsche mar$ and while costing the transaction had rec$oned on getting say "s <9 per mar$. (y the time the exchange transaction materializes i.e. the export is effected and the mar$ sold for rupees, the exchange rate moved to say "s <= per mar$. The profitability of the export transaction can be completely wiped out by the movement in the exchange rate. /uch transaction exposures arise whenever a business has foreign currency denominated receipt and payment. The ris$ is an adverse movement of the exchange rate from the time the transaction is budgeted till the time the exposure is extinguished by sale or purchase of the foreign currency against the domestic currency.

62

FOREIGN EXCHANGE

Trans)ation Expos're
Translation exposure arises from the need to LtranslateL foreign currency assets or liabilities into the home currency for the purpose of finalizing the accounts for any given period. , typical example of translation exposure is the treatment of foreign currency borrowings. 0onsider that a company has borrowed dollars to finance the import of capital goods worth "s 6====. .hen the import materialized the exchange rate was say "s := per dollar. The imported fixed asset was therefore capitalized in the boo$s of the company for "s :=====. In the ordinary course and assuming no change in the exchange rate the company would have provided depreciation on the asset valued at "s :===== for finalizing its accounts for the year in which the asset was purchased. If at the time of finalization of the accounts the exchange rate has moved to say "s :? per dollar, the dollar loan has to be translated involving translation loss of "s?====. The boo$ value of the asset thus becomes :?==== and conse*uently higher depreciation has to be provided thus reducing the net profit.

63

FOREIGN EXCHANGE

Economic Expos're
,n economic exposure is more a managerial concept than a accounting concept. , company can have an economic exposure to say Hen; "upee rates even if it does not have any transaction or translation exposure in the >apanese currency. This would be the case for example, when the company+s competitors are using >apanese imports. If the Hen wee$ends the company loses its competitiveness 1vice-versa is also possible2. The company+s competitor uses the cheap imports and can have competitive edge over the company in terms of his cost cutting. Therefore the company+s exposed to >apanese Hen in an indirect way. In simple words, economic exposure to an exchange rate is the ris$ that a change in the rate affects the company+s competitive position in the mar$et and hence, indirectly the bottom-line. (roadly spea$ing, economic exposure affects the profitability over a longer time span than transaction and even translation exposure. 5nder the Indian exchange control, while translation and transaction exposures can be hedged, economic exposure cannot be hedged. &hat is Economic Ex#os"re: '&J/,, the Jenezuelan state-owned oil company, recently set up an oil refinery near "otterdam, The 8etherlands for shipment to Germany and other continental uropean countries. The firm planned to invoice its clients in currency unit of the 05, the official uropean 0ommunity. The treasurer is considering sources of

long term financing. In the past all long-term finance has been provided by the parent company, but wor$ing capital re*uired to pay local salaries and expenses has been financed in &utch guilders. The treasurer is not sure whether the short-term debt should be hedged, or what currency to issue long term debt in.

64

FOREIGN EXCHANGE

This is an example of a situation where the definition of exposure has a direct impact on the firm+s hedging decisions. Translation exposure has to do with the location of the assets, which in this case would be a totally misleading measure of the effect of exchange rate changes on the value of the unit. ,fter all, the oil comes from Jenezuela and is shipped to Germany; its temporary resting place, be it a refinery in "otterdam or a tan$er en route to Germany, has no import. (oth provide value added, but neither determine the currency of revenues. /o financing should definitely not be done in &utch guilders. Transactions exposure has to do with the currency of denomination of assets li$e accounts receivable or payable. Fnce sales to Germany have been made and invoicing in 05 has ta$en place, '&J/,-8etherlands has contractual, 05-denominated assets that should be financed or hedged with of determination is the 5./. dollar. conomic exposure is tied to the currency of determination of revenues and costs. /ince the world mar$et price of oil is dollars, this is the effective currency in which '&J/,+s future sales to Germany are made. If the the dollar rises against the 05 rises against the dollar, '&J/, must adjust its 05 price down to match those of competitors li$e ,ramco. If 05, '&J/, can and should raise prices to $eep the dollar price the same, since competitors would do li$ewise. 0learly the currency of determination is influenced by the currency in which competitors denominate prices. 05. For future sales, however,

'&J/,-8etherlands does not have exposure to the 05. This is because the currency

65

FOREIGN EXCHANGE

The "ole of Treasury in Foreign xchange xposure #anagement The days of corporate treasuries being aggressive profit centers are long gone although there are a few that still survive. These days 0orporates are far more conservative with foreign exchange ris$ management and have reasonably well defined guidelines for the management of Forex ris$. ,t a minimum 0orporates should have a foreign exchange policy which spells out exactly what should be done with the foreign exchange ris$s they face. Tuite often this policy is developed in tandem with an exposure measurement process. For 0orporates with minimal ris$ exposure measurement may be a very simple process of forecasting what the cash receipts or payments are li$ely to be for a given period.

The #/4ecti5es o- Ris6 ,anagement


#inimize 0osts #aximize "evenue /tabilize #argins in the Future

(oreign Exchange Po)ic*


, good foreign exchange policy is critical to the sound ris$ management of any corporate treasury. .ithout a policy, decisions are made ad-hoc and generally without any consistency and accountability. Its important for treasury personnel to $now what benchmar$s they are aiming for and its important for senior management or the board to be confident that the ris$s of the business are being managed consistently and in accordance with overall corporate strategy.

66

FOREIGN EXCHANGE

Scenario P)anning - ,a6ing Rationa) 0ecisions


The recognition of the financial ris$s associated with foreign exchange mean some decisions need to be made. The $ey to any good management is a rational approach to decision ma$ing. The most desirable method of management is the pre-planning of responses to movements in what are generally volatile mar$ets so that emotions are dispensed with and previous careful planning is relied upon. This approach helps eliminate the panic factor as all outcomes have been considered including +worst case scenarios+, which could result from either action or inaction. Eowever even though the worst case scenarios are considered and plans ensure that even the +worst case scenarios+ are acceptable 1although not desirable2, the preplanning focuses on achieving the best result.

67

FOREIGN EXCHANGE

Economic Ex)osure* (urchasing (ower (arity and The International "isher Effect
xchange rates, interest rates and inflation rates are lin$ed to one another through a classical set of relationships, which have import for the nature of corporate foreign exchange, ris$. These relationships are; 162 Te purchasing power parity theory, which describes the lin$age between relative inflation rates and exchange rates3 1<2 The international Fisher effect, which ties interest rate differences to exchange rate expectations3 and 1:2 Te unbiased forward rate theory, which relates the forward exchange rate - to exchange rate expectations. These relationships, along with two other $ey LparityL lin$ages, are illustrated below; The 'urchasing 'ower 'arity 1'''2 theory can be stated in different ways, but the most common representation lin$s the changes in exchange rates to those in relative price indices in two countries.

"ate of change of exchange rate

&ifference in inflation rates

The relationship is derived from the basic idea that, in the absence of trade restrictions changes in the exchange rate mirror changes in the relative price levels in the two countries. ,t the same time, under conditions of free trade, prices of similar commodities cannot differ between two countries, because arbitragers will ta$e advantage of such situations until price differences are eliminated. This L)aw of Fne 'riceL leads logically to the idea that what is true of one commodity should be true of the economy as a whole--the price level in two countries should be lin$ed through the exchange rate--and hence to the notion that exchange rate changes are tied to inflation rate differences.

68

FOREIGN EXCHANGE

The International Fisher

ffect 1IF 2 states that the interest rate differential will

exist only if the exchange rate is expected to change in such a way that the advantage of the higher interest rate is offset by the loss on the foreign exchange transactions. This International Fisher ffect can be written as follows; The expected rate of change of the exchange rate 7 The interest rate differential

In practical terms the IF implies that while an investor in a low-interest country can convert his funds into the currency of the high-interest country and get paid a higher rate, his gain 1the interest rate differential2 will be offset by his expected loss because of foreign exchange rate changes. The 5nbiased Forward "ate Theory asserts that the forward exchange rate is the best, and an unbiased, estimate of the expected future spot exchange rate. The theory is grounded in the efficient mar$ets theory, and is widely assumed and widely disputed as a precise explanation. The LexpectedL rate is only an average but the theory of efficient mar$ets tells us that it is an unbiased expectation--that there is an e*ual probability of the actual rate being above or below the expected value.

69

FOREIGN EXCHANGE

The unbiased forward rate theory can be stated simply; The expected exchange rate 7 The forward exchange rate

8ow we can summarize the impact of unexpected exchange rate changes on the internationally involved firm by drawing on these parity conditions. Given sufficient time, competitive forces and arbitrage will neutralize the impact of exchange rate changes on the returns to assets3 due to the relationship between rates of devaluation and inflation differentials, these factors will also neutralize the impact of the changes on the value of the firm. This is simply the principle of 'urchasing 'ower 'arity and the )aw of Fne 'rice operating at the level of the firm. Fn the liability side, the cost of debt tends to adjust as debt is re-priced at the end of the contractual period, reflecting 1revised2 expected exchange rate changes. ,nd returns on e*uity will also reflect re*uired rates of return3 in a competitive mar$et these will be influenced by expected exchange rate changes. Finally the unbiased forward rate theory suggests that loc$ing in the forward exchange rate offers the same expected return as remaining exposed to the ups and downs of the currency -- on average, it can be expected to err as much above as below the forward rate. In the long run, it would seem that a firm operating in this setting will not experience net exchange losses or gains. Eowever, because of contractual, or, more importantly, strategic commitments, these e*uilibrium conditions rarely hold in the short and medium term. Therefore the essence of foreign exchange exposure, and, significantly, its management, are made relevant by these Ltemporary deviations.L

70

FOREIGN EXCHANGE

Identi-*ing Expos're
The first step in management of corporate foreign exchange ris$ is to ac$nowledge that such ris$ does exist and that managing it is in the interest of the firm and its shareholders. The next step, however, is much more difficult; the identification of the nature and magnitude of foreign exchange exposure. In other words, identifying what is at ris$, and in what way. The focus here is on the exposure of non-financial corporations, or rather the value of their assets. This reminder is necessary because most commonly accepted notions of foreign exchange ris$ hedging deal with assets, i.e., they are pertinent to 1simple2 financial institutions where the bul$ of the assets consists of 1paper2 assets that have with contractually fixed returns, i.e., fixed income claims, not e*uities. 0learly, at such times your assets in the currency in which they are denominatedL applies in general to ban$s and similar firms. 8on-financial business firms, on the other hand, have, as a rule, only a relatively small proportion of their total assets in the form of receivables and other financial claims. Their core assets consist of inventories, e*uipment, special purpose buildings and other tangible assets, often closely related to technological capabilities that give them earnings power and thus value. 5nfortunately, real assets 1as compared to paper assets2 are not labeled with currency signs that ma$e foreign exchange exposure analysis easy. #ost importantly, the location of an asset in a country is -- as we shall see -- an all too fallible indicator of their foreign exchange exposure. The tas$ of gauging the impact of exchange rate changes on an enterprise begins with measuring its exposure, that is, the amount, or value, at ris$. This issue has been clouded by the fact that financial results for an enterprise tend to be compiled by methods based on the principles of accrual accounting. 5nfortunately, this approach yields data that fre*uently differ from those relevant for business decision-ma$ing, namely future cash flows and their associated ris$ profiles.

71

FOREIGN EXCHANGE

,s a result, considerable efforts are expended -- both by decision ma$ers as well as students of exchange ris$ -- to reconcile the differences between the point-in-time effects of exchange rate changes on an enterprise in terms of accounting data, referred to as accounting or translation exposure, and the ongoing cash flow effects which are referred to as economic exposure. (oth concepts have their grounding in the fundamental concept of transactions exposure. The relationship between the three concepts is illustrated in the xhibit <. .hile exposure concepts have been aptly analyzed elsewhere in this Eandboo$, some basic concepts are repeated here to ma$e the present chapter self-contained.

Expos're in a simp)e transaction


The typical illustration of transaction exposure involves an export or import contract giving rise to a foreign currency receivable or payable. Fn the surface, when the exchange rate changes, the value of this export or import transaction will be affected in terms of the domestic currency. Eowever, when analyzed carefully, it becomes apparent that the exchange ris$ results from a financial investment 1the foreign currency receivable2 or a foreign currency liability 1the loan from a supplier2 that is purely incidental to the underlying exports or import transaction3 it could have arisen in and of itself through independent foreign borrowing and lending. Thus, what is involved here are simply foreign currency assets and liabilities, whose value is contractually fixed in nominal terms. .hile this traditional analysis of transactions exposure is correct in a narrow, formal sense, it is really relevant for financial institutions, only. .ith returns from financial assets and liabilities being fixed in nominal terms, they can be shielded from losses with relative ease through cash payments in advance 1with appropriate discounts2, through the factoring of receivables, or via the use of forward exchange contracts, unless unexpected exchange rate changes have a systematic effect on credit ris$.B Eowever, the essential assets of non-financial firms have non-contractual returns, i.e. revenue and cost streams from the production and sale of their goods and services which can respond to exchange rate changes in very different ways.

72

FOREIGN EXCHANGE

0onse*uently, they are characterized by foreign exchange exposure very different from that of firms with contractual returns. 'eas"res /f Acco"nting Ex#os"re
0urrent4 8oncurrent ,// T/ 0ash #ar$etable #ar$et Jalue2 ,ccounts "eceivable Inventory 1,t 0ost2 Fixed ,ssets )I,(I)ITI / 0urrent )iabilities )ong Term &ebt *uity 0 E "esidual ,djustment 0 0 "esidual ,djustment 0 0 "esidual ,djustment 0 0 "esidual ,djustment /ecurities 1,t 0 0 0 0 E 0 0 0 E E 0 0 0 E E 0 0 0 0 0 #onetary4 8onmonetary Temporal 0urrent

8ote; In the case of Income /tatements, sales revenues and interest are generally translated at the average historical exchange rate that prevailed during the period3 depreciation is translated at the appropriate historical exchange rate. /ome of the general and administrative expenses as well as cost-of-goods-sold are translated at historical exchange rates, others at current rates. L0L 7 ,ssets and liabilities are translated at the current rate, or rate prevailing on the date of the balance sheet. LEL 7 ,ssets and liabilities are translated at the historical rate.

73

FOREIGN EXCHANGE

,anaging Economic Expos're Economic E--ects o- 7nanticipated Exchange Rate .hanges on .ash ()o+s
From this analytical framewor$, some practical implications emerge for the assessment of economic exposure. First of all, the firm must project its cost and revenue streams over a planning horizon that represents the period of time during which the firm is Lloc$ed-in,L or constrained from reacting to 1unexpected2 exchange rate changes. It must then assess the impact of a deviation of the actual exchange rate from the rate used in the projection of costs and revenues.

Steps In ,anaging Economic Expos're


6. stimation of planning horizon as determined by reaction period. <. &etermination of expected future spot rate. :. stimation of expected revenue and cost streams, given the expected spot rate. 4. Estimation of effect on revenue and expense streams for unexpected exchange rate changes. ?. 0hoice of appropriate currency for debt denomination. K. stimation of necessary amount of foreign currency debt. @. &etermination of average interest period of debt. B. /election between direct or indirect debt denomination. 9. ecision on trade!off "et#een ar"itrage gains vs. exchange ris$ stemming from exposure in mar$ets #here rates are distorted "% contro&s. 6=. &ecision about LresidualL ris$; consider adjusting business strategy.

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FOREIGN EXCHANGE

/ubse*uently, the effects on the various cash flows of the firm must be netted over product lines and mar$ets to account for diversification effects where gains and losses could cancel out, wholly or in part. The remaining net loss or gain is the subject of economic exposure management. For a multiunit, multi-product, multinational corporation the net exposure may not be very large at all because of the many offsetting effects.@ (y contrast, enterprises that have invested in the development of one or two major foreign mar$ets are typically subject to considerable fluctuations of their net cash flows, regardless of whether they invoice in their own or in the foreign currency. For practical purposes, three *uestions capture the extent of a company+s foreign exchange exposure. 6. Eow *uic$ly can the firm adjust prices to offset the impact of an unexpected exchange rate change on profit marginsQ 2. 'o# (uic$&% can the firm change sources for inputs and mar$ets for outputs) *r+ a&ternative&%+ ho# diversified are a compan%,s factor and product mar$ets) :. To what extent do volume changes, associated with unexpected exchange rate changes, have an impact on the value of assetsQ 8ormally, the executives within business firms who can supply the best estimates on these issues tend to be those directly involved with purchasing, mar$eting, and production. Finance managers who focus exclusively on credit and foreign exchange mar$ets may easily miss the essence of corporate foreign exchange ris$.

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FOREIGN EXCHANGE

(inancia) 5ers's operating strategies -or hedging


.hen operating 1cash2 inflows and 1contractual2 outflows from liabilities are affected by exchange rate changes, the general principle of prudent exchange ris$ management is; any effect on cash inflows and outflows should cancel out as much as possible. This can be achieved by maneuvering assets, liabilities or both. .hen should operations -- the asset side -- be usedQ .e have demonstrated that exchange rate changes can have tremendous effects on operating cash flows. &oes it not therefore ma$e sense to adjust operations to hedge against these effectsQ #any companies, such as >apanese auto producers, are now see$ing flexibility in production location, in part to be able to respond to large and persistent exchange rate changes that ma$e production much cheaper in one location than another. ,mong the operating policies are the shifting of mar$ets for output, sources of supply, product-lines, and production facilities as a defensive reaction to adverse exchange rate changes. 'ut differently, deviations from purchasing power parity provide profit opportunities for the operations-flexible firm. This philosophy is epitomized in the following *uotation.

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FOREIGN EXCHANGE

The Phi)ip examp)e


It has often been jo$ed at 'hilips that in order to ta$e advantage of currency movements, it would be a good idea to put our factories aboard a supertan$er, which could put down anchor wherever exchange rates enable the company to function most efficiently...In the present currency mar$ets... WthisX would certainly not be a suitable means of transport for ta$ing advantage of exchange rate movements. ,n aeroplane would be more in line with the re*uirements of the present era. The problem is that 'hilips+ production could not fit into either craft. It is obvious that such measures will be very costly, especially if underta$en over a sshort span of time. it follows that operating policies are not the tools of choice for exchange ris$ management. Eence operating policies, which have been designed to reduce or eliminate exposure, will only be underta$en as a last resort, when less expensive options have been exhausted. It is not surprising3 therefore, that exposure management focuses not on the asset side, but primarily on the liability side of the firm+s balance sheet. Given above a summary of the steps involved in managing economic exposure. .hether and how these steps should be implemented depends first, on the extent to which the firm wishes to rely on currency forecasting to ma$e hedging decisions, and second, on the range of hedging tools available and their suitability to the tas$. These issues are addressed in the next two sections.

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FOREIGN EXCHANGE

Introduction to Derivatives
5nderstanding the word itself, derivatives, is a $ey to mastery of the topic. The word originates in mathematics and refers to a variable, which has been derived from another variable. For example, a measure of weight in pound could be derived from a measure of weight in $ilograms by multiplying by <.<. In the financial sense, a derivative is a financial product, which has been derived from a mar$et for another product. .ithout the underlying product and mar$et it would have no independent existence. /ome one may ta$e an interest in the derivative products without having an interest in the underlying product mar$et, but the two are always related and may therefore interact with each other. &erivatives can be derived from the many widely traded mar$ets, which are commonly $nown such as sugar, oil or foreign currency. &erivative mar$ets are made by the introduction of a new security having a specific relationship to the underlying cash or spot mar$et. The common derivative products are Forwards, Futures and Fptions and /waps. Forwards is a simply contract to ta$e delivery at an agreed price, *uantity and time in the future in the underlying mar$et. Future is same as forward except it is standardized in terms of contract size, traded on future exchanges and daily settled. Fption is rights, but not obligations to ta$e future delivery of an agreed *uantity at a certain price. /wap is a contract between two parties, referred to as counterparts, to exchange two streams of payments for an agreed period of time.

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FOREIGN EXCHANGE

&erivatives have come into existence because of the prevalence of ris$s in every business. These ris$s could be physical, operating and investment and credit ris$s. /ome of the ris$s such as movements in commodity mar$ets may be beyond our control. &erivatives provide a means of managing such ris$s. The need to manage external ris$ is thus one pillar of the derivative mar$et. 'arties wishing to manage their ris$s are called hedgers. /ome people and businesses are in the business of ta$ing ris$s to ma$e money that is for the possibility of a reward. These parties represent another pillar of derivative mar$et and are $nown as speculators. /ome derivative mar$et participants loo$ for mis-pricing and mar$et mista$es and ta$e advantage of these. These mista$es thus eventually disappear and never become too large. /uch participants are $nown as arbitrageurs.

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FOREIGN EXCHANGE

+istory and Develo)ment of Derivative !ar'ets


The explosion of growth in the derivative mar$ets coincided with the collapse of the (retton .oods fixed exchange rate regime and the suspension of the dollarDs convertibility into gold. xchange rates became much more volatile, and because interest rates affect and are affected by exchange rates, interest rates also became more volatile. , means of managing ris$ was re*uired. This need eventually resulted in the creation of the financial derivatives industry. Eistorical impetus to the growth of derivatives is shown in the table below
$ear 6C@6 6C@< 6C@: 6C@9 6C@? 6C@K 6C@@-@B !eve o#ments Innovations 0ollapse of (retton .oods 0hicago #ercantile xchange, 0urrency Futures nd of gold convertibility #anaged floating rates 0ommodity price swings Growing interest in commodity futures Jolatile interest rates Interest "ate Futures "ecession ,nother attempt at exchange8H #ercantile xchange nergy Futures

rate stability ! >amaica ,ccords 6C@B-@C uropean #onetary /ystem 6C@C 8H Futures xchange 6C@C4B= (ig (ang hits )ondon 6CB=-B6 Federal "eserve to target #oney)ondon International Futures xchange and not Interest rates 6CB6-B< "eagan "ecovery 'hiladelphia 0urrency /waps xchange, 0urrency Fptions,

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FOREIGN EXCHANGE

Recent Trends
Fn over fifty exchanges around the world some form of derivative instrument is traded. ,n important feature in the growth and development has been the evaluation and the maturing of the over-the-counter 1FT02 mar$et. .hile traded futures and options are suitable for most corporations3 often there are situations where only a custom-made solution will satisfy specific commercial and financial objectives. The Yfinancial engineersZ using the derivative products available on the major exchanges, can devise one-off products to satisfy such needs. Fften hybrid derivatives can be engineered to address the combined ris$s involving several mar$ets. To address these exposures, the financial strategist might use derivatives in combination, mixing futures and options, currencies and commodities and different maturities, all to achieve a particular objective. The last fifteen years have certainly changed the economic landscape with regard to the use of derivatives in the area of ris$ management. The mar$et has now matured3 many new products cannot be expected. (ut one thing is sure that use and acceptance of derivatives will increase by the wider business community.

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FOREIGN EXCHANGE

(erformance
&erivative financial products have certain features, which are designed to ma$e the product attractive and flexible to potential and existing users. From these features, various indicators of performance have been developed to assist the user in analyzing their value and how they will perform at various times under various circumstances. Eow a derivative contract in the any form may perform during the life of contract is affected by many factors. The factors that affect the performance are following; 5nderlying ,sset 'rice Time before xpiration The rate of Interest &ividends and 0oupons Jolatility

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FOREIGN EXCHANGE

"oreign Exchange Derivatives


The main foreign exchange lin$ed derivatives are currency forwards, currency futures, currency options and currency swaps and combination of the above. For borrowers, access to the currency derivatives ensures that they have access to the lowest cost capital mar$ets around the world. The integration of international capital mar$ets through foreign exchange derivatives mar$ets encourages a competitive cost of capital. In addition to this integration role, foreign exchange derivatives serve a very real purpose. Foreign exchange fluctuations affect the competitive positions of companies, the cost of borrowing abroad, and the returns on global investment portfolios. 'recise commercial and financial objectives can be managed through such derivatives.

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FOREIGN EXCHANGE

"orwards* "utures and O)tions


Forwards , Forward contract is an agreement between two parties- a buyer and a seller- to purchase or sell something 1say foreign currency2 at a later date at a price 1say in terms of domestic currency2 agreed upon today. F[ Jalue Forward , foreign exchange contract where the settlement of currencies ta$es place on any date beyond spot is called F[ values Forward or value Futright. This product is useful to obtain cover on future foreign currency receivables and payables. Time Fption Forward xchange 0ontract .here the foreign currencies have to be settled during a specified period in the future, the F[ 0ontract is called a Time Fption Forward xchange 0ontract. The start and end date for exercising the option 1for settlement of currencies2 is always specified while entering into the contract. The product is useful to cover forward receivables and payables where the exact date of such transactions is not fixed or $nown.

Futures , Future contract is evolved out of a forward contract and posses many of the same characteristics. In essence, they are li$e li*uid forward contracts. 5nli$e forward contracts however, futures contracts trade on organized exchanges called futures mar$ets. The contract has standardized amount and is subject to daily settlement procedure.

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FOREIGN EXCHANGE

Currency Futures , currency future is the price of a particular currency for settlement in a specified future date. , currency future contract is an agreement to buy or sell, on the future exchange, a standard *uantity of foreign currency at a future date at the agreed price. The counterpart to futures contracts is the future exchange, which ensures that all contracts will be honored. This effectively eliminates the credit ris$ to a very large extent. 0urrency futures are traded on futures exchanges and the most popular exchanges are the ones where the contracts are fungible or transferable freely. The /ingapore International #onetary xchange 1/I# [2 and the International #onetary #ar$et, 0hicago 1I##2 are the most popular futures exchanges. There are smaller futures exchanges in )ondon, /ydney, To$yo, Fran$furt, 'aris, (russels, Purich, #ilan, 8ew Hor$ and 'hiladelphia.

#ptions
Fption is a contract wherein the buyer of the option has the right but no obligation to buy or sell a specific *uantity of a particular asset, at a specified price at or before a specific date in the future. ,n option may increase, decrease or remain unchanged in value depending on the price around which the particular commodity is trading. Fptions may represent the right to buy or sell commodities, e*uities, currencies or even futures on other securities. ,n option on a future would allow the owner the right to buy or sell the future agreement at specific price within a specific time frame i.e. a derivative on a derivative. Fptions trade in organized mar$ets, much li$e the stoc$ mar$et, Eowever, a large amount of option trading is conducted privately between two parties who find that contracting with each other preferable to exchange. Fptions xchange as he counter party helps to minimize the counter party credit ris$. ,de*uate collateral is ensured by a mar$et-adjusted margin.

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FOREIGN EXCHANGE

Currency Options 0urrency options is a contract wherein the buyer of the option has the right to buy or sell a fixed amount of one currency versus another at a fixed rate on a date in future but has no corresponding obligation. The rate, currencies, amount and date are predetermined, at the time of entering contract. 0urrency options are useful tools to limit losses and for unlimited access to unlimited profit potential in volatile mar$et. .riting currency options is a profitable business in calm mar$et. Fption contracts are ideal while carrying out ongoing transactions where outcome is uncertain. Fption provides the best tools to hedge balance-sheet translation exposures. xample 6 will show hedging F[ ris$ through option. xample < will show a comparison of a Foreign 0urrency Forward 4 Future Eedge and Fption Eedge.

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FOREIGN EXCHANGE

!ore a%out "oreign Exchange O)tions and "utures


0urrency options and futures are among the oldest forms of options and futures products. Traded currency options are divided into two types- options on cash and options on futures. 0ash 0urrency Fption is the right to buy or sell a fixed *uantity of one currency in exchange for a specific *uantity of another currency in a ratio by a specific exchange rate at or before a specific future date. Futures 0urrency Fption is the right to buy or sell a traded currency futures contract at a specific futures price at or before a specific date in the future. 5sing these products many ban$s ma$e mar$ets in more complicated foreign exchange lin$ed derivatives such as currency swaps and long dated swaps and combinations of the above. ,ccess to currency options and futures ensures that borrowers have access to the lowest cost capital mar$ets around the world. Foreign exchange fluctuations affect the competitive positions of companies, the cost of borrowing abroad and the returns on global investment portfolios. 'recise commercial and financial objectives can be managed through products in foreign exchange mar$ets.

87

FOREIGN EXCHANGE

Swa)s
/waps are derivatives, which involve a private agreement between two parties to exchange cash flows in the future according to a prearranged formula. The underlying instruments are liabilities or assets with interest expenses or incomes. /waps can be broadly classified into two types ! interest rate swaps and currency swaps. The first recorded swaps were negotiated in 6CB6. /ince then, the mar$ets have grown very rapidly.

Wh* did s+aps emerge?


In the late 6C@=+s, the first currency swap was engineered to circumvent the currency control imposed in the 5I. , tax was levied on overseas investments to discourage capital outflows. Therefore, a (ritish company could not transfer funds overseas in order to expand its foreign operations without paying sizeable penalty. #oreover, this (ritish company had to ta$e an additional currency ris$s arising from servicing a sterling debt with foreign currency cash flows. To overcome such a predicament, bac$-to-bac$ loans were used to exchange debts in different currencies. For example, a (ritish company wanting to raise capital in the France would raise the capital in the 5I and exchange its obligations with a French company, which was in a reciprocal position. Though this type of arrangement was providing relief from existing protections, one could imagine, the tas$ of locating companies with matching needs was *uite difficult in as much as the cost of such transactions was high. In addition, bac$-to-bac$ loans re*uired drafting multiple loan agreements to state respective loan obligations with clarity. Eowever this type of arrangement lead to development of more sophisticated swap mar$et of today.

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FOREIGN EXCHANGE

What are s+aps?


, contract between two parties, referred to as counter-parties, to exchange two streams of payments for agreed period of time. The payments, commonly called legs or sides, are calculated based on the underlying notional using applicable rates. /waps contracts also include other provisional specified by the counter-parties. /waps are not debt instrument to raise capital, but a tool used for financial management. /waps are arranged in many different currencies and different periods of time. 5/A swaps are most common followed by >apanese yen, sterling and &eutsche mar$s. The length of past swaps transacted has ranged from < to <? years.

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FOREIGN EXCHANGE

Facilitators The problem of locating potential counter-parties was solved through dealers and bro$ers. , swap dealer ta$es on one side of the transaction as counter-party. &ealers wor$ for investment, commercial or merchant ban$s. L(y positioning the swapL, dealers earn bid-as$ spread for the service. In other words, the swap dealer earns the difference between the amount received from a party and the amount paid to the other party. In an ideal situation, the dealer would offset his ris$s by matching one step with another to streamline his payments. If the dealer is a counter-party paying fixed rate payments and receiving floating rate payments, he would prefer to be a counterparty receiving fixed payments and paying floating rate payments in another swap. , perfectly netted position as just described is not necessary. &ealers have the flexibility to cover their exposure by matching multiple parties and by using other tools such as futures to cover an exposed position until the boo$ is complete. /wap bro$ers, unli$e a dealer do not ta$e on a swap position themselves but simply locate counter-parties with matching needs. Therefore, bro$ers are free of any ris$s involved with the transactions. ,fter the counter-parties are located, the bro$ers negotiate on behalf of the counter-parties to $eep the anonymity of the parties involved. (y doing so, if the swap transaction falls through, counter-parties are free of any ris$s associated with releasing their financial information. (ro$ers receive commissions for their services.

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FOREIGN EXCHANGE

Swa) !ar'et (artici)ationDs


/ince swaps are privately negotiated products, there is no restriction on who can use the mar$et. Eowever, parties with low credit *uality have difficulty entering the mar$et. This is due to fact that they cannot be matched with counter-parties who are willing to ta$e on their ris$s. In the 5./. many parties re*uire their counter-parties to have minimum assets of A6= million. This re*uirement has become a standardized representation of Yeligible swap participantsL. The following list includes a sample of swaps mar$et participants; #ultinational companies /hell, I(#, Eonda, 5nilever, 'rocter G Gamble, 'epsi 0o. (an$s (an$s participate in the swap mar$et either as an intermediary for two or more parties or as counter-parties for their own financial management. /overeign and public sector institutions >apan, "epublic of Italy, lectricity de France, /allie #ae 15./. /tudent )oan #ar$eting ,ssociation2. /uper nationals .orld (an$, uropean Investment (an$, ,sian &evelopment (an$. #oney #anagers Insurance companies, 'ension funds.

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FOREIGN EXCHANGE

"oreign Exchange Swa)


, basic foreign exchange swap is the simultaneous purchase and sale of one currency for another, where the two contracts have different dates 1different positions of same or different amount on different dates2. -ash.'anagement S+a# It is used to realize efficient cash management or to adjust the maturity dates of existing forward contracts. 9and ing S"r# "s and !eficit -ash Positions The international scope of business conducted by financial and non-nonfinancial organization will often re*uire the management of cashflows in more than one currency. From time to time , an entity will find itself with surplus cash balance in one currency and deficit balances in another currency. /ee example :.

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FOREIGN EXCHANGE

8etting o- (oreign Exchange Expos'res


Frganization will often face situations where there are offsetting foreign currency inflows and outflows. The ideal situation in the most cases would occur if the amounts were e*ual and cash flows materialized on the same day. That seldom happens, however, and mismatches in timings and amounts predominate. If the issue is timing, the problem is a cash management issue similar to topic discussed above. The company may invest the temporary surplus or borrow to fund the temporary deficit. ,lternatively, it may do a cash-management swap. If the problem is not just timing of cash-flows, but also different amounts of incoming and outgoing cash, then cash manager may view the difference as one exposure and handle it using forward contracts, currency options, or spot contracts.

Swapping Forward Contracts Forward at Historical Rates 0orporations often face considerable uncertainty in timing and4or amount when forecasting currency cash flows. Forward contracts that were dealt to hedge such flows may mature on a date that does not match the actual cash flow. In such cases, the maturity of the original forward contract creates cash flows for which there is no immediate offset. Fnce again, the cash manager can borrow to fund the deficit, invest the surplus, or execute a cash-management swap. ,nother method to deal with this type of situation is to swap contracts at historical rates. This method involves dealing a swap in which the spot sale is dealt at a rate e*ualing the original forward contract rate. The new forward contract consists of the maturing forward rate adjusted by the current points and a wor$ing capital interest factor.

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FOREIGN EXCHANGE

Eistorical-rate rollovers have the same basic economic as mar$et-rate saps. They also eliminate the need for any cash settlements on the original maturity date and avoid the accounting problems fre*uently associated with the F[ gain4loss account. Fn small forward contracts, the actual dollar amount of the net settlement may be small, and cost of settling may be excessive given the amount involved. In other cases, an entity may not have the cash to settle on the swap but still want the swap done. ,s a general comment, usage of historical-rate swaps varies from mar$et to mar$et, but this type of swap is not a heavily traded transaction. Fne of the major reasons is its susceptibility to abuse.

Investment Swaps Investment swaps are investments in a foreign currency asset, which have no foreign exchange ris$. In most cases, the ris$ is eliminated by the execution of a foreign exchange swap. The most common investment swap is not li*uid, although a semili*uid swap can be dealt. The appeal of the investment swap to the investor is higher yield. 0redit ris$ is usually comparable to other ban$ paper.

Negotiable Investment Swaps The underlying foreign currency investment vehicle in most swaps is a ban$ term deposit that is nonnegotiable. (ecause the underlying deposit is illi*uid, the swap is also illi*uid. Eowever, a swap could be done using a negotiable investment such as treasure bills, ban$erDs acceptances, or commercial paper. In this case the investment could be li*uidated, although not as simple as if underlying currency of investment is home currency. To li*uidate the swap, the investor would sell the negotiable investment of underlying foreign currency and unwind the outstanding forward contract by doing a foreign exchange swap.

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FOREIGN EXCHANGE

Borrowing in Foreign Currencies (orrowers in todayDs mar$ets have a variety of ways of raising money. /ome borrow in foreign currency because they have revenues in that currency which was used to service debt. Fthers borrow in another currency because they believe that the currency being borrowed will wea$en, thereby reducing the overall cost of borrowing. Fther borrowers in foreign currencies have no offsetting revenues and do not want to incur any foreign exchange ris$. They will fully hedge their foreign borrowings by means of a foreign exchange swap transaction in much the same way investorsD hedge their foreign fixed income investments.

Swaps Using Currency Options In managing foreign currency exposure in foreign currency investment, three principal alternatives are available; 6. The first alternative is simply to leave the exposure un-hedged for the time being. Eowever, doing nothing has considerable ris$, which may be beyond the ris$ that the investor wants to assume. <. :. , second alternative is to use forward contracts. &oing so, however, will generate a return similar to investment made in home currency. The third alternative is currency options.

Currency Swaps ach entity has a different access and different long term needs in the international mar$ets. 0ompanies receive more favorable credit ratings in their country of domicile than in the country in which they need to raise capital. Investors are li$ely to demand a lower return from a domestic company, which they are more familiar with than from a foreign company. In some cases a company may be unable to raise capital in a certain currency.

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FOREIGN EXCHANGE

0urrency swaps are also used to lower the ris$ of currency exposure or to change returns on investment into another, more favorable currency. Therefore, currency swaps are used to exchange assets or capital in one currency for another for the purpose of financial management. , currency swap transaction involves an exchange of a major currency against the 5./. dollar. In order to swap two other non-5./. currencies, a dealer may need to arrange two separate swaps. ,lthough, any currency can be used in swaps, many counter-parties are unable to exchange their currencies due to a lac$ of demand. /ince currency swap transaction involves the exchange of two or more types of currencies, the actual exchange of principals ta$es place at the commencement and the termination of the swaps in addition to exchange of interest payments on agreed intervals. The exchange of principal and interest is necessary because counter-parties may need to utilize the respective exchanged currencies. The uses of currency swaps are summarized below; )owering funding cost ntering restricted capital mar$ets "educing currency ris$ /upply-demand imbalances in the mar$ets

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FOREIGN EXCHANGE

,s for interest rate swaps, many variants of the plain vanilla currency swaps were created to meet some of the common financial management needs. ,mortizing currency swaps The notional principals of these swaps are scheduled to decrease over the life of the swaps. Therefore, principals are exchanged accordingly. ,ccreting currency swaps The notional principals of these swaps increase periodically. 'rincipals are exchanged as scheduled. Floating- for -floating rate currency swaps ,s indicated by the name, this swap involves the exchange of a floating interest rate payment schedule in one currency against another floating interest rate payment schedule in another currency.

97

FOREIGN EXCHANGE

Swa) Documentation
/wap agreements are usually initiated over the phone. The phone agreements are confirmed, usually within <9 hrs., by a telex, fax or letter. The agreement is not final until proper documentation covering all the relative issues are exchanged and signed by counter-parties. 8ew Hor$ based International /wap and &erivatives ,ssociation 1I/&,2, (ritish (an$erDs ,ssociation 1((,2 and ,ustralian (an$erDs ,ssociation standardized the documentation of swap. ((,+s code ((,s Interest "ate /wap 1((,I"/2 focuses primarily on the documentation of interban$ swaps and the ,ustralian (an$er+s ,ssociation+s code focuses on documenting ,ustralian interest rates swaps. In, 6CB@, I/&, introduced two standards forms of agreements. The Interest "ate /wap ,greement is an agreement for 5/ dollar denominated swaps. This master swap agreement is based on the 6CBK "evised Jersion of the 0ode of /tandard .ording, ,ssumptions and 'rovisions for /waps. The other master swap agreement is called the Interest "ate and 0urrency xchange ,greements. This agreement is used for currency swap and interest rate swaps in any currency. ,ny new swap is a supplement to this master swaps agreements. The standardization of swap agreements eliminated many impediments to the swap mar$et. The decrease in the number of hours spent on drafting agreements lowered legal expenses as well as expedited the transaction process. The standardization allowed dealers to match potential counter-parties with more ease and allowed existing counter-parties to reverse swaps with fewer complications.

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FOREIGN EXCHANGE

The documentation covers the following issues; 'ayments "epresentations ,greements vents of &efault and Termination vent Transfer Tax matter 0redit /upport &ocumentation xiting /wap ,greement Following are ris$s associated with swaps; Interest rate ris$ xchange rate ris$ &efault ris$ /overeign ris$ #ismatch ris$ 1for dealers only2 In 6CB@, a set of principal were arranged by the central ban$ing authorities of the Group of Ten plus )uxembourg $nown as the (asle /upervisor+s 0ommittee to standardize capital re*uirements across nations. ,ccording to this set of re*uirements, called the (asle ,ccord, dealers of swaps and other off-balance sheet instruments are imposed ris$-adjusted capital re*uirements.

99

FOREIGN EXCHANGE

Exam)les "rom Indian !ar'et


SBI-HU CO enter into yen swap deal Fur (ureau, #5#(,I, ,ug. @ (usiness )ine, ,ugust B, 6CCB /T,T (an$ of India has entered into a long-term rupee- >apanese yen swap with Eousing and 5rban &evelopment 0orporation 1E5&0F2. ,ccording to a press release, E5&0F has swapped its foreign currency liability of Hen <.BC billions for e*uivalent rupee resources with /(I for a tenor of 6= years. 5nder the arrangement, E5&0F will deposit its yen with /(I on the day of transaction and /(I in return will pay the e*uivalent rupee resources to E5&0F. ,ccording to officials, the swap will be done at the prevailing exchange rate on the day of the transaction. ,ccording to officials, E5&0F will use the rupee resources for lending to their projects in India. The overseas branches of /(I in >apan to fund their own assets will use yen. ,s per the swap agreement, /(I would provide the long-term hedge to E5&0F for a period of 6= years to cover the exchange ris$ of the foreign liability. ,s a result of this, the swap will neutralize both the exchange rate ris$ and interest rate ris$ of E5&0F on yen loan by converting the yen flows into ris$ neutral fixed interest rate rupee flows for the company. ,t the end of 6= years, E5&0F will ta$e bac$ the yen by giving the rupee e*uivalent to /(I. arlier /(I had struc$ a rupee-dollar swap of sizable transaction with I0I0I. ,t present, the ban$ is considering similar deals with companies, which do not have international presence to manage the foreign currency ris$ effectively, said an official.

100

FOREIGN EXCHANGE

The ban$ is actively involved in developing the derivative mar$et in India by facilitating the use of hedging instruments such as currency swaps. This has been possible after the permission was granted by the "eserve (an$ of India to enable the corporate to obtain suitable hedge for their exposures arising out of their foreign currency loans.

101

FOREIGN EXCHANGE

Nalco contains loss on yen loan via swap deal " "adha$rishnan, #5#(,I <? >58 The conomic Times, >une <K, 6CCB 8,TIF8,) ,luminum 0o 18alco2 has hedged its Hen <=-billion loan by swapping ?= per cent of the principal into 5/ dollars when the yen was at 699.6? against the dollar. )ast wee$ the yen tumbled to 69@ to a dollar. The yen bullet loan is due for redemption on /eptember, 6CCB. (y covering its exposure, 8alco has insulated itself against possible foreign exchange fluctuations. The benefits arising from sharp depreciation of the yen against the 5/ dollar was partially nullified by the simultaneous depreciation of rupee. \\&epreciation of one yen to "s 6.:= to neutralizes the effect on the loan,++ said #r. 0 Jen$atramana, finance director, 8alco. In other words, there will be no impact on the bottom-line of 8alco as far as the fluctuation is within this range mentioned above. Further, 8alco has par$ed about Hen 6= billion and A6K million in the exchange earners foreign currency 1 F02 account abroad. The F0 corpus would more than mitigate the forex ris$ and its impact on the loan.

102

FOREIGN EXCHANGE

Interest Rate Swa)s


&hat are interest rate s+a#s 7IRS8: The most common type of interest rate swaps are Yplain vanillaZ I"/. Eere, one party , agrees to pay to the other party (, cash flows e*ual to interest at a predetermined fixed rate on a notional principal for a number of years. /imultaneously, , agrees to pay party ( cash flows e*ual to interest at a floating rate on the same notional principal for the same period of time. The currencies of the two sets of interest cash flows are the same. #oreover, only the difference in the interest payments is paid4received3 the principal is used only to calculate the interest amounts and is never exchanged. ,n example will ma$e the concept clear; )etDs consider a swap agreement between parties , and ( initiated on /eptember 6, 6CCC. Eere , agrees to pay the K-month 8/ -#I(F" rate on a notional principal of "s. 6 cr, while ( pays a fixed 6<.6?M rate on the same principal. .e assume that payments are to be exchanged every six months and the 6<.6?M interest rate is to be compounded semiannually. This swap can be depicted diagrammatically as shown in Figure 6;

It must be noted that I"/ are different from Forward "ate ,greements 1F",2. .hile in F",, a certain interest rate applies for a certain period of time in the future3 an I"/ is a portfolio of F",Ds. ,ll I"/ can be decomposed into separate F",Ds. The basic purpose in entering an I"/ is to transform the nature of a liability or asset. , swap can be used to transform a floating rate loan into a fixed rate loan, or vice versa. To understand this, consider that in the above example, , had borrowed a : yr 6 crore loan at 6<M.

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This means that following the swap, it will; 1a2 pay 6<M to the lender, 1b2 receive 6<.6?M from ( 1c2 pay K month #I(F"

Thus, its 6<M fixed loan is transformed into a floating rate loan of #I(F"!=.6?M. /imilarly, if ( had borrowed at #I(F"S6.?=M, it can transform this loan to a fixed rate loan N 6:.:?M. Figure < summarizes this transaction; I"/ can also be used to transform assets. For e.g., a fixed rate earning bond can be transformed into variable rate earning asset and vice versa. In the above example, it could be that , had a bond earning #I(F"S=.?M and ( a bond earning 6<.?M interest compounded semiannually. The swap would then result in , receiving a fixed income of 6<.K?M and ( receiving a variable income of #I(F"S=.:?M. This can be shown diagrammatically as follows;

8ormally, a ban$ or financial intermediary is involved in the swap which matches the two re*uirements of two parties, and guarantees payments. It charges a commission for this. The two parties often do not even $now who the other party is. For them, the intermediary is the counter-party.

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In our example, if a financial institution charging 9 basis points were acting as intermediary, the swap would loo$ as follows;

&hy do firms enter into interest rate s+a#s: ,s we have seen, firms can use I"/ to transform assets and liabilities. (ut then, why donDt firms ta$e the desired form of loan or asset 1fixed or floating2 in the first placeQ The comparative advantage theory explains this behavior to some extent. 0ontinuing with the same example, let us assume that ,D credit rating is better than (, and , and ( can raise loans for fixed and floating rates as per Table 6; Table 6; Firm , Firm ( Fixed rate loan rate 6<M 69M Floating rate loan rate #I(F"S=.<=M #I(F"S6.?=M

These figures are consistent with the example in figure <. Eere, we see that though firm , can borrow cheaply compared to firm ( in both the mar$ets, the difference in rates available is not the same. Firm ( has a comparative advantage in the floating rate mar$et because it pays only 6.:=M higher here, compared to the <M difference in the fixed rate mar$et. /o, firm ( will borrow at a floating rate, and firm , at fixed rate. ,fter the swap deal, the cost of the floating rate loan to firm , will be #I(F"=.6?M, a clean gain of :? basis points. /imilarly, firm ( also gains :? basis points, because the cost of its loan will be 6:.:?M only, after the swap. Thus, both parties gain from the swap.

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In a perfect mar$et however, the spread between fixed and floating rates offered should vanish due to I"/. This is not seen in reality, and spreads continue to persist. /o, the credit ratings of the firms are not the only criteria by which lenders judge firms, and the comparative advantage theory continues to hold. Fther reasons for using I"/ are speculation on future interest rate movements, management of asset-liability mismatch, altering debt structure, off-balance sheet gains, and interest ris$ management. It has been observed that F",Ds are more popular for hedging against interest ris$s, while I"/ are more popular for speculation and transforming nature of assets and liabilities.

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!ypes o" IRS .e have discussed the plain vanilla swaps till now. These swaps can be subdivided into swaps made directly between two parties or with an exchange. #oreover, they can be classified on the basis of the floating reference rate used, which may be )I(F", 0' rate, T-(ill rate, etc. ,part from Yplain vanillaZ I"/ discussed above, there are several other types of swaps. %asis S+a#s ! where both the legs are floating interest rates Amorti=ing S+a# ! where the principal reduces in a predetermined way to correspond to the amortization schedule on a loan. Ste#."# S+a# ! where principal increases in a predetermined way !eferred<For+ard S+a# ! where parties do not begin to exchange interest payments until some future date -ombinations +ith -"rrency S+a#s ! where fixed rate in one currency is exchanged with floating rate in another currency Extendab e S+a# ! where one party has the option to extend the life of the swap beyond the specified period P"ttab e S+a# ! where one party has the option to terminate the swap early S+a#tions ! which are options on swaps -onstant 'at"rity S+a# 7-'S8 ! where )I(F" is used as referance rate

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-onstant 'at"rity Treas"ry S+a# 7-'T8 ! where )I(F" is exchanged for a particular Treasury rate Indexed Princi#a S+a# ! where the principal reduces based on an index of interest rate levels !ifferentia S+a# - where a floating rate in domestic currency is exchanged for a floating rate in foreign currency, with both interest rates applied on same domestic principal %ack Va "ed S+a#s ! where past effective dates are used Pre#aid S+a# ! where the fixed leg payer pays his obligations in advance, and only receives payments till maturity, Pero coupon swaps are exactly opposite to prepaid swaps, where the whole payment is given at the maturity.

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History and Evolution


,fter the fall of the (retton .oods /ystem, the government of the Great (ritain undertoo$ various steps to prevent the downslide of the 'ound and instituted new internal controls. Fne of the control measures was the creation of the &ollar premium mar$et to discourage the direct foreign investment. Eowever, this created opportunities for financial ingenuity by the (ritish merchant ban$ers. To avoid &ollar premium, 'arallel )oans were introduced. Eere, the parties were re*uired to exchange the principal on the value date. &uring the life of the contract, each party was to pay the interests on the currency it had received. The next crucial step was the introduction of the (ac$-to-bac$ )oans, in which the loan was directly arranged between two parent companies in different countries and structured under one agreement. 'arallel )oans were strictly designed to satisfy the letter of the law. That is why four entities ! the parent and the subsidiary in each of the two different countries ! had to be involved in structuring each loan. In (ac$-to-bac$ loans, the intermediary level of the subsidiary was eliminated. (ac$-to-bac$ loans tested the legal waters and did not face any problems. In (ac$-to-bac$ )oans, only one documentation covered the transaction. These two instruments played an important role in paving the way for the emergence of the /waps.

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-"rrency S+a#s The brea$down of the (retton .oods /ystem had opened up a whole new area of the foreign exchange trading. In a deregulated mar$et, ban$s could offer products to the clients, collect a fee, and improve their profit margins. Gaining entry into the 'arallel and the (ac$-to-bac$ )oans was easy for the ban$s. (ut two problems began to emerge. Fne was the old issue of the paperwor$, except that increased volume of the loans gave a new urgency to its resolution. The other problem was related to accounting. (oth of the above mentioned loans were recorded as two separate transactions. This ignored the contingent nature of the loans, inflated the balance sheets and distorted the accounting ratios that were used in analyzing the financial health of the ban$s. The answer, drawing heavily on the experience of the swap networ$, came in the form of the 0urrency /waps. In a 0urrency /wap, the notional amount of the trade was designated as off-balancesheet, and payment of interest by each party was made contingent upon the other partyDs performance. .ith the principal amount of the 0urrency /wap no longer subject to the counterparty default ris$, it was possible to classify swaps as offbalance-sheet instruments. Incorporating the cash-flow structure of the (ac$-to-bac$ )oans into the legal notion of the contingency too$ the 0urrency /wap one step further from being a concept and made it a financial instrument as well. The early 0urrency /wap deals were not disclosed to the public because of the proprietary nature. In 6CB6, the .orld (an$ and I(# announced a 0urrency /wap deal which was well publicized and gave an impetus to the swap mar$et.

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Interest Rate S+a#s (uilding on the two important features of the 0urrency /waps - contingency of the payments and the off-balance-sheet nature of the transaction - international ban$s created and then expanded the idea of the I"/ mar$et. ,lthough I"/ were created based on the concept of the 0urrency /waps, a different set of circumstances brought about their explosion. The birthplace of the I"/. E"ro market (eginning in the +?=s, the /ocialist governments began to deposit their hard currency holdings in uropean ban$s because they were concerned that, in the 0old .ar environment of the +?=s, the 5/ would freeze their assets. Eowever these deposits were not enough to create and sustain a large mar$et. It was the &ollar holdings of the 5/ corporations that created the uro mar$et, as it was against the outflow of the 5/ funds that the Interest *ualization Tax ,ct 1I T,2 was passed 1I T, created a strong incentive for the 5/ investors to $eep their &ollars in urope2. The uro mar$et was created because of the higher rates of return in urope and it was sustained due to the tax differentials that could not be arbitraged because of the sovereignty. uro mar$et was a concept of the laissez-faire. Transactions in this mar$et are mostly wholesale in the nature and the interest rates are heavily influenced by the availability of, and demand for the funds. )oans in this mar$et are basically variable in nature and if necessary, on a roll over basis with fixed maturities and non-prepayment clauses. uro mar$et, where the urodollars are traded, is the

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,s the +B=s began, interest rates in the 5/ mar$et reached unprecedented high levels and this trend split into the rate-sensitive uro mar$et. /o the corporations sought hedging vehicles against interest rate fluctuations. This was the starting point of the I"/. Eere, the parties agree to the exchange of the interest payments calculated on a notional amount. Eowever, interest payments in the I"/ are based on the different modes of the same currency. Thus, we can see that I"/ or more precisely the swap mar$et was born as insurance mar$et directly related to the uro mar$et loans. This insurance mar$et fuelled and sustained the swap mar$et. /waps became insurance vehicle of the borrowers because their premiums were borrowed. Secondary Factors in the !eve o#ment of the S+a# 'arket ,s international barriers to financial mar$ets began to disappear, swap dealers were able to switch between different indexes and different mar$ets. (y arbitraging capital and credit mar$ets, they were able to borrow at the best index available and then swap to the desired index. Eeavy borrowing by the 5/ government and government agencies in the +B=s played a major role in the development of the swap mar$et. (orrowing at the floating rates and swapping to the fixed rates met the needs of the corporations and in effect added to the depth and the li*uidity of the swap mar$et. Ta$ing a view on the future direction of the interest rates, swaps can be proved to very attractive instrument, and under a variety of yield curve conditions, they are among the cheapest to transact. /peculative trading of the swaps added enormously to the depth and li*uidity of the mar$et.

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A Brief Look at the Global Markets


,fter the first swap in 6CB6, the interest rate swap mar$et has exploded. In 6CCB, the annual turnover, in terms of notional principal, is around A:< trillion. The mar$et is regulated by the local level exchanges, which together form the International /wap and &erivatives ,ssociation 1I/&,2. I/&, has set for the guidelines and the regulatory framewor$, and most of the local regulations are based on these. I/&, has about 6=9 members, and it publishes regular statistics about the mar$ets. It also holds conferences and spreads awareness of the instruments. I/&, has contributed significantly to the standardization and documentation of swaps and conse*uently, their acceptance in financial mar$ets. The I/&, #aster &ocument is used to record swaps. #ost of the I"/ deals are pegged to the six-month )I(F". The *uotations for the fixed rate are normally in terms of basis points over the 5/ T-bill rates. #ost swaps are of duration of < to K years, with swaps as long as 6? years also having been recorded. I"/ are mature products, and there are widely accepted theories and research on their pricing and various varieties. #ost players have ade*uate systems and exposure limits to internally control their ris$ management. 8ew forms of swaps $eep on emerging, and then, theories for pricing them also follow. Gradually small ban$s and corporates have also realized the usefulness of swaps as hedging instruments, and their use is still increasing. For the last ? years, the turnover for I"/ has been increasing by about <?-:=M annually. It must also be noted that more than B=M of the deals are speculative in nature, and this will continue to be the case in the future in world mar$ets. /waps in currencies other than 5/& have gradually come of age, and now, form substantial part of the total swap mar$et.

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(resent Scenario of the Indian !ar'et


#enesis o" t$e Interest Rate Swaps in India Interest rates in India have been "(I determined for decades now. In the past five years, we have seen this situation changing. Gradually, India is moving towards a mar$et determined interest rate regime. "(I is gradually freeing interest rates, and this has forced ban$s to manage ris$s on their own. #oreover, the Indian companies were used to the earlier easy go approach and surety in interest rates that they can borrow on. (ut now, corporates have a plethora of rates at which they can borrow. They have the option of loans lin$ed to fixed or floating rates. Thus, Indian companies have to be self sufficient with regards to management of financial uncertainties, li$e firms are elsewhere in the world. .ith all this deregulation and integration with global practices, there was a felt need for instruments to hedge against various ris$s. &erivatives for the money mar$et were the next logical step in the process. This is exactly what "(I has done. The "(I GovernorDs /tatement on O#id-Term "eview of #onetary and 0redit 'olicy for 6CCB-CCD announced on Fctober :=, 6CCB, indicated that to further deepening the money mar$et and to enable ban$s, primary dealers 1'&s2 and all-India financial institutions 1FIs2 to hedge interest ris$s, the "(I had decided to create an environment that would favour the introduction of Interest "ate /waps. ,ccordingly, on >uly @,6CCC "(I issued final guidelines to introduce I"/ and Forward "ate ,greements 1F",s2. The players are allowed to practice I"/4F",s as a product for their own balance sheet management and for mar$et ma$ing purposes. The "(I has been criticized for being hasty in introducing such interest rate derivatives. It was said that our debt mar$et is not mature enough to incorporate and deal with such products.

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Though the Indian debt mar$et has not been properly developed, blaming the "(I move does not seem to be proper because these products will have to be introduced sooner or later and the present time appears to be as good a time as any other. #oreover, this move may also help in *uic$ening the development of a mature debt and money mar$et.

The 1ega) (rame+or6: RBI 9'ide)ines (S'mmar*"


, brief summary of "(I guidelines regarding I"/ issued on >uly @, 6CCC follows; Interest rate swap refers to a financial contract between two parties exchanging a stream of interest payments for a notional principal amount on multiple occasions during a specified period. Forward rate agreement 1F",2 is being defined as the same on settlement date for a specified period from start date to maturity date. The P ayers /cheduled commercial ban$s excluding regional rural ban$s, primary dealers 1'&s2 and all-India financial institutions have been allowed to underta$e I"/ as a product of their own asset liability management and mar$et-ma$ing purposes. Ty#es (an$s4'&Ds 4FIDs underta$e different types of plain vanilla F",Ds4I"/ for interest rate ris$s arising on account of landings or borrowings made at fixed or variable interest rates. Eowever, swaps having explicit4implicit option features li$e caps, floors or collars are not permitted. %enchmark rate The players can use any domestic money or debt mar$et rates as reference rate for entering into F",4I"/, provided methodology of computing the rate is objective, transparent and mutually acceptable to counter-parties. The reason stated for the same is that the benchmar$ rate is expected to evolve on its own in the mar$et.

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/ize of the notional principal amount; There will be no limit on the maximum or minimum size of the notional principal amounts of F",Ds4I"/ or the tenor of the I"/4F",Ds. "egarding the exposure limits the ban$s3 FIDs and '&Ds have to arrive at the credit e*uivalent amount for the purpose of rec$oning exposure to counter-party. Ex#os"re The exposure should be within the sub-limits and this should be fixed for the F",Ds4I"/ to corporates4FIDs, ban$s4'&Ds by the participants concerned. In case of the ban$s and the FIDs, the credit exposure should be within the single4group borrower limits as prescribed by the "(I.

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Recent IRS eals in India The following table summarizes recent deals in Indian mar$ets;
Sr3 *o3 %"yer Se er Reference "sed rate*otiona amt 7Rs3 6 <] I0I0I 0redit )yonnais &eutsche (an$ Jysya (an$ #ibor ]5/& )ibor month -rores8 <? two-6= dollar 6< < months Tenor 7mths8

starting end->uly 6= 6== 6< K

premium prevailing : 9 0enturion (an$ /tandard (an$ ? K Times (an$ /tandard (an$ @ B C 6= 66 6< /tandard 0harteredI0I0I "I) "I) I 0 International 0hartered lectrolux Ielvinator ,m x (an$ -8,8/ -#ibor 8/ #ibor #ibor "euterDs #ibor -8,<? ?= -8,-8,-8,6= I0I0I at the end of >uly "euterDs #ibor lectric Group-8,-

0harteredGeneral 0ompany Indian

0apital#ibor "euterDs #ibor

-8,<?

: 6<

0orporation 0hartered&eutsche (an$

6< 6< -8,K 6 :

(an$ ,(8-,#"F (an$ E&F0 (an$ E&F0 ban$ /tandard (an$ Jysya (an$

]The "(I canceled the deal because the use of foreign reference rates for swaps is not permitted.

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FOREIGN EXCHANGE

Trends in Indian ,ar6ets


(efore coming to the actual trends in the mar$et, let us loo$ at the players. #ost of the active participation is by foreign ban$s, followed by Indian ban$s, corporates and finally, FIDs. The absence of nationalized ban$s from the I"/ scene is noteworthy. Today, if a corporate wishes to enter an I"/ deal, it will have to submit the following to its ban$er; 0ertified copy of the firmDs #emorandum and ,rticles of ,ssociation (oard resolution authorizing derivative deals ,n I/&, #aster ,greement "is$ disclosure statement 0ertificate showing underlying loan exposure , certificate stating that I"/ is for hedging ris$s, not for speculation. Thus, we see that I"/ today can be used by corporates only for an actual hedging exercise, and it has to have board permission. #oreover, the deal would be within the exposure limits of that firm for the ban$ with which it is dealing. These measures are to ensure that corporates do not underta$e speculative activities, and start dealing only after they have proper ris$-management systems in place. Fn the first day of trading, more than := deals were recorded, worth over "s, K== crores in notional principal terms. "s. ?== crores of this was accounted for by corporate deals. The rush was because the uropean and private ban$s wanted to be a part of the history, dealing on first day, rather than actual hedging. It has also been reported that some deals were circular between three players, with no real effect in any playersD position. 8o deal was stuc$ for more than a yearDs tenor.

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/ince the first day, there have been almost no deals, and the mar$ets are cold. The reasons for this are many. ,t the short-term level, almost all the players expect the interest rates to go down in the next few months. This means that there are no conflicting views among players about interest rates, and so I"/ deals are not very tempting. ,gain, there are very few floating rate loans around. These and other fundamental reasons have been discussed in the next section. In spite of these, there are many underlying reasons for going for I"/. Today, the major financial intermediaries viz. Indian ban$s, foreign ban$s, financial institutions, and corporates have radically different sets of asset-liability structures. Thus for ,)# alone, I"/ are a good options. For example, the FIDs have much of their liabilities as bullet repayment bonds, and the bul$ of their assets by way of installment repayment loans. Thus, chances are that their liabilities portfolio is longer than their assets portfolio. 0ommercial ban$s, on the other hand, have bul$ of their liability portfolio in relatively short-term maturities, and assets are at longer maturities with fixed interest rates. Thus, ban$s and FIDs alone can enter in a lot of mutually beneficial deals. This can be diagrammatically represented as in Figure ?. 0orporates would also li$e to hedge their interest rate ris$s, and convert their fixed rate loans to floating rates, now that the options are available. Eowever, their needs would be medium term in nature 1< to B years2, and as yet there are no ta$ers for this long maturity. The mar$et is only about < months old now, and is yet to evolve. The li$ely problems in its evolution and the future are discussed in the following chapters.

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FOREIGN EXCHANGE

O%stacles to Develo)ment of IRS in India


.hen we tal$ of I"/, we are actually referring to derivatives based on underlying instruments, which are lin$ed to interest rates. 8ow, for a good derivatives mar$et for any underlying instrument, the mar$et for that instrument should be well developed, mature and competitive. Eowever, in India, we do not have a very mature and competitive money mar$et, especially the term money mar$et and the floating rate loan mar$et. Thus, the derivatives based on these instruments are bound to be far and few. #oreover, India does not even have a very good inter-ban$ rate measure for different parties, which are acceptable to all parties. Then, ris$ management systems are almost non-existent in most corporates. These and other obstacles in development of the I"/ mar$et have been discussed in greater detail below. *on.avai abi ity of an Acce#tab e %enchmark Rate For long term swaps in the international mar$et, the accepted benchmar$ is the inter-ban$ offer rate3 the fixed rate *uotation is against three4six-month )I(F". (ut in India, there is a problem because in the current stage of development of the money mar$et, the inter-ban$ money mar$et is not very li*uid. (ig public sector ban$s are not very active in the term money mar$et and their full participation, not just as end users but also as mar$et ma$ers, will be necessary if the term money mar$et is to become li*uid. Fnly then would more acceptable benchmar$ rates li$e :-month #I(F" and K-month #I(F" would evolve and be widely accepted. 8ow only rates for overnight money come close to being an acceptable benchmar$ among most players are widely accepted. Though : months 0', T-bill auction cutoffs and other rates are available, a complete rupee yield curve across the maturity spectrum is not available and even when they are available3 they are not acceptable to both the contracting parties. Fnly when the mar$et matures and the desired rates for I"/ evolve, will the I"/ mar$et itself emerge with deals, which are of medium term nature, rather than being restricted to the current very short-term deals.

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,ack of a !eve o#ed Term.'oney 'arket The biggest problem continues to be the structure of the money mar$et. Two-way *uotes are a fundamental necessity for a proper reference rate to be established. (an$s canDt offer two-way *uotes in a call money mar$et since the borrowing in the call is primarily driven by re*uirements of meeting 0"", etc statutory re*uirements. (y giving two-way *uotes, a ban$ runs the ris$ of running short of its minimum balance on a particular day with all its regulatory implications. ,nother problem is that while foreign ban$s and some of the new ban$s are perennial borrowers in the inter-ban$ mar$et, several nationalized ban$s and institutions are perennial lenders. This gives rise to uni-directional players who are averse to two-way *uotes. This polarization impedes the development of a benchmar$ rate around which a term-money mar$et can evolve. Fnly after this happens will the I"/ mar$et for medium term deals evolve in India. ,ack of Active 'arket for F oating Rate ,oans In India, companies do not actively borrow on floating rates of interest despite some clear advantages associated with it. , primary reason for non-evolution of floating rate loans is the perception of the interest rate movements. Floating rate loans would become popular when diverse views emerge among different players in the mar$et for these rates. Till now, as the "(I had a strong hand in determining interest rates on the Government bonds, there was very little volatility in the credit mar$et. ,s lending rates for the companies are built on the bond yields of the similar tenors, the floating rates were not very different from the fixed rate loans, and not considered to be worth the ris$. Eowever, for *uite a while now, the "(I has been slowly letting off its stronghold in determining bond-yields. The conse*uent volatility in lending rates would help create mar$et for floating rate loans and conse*uently, interest rate swaps.

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*on.avai abi ity of a Variety of Acce#tab e $ie d -"rves , yield curve is re*uired for effectively pricing I"/ and F",Ds and therefore, the lac$ of one hinders the development of derivatives. Eowever, proper rupee yield curve has not emerged so far due to the insufficient attention paid by the mar$et participants. mergence of a proper yield curve would correctly reflect the spread between retail deposit and inter-ban$ rates or the credit spread for prime corporates over the inter-ban$ rate. #oreover forward interest rates can be derived from such a yield curve. This would enable the development of the rupee interest rate swaps. >ustifying the move to introduce derivatives now in the absence of a proper I8" yield curve is li$e classic Ythe chic$en and egg story.Z Partici#ants4 Inertia There is a real problem of inertia among the Indian ban$s to use the newfound freedom. Fnly a handful of ban$s have declared differential ')"Ds. &ifferential ')"Ds implies different ')" for different levels of maturities. The broader acceptance of differential ')"Ds by nationalized ban$s will boost the I"/ mar$et. ,ack of A+areness The very concept of swaps is new to India. There is very little $nowledge about these instruments even among the active participants in Indian mar$ets. ,nd the awareness among the smaller players, for whom these instruments can be really useful, is abysmally low. 0orporates do not have any sophisticated ris$ management systems in place and there are very few competent people who can use these instruments well. #oreover, the common press and media have not really tried to spread awareness of these instruments.

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Re "ctance on Part of Sma -or#orates and Sma %anks ven among those who are aware, there is lac$ of willingness among the smaller ban$s and companies to enter into I"/ deals. I"/ is generally perceived as complicated deal that is li$ely to benefit #80Ds and big corporates. (ut the truth is that benefits derived from I"/ are independent of the size of the parties involved. #ost of the deals reported in India so far were either circular deals among the ban$s or restricted to few big corporates. (ut there is no need to fear financial derivatives when they are used properly and with the firm+s corporate goals as guides.

/ther Technica Iss"es In terms of the "(IDs guidelines, the ris$ weight for primary dealers is much higher than for ban$s or institutions. .hile technically, '&Ds are non-ban$ finance companies3 in terms of their debt-e*uity ratios and *uality of assets they are far superior to the other financial intermediaries. /urely, the ris$ weights should be at least identical.

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Short.term Reasons There is a consensus among the mar$et participants that the interest rates are headed south. This means that there are no ta$ers for the opposite view, and so few I"/ deals. #oreover, with the current political uncertainty, a possible recovery, easy availability of credit, concentration on the stoc$ mar$et boom, a not-so-li*uid debt mar$et, and other short-term reasons, the I"/ mar$ets are not very active. 0oncluding, there are many fundamental reasons for the inactive I"/ mar$et in India. ,s and when these are tac$led, the I"/ mar$et in India will evolve.

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FOREIGN EXCHANGE

"uture Outloo' for IRS in India


,s India shifts from "(I controlled to mar$et driven interest rate regime, volatility in the interest rate is bound to increase. This implies greater use of ris$ hedging mechanism li$e I"/. ,s the obstacles discussed in /ection ? are tac$led, we shall see the evolution of the money mar$et derivative mar$ets. The speed of this evolution depends on how *uic$ly the fundamental problems are addressed and the mar$et revives. The major concern, of course, will be the emergence of a floating rate loan mar$et, as at least one leg of the I"/ has necessarily to be a floating rate. This is the single major reason why there are not only many I"/ deals, but even no possibilities of deals in the current scenario for corporates. #oreover, as we move towards capital account convertibility and more deregulation we shall observe a better integration of the money mar$et, the Forex mar$et and the capital mar$ets. This will result into a more competitive mar$ets and emergence of benchmar$ rates. Hield curve calculations and acceptability will also increase. Then, we have seen that the stage is set for the financial institutions, commercial ban$s and corporates to enter into swaps as soon as they have ris$ management systems in place and the mar$et matures. In the short run however, there will not be much activity as the fundamentals are unli$ely to change *uic$ly. , major concern is the govt. borrowing, which distorts the interest rates and has a major impact on the mar$et. In a mature mar$et, no player should be so big that it can affect the interest rates in a large way, causing rates, which do not really reflect the sentiments of the mar$ets. Fn the other hand, this same point causes volatility in the mar$ets, which is another reason to hedge against ris$s, where I"/ come in. .e wait to see how the mar$ets evolve.

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,lso li$ely in the medium term is the emergence of various types of swaps not currently allowed in India. )i$e I"/4F",Ds $ic$ed off the derivative mar$et in India, swaptions may well $ic$ off the options mar$et in India, though today, it loo$s as though e*uity options will come up earlier. ,s awareness increases, and it dawns on the players that swaps are excellent hedging instruments, the mar$et can only improve. Finally, we come to speculation. This is li$ely to stay away from Indian mar$ets, at least for the corporates till a long time to come. "(I or the govt. does not encourage speculation in any other mar$ets by the corporates or individuals. This is li$ely to continue, as the current guidelines show. #oreover, for speculation, one needs volatility and diverse views, which are not present today. ,s these emerge, some players may be allowed to speculate, but the limits are li$ely to be strict and discouraging. Fverall, I"/ are here to stay, and players will soon learn to use them effectively. Though in infancy now, the mar$ets may evolve sooner than one may expect.

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,hat is Exchange Ris'Q


xchange ris$ is simple in concept; a potential gain or loss that occurs as a result of an exchange rate change. For example, if an individual owns a share in Eitachi, the >apanese company, he or she will lose if the value of the yen drops. Het from this simple *uestion several more arise. First, whose gain or lossQ 0learly not just those of a subsidiary, for they may be offset by positions ta$en elsewhere in the firm. ,nd not just gains or losses on current transactions for the firm+s value consists of anticipated future cash flows as well as currently contracted ones. .hat counts, modern finance tells us, is shareholder value3 yet the impact of any given currency change on shareholder value is difficult to assess, so proxies have to be used. The academic evidence lin$ing exchange rate changes to stoc$ prices is wea$. #oreover the shareholder who has a diversified portfolio may find that the negative effect of exchange rate changes on one firm is offset by gains in other firms3 in other words, that exchange ris$ is diversifiable. If it is, than perhaps it+s a non-ris$. Finally, ris$ is not ris$ if it is anticipated. In most currencies there are futures or forward exchange contracts whose prices give firms an indication of where the mar$et expects currencies to go. ,nd these contracts offer the ability to loc$ in the anticipated change. /o perhaps a better concept of exchange ris$ is unanticipated exchange rate changes. These and other issues justify a closer loo$ at this area of international financial management.

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FOREIGN EXCHANGE

Should "irms !anage "oreign Exchange Ris'Q


#any firms refrain from active management of their foreign exchange exposure, even though they understand that exchange rate fluctuations can affect their earnings and value. They ma$e this decision for a number of reasons. 6. First, management does not understand it. They consider any use of ris$ management tools, such as forwards, futures and options, as speculative. Fr they argue that such financial manipulations lie outside the firm+s field of expertise. L.e are in the business of manufacturing slot machines, and we should not be gambling on currencies.L 'erhaps they are right to fear abuses of hedging techni*ues, but refusing to use forwards and other instruments may expose the firm to substantial speculative ris$s. <. /econd, they claim that exposure cannot be measured. They are right -currency exposure is complex and can seldom be gauged with precision. (ut as in many business situations, imprecision should not be ta$en as an excuse for indecision. :. Third, they say that the firm is hedged. ,ll transactions such as imports or exports are covered, and foreign subsidiaries finance in local currencies. This ignores the fact that the bul$ of the firm+s value comes from transactions not yet completed, so that transactions hedging is a very incomplete strategy. 9. Fourth, they say that the firm does not have any exchange ris$ because it does all its business in dollars 1or yen, or whatever the home currency is2. (ut a moment+s thought will ma$e it evident that even if you invoice German customers in dollars, when the mar$ drops your prices will have to adjust or you+ll be undercut by local competitors. /o revenues are influenced by currency changes. ?. Finally, they assert that the balance sheet is hedged on an accounting basis-especially when the Lfunctional currencyL is held to be the dollar. The misleading signals that balance sheet exposure measure can give are documented in later sections.

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%"t is there any economic j"stification for a >do nothing> strategy: #odern principles of the theory of finance suggest prima facie that the management of corporate foreign exchange exposure may neither be an important nor a legitimate concern. It has been argued, in the tradition of the #odigliani-#iller Theorem, that the firm cannot improve shareholder value by financial manipulations; specifically, investors themselves can hedge corporate exchange exposure by ta$ing out forward contracts in accordance with their ownership in a firm. #anagers do not serve them by second-guessing what ris$s shareholders want to hedge. Fne counter-argument is that transaction costs are typically greater for individual investors than firms. Het there are deeper reasons why foreign exchange ris$ should be managed at the firm level. ,s will be shown in the material that follows, the assessment of exposure to exchange rate fluctuations re*uires detailed estimates of the susceptibility of net cash flows to unexpected exchange rate changes 1&ufey and /rinivasulu, 6CB:2. Fperating managers can ma$e such estimates with much more precision than shareholders who typically lac$ the detailed $nowledge of competition, mar$ets, and the relevant technologies. Furthermore, in all but the most perfect financial mar$ets, the firm has considerable advantages over investors in obtaining relatively inexpensive debt at home and abroad, ta$ing maximum advantage of interest subsidies and minimizing the effect of taxes and political ris$.

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,nother line of reasoning suggests that foreign exchange ris$ management does not matter because of certain e*uilibrium conditions in international mar$ets for both financial and real assets. These conditions include the relationship between prices of goods in different mar$ets, better $nown as 'urchasing 'ower 'arity 1'''2, and between interest rates and exchange rates, usually referred to as the International Fisher ffect Eowever, deviations from ''' and IF can persist for considerable periods of time, especially at the level of the individual firm. The resulting variability of net cash flow is of significance as it can subject the firm to the costs of financial distress, or even default. #odern research in finance supports the reasoning that earnings fluctuations that threaten the firm+s continued viability absorb management and creditors+ time, entail out-of-poc$et costs such as legal fees, and create a variety of operating and investment problems, including under-investment in "G&. The same argument supports the importance of corporate exchange ris$ management against the claim that in e*uity mar$ets it is only systematic ris$ that matters. To the extent that foreign exchange ris$ represents unsystematic ris$, it can, of course, be diversified away -- provided again, that investors have the same *uality of information about the firm as management -- a condition not li$ely to prevail in practice. This reasoning is buttressed by the li$ely effect that exchange ris$ has on taxes paid by the firm. It is generally agreed that leverage shields the firm from taxes, because interest is tax deductible whereas dividends are not. (ut the extent to which a firm can increase leverage is limited by the ris$ and costs of ban$ruptcy. , ris$ier firm, perhaps one that does not hedge exchange ris$, cannot borrow as much. It follows that anything that reduces the probability of ban$ruptcy allows the firm to ta$e on greater leverage, and so pay less taxes for a given operating cash flow. If foreign exchange hedging reduces taxes, shareholders benefit from hedging.

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Eowever, there is one tas$ that the firm cannot perform for shareholders; to the extent that individuals face uni*ue exchange ris$ as a result of their different expenditure patterns, they must themselves devise appropriate hedging strategies. 0orporate management of foreign exchange ris$ in the traditional sense is only able to protect expected nominal returns in the reference currency 1 a$er, 6CB62.

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,ll the parties in an international transaction are subject to exchange rate ris$. Given now are the various ways in which each party can manage its own ris$

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FOREIGN EXCHANGE

Ris' !anagement "rom !erchantDs (oint of -iewV


For+ard Exchange -ontract .hat is the need for forward exchange contractQ The ris$ on account of exchange rate fluctuations, in international trade transactions increases if the time period needed for completion of transaction is longer. It is not uncommon in international trade, on account of logistics3 the time frame cannot be foretold with cloc$ precision. xporters and importers ali$e can not be precise as to the time when the shipment will be made as sometimes space on the ship is not available, while at the other, there are delays on account of congestion of port etc. In international trade there is considerable time lag between entering in to a sales4purchase contract, shipment of goods, and payment. In the meantime, if exchange rate moves against the party who has to exchange his home currency in to foreign currency, he may end up in loss. 0onse*uently, buyers and sellers want to protect them against exchange rate ris$. Fne of the methods by which they can protect themselves is entering in to a foreign exchange forward contract. .e can see from the daily report of the Jadilal Industries )imited 1Forex division2 that the rupee fell down nearly <? paise in a day. The date of this fluctuation is <?th #ay <===. 8ow let suppose that the exporter has dealt.

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For+ard Exchange For+ard -ontract Forward exchange forward contract is a contract wherein two parties agree to deliver certain amount of foreign exchange at an agreed rate either at a fixed future date or during a fixed future period. If the merchants are sure about the remittance or the payment of the foreign exchange then they can choose the fix date forward exchange contract, in which they are bound by the date on which they have to meet their part of liability in the agreement. If the customers are not sure about the date of remittance or the payment of the foreign exchange they can enter in to the option period forward exchange contract. (oth the types are explained below. 6. Fixed date foreign exchange forward contract If under the foreign exchange forward contract, foreign exchange is to be delivered at fixed date, the contract is $nown as fixed date foreign exchange forward contract. <. Fption foreign exchange forward contract If under the foreign exchange forward contract, foreign exchange is to be delivered in future, during a specified period, the contract is $nown as option foreign exchange forward contract. In this type of contract there is no option for ta$ing4 delivery of foreign exchange. /uch contracts provide for option as far as date of delivery of foreign exchange is concerned. .hile entering in to a option forward contract first date and the last date for exercising option for giving 4ta$ing delivery of foreign exchange is always fixed. In India, li$e developed countries, there are not many instruments available for hedging foreign exchange ris$. ,s a result the merchants have to hedge their foreign exchange exposures through forward contracts only. For merchants this is the only tool available to minimize the ris$ due to adverse foreign exchange fluctuation.

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FOREIGN EXCHANGE

Ris' !anagement "rom Ex)orterDs (oint of -iewV


If on the 6st >anuary <=== exporter signs an export contract. Ee expects to get the dollar remittance during the >une. 8ow letDs assume that on first >anuary exchange rate between dollar and rupee is 9:.@?== and due to the adverse fluctuation of exchange rate the actual rate in >une is 9:.?=== so we can infer from the above that the export may loose <9 paise per dollar. ,s per instrument available in India exporter may enter a forward exchange contract with a ban$. .hile entering the contract with ban$, ban$ will give him a forward rate for >une adding the premium to the spot rate of first >anuary. )ets suppose it is 9:.B9== so exporter can earn C paise my exchange rate between dollar and rupee is 9:.@?== and due to the adverse fluctuation of exchange rate the actual rate in >une is 9:.?=== so we can infer from the above that the export may loose <9 paise per dollar. ,s per instrument available in India exporter may enter a forward exchange contract with a ban$. .hile entering the contract with ban$, ban$ will give him a forward rate for >une adding the premium to the spot rate of first >anuary. )et suppose it is 9:.B9== so exporter can earn C paise may cancel and reboo$ the contract as many as times they want.

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FOREIGN EXCHANGE

Ris' !anagement "rom Im)orterDs (oint of -iewV


)et suppose on first >anuary an importer signs a deal with foreign party. Ee expects to pay the bill in #arch. Fn first >anuary the exchange rate is 9=.@?==. ,nd the importer expects that the dollar will depreciate in the month of #arch. /o the importer will enter in to the agreement with the ban$ for the forward exchange contract. The ban$ will give him the forward rate. If the rate is lower than the todayDs rate then the importer will enter in to the contract with the ban$. ,nd the rate is high then he will not enter in to the contract. In India importers canDt cancel the contract. They can cancel the contract at once and roll over for the future date. This way importers and exporters can minimize the ris$ due to the adverse foreign exchange rate movement.

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FOREIGN EXCHANGE

Ris' !anagement "rom .an'Ds (oint of -iewV


,s per "(I rules and F &,I guidelines ban$ has to maintain s*uare position by buying and selling e*ual or nearly e*ual amount of dollars. For that ban$ has to do swap operation.

SW2P
In foreign exchange mar$ets swap means simultaneous purchase and sell of the same amount of currency for two different value dates. In case of a swap as the ban$ buys and sales the same amount of currency against another currency, no exchange position is created. Therefore in a swap deal there in no exchange rate ris$. Eowever as value dates are different mismatch is created. )et us consider the following transactions underta$en by a ban$. (an$ buys 5/A 6 million spot and simultaneously sells 5/A 6 million one month forward. .e can appreciate from the above illustrations that after underta$ing a swap transaction, though no exchange position is created but as the inflows4 out flows do not match3 the ban$ runs the ris$ of forward differentials 1interest differentials2 moving against it. 6. (an$s enter in to forward purchase 4 sale contracts with customers4 ban$ and at that point of time cover for the same value date many not be available. Eowever if a ban$, which has entered in to a forward contract, does not cover its position, run exchange ris$s. Therefore, it covers the transaction on spot basis i.e. if it bought 5/A 6 million two months forward, it will sell 5/A 6 million spot and s*uare its position. Therefore to correct the mismatch of spot

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and two months forward it will do a swap by buying spot and selling two months forward.

<. Theoretically a ban$, which enters in to a forward contract with a customer to avoid ris$ on account of exchange rate movement, always covers itself. Eowever the customer may not ta$e 4 give delivery of foreign exchange on due date i.e. the customer may give4ta$e early delivery or cancel the contract or may extend the contract, and as the ban$ covers itself in inter ban$ mar$et by doing opposite deal, to meet its commitment may have to do a swap. For example if a ban$ entered in to a forward sale contract for say, ,pril := and if the customer received the import documents on #arch :6, he may re*uest the ban$ to remit the foreign exchange on #arch :6st against the forward contract boo$ed for ,pril :=, initially. Thus the ban$ may have to under ta$e the swap in the inter ban$ mar$et by buying for #arch :6st and selling the same amount forward for ,pril :=. :. (an$s underta$e swap transaction for funding operations. /uppose a ban$ has to pay today against an )40 opened by it and as at that point of time its 8ostro account does not have sufficient balance the ban$ to avoid overdraft interest and in order to avoid default, will underta$e a swap in the inter ban$ mar$et by buying cash and selling say spot or forward. Thus ban$ is in a position to fund its 8ostro a4c through swap without having exchange rate ris$. 9. (an$s underta$e swap transactions to ta$e advantage of arbitrage opportunities buy converting one currency in to another temporarily without creating any exchange position. ?. /ome ban$s underta$e swap transactions for running a O swap boo$D. This is generally done by doing a forward 4 forward swap.

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FOREIGN EXCHANGE

K. Foreign exchange swaps are used to manufacture a currency fund through one currency in another currency.

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FOREIGN EXCHANGE

xchange &ealings and "is$ #anagement for (an$s The ban$, dealing in foreign exchange has not only to loo$ for profits but also has also to ensure that the losses, which may be incurred in foreign exchange dealings, are minimized. The foreign exchanged dealing is ris$ reward business and therefore the lure for profits is very strong. (ut it is not free from ris$. Foreign exchange dealings have got certain special features, which ma$e the transactions all the more ris$y. These are as follows; The foreign exchange dealings are transnational and therefore prices of foreign currencies are subject to the control4restrictions of the governments of the foreign countries. These are also dependent upon their fiscal and monetary policies and the same are dictated buy the needs of their domestic economy. Foreign exchange dealings involve two currencies and therefore the exchange rate is influenced by domestic as well as international issues4factors. The foreign exchange mar$et is a <9 hours mar$et and different time zones for foreign exchange dealings at different centers offer threat of ris$ adverse movement of rates on account of unexpected developments. The foreign exchange dealings are to be underta$en at a very fast speed and pace. There is no time for second thoughts. Therefore the fast decision ma$ing process itself opens the foreign exchange dealing to ris$.

140

FOREIGN EXCHANGE

Globally, foreign exchange dealing operations are underta$en with a view to maximize profits of ban$. Eowever till the year 6CC6 in India foreign exchange dealings operations were subject to stringent controls and the only objective of the dealing was to conduct cover operations so as to facilitate international business. The regulatory environment in India hardly offered any scope for free foreign exchange dealings. Eowever with introduction of liberalized exchange rate management system a new dimension has been added. "upee has now becomes a free-floating currency under modified liberalized exchange rate management system 1) "#/2 and the mar$et forces of demand and supply decide rupee exchange rate. "eserve (an$ of India slowly but steadily has been liberalizing foreign exchange mar$ets with a view to; 6. nsure sufficient volume as far as demand and supply for a particular currency is concerned and thus paving the way for competitive prices for various currencies for covering merchant transactions. <. To develop Indian foreign exchange mar$ets so that dealer develops dealing s$ills and sophistication. :. To $eep Indian foreign exchange mar$et getting integrated with the global foreign exchange mar$et in due course of time. ,s and when rupee becomes fully convertible on current as well as capital account.

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FOREIGN EXCHANGE

Ty)es of Ris's for .an's


Foreign exchange dealings entail many types of ris$s for ban$s. Eow ever for the purpose of broad classifications the following are the major types of ris$s. 62 <2 :2 92 ?2 'osition or exchange rate ris$3 1"is$ from the mar$et movement2 0redit or counterpart ris$3 1"is$ from the customers2 #ismatch or li*uidity ris$31"is$ due to improper transaction2 Fperational ris$3 1"is$ due to operating system2 )egal ris$3

Position #r Exchange Rate Ris6


.hen a dealer buys or sells foreign currency the ban$ gets in to a position and if purchases are more than sales, it is said to have overbought4long4plus position, if sales are more than purchases it is said to have oversold4sold4minus position. In simple terms an excess of assets over liabilities is called net long position and conversely, liabilities in excess of assets results in to a short position. /ince these positions are ta$en at the particular rate and if the rate moves adversely then the ban$ can suffer a loss. To illustrate if a ban$ has gone in to long position in a currency which is depreciating it will result in exchange loss because when foreign currency assets are converted in to local currency the ban$ realize lesser amount as compared to the amount paid for ac*uiring these assets. /imilarly if a ban$ has3 gone in to short position currency, which is appreciating, it will result in exchange loss because when the liability so created is to be paid, the ban$ will have to shell out more amount of local currency. In these days when exchange rates are fluctuating continuously, from moment to moment times wild, it is prudent on the part of ban$ to have some chec$s and balances so that loss incurred in such a situation is manageable.

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FOREIGN EXCHANGE

,imits for %anks to 'inimi=e the Risk 62 &aylight limits This limit is fixed for the dealing room operations. It means dealer can not ta$e position of more than the day light limit fixed by the management. &ealers can cross the limit after prior approval from the management for specific cases. <2 Fvernight limits &uring the daytime, position can be monitored continuously and corrective actions can be ta$en. /ame is not possible at the night. /o overnight limits are fix conservatively. (ut the same time it is big enough to accommodate pipeline transactions. :2 0ut loss limit (an$ is having open position and if the rate moves against the ban$ then ban$ may loss. &ealer has the free hand to deal and he never $now that what will be the loss. If the rate goes against then ban$ may loss. To prevent this limit is fixed by the management. , maximum a dealer will loss due transaction is called the cut loss limit. ,s for example, if the permissible amount of *uantum of absolute loss translates in to 9=-point movement of the rate on a position of one million. The cut loss has to be applied by the dealer when there is an adverse movement of twenty points on a position of two million.

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FOREIGN EXCHANGE

-redit or -o"nter Party Risk This is a ris$ due to inability or unwillingness of the counterpart to meet its obligations. Fver this $ind of ris$ ban$ has not proper control but ban$ can avoid or minimize the ris$ by ta$ing following actions; (y fixing counterpart limits (y appropriate measurements of exposure 0redit evaluation and monitoring (y following sound operating procedure This ris$ can be classified into two ways; Pre.Sett ement Risk 're settlement ris$ is the ris$ of loss due to counter-party defaulting on a contract during the life of a transaction. This exposure is also referred to as the replacement cost. , $ey tool for effective management of this ris$ is the fixation of exposure limits on counter-parties. Sett ement Risk

Settlement ris' is the ris' arising when a %an' )erforms on its o%ligation under a contract )rior to the counter/)arty does so0 This ris' fre$uently arises in international transactions %ecause of the time 1one differences0
The credit ris$ can also be classified in to; -ontract Risk

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FOREIGN EXCHANGE

If %efore the )erformance of the contract* the counter )arty fails the contract has to %e canceled0 In the mean time if rate has moved against it* then the loss is to %e %orn %y the %an' as the contract is to %e closed at the on going mar'et rates0
- ean Risk In an exchange contract the currencies are to be exchanged on the value dates. The time zone difference between various center sometimes results in situations when one ban$ has already paid the amount of currency to be given before receiving the amount the currency to be received the counter party fails, it may result in total loss.

Sovereign Risk If the counter party ban$ is situated in different country then there is a possibility of having sovereign ris$. ,lso because of the political and economic factors in that country. If a country suspends the foreign currency payments the ban$ may stand to lose, although the counter party have performed its part of the contract in local currency. The ban$ while fixing counter party limits for the overseas ban$ has to give due weight age to the political stability, health of the economy, availability of financial infrastructure, and expected state interference in financial transactions, particularly foreign exchange transactions.

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FOREIGN EXCHANGE

!ismatch2 Li$uidity Ris'23a) Ris'2Interest Rate Ris'


)i*uidity ris$ is the ris$ that ban$ will be unable to meet its funding re*uirements or execute a transaction at a reasonable price. #ar$et li*uidity ris$ is the ris$ of ban$ not being able to exit or offset positions *uic$ly at a reasonable price. If a ban$ has underta$en a swap i.e. bought and sold same amount of foreign currency for different value dates, it does not have exchange position but runs the ris$ of mismatches thus created. These are also called gaps. These gaps give rise to ris$ on account of forward premium 4 discount moving against the ban$. .e have already seen that the forward differentials are nothing but interest differentials. It is not uncommon, particularly now days that interest rate differentials of two currencies may widen or narrow down. #ismatches or gaps are the result of unmatched forward maturities witch create uneven cash inflows and out flows. If the forward differentials go against the ban$, the ban$ may incur a loss in covering the gaps at a cost higher than provided for. In India forward mar$et being very shallow and being driven by pure supply and demand for forwards, movements in forward differentials are wild and erratic. This occurrence is more fre*uent after introduction of ) "#/ and allowing integration of money and Forex mar$ets albeit limited.

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FOREIGN EXCHANGE

The following limits are fixed for managing mismatch ris$. 03 Individ"a (a# ,imits 7I(,8

"oreign currency )urchases and sales with value dates falling in a )articular month may not %e e$ual0 This will give rise to either over%ought or oversold )osition in that month0 .ut if the overall )osition of the %an' in a )articular currency is s$uare it is %ut natural that the %an' will have an o))osite o)en )osition in any other months0 This is called ga)0 .an's )ut a ceiling in a form of I3L for each month0 The dealer can not have a )osition in a )articular month exceeding the said limit although overall )osition of the %an' may %e s$uare0
23 Aggregate (a# ,imit 7A(,8 This limit is the absolute total 1ignoring plus4minus2 of all the over bought and oversold position ban$ is having for all the month in a particular currency. ?3 Tota Aggregate (a# ,imit 7T(,8 Total aggregate gap limit is the total of all ,G)s in all currencies put together. This not only ensures controlling uneven cash flows on account of mismatches but puts under control trading in forward also. Trading in forwards is also called running a

147

FOREIGN EXCHANGE

Oswap boo$D. 5ncontrolled mismatches can create li*uidity problem for the ban$, which may ultimately result in unintended losses.

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FOREIGN EXCHANGE

/#erationa Risk The data processing system in use must be appropriate to the nature and volume of trading activities. , written contingency plan has to ensure amount other things that in the event of brea$ down of the e*uipment, bac$ up facilities can be deployed at short notice.

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FOREIGN EXCHANGE

,ega Risk In addition to the foregoing ris$ there is a legal ris$ which exists in all $inds of financial mar$ets. It is probably more so in foreign exchange and interest rates given that inherent volatility. It is therefore extremely important the ban$s as also the corporate dealing in such products ta$e such steps as would sufficiently protect them from the legal stand point. The surest way to do so is to insist on exchange of internationally accepted master agreements between the parties to be supported by other relevant documentation.

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FOREIGN EXCHANGE

Incertions

Exchange Rate Determination


The rate of exchange means the price of one currency in terms of another currency. &ifferent countries have adopted different exchange rate systems at different times li$e the Gold (ullion, Gold /tandard and the (retton .oods /ystem. The last system was soon replaced by the Floating rate system. This part deals with xchange rate systems and outlines the major changes in this xchange rates li$e the 'urchasing

regard. Further, this section deals with the historical determinants of the xchange rates and gives various models and theories of 'ower 'arity Theory, The &orn (ush Theory and the #undell Fleming #odel. )astly it covers the techni*ues of forecasting the xchange rates and its importance to managers.

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FOREIGN EXCHANGE

.ontents
xchange "ate ! ,n Fverview Fixed "ate to Flexible xchange "ate /ystem Floating "ate /ystem xchange "ate /ystems in &ifferent 0ountries The volution of IndiaDs xchange rate "egime Eistorical &eterminants of xchange "ates #odels and Theories of xchange "ate Forecasting /uitability for use in Foreign 0urrency Translation

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FOREIGN EXCHANGE

"oreign Exchange !ar'et


The foreign exchange mar$et does not have a physical mar$et place called the foreign exchange mar$et. It is a mechanism through which one country+s currency can be exchange i.e. bought or sold for the currency of another country. The foreign exchange mar$et does not have any geographic location. The mar$et comprises of all foreign exchange traders who are connected to each other through out the world. They deal with each other through telephones, telexes and electronic systems. This section gives us an insight into the participants in the Foreign xchange mar$et for e.g. customers, commercial ban$s, central ban$, exchange bro$ers and speculators. ,lso this section discusses the fundamentals of exchange rates and also certain factors affecting exchange rates.

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FOREIGN EXCHANGE

.ontents
Foreign xchange #ar$et The 'articipants in Foreign xchange #ar$et Fundamentals Ff xchange "ates Factors ,ffecting xchange "ates

154

FOREIGN EXCHANGE

"oreign Exchange Ex)osure and its !anagement


Foreign exchange ris$ is related to the variability of the domestic currency values of assets, liabilities or operating income due to unanticipated changes in exchange rates, whereas foreign exchange exposure is what is at ris$. Foreign currency exposures and the attendant ris$ arise whenever a business has an income or expenditure or an asset or liability in a currency other than that of the balance-sheet currency. Indeed exposures can arise even for companies with no income, expenditure, asset or liability in a currency different from the balance-sheet currency. .hen there is a condition prevalent where the exchange rates become extremely volatile the exchange rate movements destabilize the cash flows of a business significantly. /uch destabilization of cash flows that affects the profitability of the business is the ris$ from foreign currency exposures. This section deals with exchange exposure, its types, identification and management.

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FOREIGN EXCHANGE

.ontents
Foreign xchange xposure Types of xposures The "ole of Treasury in Foreign xchange xposure #anagement conomic xposure, 'urchasing 'ower 'arity and The International Fisher ffect

Identifying Ex)osure !anaging Economic Ex)osure

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FOREIGN EXCHANGE

!ethods and Techni$ues of Ris' Coverage / Exchange Derivatives

Trade and (usiness is no more confined to national boundaries and that is why foreign exchange ris$ management is becoming a necessary tool to prevent business form any foreign exchange ris$. , variety of foreign exchange derivatives provide a mean to hedge against any Foreign futures, options and swaps.2. xchange "is$. This section highlights some of xchange "is$ 1namely forwards, the ways in which one can hedge ones Foreign

157

FOREIGN EXCHANGE

.ontents
Introduction to &erivatives Eistory and &evelopment of &erivatives #ar$et "ecent Trends 'erformance Foreign xchange &erivatives Forwards, Futures and Fptions #ore about Foreign xchange Fptions and Futures /waps /wap #ar$et 'articipants Foreign xchange /wap /wap &ocumentation xamples from Indian #ar$et Interest "ate /waps Eistory ,nd volution , (rief )oo$ ,t The Global #ar$ets 'resent /cenario Ff The Indian #ar$et Fbstacles To &evelopment Ff I"/ In India Future Futloo$ For I"/ In India

158

FOREIGN EXCHANGE

Ris' !anagement
The ris$ on account of exchange rate fluctuations, in international trade transactions increases if the time period needed for completion of transaction is longer. It is not uncommon in international trade, on account of logistics3 the time frame cannot be foretold with cloc$ precision. In international trade there is considerable time lag between entering in to a sales4purchase contract, shipment of goods, and payment. In the meantime, if exchange rate moves against the party who has to exchange his home currency in to foreign currency, he may end up in loss. 0onse*uently, buyers and sellers want to protect them against exchange rate ris$. The objectives of risk management #inimize 0osts #aximize "evenue /tabilize #argins in the Future

159

FOREIGN EXCHANGE

.ontents
.hat is xchange "is$Q /hould Firms #anage Foreign xchange "is$Q "is$ #anagement From #erchantDs 'oint Ff Jiew "is$ #anagement From xporterDs 'oint Ff Jiew "is$ #anagement From ImporterDs 'oint Ff Jiew "is$ #anagement From (an$Ds 'oint Ff Jiew xchange &ealings ,nd "is$ #anagement For (an$ Types Ff "is$s For (an$s

160

FOREIGN EXCHANGE

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