PROJECT REPORT ON

A study on FOREX Risk Management

with a special emphasis on banks

SUBMITTED BY
RBHYA PAL
Roll number: 033
UID: 144056

TYBMS SEMESTER V (C.BMS.5.08)

ACADEMIC YEAR 2016-2017
PROJECT GUIDE: PROF. PRITESH ARTE
ST. XAVIER’S COLLEGE- AUTONOMOUS
5, MAHAPALIKA MARG,
MUMBAI, MAHARASHTRA- 400001.
Acknowledgement

I, Rbhya Pal, student of TYBMS of St.Xavier's College- Autonomous, Mumbai would like to
extend my heartfelt gratitude towards the University of Mumbai and, St.Xavier’s College-
Autonomous, Mumbai for conferring upon me the opportunity to undertake a research project.

I would especially like to thank my International Finance Professor, Mr.Pritesh Arte, for guiding
and supporting me throughout this project with his invaluable inputs, support and
recommendations without which, this project would not have shaped the way it has. I have gained
an immense amount of knowledge about dealings in Foreign Exchange and have gained a better
perspective on how this market actually functions.

I would also like to thank my professor and Head of Department, Ms.Soni George Tharakan for
enabling us to undertake such intensive projects and to have guided me through her support
throughout the course of this project.

Further, I would like to thank my family and friends for their constant support and patience
throughout this project.
Table of Contents
1. Executive Summary ...............................................................................................1
2. Research Objectives ...............................................................................................2
3. Literature Review ..................................................................................................3
4. Introduction ............................................................................................................4
What is FOREX? .....................................................................................................4
History: The International Monetary System ..........................................................6
Foreign Exchange Market…………………………………………………………6
Types of Exchange Rates.........................................................................................8
Exchange Rate Quotations………………………………………………………9
Balance of Payments and Forecasting Exchange Rates………………………….10
5. FOREX in India………………………………………………………………...11
6. Role of RBI in FOREX Management….............................................................12
FEMA………………............................................................................................13
FEDAI……………………………………………………………………………15
7. How do banks deal in FOREX?..........................................................................16
Dealing Room……………………………………………………………………18
8. Risks in Foreign Exchange……………………………….................................19
9. How do banks reduce the chances of risks associated with FOREX?............22
10. How do banks exercise hedging?........................................................................25
11. FOREX trading in Indian
Banks………………………………………………………………………….....30
12. Commercial
Banks…………………………………………………………………………….31
ICICI
Bank……………………………………………………………………………..31
State Bank of
India…………………………………………………………………………….33
13. Current Scenario and Scope of FOREX Market in India……….…………34
14. Impact of Brexit on the GBP/INR……………................................................36
15. Major
Findings……….……………………………………………………………….39
16. Conclusion……………………………………………………………………..40
17. Bibliography…………………………………………………………………………………………………………41
 Executive Summary
The purpose of this report is to understand the history and concept of foreign
exchange transactions in a better way and to get to know about the various types of risks
which are imminent to banks associated with FOREX transactions and, how these
commercial banks stave off that risk by mitigating or eliminating the loss.

The report focuses on the various kinds of risks that the banks face and what are the ways
by which these commercial banks can prevent those risks associated with FOREX. Then
with reference to two Indian banks- one private and one government, it has been briefly
discussed that how banks in India prefer or rather, how a particular type of risk
management technique is more applicable to Indian banks as compared to the rest.

It starts with discussing in detail what the Foreign Exchange market is and how it has
evolved over the years, the different kinds of transactions- long term and short term that
happen, the function that banks play in it and how they manage the various risks
associated with foreign exchange transactions when, the exchange rates of a currency pair
keep changing by the minute.

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 Research Objectives
The present study is an attempt to get a clearer perspective on FOREX, its evolutions
over time, in the world and in India, the risks associated with it and, most importantly,
methods which are undertaken, especially by banks, to stave off and/or mitigate these
risks. The objectives of the study can be summarized as follows:

 To study the FOREX Risk Management (especially in the Indian Banking

System)
 Role of RBI in FOREX and success of FOREX Risk Mitigation
 To study the tools of FOREX Risk Management to find the different Risk
Management Methodologies

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 Literature Review
As the after shocks of the credit crisis fade away from the world’s strongest economy, all
companies in the global economy are now pursuing global trade opportunities, which in turn has led
to banks enabling FOREX (Foreign Exchange) transactions. This has given a boost to FOREX
transactions to people and companies in India as well, which is now among the major players in the
merging global market, capitalizing on this, banks in India too have improvised upon and enabled
quicker and varying kinds of foreign exchange transactions to everyone in their country.
Liberalization has transformed India’s external sector and a direct beneficiary of this has been the
foreign exchange market in India. From a foreign exchange-starved, control-ridden economy, India
has moved on to a position of $150 billion plus in international reserves with a confident rupee and
drastically reduced foreign exchange control. As foreign trade and cross-border capital flows
continue to grow, and the country moves towards capital account convertibility, the foreign
exchange market is poised to play an even greater role in the economy
A sizable foreign exchange reserve acts as liquidity cover and protects against a run on the
country’s currency, and reduces the rate of interest on Indian debt in the world market by lowering
the country risk perception by international rating agencies. However, beyond a point, it begins to
affect the money supply in the country, and interest rates. There are significant “sterilization costs”
to avoid this and the RBI loses money by earning low returns on the safe assets used to park the
reserves. Given this low rate of return, there has been discussion about the unique proposal to use
part of the reserves to fund infrastructure projects. This is one of the major reasons why the RBI
intervenes in the day to day functioning of the commercial banks and authorized dealers of the
FOREX and, why banks need to carefully manage their funds and dealings in FOREX.

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 Introduction
(Apte), (FICCI, n.d.)

What is FOREX?

Foreign exchange, more commonly and popularly known as FOREX is the

conversion of a country's currency into another country's currency. The rampant
globalisation existing today makes the entire world one market and gives birth to what we
know as a free economy; exchange and conversion of currencies is thus a part and parcel
of all trade, commerce and business that exists due to this, the value of a country's
currency is not solely determined by its domestic or internal affairs but also the supply
and demand of the currency in domestic and international markets that is, a currency can
basically be 'pegged to' another country's currency or a basket of currencies in order to
determine its value and demand with respect to these other currencies.

Globally, foreign exchange is handled between/among banks and all FOREX

transactions fall under the auspice of the Bank of International Settlements which is an
international financial institution owned by Central banks to serve the purpose of a bank
for them and foster international monetary and financial cooperation.

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History: The International Monetary System

The evolution of the international monetary system, the FOREX, can be traced
according to the following timeline:

Gold Standard: The international monetary system that operated immediately prior to
the 1914-18 war was termed as the 'gold standard'. Most major countries operated on the
gold standard system. A unit of the country's currency was defined as a certain weight - a
part of an ounce - of gold. A country is said to be on the gold standard when its central
bank is obliged to give gold in exchange for its currency when presented it.

The gold standard was a keystone in the classical economic theory of equilibrium
in international trade. The UK came off the gold standard in 1914 but, in 1925 returned it
returned to a modified version termed the 'gold bullion standard'.

The First World War: WWI had a grave impact on the international monetary system.
Britain was forced to abandon the gold standard because of the wartime deficit on its
balance of payments, and its reluctance at that time to provide gold to settle international
differences. Many other countries abandoned the gold standard temporarily, but none had
the same significance. In the mid-1920s a lot of countries returned to the gold standard,
the difference being that Britain's Sterling was not the only international reserve asset

5
alongwith gold, there were several- dollar, franc, to mention the most important.
Ultimately, due to the inflexibility in costs and, the Great Depression of the late 1920s
and early 1930s, Britain abandones the gold standard in 1931, followed by a lotmany
other countries.

Exchange Rates- 1914 to 1944: With the First World War, the stability of exchange
rates for major currencies ended. The Second World War, however, led to more extensive
and tighter controls on international trade and investment. By the end of the Second
World War, many bankers and economists agreed upon the need for a new monetary
system, giving birth to the Bretton Woods System.

Bretton Woods System: This immediately occupied the international stage for the
immediate post-war period through to 1971. The prime movers for it were John Maynard
Keynes and Harry Dexter White. This system led to the establishment of the International
Monetary Fund (IMF) to promote consultation and collaboration on international
monetary problems and lend to member countries in need due to recurring balance of
payments deficit. SDRs (Special Drawing Rights) were also allocated to individual
countries by the IMF.

Post all of this, the exchange rate was finally formulated. The global market functioned
on fixed exchange rate systems up till 1973, when managed float was then introduced and
started by the London exchange market.

Foreign Exchange Market

The foreign exchange market is the forum which facilitates foreign exchange. It is the
framework of individuals, firms, banks and brokers who buy and sell foreign currencies.

The foreign exchange market for any one currency, for example, the French Franc,
consists of all the locations such as Paris, London, New York, Zurich, Frankfurt and so
on, in which the French Franc is bought and sold for other currencies. The most
important foreign exchange markets are found in London, New York, Tokyo, Frankfurt,
Amsterdam, Paris, Zurich, Toronto, Brussels, Milan, Singapore and Hong Kong.

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The main participants in the market are companies and individuals, commercial banks,
central banks and brokers. Companies and individuals need foreign currency for business
or travel. Commercial banks are the source from which companies and individuals obtain
their foreign currency. Through their extensive network of dealing rooms, their arbitrage
operations (buying in one centre and selling in another) banks ensure that quotations in
different centres tend towards the same price. Besides this, there are also foreign
exchange brokers who bring buyers, sellers and banks together and receive commissions
on deals arranged. The other main player operating in the market is the central bank, the
main part of whose foreign exchange activities involves the buying and selling of the
home currency or foreign currencies with a view to ensuring that the exchange rate
moves in line with established targets set for it by the Government.

There are four main types of transactions undertaken in these foreign exchange markets:

 Spot transaction
 Forward deals
 Futures transactions
 Currency options

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Types of Exchange Rates

(Stern)

There are three major types of exchange rates:

 Floating
 Fixed
 Managed

Floating exchange rate: Flexible exchange rate system refers to a system in which
exchange rate is determined by forces of demand and supply of different currencies in
the foreign exchange market. The exchange rate is determined by the market, i.e.
through interactions of thousands of banks, firms and other institutions seeking to buy
and sell currency for purposes of making transactions in foreign exchange.

Fixed exchange rate: It is the system where the government determines the exchange
rate for a period of time based on the value of another country's currency such as, the
US dollar. The basic reason for adopting this system is to ensure stability in foreign
trade and capital movements.

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 For this, the governments of countries following this exchange rate system have to
maintain large reserves of foreign currencies to maintain the exchange rate at the
level fixed by it. When value of a currency is fixed in terms of some other currency or
in terms of gold, it is known as ‘Parity value’ of currency.

Managed Floating rate: It is the exchange rate system where the forces of demand
and supply decide the exchange rate and the central bank influences the exchange rate
through intervention in the foreign exchange market. It does so to restrict the
fluctuations in the exchange rate within certain limits.

The aim is to keep exchange rate close to desired target values. For this, the central
bank maintains reserves of foreign exchange so as to ensure that the exchange rate
stays within the targeted value.

Exchange Rate Quotations

For a foreign exchange transaction to occur there are two rates that are essentially
displayed. They are:

 Ask rate: It is the price at which the bank or any other FOREX dealer is willing to
sell a unit of the base currency.
 Bid rate: It is the highest price that a buyer of a currency is willing to pay for a
unit of the base currency.

Exchange rate is denotation of the ask and bid rate of the home currency with respect to
another foreign currency. For instance, the exchange rate between USD and INR, with
INR being the home currency can be depicted in two ways:

1. Direct Quotation: 60 INR/USD

This would mean that it takes 60 Rupees to purchase 1 US dollar.
In a foreign exchange quotation, the foreign currency is the commodity
that is being bought and sold. The exchange quotation that gives the price for the
foreign currency in terms of the domestic currency is known as direct quotation.

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 In a direct quotation, the unit of the foreign currency is kept constant and
the change in price is indicated by change in the number of units of the domestic
currency equivalent to one unit of the foreign currency. It is also known as home
currency quotation.
2. Indirect Quotation: 0.0.167 USD/INR
This would mean that it takes 0.0167 units of US dollar to purchase 1 Rupee
This type of quotation gives the quantity of foreign currency per unit of
domestic currency and is known as indirect quotation. In this, the unit of domestic
currency is kept constant and the change in the price of the currency is indicated
by varying units of the foreign currency for fixed sum of domestic currency.

In India, Direct quotation was prevalent till 1966. After devaluation of rupee in 1966,
following the practice in London Exchange Market, indirect quotation was adopted.
Effective from 2nd August, 1933, India has switched over to direct method of quotation.

Balance of Payments and forecasting exchange rates

The balance of payments summarises the flow of economic transactions between the
residents of a given country and the residents of other countries during a certain period of
time. BOP flows represent payments and receipts and its data record only changes in
asset holdings and liabilities; they do not represent the absolute levels of these items.

The use of balance of payments data to forecast foreign exchange rates is predicted upon
the assumption that when a country's currency is in equilibrium, that country will display
a break-even position in respect of trade and the invisibles which reflect the rendering of
services. The other key assumptions in forecasting foreign exchange rates from the
balance of payments are that currencies which are undervalued will have the effect of
creating positive current account outruns, while currencies which are overvalued will
have the effect of creating negative current account results.

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 FOREX in India
(Chakrabarti)

The FOREX market in India is growing very rapidly, with an annual turnover of more
than $400 billion. The main center of foreign exchange transactions in India is its
commercial capital, Mumbai.

The Foreign Exchange Market in India is regulated by the RBI via the Exchange Control
Department as per the Foreign Exchange Management Act (FEMA), 1999. Before the
introduction of FEMA, the entire foreign exchange market was regulated by the Foreign
Exchange Regulations Act (or FERA), 1947 which was introduced post independence as
a temporary measure to regulate the inflow of foreign capital into the country. During
2003-04 the average monthly turnover in the Indian foreign exchange market touched
about 175 billion US dollars. Compare this with the monthly trading volume of about 120
billion US dollars for all cash, derivatives and debt instruments put together in the
country, and the sheer size of the foreign exchange market becomes evident. Since then,
the foreign exchange market activity has more than doubled with the average monthly
turnover reaching 359 billion USD in 2005-2006, over ten times the

daily turnover of the Bombay Stock Exchange. As in the rest of the world, in India too,
11
foreign exchange constitutes the largest financial market by far.

Until 1992, all Foreign Investments in India and the repatriation of Foreign
Capital required previous approval of the government. The Foreign Exchange Regulation
Act rarely allowed foreign majority holdings for Foreign Exchange in India. However, a
new Foreign Investment Policy announced in July 1991, declared automatic approval for
Foreign Exchange in India for thirty-four industries; they were designated with high
priority, up to an equivalent limit of 51 percent. Initially, the Government required that a
company's routine approval shall rely on identical exports and dividend repatriation. But,
in May 1992, this requirement was removed, with an exception to low-priority sectors.
As a consequence, in 1994, foreign nationals and NRI (non-resident Indian) investors
were permitted to repatriate their profits as well as their capital for Foreign Exchange in
India. Indian exporters enjoyed the freedom to use their export earnings as they found it
suitable. Today, the Indian FOREX market is highly flourishing and is one of the biggest
avenues for profit.

Role of RBI in FOREX Management

(Buckley), (Apte)

The Reserve Bank of India is India's central banking institution. It commenced its
operations on 1st April, 1935 during the British Rule, in accordance with the provisions
of the Reserve Bank of India Act, 1934.

It’s major roles are:

 Financial Supervision
 Regulation and supervision of the financial system
 Management (and Control) of Foreign exchange Issue of currency

The Reserve Bank of India plays a key role in the regulation and development of the
foreign exchange market and assumes three broad roles relating to foreign exchange:

 Regulating transactions related to the external sector and facilitating the

development of the foreign exchange market
12
  Ensuring smooth conduct and orderly conditions in the domestic foreign exchange
market
 Managing the foreign currency assets and gold reserves of the country

The foreign exchange regulations under the law previously required that all
foreign exchange receipts be sold to the RBI either directly or through authorized dealers
(mostly major commercial banks). But, as mentioned above RBI, later, with the advent of
liberalisation revoked this law.

The RBI has been vested with the power to issue licenses to those who are
involved in foreign exchange transactions. It has appointed a number of authorised
dealers who are permitted to carry out all transactions involving foreign exchange. The
'Exchange Control Manual' contains all directions and procedures given by RBI to
authorised dealers from time to time.

The RBI also has the responsibility of fixing the exchange value/rate of the home
currency i.e. the Indian Rupees in terms of other currencies. This rate is known as
official rate of exchange. All authorised dealers and money lenders are required to
follow this rate strictly in all their foreign exchange transactions.

Foreign Exchange Management Act

While booking forward contracts for customers, banks are required to observe that the
exchange regulations are complied with. Foreign Exchange Management Regulations
govern forward exchange contracts in India. A few of the major operational aspects listed
down for FOREX exchange, as per FEMA are:

 Forward contracts can be booked for resident customers who are exposed to
exchange risk in aspect of genuine transactions permitted under current
regulations.
 While booking forward contracts, irrespective of the underlying transaction being
a current account transaction or a capital account transaction, the bank should
verify suitable documents to ensure authenticity and the amount of the permitted
currency of the underlying transaction.

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Stipulations for transactions made by authorised dealers

1) A deposit made by an authorised dealer with its branch, head office or correspondent
outside India, and a deposit made by a branch or correspondent outside India of an
authorised dealer, and held in its books in India, shall be governed by the directions
issued by the Reserve Bank in this regard from time to time.

2) A shipping or airline company incorporated outside India, may open, hold and
maintain a Foreign Currency Account with an authorized dealer for meeting the local
expenses in India of such airline or shipping company:

Provided that the credits to such accounts are only by way of freight or passage fare
collections in India or by inward remittances through banking channels from its office
outside India.

3) An authorised dealer in India, may subject to the directions issued by the Reserve
Bank, allow unincorporated joint ventures (UJV) of foreign companies/ entities, with
Indian entities, executing a contract in India, to open and maintain non-interest bearing
foreign currency account and a SNRR account as specified in schedule 4 for the purpose
of undertaking transactions in the ordinary course of its business. The debits and credits
in these accounts shall be incidental to the business requirement of the UJV.

Provided that the tenure of the account is concurrent to the tenure of the contract/ period
of operation of the UJV.

Provided further that all operations in the account shall be in accordance with the
provisions of the Act or the rules or regulations made or the directions issued thereunder.

Note: Opening of accounts by companies/ entities of Pakistan/ Bangladesh ownership/

nationality would require the prior approval of the Reserve Bank

4) An authorised dealer in India, with the prior approval of Reserve Bank, may open an
account expressed in foreign currency in the name of a person resident outside India for
the purpose of adjustment of value of goods imported into India against the value of
goods exported from India in terms of an arrangement voluntarily entered into by such
person with a person resident in India.

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Nomination

Authorised dealers may provide nomination facility in respect of the deposits/ accounts
in these regulations maintained by individual account holders.

Foreign Exchange Dealer's Association of India (FEDAI)

(Apte)

It was set up in 1958 as an Association of banks dealing in foreign exchange in

India (typically called Authorised Dealers - ADs) as a self regulatory body and is
incorporated under Section 25 of The Companies Act, 1956. The major activities of the
association include framing of rules governing the conduct of inter-bank foreign
exchange business among banks vis-à-vis public and liaison with RBI for reforms and
development of FOREX market. Some ancillary functions of FEDAI also include:

 Guidelines and Rules for FOREX Business.

 Training of Bank Personnel in the areas of Foreign Exchange Business.

 Accreditation of FOREX Brokers

 Advising/Assisting member banks in settling issues/matters in their dealings.

 Represent member banks on Government/Reserve Bank of India/Other Bodies.

 Announcement of daily and periodical rates to member banks.

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 How do banks deal in FOREX?
(BrightHub, n.d.)
Banks deal in FOREX through Swap points. In FOREX, swap is the interest rate
differential between the two currencies of the pair that is being traded and, it is calculated
whether the position going to be held or rather, the duration of the investment/transaction
is going to be long or short.

Foreign exchange swap entails a simultaneous sale and purchase of equal amounts of a
currency.

FOREX is a non-business operation for banks, income from it is therefore Non-

Operational Income. The trading of FOREX in banks is done in what is known as the
'dealing room'.

Through its dealing room operations, every bank comes up with two of its own respective
rates:

 Card rate
 Ready rate

CARD RATE READY RATE

Two rates: Pre-lunch Depends on demand and supply
Post-lunch Calculated daily
Dealing </= $5,000/- Dealing > $5,000/-

Card Rate: Every bank calculates its own card rates pre and post lunch based on the
exchange rates at which they have had transactions that day till that point.

Ready Rate: It is calculated daily by the RBI for the next trading day, on the basis of the
card rates submitted to it by all commercial banks dealing/trading in FOREX.

Rates which different banks quote may differ greatly as mentioned earlier, this is
because, the banks' quotations are a function of their own currency positions that is the
kind and/or amount of currency they possess at that particular point in time. This

16
basically implies that a bank, which was able to quote a very competitive price on one
occasion, might not be able to do so next time. The more banks that are approached for
quotations, the better the chance for an advantageous rate but what the arbitrageur needs
to bear in mind is that the exchange rate keeps fluctuating by the second, it is therefore
necessary to make a quick decision before the rate falls or rises by a great deal.

Also, FOREX is not subject to investment therefore, the maximum duration for which
FOREX can be kept is for 6 months, with the exception of investors. There are three
major kinds of facilitators for FOREX:

 Speculator
 Investor
 Trader

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DEALING ROOM

FRONT OFFICE: Interaction with customers

MID OFFICE (Deal Slip)

Risk Management

 Intra-day limits
 Overnight limits
 Limit on aggregate position for all currency
 Limit for each currency
 Broker-wise business limit

BACK OFFICE

 Accounts (Mirror A/c)

o Report to RBI (Central Bank of India)

Front office: This is the face of the bank/dealing room. This is the place where the
bank gets in touch and interacts with the customers who wish to trade/transact in
foreign exchange.

Mid office: This is where all the transactions take place, via a deal slip handed over
from the front office to the mid office. It decides how to mitigate losses in every
transaction that takes place every minute and calculates the rates for a trading day.

Back office: It maintains all accounts as per the mid office's transactions and reports
the accounts as well as the intra-day rates to the Reserve Bank of India.

The gist of the dealing room operations can thus be understood by understanding that
Foreign Currency Operation in banks includes FOREX management that is, buying
and selling of foreign exchange (any currency). The Mid-office decides "which"
currency as, they manage the risk and, excessive sale of any type of currency is a
pertinent risk since the characteristic of being 'oversold' implies a negative balance in
the bank's Nostro account and can lead to the appreciation of any currency with
respect to the domestic currency, the Indian Rupees (INR) in our case.

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 Risks in Foreign Exchange

Risks associated with FOREX for banks can be majorly listed down as:

 Credit Risk
 Operational Risk
 Translational Risk
 Mismatch Risk

Credit Risk

It is the potential that a bank borrower or any other counterparty of it shall fail to meet its
obligations in accordance with the agreed rems and conditions. The goal of credit risk
management is to maximise a bank's risk-adjusted rate of return by maintaining credit
risk exposure within acceptable parameters.

To avoid credit risk, bank takes what is known as a 'bank guarantee' from the
client/company. Bank guarantee is/are specific assets of the company which the bank can
take in case of insolvency of the company.

 Guarantee against fixed assets

 Guarantee against cash

Guarantee against cash is preferable as interest can be earned on it and during the case of
an insolvency, the interest can also be claimed by the bank.

Operational Risk

This is the risk associated with the employees working in the bank, dealing with FOREX.
Intense training including, skills like ability to work under pressure and work quickly and
efficiently are therefore, mandatorily required to remove any errors due to human
discrepancy that might creep in.

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For instance, if the employee is told to transact at 11:03 am, and he instead, transacts at
11"08 am, the dollar price might have gone down in five minutes, causing the bank a
huge loss.

Translational Risk

This risk is associated to accountancy and putting all the transactions on paper.

India uses Accounting Standard- II while dealing with foreign exchange, which might be
a profitable or loss-making transaction for the bank.

Example: Actual transactions are happening in dollars (USD) but we need to record them
in Indian Rupees (INR). Due to this, the change resulting in between the two values that
is, the change in currency value is the loss that the bank is suffering.

Also, there can be a (accounting) translational risk if depreciation method used in India
and US are not the same.

Example: In India, all buildings are subject to depreciation by the Straight Line Method
while in the US commercial buildings are subject to depreciation by Written Down Value
method and residential buildings are subject to the Straight Line Method of depreciation.

Mismatch Risk

It is related to spot transactions and future transactions and, is a combination of the

following two risks:

 Position risk- they are over-purchased

 Credit risk- Mr.X is not willing to pay

It is a category of risk which refers to the possibility that a swap dealer has
been/shall be unable to find a suitable counterparty for a swap transaction for which it is
facilitating the transaction as an intermediary. It is the risk that an investor has chosen
investments that are not suitable for his or her circumstances.
1) A number of different factors can make it difficult for a swap bank to find a

20
counterparty for a swap transaction. For example, wanting to participate in a swap with a
very large notional principal may limit the number of available counterparties.
2) A mismatch between investment type and investment horizon can be a source of
mismatch risk. For example, mismatch risk would exist in a situation where an investor
with a short investment horizon (such as one who is near retirement) invests heavily in
speculative hi-tech stock. Typically, investors with short investment horizons should
focus on less speculative investments such as fixed income securities and blue chip
equities.

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How do banks reduce the chances of risks associated with
FOREX?

Currency Swap

To understand why we have FOREX risk and its management as an essential part of
FOREX, we need to understand what Currency Swap is.

A currency swap, as the name indicates, is an exchange, by two foreign borrowers (or
firms or, any two entities) with opposing needs, of a certain amount of currencies via
a financial intermediary (usually a bank). The main goal of a currency swap is to
decrease the cost of financing for both firms involved. It requires that:

1) Their financial needs are opposed and,

2) There exists an absolute (or a comparative) advantage in borrowing for one (both)
of the firms involved in the transaction.

Since, banks enable such transactions of change in currency between two (or more)
different parties, the volatility of the exchange rates can cause them huge losses if not
managed properly, this is the reason we have FOREX Risk Management as an
integral part of every bank dealing in FOREX.

FOREX Hedge

(J P Morgan, 2012)

FOREX hedge is a transaction implemented by the bank (or any FOREX

trader for that matter) to protect an anticipated or existing position from an unwanted
change/move in the exchange rates. Hedging is practiced by FOREX dealers/traders
to manage upside or downside risk to mitigate or remove the losses that might occur
as a result of the increase or decrease, respectively, in the exchange rates of the
currencies they are dealing with.

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To get a better perspective we need to understand how hedging, in general, works.
Let us consider an example: A developing company makes quarterly loan instalments
in US dollars and receives income from leasing premises on its sites in Russian
rubles. In order to protect itself from a downslide of the Russian ruble throughout the
year and from the actual growth of the loan maintenance costs, the company sells a
certain amount of futures contracts for Russian rubles against US dollars for the entire
amount of future loan instalments in the beginning of the year. Later, upon closing
(paying) such contracts on the market and once the funds are received and exchanged,
the company would earn profit if the Russian ruble drops. Such profit would “mirror”
the loss upon the actual exchange (i.e., the company would have fully protected itself
from losses). The opening of a futures contract would require collateral of about
5% of the total amount being insured, and costs resulting from buying and
selling the futures contracts would not exceed 0.001%. This is essentially what
hedging does, it gives any person dealing with FOREX (or any other security as well)
the chance to cover up its potential losses by speculating or predicting the future
market and taking steps in the present, accordingly.

There are two primary ways for FOREX hedging: (Prof.Ian Giddy)

1. Spot contracts

Spot rate is the current exchange rate for a currency pair at which it can be bought
or sold. It differs from forward rate in the way that it determines the values/rates of
currencies based upon the current values/rates of the other currencies. Traders that
hold a position for longer than two days will have their trades "reset" by the broker,
i.e. closed and reopened at the same price, just prior to the two-day deadline thus,
though spot rate is all about the transaction closing in a time period of two days, it
rarely happens.

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2. Foreign currency option

Since spot contracts have a very short term delivery date of two days, they are
usually not the most effective means of FOREX hedging, in fact, they are one of the
reasons that hedging is required in FOREX transactions and dealings. This is where
foreign currency option comes into the picture, it is the most effective way- till now-
of hedging FOREX transactions.

Simply stated, an option contract is a choice. The holder of the option has the
right but not the obligation to buy or sell a fixed amount of currency at a fixed
rate of exchange at a predetermined date in the future. It is entirely up to that
buyer whether or not to exercise that right (that is take up the right of the option),
only the seller of the option is obligated to perform. The option holder (buyer) can
therefore choose the better price – either from the prevailing market price at the time,
or the price specified in the option. An option can be regarded as a form of insurance;
if the market moves against you, you will be protected and can still take advantage of
better prices should the market move in your favour.

There are two types of options contracts that can be bought and/or sold:

i. Call option
ii. Put option
i. Call option: This basically gives the buyer the right to call i.e. buy the underlying
currency. The holder (of the call option) has the right to buy the underlying
currency while, the seller of the call option has an obligation to sell the currency
if and when the holder exercises his right.
ii. Put option: This gives the buyer the right to sell the underlying currency. Here,
in contrast to the call option, the holder has the right to sell the underlying
currency while, the seller of the put option is obligated to buy the underlying
currency if and when the holder exercises his right.

24
 How do banks exercise hedging?
(Armands)

Hedging approaches by banks:

 Open
 Forward
 Swap + Spot
 Rollover
 Money Market

How Banks Hedge?

Short Long
Today (Intra-day) 

T+2 (Spot) ✔

T+90(Futuresand ✔
Forward)
Methods:
 Spot +Swap
 Spot+ Rollover swap
 Money Market
 Outright forward
The table above shows what kind of hedging for long or short duration
investments do banks undertake.

Intra-day
These are the transactions that are closed in the same day itself. The major way
banks hedge themselves against it is by accounting for and enabling the FOREX
transaction for customers at greater price than the ongoing exchange rate which is also
known as the transaction fee.

25
Spot Contracts (T+2)

Spot contracts as mentioned earlier, are the FOREX transactions that occur at the
present value of the exchange rates for a currency pair. How banks go about it is an
interesting way. Like we read earlier that the 'dealing room' within a bank comes up with
card rates and daily rates as well, these are the exchange rates at which the transactions
occur.

So, basically, all the commercial banks in India come up with their daily card
rates during the course of the day based upon the fluctuating exchange rates of different
currencies as per their demand and supply and other external factors. At the end of every
day, they submit their highest and lowest rates of the FOREX dealings to the Reserve
Bank of India which, then, based upon the cumulative results and average of the rates
submitted by all banks, comes up with the an exchange rate for the next day. This is the
rate with reference to which, the FOREX dealings/transactions begin the next day for all
banks.

As we know, all banks have different spot rates that is, while facilitating FOREX
for their customers, they charge an amount greater than the ongoing exchange rate as a
fee for the bank. This amount is set according to the trend in the price of the different
currencies and their relation with the Indian Rupee (INR) and, this is the amount which is
said to 'hedge off' any losses that might occur as a result of the drop in the value of the
INR (or if any other currency) that the bank is dealing with. This is the reason that the
transaction rates of the banks are usually a little higher than the ongoing exchange rates.

26
FUTURES AND FORWARD RATES (Prof.Ian Giddy)

Forward Contracts

 Agreement to exchange currencies at certain exchange rate in the future.

 Default risk in forward contracts arises because such a contract is a commitment
for future performance, and one or other party may be unwilling or unable to
honor that commitment.
 On the settlement date, one party in effect owes the other party a net amount.

The FOREX Swap Hedge

Dealers typically hedge a forward foreign exchange commitment with a spot plus
“FX Swap”: spot sale plus forward purchase of a foreign currency where, the FOREX
swap rate is determined by an interest rate differential. I shall be further discussing this
with the help of an example.

Consider, a USA based company ABC ltd. with a subsidiary in UK where, the
subsidiary wants to borrow £100,000 @ 9% GBP (which is 6% in USD) and a UK based
company XYZ ltd. with a subsidiary in USA which wants to borrow $1,50,000 available
to it @ 8% USD (which is 7% in GBP).

27
Now, let us say that XYZ ltd. in USA and ABC ltd. in UK decide to mutually enter into
agreements with their parent companies in their countries to stave off the excess
exchange cost. This still results in a huge amount of interest being paid to the respective
parent companies by the other company's subsidiaries. This is where an FI or a Foreign
Institution such as a bank with a foothold in both countries comes into play. It acts as an
intermediary as follows:

The Rollover Swap Hedge

Often referred to as 'tomorrow next' in the FOREX market, rollover is the process
of extending the settlement date of an open position. Oftentimes, the bank needs to take
the delivery of the currency being traded within two days (spot rate transactions) but,
sometimes it extends the procedure by 'rolling over the position' that is, closing the
existing position at the closing rate of the day and simultaneously re-entering it at the
opening rate of the next trading day.

28
 The question arises, why do banks do this? Rollover is useful in FX and banks
and traders do this because they want to profit from changes in the exchange rates. Since
every FOREX trade is transacted by borrowing one country's currency to buy another,
receiving and paying interest is a regular occurrence. At the close of every trading day, a
trader who took a long position in a high yielding currency relative to the currency that he
or she borrowed will receive an amount of interest in his or her account.

29
 FOREX Trading in Indian Banks
(Chakrabarti)

As we know, only currency pairs involving the Indian Rupee (INR) can be
traded legally on Indian Exchanges. There are 4 such pairs available to trade. Trading
on other pairs is illegal under FEMA Act. Trading in the foreign exchange market is
illegal and is a non-bailable offence.

But, that does not mean FOREX trading is completely prohibited in India, there
are legal ways of trading FOREX in India through Indian exchanges like the National
Stock Exchange (NSE), Bombay Stock Exchange (BSE) and Metropolitan Stock
Exchange (MSEI) which provide an opportunity to trade in currency derivatives and the
list of registered brokers for currency derivatives segment can be easily be found on
Securities and Exchange Board of India’s (SEBI) website.

The banks which are the top facilitators of FOREX transactions in India are:

 ICICI Bank
 HDFC Bank
 Axis Bank
 State Bank of India

ICICI Bank is the top player in the market when it comes to providing good
FOREX return and quick services to its customers while the State Bank of India is the
best provider of FOREX services among all Government banks, with the largest
customer base in general.

30
COMMERCIAL BANKS
The top two banks with the highest number of FOREX services transactions are:

 ICICI Bank- Privatised commercial bank

 State Bank of India- Government bank

Now, we shall look at the number of services provided by them and the methods
undertaken by them to mitigate FOREX risk in their banks.

ICICI Bank

(Bank)

ICICI Bank has the highest number of foreign exchange transactions in

India among all the commercial banks dealing with FOREX. There are a number
of services that the bank provides its customers with but, the most widely used
services of the bank are:

 Travel currency card: It is the service where a customer before leaving for
travelling abroad can deposit a certain amount of money in the travel card

31
 that is provided from the bank, in the currency of the place that he/she is
travelling to.
 Outward remittance: It is the service of sending money to someone in
another country, in their currency. The bank has a quick outward
remittance service, enabling complete transactions within a day.
 FOREX Currency swap: This is by far the most used and popular service
of the bank.

While speaking with Ms.Sweeti Pal, Manager at the ICICI Bank in Kanpur, Uttar
Pradesh, I was able to gain the following pieces of information.

Q. How does the bank have such a wide customer base especially for FOREX
service when there are multiple number of commercial banks offering the
same services and maybe even higher cash buying but, lower cash selling
exchange rates?

Firstly, the reason why the bank has such a wide customer base particularly when
it comes to foreign exchange of currency, she said, is because of its relatively
lower volatile prices and good returns. Also, their other services like quick
outward remittances and easy and quick availability of Travel currency cards
make their customers loyal to them and the bank makes sure that the redressal of
any grievances or complaints by the customers is done at the earliest possible
time, this further helps them in retaining and therefore expanding their current
customer base.

Q. How many FOREX transactions does the bank have on an average,

monthly? Which currency is the most sought after?

Around 5 to 6 transactions monthly. The US Dollar is but obviously the

most sought after currency and, the number of transactions too increase when
the exchange rate falls with respect to INR.

Q. What are the major steps that the bank takes to offset FOREX risk?

32
 Often times the major pertinent risk in the branch is the Mismatch risk and to
offset that we basically roll it over for a few days and hedge it. Besides that, to
offset minor losses, we have exchange rates high enough- not too high for the
customer to feel cheated- to cover up any such minor loss that might be possible.

State Bank of India

(SBI)
It is the largest Government bank in general, with 198 offices in 37 countries and
301 correspondent banks across 72 countries. It also has the largest number of foreign
exchange services offered by any Government bank in India. The major FOREX services
offered by the bank include:

 FOREX market
 Currency Purchase/Sale
 Gold Purchase/Sale

During my conversation with Mr.Rathi, I found that the bank's major focus is to
make available FOREX services to all its customers easily and promote the use of
services and products like travel currency cards and, also to enable its high end
customers have a great experience in investing in FOREX.

The bank is currently trying to bring its foreign exchange services at par with
those proffered by the private banks in order to break the stereotype in the minds of
the people of India that Government banks do not or rather, cannot provide services
at par with privatised banks.

Another unique feature of the bank is that, it has an exclusive 'Gold

sale/purchase' FOREX option easily available with it, which is not the case with other
private banks. The purchase of Gold in the spot and forward markets is
undertaken to cover the customer transactions and bullion sale of the bank
including sale of gold coins.

33
Current Scenario and Scope of the FOREX Market in India

(Indianetzone)

As per the FEMA, 1999 contraventions, individuals in India were strictly

forbidden from electronic and internet based foreign trading till 2014. The reports issued
by banks on this also said that only corporations are allowed to trade that too with the
condition that the corporations are to use only free dollars from their reserves. Free
dollars usage means that they are not allowed to convert the Indian Rupee to dollars to
use the then converted dollars for trading. Also, they are conditioned to stick to a
leverage of less than ten times.

But, the Reserve Bank of India (RBI) in 2014 told several large lenders that they
are free to carry out foreign exchange proprietary trades in which bank treasuries bet on
the dollar-rupee movement. The move will deepen the currency market and offer finer
foreign exchange rates to customers, particularly large corporates with regular exports,
imports and dollar borrowings.

Due to further relaxation of the rules and regulations by India's FOREX reserves
increased to a record high of $363.46 billion in June, 2016 and India, is also supposedly
going to contribute $18 billion to the BRICS FOREX reserve pool. [Source: India Times-
June, 2016; dnaindia- July, 2015]

Indian FOREX marketplace is tiny when compared with other created nations but
with the multinationals coming up and new government policies the path of expansion is
on its new heights. The Indian government has now open up new ways to trade and
regulated this market as well. India has shown fantastic rise in its FOREX turnover in
final 3 years. Folks now feel comfy to trade in and exit from the market. In India people
are now more aware of the kinds of trading like derivative markets, choices, swapping,
hedging and so on. The most crucial characteristic of FOREX is the impact on various
currencies by the modify in 1 currency rates. Any financial activity in world impacts the
FOREX marketplace immediately.

34
Apart from the transaction value, FOREX management finds scope as a mode of
investment. Because of the frequent and often miniscule fluctuation in FOREX values,
enough arbitrage and speculative opportunities crop up in FOREX market for astute
investors. There are many expert FOREX dealers specializing in trading of FOREX. This
leads us to believe that FOREX indeed has good prospects for the future

India’s share ‘Free FOREX Teaching’ in the global FOREX marketplace showed
a development of 0.9% in the year from 2013-14 and has been predicted to grow
manifold times over the years. Also, the three fold growth and development of FOREX
trades in India has been a testimony to its potential and it has already started to being
referred as the investment hub as we have seen FDI s increase by 29% in 2016 already
when the total FDI investments received for the financial year 2015-16 was US$ 40
billion. [Hindu, May 28, 2016]

35
 Impact of Brexit on the GBP/INR
(Times), (Post)

With the financial and political consequences of Brexit that continued to reverberate
around the world, questions persisted over a long time over its impact for the global
economy, including the world’s emerging markets. The Brexit referendum on June 23,
2016 was an unprecedented global development. The United Kingdom (UK) voting for
the ‘Leave’ from the European Union (EU) is expected to have considerable socio
economic and political ramifications in the years ahead

What does Brexit mean for India? As a former British colony, the country enjoys
particularly close economic, trade, political and cultural ties to the United Kingdom.
Firstly, the massive sell-off of the British pound immediately after Brexit resulted in an
approximate 8% decline of the currency relative to the Indian rupee. Following Brexit,
the Sensex opened 635 points lower than the previous day, further plunging by 1,091
points before bottom fishing brought some stability and, though the day index recovered
by 486 points from the day's low, it still closed 2.24% or 605 points lower.
the debt market still remained relatively calm, however, the currency market took a huge
hit, ending the week with a loss of 89 paisa against the dollar.

36
A few other of the negative impacts of Brexit would be:

 Oil price may fall but stronger dollar will offset

 Bad for automobile sector
 Rupee may hit 70 vs US Dollar

India’s exports to the UK have been around 3% of our total exports and exports to the
European Union are around 17% of total exports. Both the exports have been on a
downtrend since Brexit and are estimated to reduce even further due to the high
probability of disturbances in currencies and UK facing a slowdown in growth as well.
The Rupee was expected to display a a state of volatility in the coming weeks and months
due to anxiety in the global markets. However, RBI had been quick to intervene to
manage liquidity through open market operations and use the foreign exchange reserves
to tackle currency volatility and capital outflows in case of any skewed movements, this
is further expected to continue.

Information Technology

India is one of the largest exporters of IT-enabled services and the sector has
significant exposure to the European market especially the UK, which accounts for
around 17% of India’s total IT exports. India’s IT exports to other European countries too
is around 11%. The IT companies thus are expected to face the heat in light of the Brexit.
Moreover, with the imminent risk of further moderation in growth in the UK and EU,
there is an increased probability that the companies (in general) will lower their IT
budgets (a discretionary spend). This would have an impact on the domestic software
companies. Further, the depreciation of Pound does not augur well for the sector and can
negatively impact the growth in the sector anyway.

Besides, the Indian IT sector has had some issues with the EU data security
policies, including rules on transferring personal data. So, on the positive side the UK
could look at abandoning the stringent stance on data management post Brexit. Also, UK
would be under no obligation to adhere to restrictive localization norms adopted by EU,
and further strengthen ties with India on this and other trade relations as well.

37
In general too, on a positive note, Brexit shall likely compel London to seek a more
robust trade relationship with New Delhi. Besides this, it was mentioned that although the
scenario seems unfavourable for INR, there won't be a long standing negative impact of
Brexit on the Indian Rupee because of RBI's FOREX reserves.

"India's FOREX reserves of more than $360 billion and import cover of more than a year
would be adequate in managing the temporary effects of the recent Brexit, if at all there
is an impact," - RBI Regional Director, Thiruvananthapuram, SMN Swamy

38
 Major Findings

One of my major findings from this study has been that over the years India as a country
has greatly evolved in the foreign exchange market and is expected to grow both, in terms of the
investments made in the FOREX market and in its magnitude. This is evident due to the gradual
laxation in stringent policies that the RBI provides.
In 1991, with the advent of liberalization, RBI permitted FOREX to take place without
extreme interference by it. It has now further reduced the restrictions on the kinds of Foreign
exchange investments permitted and considered legal.
Another thing that I found in the course of my study for this project is that, banks in general,
prefer hedging to be the most preferable kind of risk management for Foreign Exchange Risk. This
is primarily because, hedging permits them more control over the situation/scenario based upon
their speculation.

39
 Conclusion
Risks and their management have always been inseparably associated with all
forms of economic activities. While the complexities, magnitude and dimensions of
economic risks have grown manifold concomitant with the growth and complexity of the
world economy, stakeholders exposed to risks have tried to manage their impact through
a host of means. Hedging primarily involves a bit of speculation and smart work in the
beginning of any FOREX transaction to ensure that at least there is no loss incurred if
there are no profits earned. Out of all the risk management methodologies, it the most
preferred method since it is the 'most-in-control' method.

It gives the traders the chance to hedge off even future and forward contracts as
per the contract entered into today. Hedging does not eliminate risks but helps to
transform risks. Hedging accords differentiation to firms in a highly competitive
environment; an edge which goes beyond the protection of bottom-lines. Also, besides
saving on managerial costs relating to managing price volatility, hedging also
significantly lowers the distress costs in the event of adverse circumstances confronting a
bank/firm. FOREX hedging further helps banks to enter into contracts without letting the
fear of fluctuating exchange rate tamper with its trading operations.

40
 Bibliography

Apte. (n.d.). International Finance.

Armands. (n.d.). How the banks trade FOREX. How the banks trade FOREX.
Bank, I. (n.d.). FOREX services.
BrightHub. (n.d.). www.brighthub.com. Retrieved from Brighthub.
Buckley, A. (n.d.). Multinational Finance.
Chakrabarti, R. (n.d.). Foreign Exchange Markets.
FICCI, B. (n.d.). Foreign Exchange. Retrieved from blog.ficci.com.
Indianetzone. (n.d.). FOREX Exchange Market and Services in India.
J P Morgan. (2012). Foreign Exchange Risk Management.
Post, F. (n.d.). Brexit Impact on India. First Post.
Prof.Ian Giddy, N. Y. (n.d.). Forwards, Futures and Money Market Hedging.
SBI. (n.d.). FOREX Services.
Stern, N. (n.d.). FOREX AND FOREX Risks.
Times, E. (n.d.). How Brexit will Impact the Indian Market and Rupee.

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