down to ` 57 leading to wiping off of commercial profit for exporter. Such transaction exposures arise whenever a business has foreign currency denominated receipts or payments. The risk 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. Translation Exposure Also known as accounting exposure, it refers to gains or losses caused by the translation of foreign currency assets and liabilities into the currency of the parent company for consolidation purposes. Translation exposure, also called as accounting exposure, is the potential for accounting derived changes in owner’s equity to occur because of the need to “translate” foreign currency financial statements of foreign subsidiaries into a single reporting currency to prepare worldwide consolidated financial statements. Translation exposures arise due to the need to “translate” foreign currency assets and liabilities into the home currency for the purpose of finalizing the accounts for any given period. A typical example of translation exposure is the treatment of foreign currency loans. Consider that a company has taken a medium-term loan to finance the import of capital goods worth dollars 1 million. When the import materialized, the exchange rate was, say, USD/INRR-55. The imported fixed asset was, therefore, capitalized in the books of the company at ` 550 lacs through the following accounting entry: Debit fixed assets ` 550 lacs Credit dollar loan ` 550 lacs In the ordinary course assuming no change in the exchange rate, the company would have provided depreciation on the asset valued at ` 550 lacs, for finalizing its account for the year in which the asset was purchased. However, what happens if at the time of finalization of the accounts the exchange rate has moved to say USD/INR-58. Now the dollar loan will have to be “translated” at ` 58, 101 CU IDOL SELF LEARNING MATERIAL (SLM)
involving a “translation loss” of a ` 30 lacs. It shall have to be capitalized by increasing the book value of the asset, thus making the figure ` 380 lacs and consequently higher depreciation will have to be provided, thus reducing the net profit. It will be readily seen that both transaction and translation exposures affect the bottom line of a company. The effect could be positive as well if the movement is favorable – i.e., in the cited examples, in case the USD would have appreciated and the USD would have depreciated against the rupee. An important observation is that the translation exposure, of course, becomes a transaction exposure at some stage: the dollar loan has to be repaid by undertaking the transaction of purchasing dollars. Economic Exposure It refers to the extent to which the economic value of a company can decline due to changes in exchange rate. It is the overall impact of exchange rate changes on the value of the firm. The essence of economic exposure is that exchange rate changes significantly alter the cost of a firm’s inputs and the prices of its outputs and thereby influence its competitive position substantially. 102 CU IDOL SELF LEARNING MATERIAL (SLM)
5.6 RISK IN FOREIGN EXCHANGE BUSINESS The firm’s risk that its future cash flows get affected by the change in the value of the foreign currency, in which it has maintained its books of accounts (balance sheet), due to the volatility of the foreign exchange rates is termed as foreign exchange exposure. It is not only those firms who directly make the financial transactions in the foreign currency denominations faces the risk of foreign exposure, but also, the other firms who are indirectly related to the foreign currency is exposed to foreign currency risk. For example, if Indian company is competing against the products imported from China and if the Chinese yuan per Indian rupee falls, then the importers enjoy decreased cost advantage over the Indian company. This shows, that the companies not having any direct link to the forex do get affected by the change in the foreign currency. Fig 5.2 Steps to Manage Foreign Exchange Risk 5.7 TYPES OF RISK IN FOREIGN EXCHANGE There are three types of foreign exchange risk: Transaction Risk: This is the risk that a company faces when it's buying a product from a company located in another country. The price of the product will be denominated in the selling company's currency. If the selling company's currency were to appreciate versus the buying company's currency then the company doing the buying will have to make a larger payment in its base currency to meet the contracted price. The risk of changes in the expected value of a contract between its signing and its execution as a result of unexpected changes in foreign exchange rates. Whoever makes a contract denominated in a foreign currency bears transaction risk. Ocean Drilling has transaction risk if it borrows money in French francs or Japanese yen, and 103 CU IDOL SELF LEARNING MATERIAL (SLM)
Hintz-Kessels-Kohl has transaction risk if it agrees to accept future payments for its vehicles in U.S. dollars. Translation Risk: A parent company owning a subsidiary in another country could face losses when the subsidiary's financial statements, which will be denominated in that country's currency, have to be translated back to the parent company's currency. Gains or losses from exchange rate changes that occur as a result of converting financial statements from one currency to another in order to consolidate them. Every company having at least one subsidiary using a different functional currency bears translation risk. MSDI has translation risk from having a subsidiary, MSDI Alcala de Henares, whose financial statements are kept in Spanish pesetas and not in U.S. dollars. Economic Risk: Also called forecast risk, refers to when a company’s market value is continuously impacted by an unavoidable exposure to currency fluctuations. Changes in competitive position because of permanent changes in exchange rates. Every company buying or selling abroad or even just competing with foreign companies has economic risk. Maybach has economic risk from manufacturing its automobiles in Germany for export to the United States, where it competes with Rolls Royce’s manufactured in England. Contingent Risk A firm has contingent risk when bidding for foreign projects, negotiating other contracts, or handling direct foreign investments. Such a risk arises from the potential of a firm to suddenly face a transnational or economic foreign-exchange risk contingent on the outcome of some contract or negotiation. For example, a firm could be waiting for a project bid to be accepted by a foreign business or government that, if accepted, would result in an immediate receivable. While waiting, the firm faces a contingent risk from the uncertainty as to whether or not that receivable will accrue. 5.8 OTHER CLASSIFICATIONS OF FOREX RISKS The following are the major risks in foreign exchange dealings 104 Open Position Risk Cash Balance Risk Maturity Mismatches Risk Credit Risk Country Risk Overtrading Risk Fraud Risk, and Operational Risks CU IDOL SELF LEARNING MATERIAL (SLM)
Open Position Risk The open position risk or the position risk refers to the risk of change in exchange rates affecting the overbought or oversold position in foreign currency held by a bank. Hence, this can also be called the rate risk. The risk can be avoided by keeping the position in foreign exchange square. The open position in a foreign currency becomes inevitable for the following reasons: (a) The dealing room may not obtain reports of all purchases of foreign currencies made by branches on the same day. (b) The imbalance may be because the bank is not able to carry out the cover operation in the interbank market. (c) Sometimes the imbalance is deliberate. The dealer may foresee that the foreign currency concerned may strengthen. Cash Balance Risk Cash balance refers to actual balances maintained in the nostro accounts at the end-of each day. Balances in nostro accounts do not earn interest: while any overdraft involves payment of interest. The endeavor should, therefore, be to keep the minimum required balance in the nostro accounts. However, perfection on the count is not possible. Depending upon the requirement for a single currency more than one nostro account may be maintained. Each of these accounts is operated by a large number of branches. Communication delays from branches to the dealer or from the foreign bank to the dealer may result in distortions. Maturity Mismatches Risk This risk arises on account of the maturity period of purchase and sale contracts in a foreign currency not coinciding or matching. The cash flows from purchases and sales mismatch thereby leaving a gap at the end of each period. Therefore, this risk is also known as liquidity risk or gap risk Mismatches in position may arise out of the following reasons: a) Under forward contracts, the customers may exercise their option on any day during the month which may not match with the option under the cover contract with the market with maturity towards the month end. b) Non-availability of matching forward cover in the market for the volume and maturity desired. c) Small value of merchant contracts may not aggregative to the round sums for which cover contracts are available. d) In the interbank contracts, the buyer bank may pick up the contract on any day during the option period. e) Mismatch may deliberately create to minimise swap costs or to take advantage of changes in interest differential or the large swings in the demand for spot and near forward currencies. 105 CU IDOL SELF LEARNING MATERIAL (SLM)
Credit Risk Credit Risk is the risk of failure of the counterparty to the contract Credit risk as classified into (a) Contract risk and (b) Clean risk. Contract Risk: This arises when the failure of the counterparty is known to the bank before it executes its part of the contract. Here the bank also refrains from the contract. The loss to the bank is the loss arising out of exchange rate difference that may arise when the bank has to cover the gap arising from failure of the contract. Clean Risk Arises when the bank has executed the contract, but the counterparty does not. The loss to the bank in this case is not only the exchange difference, but the entire amount already deployed. This arises, because, due to time zone differences between different centers, one currently is paid before the other is received. Country Risk This type of risk is known as “sovereign risk” or “transfer risk”, country risk relates to the ability and willingness of a country to service its external liabilities. It refers to the possibility that the government as well other borrowers of a particular country may be unable to fulfill the obligations under foreign exchange transactions due to reasons which are beyond the usual credit risks. For example, an importer might have paid for the import, but due to moratorium imposed by the government, the amount may not be repatriated. Overtrading Risk A bank runs the risk of overtrading if the volume of transactions indulged by it is beyond its administrative and financial capacity. In the anxiety to earn large profits, the dealer or the bank may take up large deals, which a normal prudent bank would have avoided. The deals may take speculative tendencies leading to huge losses. Viewed from another angle, other operators in the market would find that the counterparty limit for the bank is exceeded and quote further transactions at higher premium. Expenses may increase at a faster rate than the earnings. There is, therefore, a need to restrict the dealings to prudent limits. The tendency to overtrading is controlled by fixing the following limits: a) A limit on the total value of all outstanding forward contracts; and b) A limit on the daily transaction value for all currencies together (turnover limit). Fraud Risk 106 CU IDOL SELF LEARNING MATERIAL (SLM)
Frauds may be indulged in by the dealers or by other operational staff for personal gains or to conceal a genuine mistake committed earlier. Frauds may take the form of the dealings for one‘s own benefit without putting them through the bank accounts. Undertaking unnecessary deals to pass on brokerage for a kick back, sharing benefits by quoting unduly better rates to some banks and customers, etc. The following procedural measures are taken to avoid frauds: (a) Separation of dealing form back-up and accounting functions. (b) On-going auditing, monitoring of positions, etc., to ensure compliance with procedures. (c) Regular follow-up of deal slips and contract confirmations. (d) Regular reconciliation of nostro balances and prompts follow-up unreconciled items. (e) Scrutiny of branch reports and pipe-line transactions. (f) Maintenance of up-to records of currency position, exchange position and counterparty registers, etc. Operational Risk These risks include inadvertent mistakes in the rates, amounts and counterparties of deals, misdirection of funds, etc. The reasons may be human errors or administrative inadequacies. The deals are done over telecommunication and mistakes may be found only when the written confirmations are received later. 5.9 SUMMARY Foreign exchange is a cost of doing business abroad which the management requires effective planning and knowledge of foreign exchange contracts like fixed, forward, spot and other aspects such as exchange fluctuations risk cover scheme, hedging, speculations, margin rate, currency call options, adjustable peg system, crawling peg system, managed floating system and interbank operation of foreign exchange, etc. Therefore a sound knowledge of the different aspect of FOREX is essential for any export management. Foreign Exchange Dealing is a business in which foreign currency is the commodity. It is understood that exchange rate is not very constant always. Several factors are contributing to changes in exchange rate in International currency market. Exchange rates respond quickly to all sort of events. The movement of exchange rates is the result of the combined effect of a number of factors that are constantly at play. Among the factors, Economic factors are most fundamentals which better guides as to how a currency moves in the long run. 107 CU IDOL SELF LEARNING MATERIAL (SLM)
5.10 KEYWORDS Foreign exchange risk – it refers to the losses that an international financial transaction may incur due to currency fluctuations. Exchange rate- it is the price of one currency in terms of another currency. 5.11 LEARNING ACTIVITY 1. Learn about Swap contracts and how it impacts the FOREX risk ___________________________________________________________________________ ___________________________________________________________________________ 5.12 PRATICAL APPLICATIONS An importer based out of Delhi had taken up TPO and Advisory services from My forex eye. He had an import payment of $500,000 ten days later which he wanted to hedge using multiple forward contracts. My forex eye dealers called his bank to book the contracts. The bank did not give direct treasury access to the client. Also, the bank was offering a net forward rate of 5 paise higher than the actual rate. Solution: After a long discussion, advisor asked for annualized premium which the bank denied providing by further unreasonable arguments. The total loss client was incurring on this deal was Rs.25,000. The only way to provide transparency to the client was to change the bank. Advisor associated the client with a partner bank which gives treasury access and is sure to provide transparent rates to the client in the future. 5.13 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Briefly describe the characteristics of foreign exchange market. 2. What are the factors that determine the exchange rate? Briefly describe the primary and secondary determinants 3. Who are the participants in the foreign exchange market? 4. What is a currency swap‘? Can they be used to overcome the exchange rate fluctuations? 108 CU IDOL SELF LEARNING MATERIAL (SLM)
5. What are the various problems faced by a firm when dealing in foreign exchange related business? Long Questions 1. Bring out the difference between hedging the speculation. 2. Describe the various foreign currency account schemes available in India. In what respects do they help to overcome the problems of foreign exchange available in India? 3. What are forward rate agreements? 4. What is Exchange Rate Forecast? Can we forecast exchange rates? 5. There are a number of foreign exchange rates‖. Do you agree? Elaborate. B. Multiple Choice Questions 1. The term risk in business refers to- a. Chance of losing business b. Chance of making losses c. Uncertainty associated with expected event leading to losses or gains d. Threat from competitors 2. A currency future is not a. Traded on futures exchanges b. A special type of forward contract c. of standard size d. Available in India 3. The external methods of hedging transaction exposure does not include- a. Forward contract hedge b. Money market hedge c. Cross hedging d. Futures hedging 4. Foreign currency exposure can be avoided by a. Entering into forward contracts b. Denominating the transaction in domestic currency c. Exposure netting d. None of these 5. ____________measures the rate of change of option value to volatility of price of the underlying asset. 109 CU IDOL SELF LEARNING MATERIAL (SLM)
a. Vega b. Theta c. Gamma d. rho Answer 1 -c 2 - d 3 – c 4 – b 5-a 5.14 REFERENCES OP Aggarwal, Trade and forex exchange, Himalaya Publications, 8th Edition Ranjit Singh, Forex Trading: RT Publications Shah Paresh, Forex Management, Wiley Ankit Gala and Jitendra Gala; Foreign Exchange and Forex Trading, Buzzing stock Publishing House Peters Jelle: Forex for Ambitious Beginners: Odyssean Publishing Sudhir Kochhar: Foreign Exchange Operations under FEMA: Bloomsbury Publishing (IN) 110 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT - 6: FOREIGN EXCHANGE RISK MANAGEMENT Structure 6.0 Learning Objectives 6.1 Introduction 6.2 Hedging Currency Risk 6.3 Manage Foreign Exchange Risk 6.4 Impact of Global Milieu 6.5 Types of Forex Risks 6.6 Summary 6.7 Keywords 6.8 Learning Activity 6.9 Practical Applications 6.10 Unit End Questions 6.11 References 6.0 LEARNING OBJECTIVES After studying this unit, you will be able to: Explain the meaning of Forex Risk Management Significance and importance of Exchange Fluctuations Various Impacts of Global Milieu Various Risk involved in Forex Business. 6.1 INTRODUCTION Exchange rate volatility is unpredictable since there are so many factors that affect the movement of the exchange rates i.e. economic fundamental, monetary policy, fiscal policy, global economy, speculation, domestic and foreign political issues, market psychology, rumors, and technical factors. The exchange rate volatility poses a risk, called foreign exchange risk or currency risk, to business sector, in particular, the importers and exporters or those ones who associate with international businesses. Foreign exchange (FX) risk management is important for any organization that's doing international business. The values of major currencies constantly fluctuate against each other, 111 CU IDOL SELF LEARNING MATERIAL (SLM)
creating income uncertainty for your business. Many businesses like to eliminate this uncertainty by locking in future exchange rates. But some businesses regard exchange rate movements as a profit opportunity. The simplest risk management strategy for reducing risk is to make and receive payments only in your own currency. But in doing so, companies may risk paying higher prices if suppliers with different native currencies time their payments to take advantage of exchange rate fluctuations. You might also lose customers to competitors who offer more currency flexibility and your suppliers may be unwilling to accept payments in what is to them a foreign currency. So you may therefore find that competitive pressures force you to explore a risk management strategy that helps manage your foreign exchange risk more efficiently. 6.2 HEDGING CURRENCY RISK There are a range of hedging instruments that can be used to reduce risk. Broadly these techniques can be divided into Internal Techniques: These techniques explicitly do not involve transaction costs and can be used to completely or partially offset the exposure. These techniques can be further classified as follows: Invoicing in Domestic Currency: Companies engaged in exporting and importing, whether of goods or services, are concerned with decisions relating to the currency in which goods and services are invoked. Trading in a foreign currency gives rise to transaction exposure. Although trading purely in a company's home currency has the advantage of simplicity, it fails to take account of the fact that the currency in which goods are invoiced has become an essential aspect of the overall marketing package given to the customer. Sellers will usually wish to sell in their own currency or the currency in which they incur cost. This avoids foreign exchange exposure but buyers' preferences may be for other currencies. Many markets, such as oil or aluminum, in effect require that sales be made in the same currency as that quoted by major competitors, which may not be the seller's own currency. In a buyer's market, sellers tend increasingly to invoice in the buyer's ideal currency. The closer the seller can approximate the buyer's aims, the greater chance he or she has to make the sale. Should the seller elect to invoice in foreign currency, perhaps because the prospective customer prefers it that way or because sellers tend to follow market leader, then the seller should choose only a major currency in which there is an active forward market for maturities at least as long as the payment period. Currencies, which are of limited 112 CU IDOL SELF LEARNING MATERIAL (SLM)
convertibility, chronically weak, or with only a limited forward market, should not be considered. The seller’s ideal currency is either his own, or one which is stable relative to it but often the seller is forced to choose the market leader’s currency. Whatever the chosen currency, it should certainly be one with a deep forward market. For the buyer, the ideal currency is usually its own or one that is stable relative to it, or it may be a currency of which the purchaser has reserves. Leading and Lagging: Leading and Lagging refer to adjustments at the time of payments in foreign currencies. Leading is the payment before due date while lagging is delaying payment post the due date. These techniques are aimed at taking advantage of expected devaluation and/or revaluation of relevant currencies. Lead and lag payments are of special importance in the event that forward contracts remain inconclusive. For example, Subsidiary b in B country owes money to subsidiary an in-country A with payment due in three months’ time and with the debt denominated in US dollar. On the other side, country B’s currency is expected to devalue within three months against US dollar, vis-à-vis country A’s currency. Under these circumstances, if company b leads -pays early - it will have to part with less of country B’s currency to buy US dollars to make payment to company A. Therefore, lead is attractive for the company. When we take reverse the example-revaluation expectation- it could be attractive for lagging. Netting: Netting involves associated companies, which trade with each other. The technique is simple. Group companies merely settle inter affiliate indebtedness for the net amount owing. Gross intra-group trade, receivables and payables are netted out. The simplest scheme is known as bilateral netting and involves pairs of companies. Each pair of associates nets out their own individual positions with each other and cash flows are reduced by the lower of each company’s purchases from or sales to its netting partner. Bilateral netting involves no attempt to bring in the net positions of other group companies. Netting basically reduces the number of intercompany payments and receipts which pass over the foreign exchanges. Fairly straightforward to operate, the main practical problem in bilateral netting is usually the decision about which currency to use for settlement. 113 CU IDOL SELF LEARNING MATERIAL (SLM)
Netting reduces banking costs and increases central control of intercompany settlements. The reduced number and number of payments yield savings in terms of buy/sell spreads in the spot and forward markets and reduced bank charges. Matching: Although netting and matching are terms which are frequently used interchangeably, there are distinctions. Netting is a term applied to potential flows within a group of companies whereas matching can be applied to both intra-group and to third-party balancing. Matching is a mechanism whereby a company matches its foreign currency inflows with its foreign currency outflows in respect of amount and approximate timing. Receipts in a particular currency are used to make payments in that currency thereby reducing the need for a group of companies to go through the foreign exchange markets to the unmatched portion of foreign currency cash flows. The prerequisite for a matching operation is a two-way cash flow in the same foreign currency within a group of companies; this gives rise to a potential for natural matching. This should be distinguished from parallel matching, in which the matching is achieved with receipt and payment in different currencies but these currencies are expected to move closely together, near enough in parallel. Both Netting and Matching presuppose that there are enabling Exchange Control regulations. For example, an MNC subsidiary in India cannot net its receivable(s) and payable(s) from/to its associated entities. Receivables have to be received separately and payables have to be paid separately. Price Variation: Price variation involves increasing selling prices to counter the adverse effects of exchange rate change. This tactic raises the question as to why the company has not already raised prices if it is able to do so. In some countries, price increases are the only legally available tactic of exposure management. Let us now concentrate to price variation on intercompany trade. Transfer pricing is the term used to refer to the pricing of goods and services, which change hands within a group of 114 CU IDOL SELF LEARNING MATERIAL (SLM)
companies. As an exposure management technique, transfer price variation refers to the arbitrary pricing of intercompany sales of goods and services at a higher or lower price than the fair price, arm’s length price. This fair price will be the market price if there is an existing market or, if there is not, the price which would be charged to a third-party customer. Taxation authorities, customs and excise departments and exchange control regulations in most countries require that the arm’s length pricing should be used. Asset and Liability Management: This technique can be used to manage balance sheet, income statement or cash flow exposures. Concentration on cash flow exposure makes economic sense but emphasis on pure translation exposure is misplaced. Hence our focus here is on asset liability management as a cash flow exposure management technique. In essence, asset and liability management can involve aggressive or defensive postures. In the aggressive attitude, the firm simply increases exposed cash inflows denominated in currencies expected to be strong or increases exposed cash outflows denominated in weak currencies. By contrast, the defensive approach involves matching cash inflows and outflows according to their currency of denomination, irrespective of whether they are in strong or weak currencies. External Techniques: Under this category range of various financial products are used which can be categorized as follows: Money Market Hedging: At its simplest, a money market hedge is an agreement to exchange a certain amount of one currency for a fixed amount of another currency, at a particular date. For example, suppose a business owner in India expects to receive 1 Million USD in six months. This Owner could create an agreement now (today) to exchange 1Million USD for INR at roughly the current exchange rate. Thus, if the USD dropped in value by the time the business owner got the payment, he would still be able to exchange the payment for the original quantity of U.S. dollars specified. Advantages and Disadvantages of Money Market Hedge: Following are the advantages and disadvantages of this technique of hedging. 115 CU IDOL SELF LEARNING MATERIAL (SLM)
Advantages Fixes the future rate, thus eliminating downside risk exposure. Flexibility with regard to the amount to be covered. Money market hedges may be feasible as a way of hedging for currencies where forward contracts are not available. Disadvantages include: More complicated to organize than a forward contract. Fixes the future rate - no opportunity to benefit from favorable movements in exchange rates. Derivative Instruments: A derivatives transaction is a bilateral contract or payment exchange agreement whose value depends on - derives from - the value of an underlying asset, reference rate or index. Today, derivatives transactions cover a broad range of underlying - interest rates, exchange rates, commodities, equities and other indices. In addition to privately negotiated, global transactions, derivatives also include standardized futures and options on futures that are actively traded on organized exchanges and securities such as call warrants. The term derivative is also used to refer to a wide variety of other instruments. These have payoff characteristics, which reflect the fact that they include derivatives products as part of their make- up. Transaction risk can also be hedged using a range of financial derivatives products which include: Forwards, futures, options, swaps, etc. These instruments are discussed in detailed manner in following pages. 6.3 MANAGE FOREIGN EXCHANGE RISK The proceeds of a closed trade, whether it’s a profit or loss, will be denominated in the foreign currency and will need to be converted back to the investor's base currency. Fluctuations in the exchange rate could adversely affect this conversion resulting in a lower- than-expected amount. The most complicated, albeit probably well-known way of hedging foreign currency risk is through the use of hedging arrangements via financial instruments. The two primary methods of hedging are through a forward contract or a currency option. Methods of exchange risk hedging 116 CU IDOL SELF LEARNING MATERIAL (SLM)
There are two other methods of exchange risk hedging which you are required to know about, but you will not be required solve numerical questions relating to these methods. They involve the use of derivatives: financial instruments whose value derives from the value of something else – like an exchange rate. 1. Currency futures. Simply think of these as items you can buy and sell on the futures market and whose price will closely follow the exchange rate. Let’s say that a US exporter is expecting to receive €5m in three months’ time and that the current exchange rate is US$/€1.24. Assume that this rate is also the price of US$/€ futures. The US exporter will fear that the exchange rate will weaken over the three months, say to US$/€1.10 (that is fewer dollars for a euro). If that happened, then the market price of the future would decline too, to around 1.1. The exporter could arrange to make a compensating profit on buying and selling futures: sell now at 1.24 and buy later at 1.10. Therefore, any loss made on the main the currency transaction is offset by the profit made on the futures contract. This approach allows hedging to be carried out using a market mechanism rather than entering into the individually tailored contracts that the forward contracts and money market hedges require. However, this mechanism does not offer anything fundamentally new. 2. Basis risk: can arise for both interest rate and exchange rate hedging through the use of futures. Futures contracts will suffer from basis risk if the value of the futures contract does not match the underlying exposure. This occurs when changes in exchange or interest rates are not exactly correlated with changes in the futures prices. Note that another form of basis risk also exists as part of interest rate risk. In this case basis risk exists where a company has matched its assets and liabilities with a variable rate of interest, but the variable rates are set with reference to different benchmarks. For example, deposits may be linked to the one-month LIBOR rate, but borrowings may be based on the 12-month LIBOR rate. It is unlikely that these rates will move perfectly in line with each other and therefore this is a source of interest rate risk. 2. Options. Options are radically different. They give the holder the right, but not the obligation, to buy or sell a given amount of currency at a fixed exchange rate (the exercise price) in the future (if you remember, forward contracts were binding). The right to sell a currency at a set rate is a put option (think: you ‘put’ something up for sale); the right to buy the currency at a set rate is a call option. Suppose a UK exporter is expecting to be paid US$1m for a piece of machinery to be delivered in 90 days. If the £ strengthens against the US$ the UK firm will lose money, as it will receive fewer £ for the US$1m. However, if the £ weakens against the US$, then the UK company will gain additional money. Say that the current rate is US$/£1.40 and that the exporter will get particularly concerned if the rate moved beyond US$/£1.50. The company 117 CU IDOL SELF LEARNING MATERIAL (SLM)
can buy £ call options at an exercise price of US$/£ = 1.50, giving it the right to buy £ at US$1.50/£. If the dollar weakens beyond US$/£1.50, the company can exercise the option thereby guaranteeing at least £666,667. If the US$ stays stronger – or even strengthens to, say, US$/£1.20, the company can let the option lapse (ignore it) and convert at 1.20, to give £833,333. This seems too good to be true as the exporter is insulated from large losses but can still make gains. But there’s nothing for nothing in the world of finance and to buy the options the exporter has to pay an up-front, non-returnable premium. Options can be regarded just like an insurance policy on your house. If your house doesn’t burn down you don’t call on the insurance, but neither do you get the premium back. If there is a disaster the insurance should prevent massive losses. Options are also useful if you are not sure about a cash flow. For example, say you are bidding for a contract with a foreign customer. You don’t know if you will win or not, so don’t know if you will have foreign earnings, but want to make sure that your bid price will not be eroded by currency movements. In those circumstances, an option can be taken out and used if necessary or ignored if you do not win the contract or currency movements are favourable. 6.4 IMPACTS OF GLOBAL MILIEU The foreign exchange or forex market is the biggest and most active financial market in the world. Every day, participants from all over the world engage in trillions worth of foreign exchange transactions. Events from all corners of the globe can have an immediate effect on exchange rates and currency values due to the global and inter-connectedness of the forex marketplace. Fig 6.1 Impacts of Global Milieu Let us now discuss a few typical global events that may influence the forex market:- Political Impact on Currency Prices 118 CU IDOL SELF LEARNING MATERIAL (SLM)
A political election—a common event in almost every nation—can have a large impact on a country's currency. Elections can be viewed by traders as an isolated case of potential political instability and uncertainty, which typically equates to greater volatility in the value of a country's currency. In most situations, forex participants will simply keep an eye on pre- election polls to get a sense of what to expect and see if there will be any changes at the top. That's because a change in government can mean a change in ideology for the country's citizens, which usually equates to a different approach to monetary or fiscal policy, each serving as big drivers of a currency's value. Additionally, political parties or individuals who are seen as more fiscally responsible or concerned with promoting economic growth tend to boost a currency's relative value. For instance, an incumbent who is seen as a \"pro economy\" that is in danger of losing their position of power may lead to currency drops for fears of limited future economic growth and predictability. Another circumstance of great importance is an unexpected election. Whether it comes via a non-confidence vote, corruption scandals, or other situations, unplanned elections can wreak havoc on a currency. For example, cases of upheaval among citizens that result in protests or work stoppages can cause great uncertainty in countries and increased political instability. Even in cases where an autocratic government is being challenged in favor of a new, more democratic, and economically open-minded government, forex traders don't like the uncertainty. Political instability has a tendency to outweigh any positive outcomes from a new government in the short run, and related currencies will usually suffer losses. However, basic valuation factors and principals will once again apply, and currencies should settle at or around a rate indicative of the country's economic growth prospects over the long term. Impact of Natural Disasters on Currency Prices The fallout from a natural disaster can be catastrophic for a country. Earthquakes, floods, tornadoes, and hurricanes harm a country's citizens, morale, and infrastructure. Additionally, such disasters will also have a negative effect on a nation's currency. The loss of life, damage to major factories and distribution centers, coupled with the uncertainty that inevitably comes with natural disasters, are all bad news for a currency. Infrastructure damage is also a key concern when it comes to the impact of natural disasters. The fact that basic infrastructure is the backbone of any economy breaks in that infrastructure can severely limit the economic output of a region. Furthermore, the additional costs that are incurred to clean up and rebuild after a disaster take away from government and private spending that could have been used towards economically advantageous ventures, rather than towards patching up a break in the value chain from damages in infrastructure. 119 CU IDOL SELF LEARNING MATERIAL (SLM)
Add to this a probable decrease in consumer spending due to the economic uncertainty and a possible loss of consumer confidence, and any economic strengths can be turned into economic weaknesses. In all, a natural disaster will almost surely negatively affect a nation's currency. Effect of War on Currencies Unlike a currency war, wherein countries actively attempt to devalue their currencies to aide their domestic economies in global export trading, a physical war can be far more devastating to a country's economy. Much like a natural disaster, the impact of war is brutal and widespread. Similar to disasters, the damage of war to infrastructure deals a huge blow to a nation's short-term economic viability, costing citizens and governments billions of dollars. History has shown than war rebuilding efforts must often be financed with cheap capital resulting from lower interest rates, which inevitably decrease the value of domestic currency. There is also a huge level of uncertainty surrounding such conflicts on future economic expectations and the health of affected nations. Thus, nations that are actively at war experience a higher level of currency volatility compared to those not engaged in conflict. That said, some economists believe that there is a potential economic upside to war. War can kick-start a fledgling economy, especially its manufacturing base when it is forced to concentrate its efforts on war time production. For instance, the U.S. entry into World War II following the attacks on Pearl Harbor helped pull the country out of the grips of the Great Depression. While there is some historical precedent for this viewpoint, most would agree that an improved economy at the cost of human lives is a very poor trade-off. 6.5 TYPES OF FOREX RISKS Foreign exchange risk refers to the losses that an international financial transaction may incur due to currency fluctuations. 120 CU IDOL SELF LEARNING MATERIAL (SLM)
Foreign exchange risk can also affect investors, who trade in international markets, and businesses engaged in the import/export of products or services to multiple countries. Fundamentally, there are three types of foreign exchange exposure companies face: transaction exposure, translation exposure, and economic (or operating) exposure. Transaction Exposure This is the simplest kind of foreign currency exposure and, as the name itself suggests, arises due to an actual business transaction taking place in foreign currency. The exposure occurs, for example, due to the time difference between an entitlement to receive cash from a customer and the actual physical receipt of the cash or, in the case of a payable, the time between placing the purchase order and settlement of the invoice. Example: A US company wishes to purchase a piece of equipment and, after receiving quotes from several suppliers (both domestic and foreign), has chosen to buy in Euro from a company in Germany. The equipment costs €100,000 and at the time of placing the order the €/$ exchange rate is 1.1, meaning that cost to the company in USD is $110,000. Three months later, when the invoice is due for payment, the $ has weakened and the €/$ exchange rate is now 1.2. The cost to the company to settle the same €100,000 payable is now $120,000. Transaction exposure has resulted in an additional unexpected cost to the company of $10,000 and may mean the company could have purchased the equipment at a lower price from one of the alternative suppliers. 121 CU IDOL SELF LEARNING MATERIAL (SLM)
Translation Exposure This is the translation or conversion of the financial statements (such as P&L or balance sheet) of a foreign subsidiary from its local currency into the reporting currency of the parent. This arises because the parent company has reporting obligations to shareholders and regulators which require it to provide a consolidated set of accounts in its reporting currency for all its subsidiaries. Following on from the above example, let’s assume that the US Company decides to set up a subsidiary in Germany to manufacture equipment. The subsidiary will report its financials in Euros and the US parent will translate those statements into USD. The example below shows the financial performance of the subsidiary in its local currency of Euro. Between years one and two, it has grown revenue by 10% and achieved some productivity to keep cost increases to only 6%. This results in an impressive 25% increase in net income. However, because of the impact of exchange rate movements, the financial performance looks very different in the parent company’s reporting currency of USD. Over the two year period, in this example, the dollar has strengthened and the €/$ exchange rate has dropped from an average of 1.2 in Year 1 to 1.05 in Year 2. The financial performance in USD looks a lot worse. Revenue is reported as falling by 4% and net income, while still showing growth, is only up by 9% rather than 25%. 122 CU IDOL SELF LEARNING MATERIAL (SLM)
The opposite effect can of course occur, which is why, when reporting financial performance, you will often hear companies quote both a “reported” and “local currency” number for some of the key metrics such as revenue. Economic (Or Operating) Exposure This final type of foreign exchange exposure is caused by the effect of unexpected and unavoidable currency fluctuations on a company’s future cash flows and market value, and is long-term in nature. This type of exposure can impact longer-term strategic decisions such as where to invest in manufacturing capacity. In my Hungarian experience referenced at the beginning, the company I worked for transferred large amounts of capacity from the US to Hungary in the early part of the 2000s to take advantage of lower manufacturing cost. It was more economical to manufacture in Hungary and then ship product back to the US However, the Hungarian Forint then strengthened significantly over the following decade and wiped out many of the predicted cost benefits. Exchange rate changes can greatly affect a company’s competitive position, even if it does not operate or sell overseas. For example, a US furniture manufacturer who only sells locally still has to contend with imports from Asia and Europe, which may get cheaper and thus more competitive if the dollar strengthens markedly. How to Mitigate Foreign Exchange Risk? The first question to ask is whether to bother attempting to mitigate the risk at all. It may be that a company accepts the risk of currency movement as a cost of doing business and is prepared to deal with the potential earnings volatility. The company may have sufficiently high profit margins that provide a buffer against exchange rate volatility, or they have such a strong brand/competitive position that they are able to raise prices to offset adverse movements. Additionally, the company may be trading with a country whose currency has a peg to the USD, although the list of countries with a formal peg is small and not that significant in terms of volume of trade (with the exception of Saudi Arabia which has had a peg in place with the USD since 2003). For those companies that choose to actively mitigate foreign exchange exposure, the tools available range from the very simple and low cost to the more complex and expensive. Transact In Your Own Currency Companies in a strong competitive position selling a product or service with an exceptional brand may be able to transact in only one currency. For example, a US company may be able to insist on invoicing and payment in USD even when operating abroad. This passes the exchange risk onto the local customer/supplier. In practice, this may be difficult since there are certain costs that must be paid in local currency, such as taxes and salaries, but it may be possible for a company whose business is primarily done online. 123 CU IDOL SELF LEARNING MATERIAL (SLM)
Build Protection into Your Commercial Relationships/Contracts Many companies managing large infrastructure projects, such as those in the oil and gas, energy, or mining industries are often subject to long-term contracts which may involve a significant foreign currency element. These contracts may last many years and the exchange rates at the time of agreeing to the contract and setting the price may then fluctuate and jeopardize profitability. It may be possible to build foreign exchange clauses into the contract that allow revenue to be recouped in the event that exchange rates deviate more than an agreed amount. This obviously then passes any foreign exchange risk onto the customer/supplier and will need to be negotiated just like any other contract clause. In my experience, these can be a very effective way of protecting against foreign exchange volatility but does require the legal language in the contract to be strong and the indices against which the exchange rates are measured to be stated very clearly. These clauses also require that a regular review rigor be implemented by the finance and commercial teams to ensure that once an exchange rate clause is triggered the necessary process to recoup the loss is auctioned. Finally, these clauses can lead to tough commercial discussions with the customers if they get triggered and often, I have seen companies choose not to enforce to protect a client relationship, especially if the timing coincides with the start of negotiations on a new contract or an extension. 6.6 SUMMARY Foreign exchange risk refers to the losses that an international financial transaction may incur due to currency fluctuations. Foreign exchange risk can also affect investors, who trade in international markets, and businesses engaged in the import/export of products or services to multiple countries. Three types of foreign exchange risk are transaction, translation, and economic risk. Foreign exchange risk is a major risk to consider for exporters/importers and businesses that trade in international markets. 6.7 KEYWORDS Cross Rates – it is the exchange rate which is expressed by a pair of currency in which none of the currencies is the official currency of the country in which it is quoted. PIPs – Price Interest Point Bid – It is the price at which the dealer is willing to buy another currency. 124 CU IDOL SELF LEARNING MATERIAL (SLM)
6.8 LEARNING ACTIVITY 1. Learn about the impact of BREXIT on international FOREX market ___________________________________________________________________________ ___________________________________________________________________________ 6.9 PRATICAL APPLICATIONS A Chennai based metal importer had import payments of 3-4 million dollars scheduled every month. The client was getting extremely worried about the weakening rupee. The rupee has already depreciated 7.5% in 1.5 months. With growing uncertainties in the market due to C COVID-19, he wanted to be sure of not incurring any more losses Solution: Exporter was protected from adverse currency movement- an increase in the USD/INR rate (The monthly change in the pair is more than 60 paise) and had an upside potential- if rupee appreciated. The maximum loss he would have had to bear was of the premium paid - INR2.4 million (0.697*3,500,000). But looking at the uncertain circumstances, it was not a big cost for the protection he got. Thus, the importer was hedged from rupee depreciation by gaining protection from the downside. 6.10 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Briefly describe the foreign exchange Risk 2. What are the factors that determine the Forex Fluctuations? 3. What are the various types of Forex Exposure? 4. What are the various risks covered by transaction exposure? Long Questions 1. Briefly explain the translation exposure? 2. What do you mean by Economic Exposure? 3. What are the various impacts on Global Milieu? 4. Explain the various types of Forex Risks in detail. 5. How would you mitigate Forex Risks? Briefly Explain 6. What do you feel about the Forex Risk Impact on the society as a whole? 125 CU IDOL SELF LEARNING MATERIAL (SLM)
B. Multiple Choice Questions 1. The method of managing translation exposure that is also available for managing transaction exposure is- a. balance sheet hedge b. transfer pricing c. swaps d. None of these 2. Market selection as a strategy to manage economic exposure requires- a. preferring domestic market to foreign market b. preferring market with fixed exchange rate c. shifting to a market whose currency has appreciated d. shifting to a market whose currency has depreciated 3. The transaction in which the bank receives local currency from the customer and pays him foreign currency is a- a. purchase transaction b. sale transaction c. direct transaction d. None of these 4. Which among the following is not a technique for exchange rate forecasting a. Technical forecasting b. Fundamental forecasting c. Market based forecasting d. Currency based forecasting 5. ___________- theory focuses on the ‘inflation – exchange rate’ relationship a. Purchasing power parity b. Interest rate parity c. International fisher effect d. None of the above Answer 1 – b 2 – c 3 – b 4 – d 5-a 126 CU IDOL SELF LEARNING MATERIAL (SLM)
6.11 REFERENCES OP Aggarwal, Trade and forex exchange, Himalaya Publications, 8th Edition Ranjit Singh, Forex Trading: RT Publications Shah Paresh, Forex Management, Wiley Ankit Gala and Jitendra Gala; Foreign Exchange and Forex Trading, Buzzing stock Publishing House Peters Jelle: Forex for Ambitious Beginners: Odyssean Publishing Sudhir Kochhar: Foreign Exchange Operations under FEMA: Bloomsbury Publishing (IN) 127 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT - 7: STRATEGIES FOR MANAGING THE RISK Structure 7.0 Learning objectives 7.1 Introduction 7.2 Forex Risk Management 7.3 Comprising Policies 7.4 Risk Management Control 7.5 Summary 7.6 Keywords 7.7 Learning Activity 7.8 Practical Applications 7.9 Unit End Questions 7.10 References 7.0 LEARNING OBJECTIVES After studying this unit, students will be able to: State the meaning of Forex Risk Management Significance and various policies comprising risks Learn about Various risks in Foreign exchange dealings Various control measures taken to mitigate Forex risk 7.1 INTRODUCTION A risk management strategy provides a structured and coherent approach to identifying, assessing and managing foreign exchange risk. It builds in a process for regularly updating and reviewing the assessment based on new developments or actions taken. A forex risk management strategy can be developed and implemented by even the smallest of groups or projects or built into a complex strategy for a multi-site international organization. The process of identifying and reviewing the risks that you face is known as risk assessment. By assessing risks you are able to be actively aware of where uncertainty surrounding events or outcomes exists and identifying steps that can be taken to protect the organization, people and assets concerned. 128 CU IDOL SELF LEARNING MATERIAL (SLM)
7.2 FOREX RISK MANAGEMENT Forex risk management enables you to implement a set of rules and measures to ensure any negative impact of a forex trade is manageable. An effective strategy requires proper planning from the outset, since it’s better to have a risk management plan in place before you actually start trading. The following are the major risks in foreign exchange dealings (a) Open Position Risk (b) Cash Balance Risk (c) Maturity Mismatches Risk (d) Credit Risk (e) Country Risk (f) Overtrading Risk (g) Fraud Risk (h) Operational Risks i. Open Position Risk The open position risk or the position risk refers to the risk of change in exchange rates affecting the overbought or oversold position in foreign currency held by a bank. Hence, this can also be called the rate risk. The risk can be avoided by keeping the position in foreign exchange square. The open position in a foreign currency becomes inevitable for the following reasons: (a) The dealing room may not obtain reports of all purchases of foreign currencies made by branches on the same day. (b) The imbalance may be because the bank is not able to carry out the cover operation in the interbank market. (c) Sometimes the imbalance is deliberate. The dealer may foresee that the foreign currency concerned may strengthen. ii. Cash Balance Risk Cash balance refers to actual balances maintained in the nostro accounts at the end-of each day. Balances in nostro accounts do not earn interest: while any overdraft involves payment of interest. The endeavor should, therefore, be to keep the minimum required balance in the nostro accounts. However, perfection on the count is not possible. Depending upon the requirement for a single currency more than one nostro account may be maintained. Each of 129 CU IDOL SELF LEARNING MATERIAL (SLM)
these accounts is operated by a large number of branches. Communication delays from branches to the dealer or from the foreign bank to the dealer may result in distortions. iii. Maturity Mismatches Risk This risk arises on account of the maturity period of purchase and sale contracts in a foreign currency not coinciding or matching. The cash flows from purchases and sales mismatch thereby leaving a gap at the end of each period. Therefore, this risk is also known as liquidity risk or gap risk Mismatches in position may arise out of the following reasons: (i) Under forward contracts, the customers may exercise their option on any day during the month which may not match with the option under the cover contract with the market with maturity towards the month end. (ii) Non-availability of matching forward cover in the market for the volume and maturity desired. (iii) Small value of merchant contracts may not aggregative to the round sums for which cover contracts are available. (iv) In the interbank contracts, the buyer bank may pick up the contract on any day during the option period. (v) Mismatch may deliberately create to minimise swap costs or to take advantage of changes in interest differential or the large swings in the demand for spot and near forward currencies. iv. Credit Risk Credit Risk is the risk of failure of the counterparty to the contract Credit risk as classified into (a) contract risk and (b) clean risk. Contract Risk: arises when the failure of the counterparty is known to the bank before it executes its part of the contract. Here the bank also refrains from the contract. The loss to the bank is the loss arising out of exchange rate difference that may arise when the bank has to cover the gap arising from failure of the contract. Clean Risk Arises when: the bank has executed the contract, but the counterparty does not. The loss to the bank in this case is not only the exchange difference, but the entire amount already deployed. This arises, because, due to time zone differences between different centres, one currently is paid before the other is received. v. Country risk Also known as ‗sovereign risk ‘or ‗transfer risk‘, country risk relates to the ability and willingness of a country to service its external liabilities. It refers to the possibility that the government as well other borrowers of a particular country may be unable to fulfil the obligations under foreign exchange transactions due to reasons which are beyond the usual 130 CU IDOL SELF LEARNING MATERIAL (SLM)
credit risks. For example, an importer might have paid for the import, but due to moratorium imposed by the government, the amount may not be repatriated. vi. Overtrading Risk A bank runs the risk of overtrading if the volume of transactions indulged by it is beyond its administrative and financial capacity. In the anxiety to earn large profits, the dealer or the bank may take up large deals, which a normal prudent bank would have avoided. The deals may take speculative tendencies leading to huge losses. Viewed from another angle, other operators in the market would find that the counterparty limit for the bank is exceeded and quote further transactions at higher premium. Expenses may increase at a faster rate than the earnings. There is, therefore, a need to restrict the dealings to prudent limits. The tendency to overtrading is controlled by fixing the following limits: (a) A limit on the total value of all outstanding forward contracts; (b) A limit on the daily transaction value for all currencies together (turnover limit). vii. Fraud Risk Frauds may be indulged in by the dealers or by other operational staff for personal gains or to conceal a genuine mistake committed earlier. Frauds may take the form of the dealings for one‘s own benefit without putting them through the bank accounts. Undertaking unnecessary deals to pass on brokerage for a kick back, sharing benefits by quoting unduly better rates to some banks and customers, etc. The following procedural measures are taken to avoid frauds: (a) Separation of dealing form back-up and accounting functions. (b) On-going auditing, monitoring of positions, etc., to ensure compliance with procedures. (c) Regular follow-up of deal slips and contract confirmations. (d) Regular reconciliation of nostro balances and prompts follow-up unreconciled items. (e) Scrutiny of branch reports and pipe-line transactions. (f) Maintenance of up-to records of currency position, exchange position and counterparty registers, etc. viii. Operational Risk These risks include inadvertent mistakes in the rates, amounts and counterparties of deals, misdirection of funds, etc. The reasons may be human errors or administrative inadequacies. The deals are done over telecommunication and mistakes may be found only when the written confirmations are received later, 131 CU IDOL SELF LEARNING MATERIAL (SLM)
7.3 COMPRISING POLICIES Foreign exchange risk management allows currency traders to minimize losses that occur as a result of exchange rate fluctuations. Consequently, having a proper forex risk management plan in place can make for safer, more controlled and less stressful forex trading. Fundamentally, there are three types of foreign exchange exposure company’s face: transaction exposure, translation exposure, and economic (or operating) exposure. Company accepts the risk of currency movement as a cost of doing business and is prepared to deal with the potential earnings volatility. The company may have sufficiently high profit margins that provide a buffer against exchange rate volatility, or they have such a strong brand/competitive position that they are able to raise prices to offset adverse movements. Additionally, the company may be trading with a country whose currency has a peg to the USD, although the list of countries with a formal peg is small and not that significant in terms of volume of trade, for those companies that choose to actively mitigate foreign exchange exposure, the tools available range from the very simple and low cost to the more complex and expensive. Following comprising policies are considered in foreign exchange strategies. 1. Transact In Your Own Currency Companies in a strong competitive position selling a product or service with an exceptional brand may be able to transact in only one currency. For example, a US company may be able to insist on invoicing and payment in USD even when operating abroad. This passes the exchange risk onto the local customer/supplier. In practice, this may be difficult since there are certain costs that must be paid in local currency, such as taxes and salaries, but it may be possible for a company whose business is primarily done online. 2 Build Protections into Your Commercial Relationships/Contracts Many companies managing large infrastructure projects, such as those in the oil and gas, energy, or mining industries are often subject to long-term contracts which may involve a significant foreign currency element. These contracts may last many years and the exchange rates at the time of agreeing to the contract and setting the price may then fluctuate and jeopardize profitability. It may be possible to build foreign exchange clauses into the contract that allow revenue to be recouped in the event that exchange rates are deviate more than an agreed amount. This obviously then passes any foreign exchange risk onto the customer/supplier and will need to be negotiated just like any other contract clause. These can be a very effective way of protecting against foreign exchange volatility but does require the legal language in the contract to be strong and the indices against which the exchange rates are measured to be stated very clearly. These clauses also require that a regular review rigor be implemented by the finance and commercial teams to ensure that once an exchange rate clause is triggered the necessary process to recoup the loss is auctioned. 132 CU IDOL SELF LEARNING MATERIAL (SLM)
Finally, these clauses can lead to tough commercial discussions with the customers if they get triggered and often I have seen companies choose not to enforce to protect a client relationship, especially if the timing coincides with the start of negotiations on a new contract or an extension. 3. Natural Foreign Exchange Hedging A natural foreign exchange hedge occurs when a company is able to match revenues and costs in foreign currencies such that the net exposure is minimized or eliminated. For example, a US company operating in Europe and generating Euro income may look to source product from Europe for supply into its domestic US business in order to utilize these Euros. This is an example which does somewhat simplify the supply chain of most businesses, but I have seen this effectively used when a company has entities across many countries. 7.4 RISK MANAGEMENT CONTROL Foreign exchange risk arises when a company engages in financial transactions denominated in a currency other than the currency where that company is based. Any appreciation/depreciation of the base currency or the depreciation/appreciation of the denominated currency will affect the cash flows emanating from that transaction. Foreign exchange risk can also affect investors, who trade in international markets, and businesses engaged in the import/export of products or services to multiple countries. Forex risk management enables you to implement a set of rules and measures to ensure any negative impact of a forex trade is manageable. An effective strategy requires proper planning from the outset, some of the strategies will discuss bellow 1. Understand the Forex Market The forex market is made up of currencies from all over the world, such as GBP, USD, JPY, AUD, CHF and ZAR. Forex – also known as foreign exchange or FX – is primarily driven by the forces of supply and demand. Forex trading works like any other exchange where you are buying one asset using a currency – and the market price tells you how much of one currency you need to spend in order to buy another. The first currency that appears in a forex pair quotation is called the base currency, and the second is called the quote currency. The price displayed on a chart will always be the quote currency – it represents the amount of the quote currency you will need to spend in order to purchase one unit of the base currency. For example, if the GBP/USD currency exchange rate is 1.25000, it means you’d have to spend $1.25 to buy £1. There are three different types of forex market: 133 CU IDOL SELF LEARNING MATERIAL (SLM)
Spot market: the physical exchange of a currency pair takes place at the exact point the trade is settled – i.e., ‘on the spot’ Forward market: a contract is agreed to buy or sell a set amount of a currency at a specified price, at a set date in the future or within a range of future dates Futures market: a contract is agreed to buy or sell a set amount of a currency at a set price and date in the future. Unlike forwards, a futures contract is legally binding 2. Build A Good Trading Plan A trading plan can help make your FX trading easier by acting as business decision-making tool. It can also help you maintain discipline in the volatile forex market. The purpose of this plan is to answer important questions, such as what, when, why, and how much to trade. It is extremely important for your forex trading plan, it’s no good copying someone else's plan, because that person will very likely have different goals, attitudes and ideas. They will also almost certainly have a different amount of time and money to dedicate to trading. 3. Get A Grasp on Leverage When you speculate on forex price movements with spread bets or CFDs, you will be trading on leverage. This enables you to get full market exposure from initial business transactions – While trading on leverage has its benefits, there are also potential downsides – such as the possibility of magnified losses. 4. Set A Risk-Return Ratio The risk you take with your capital should be worthwhile. Ideally, you want your profit to outweigh your losses – making money in the long run, even if you lose on individual trades. As part of your forex trading plan, you should set your risk-reward ratio to quantify the worth of a trade. 5. Keep an Eye on News and Events Making predictions about the price movements of currency pairs can be difficult, as there are many factors that could cause the market to fluctuate. To make sure you’re not caught off guard, keep an eye on central bank decisions and announcements, political news and market sentiment. 7.5 SUMMARY Forex trading works like any other exchange where you are buying one asset using a currency Forex participants will simply keep an eye on pre-election polls to get a sense of what to expect and see if there will be any changes at the top. There are three types of foreign exchange exposure companies face: transaction exposure, translation exposure, and economic 134 CU IDOL SELF LEARNING MATERIAL (SLM)
7.6 KEYWORDS Risk management – It is the process of forecasting and evaluating Financial risk together with identification of procedure to reduce its impact Foreign exchange exposure- It refers to the risk a company undertakes when making financial transactions in foreign currencies 7.7 LEARNING ACTIVITY 1. Many international exchanges of goods and services are facilitated by the exchange of the currencies of the trading countries. Importers often must obtain the currency of the exporter’s country to purchase the goods to be imported. Even when they don’t need the actual currency, they must establish a relative value between currencies. Students are asked to create a chart with the name of countries, currencies, and trading relationships in the world. International monetary markets serve as the mechanism to set the relative values of currencies. The actual price (or international value) of currencies should be set through the interaction with international currency markets. Just as in any market many factors can influence either the supply of, or the demand for, a given currency and this will affect the international exchange rate of the currency. ___________________________________________________________________________ ___________________________________________________________________- 7.8 PRATICAL APPLICATIONS A Surat based woven products’ manufacturer and exporter exports woven fabric, post bags, laminated bags, cement bags, and other industrial packaging products in the international market with an annual export turnover of INR 10 Cr, the firm had an inward receivable of USD 26,000. The client had recently started using the TPO strategy. Solution The negotiation started with the bank quoting 69.10 net rate with a bank margin of 40 paisa. After long negotiations by manager, the deal was closed at a net rate of 76.35 and 5 paisa margin 7.9 UNIT END QUESTIONS A. Descriptive Questions 135 CU IDOL SELF LEARNING MATERIAL (SLM)
Short Questions 1. Briefly describe the foreign exchange Risk 2. What are the factors that determine the Forex Fluctuations? 3. What are the various types of Forex Exposure? 4. What are the various risks covered by transaction exposure? 5. What do you mean by Economic Exposure? Long Questions 1. What is the various impact of Global Milieu? 2. Explain the various types of Forex Risks in detail. 3. How would you mitigate Forex Risks? Briefly Explain 4. What do you feel about the Forex Risk Impact on the society as a whole? 5. Briefly explain the translation exposure? B. Multiple Choice Questions 1. The exchange rates quoted by an authorised dealer to its customers are known as- a. authorised rates b. commercial rates c. merchant rates d. indirect rates 2. Buying rate for ready merchant rate is derived from- a. interbank spot buying rate b. interbank ready buying rate c. interbank spot selling rate d. none of these 3. For funding the vostro account, the bank in India will apply- a. its TT buying rate b. its TT selling rate c. interbank spot buying rate d. interbank spot selling rate 136 CU IDOL SELF LEARNING MATERIAL (SLM)
4. India is facing continuous deficit in its balance of payments. In the foreign exchange market rupee is expected to a. Depreciate. b. Appreciate. c. Show no specific tendency. d Depreciate against currencies of the countries with positive balance of payment and appreciate against countries with negative balance of payment. 5. Of the below options, who will need to buy GBP? a. An Indian exporter exporting goods to UK b. An Indian importer importing goods from UK c. tourist from UK on a visit to India d. none Answers 1 – a 2 – b 3 – c 4 – a 5-b 7.10 REFERENCES OP Aggarwal, Trade and forex exchange, Himalaya Publications, 8th Edition Ranjit Singh, Forex Trading: RT Publications Shah Paresh, Forex Management, Wiley Ankit Gala and Jitendra Gala; Foreign Exchange and Forex Trading, Buzzing stock Publishing House Peters Jelle: Forex for Ambitious Beginners: Odyssean Publishing Sudhir Kochhar: Foreign Exchange Operations under FEMA: Bloomsbury Publishing (IN) 137 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT - 8: RECENT DEVELOPMENTS IN FOREX MARKETS Structure 8.0 Learning Objectives 8.1 Introduction 8.2 Development of Forex Market in India 8.2.1 Phases of Forex Market Development 8.2.2 Market Profile 8.2.3 Trade and Financial Awareness 8.2.4 Institutional Development 8.2.5 Disclosure and Transparency Initiatives 8.2.6 Tasks Ahead 8.3 Summary 8.4 Keywords 8.5 Learning activity 8.6 Practical Applications 8.7 Unit End Questions 8.8 References 8.0 LEARNING OBJECTIVES After studying this unit, you will be able to: Explain the meaning of Forex Development Recent Development in Forex Market Development in National and international level Various Factors influencing the developments in forex markets. 8.1 INTRODUCTION Happenings in the foreign exchange market (henceforth forex market) form the essence of the international finance. The foreign exchange market is not limited by any geographical boundaries. It does not have any regular market timings, operates 24 hours 7 days week 365 days a year, characterized by ever-growing trading volume, exhibits great heterogeneity 138 CU IDOL SELF LEARNING MATERIAL (SLM)
among market participants with big institutional investor buying and selling millions of dollars at one go to individuals buying or selling less than 100 dollar. A fundamental change in the international monetary system are from the fixed exchange rates arising out of the Bretton Woods agreement to a much more flexible system in which countries can float their exchange rates or follow other exchange rate practices of their own choosing. Major financial deregulation across the globe including the elimination of government controls and restrictions in almost every country, which has resulted in far greater freedom in national and international financial transactions and hugely increased competition among financial institutions. 8.2 DEVELOPMENT OF FOREX MANAGEMENT IN INDIA Traditionally Indian forex market has been a highly regulated one. Till about 1992-93, government exercised absolute control on the exchange rate, export-import policy, FDI (Foreign Direct Investment) policy. The Foreign Exchange Regulation Act (FERA) enacted in 1973, strictly controlled any activities in any remote way related to foreign exchange. FERA was introduced during 1973, when foreign exchange was a scarce commodity. Post-independence, union government’s socialistic way of managing business and the license raj made the Indian companies noncompetitive in the international market, leading to decline in export. Simultaneously India import bill because of capital goods, crude oil & petrol products increased the forex outgo leading to sever scarcity of foreign exchange. FERA was enacted so that all forex earnings by companies and residents have to reported and surrendered (immediately after receiving) to RBI (Reserve Bank of India) at a rate which was mandated by RBI. FERA was given the real power by making “any violation of FERA was a criminal offense liable to imprisonment”. It a professed a policy of “a person is guilty of forex violations unless he proves that he has not violated any norms of FERA”. To sum up, FERA prescribed a policy – “nothing (forex transactions) is permitted unless specifically mentioned in the act”. Post liberalization, the Government of India, felt the necessity to liberalize the foreign exchange policy. Hence, Foreign Exchange Management Act (FEMA) 2000 was introduced. FEMA expanded the list of activities in which a person/company can undertake forex transactions. Through FEMA, government liberalized the export-import policy, limits of FDI (Foreign Direct Investment) & FII (Foreign Institutional Investors) investments and repatriations, cross-border M&A and fund raising activities. Prior to 1992, Government of India strictly controlled the exchange rate. After 1992, Government of India slowly started relaxing the control and exchange rate became more and more market determined. Foreign Exchange Dealers association of India (FEDAI), set up in 1958, helped the government of 139 CU IDOL SELF LEARNING MATERIAL (SLM)
India in framing rules and regulation to conduct forex exchange trading and developing forex market In India. A major step in development of Indian forex market happened in 2008, when currency futures (Indian Rupee and US Dollar) started trading at National Stock Exchange (NSE). Since the introduction, the turnover in futures has increased leaps and bound. Though banks and authorized dealers were undertaking forex derivatives contracts, but the introduction of exchange traded currency futures marked a new beginning as the retail investors were able to participate in forex derivatives trading. 8.2.1 Indian forex market since independence can be grouped in three distinct phases. PHASE - I 1947 to1977: During 1947 to 1971, India exchange rate system followed the par value system. RBI fixed rupee’s external par value at 4.15 grains of fine gold. 15.432grains of gold is equivalent to 1 gram of gold. RBI allowed the par value to fluctuate within the permitted margin of ±1 percent. With the breakdown of the Bretton Woods System in 1971 and the floatation of major currencies, the rupee was linked with Pound-Sterling. Since Pound- Sterling was fixed in terms of US dollar under the Smithsonian Agreement of 1971, the rupee also remained stable against dollar. PHASE - II 1978-1992: During this period, exchange rate of the rupee was officially determined in terms of a weighted basket of currencies of India’s major trading partners. During this period, RBI set the rate by daily announcing the buying and selling rates to authorized dealers. In other words, RBI instructed authorized dealers to buy and sell foreign currency at the rate given by the RBI on daily basis. Hence exchange rate fluctuated but within a certain range. RBI managed the exchange rate in such a manner so that it primarily facilitates imports to India. As mentioned in Section 5.1, the FERA Act was part of the exchange rate regulation practices followed by RBI. India’s perennial trade deficit widened during this period. By the beginning of 1991, Indian foreign exchange reserve had dwindled down to such a level that it could barely be sufficient for three-week’s worth of imports. During June 1991, India airlifted 67 tonnes of gold, pledged these with Union Bank of Switzerland and Bank of England, and raised US$ 605 million to shore up its precarious forex reserve. At the height of the crisis, between 2nd and 4th June 1991, rupee was officially devalued by 19.5% from 20.5 to 24.5 to 1 US$. This crisis paved the path to the famed “liberalization program” of government of India to make rules and regulations pertaining to foreign trade, investment, public finance and exchange rate encompassing a broad gamut of economic activities more market oriented. 140 CU IDOL SELF LEARNING MATERIAL (SLM)
PHASE - III 1992 onwards: 1992 marked a watershed in India’s economic condition. During this period, it was felt that India needs to have an integrated policy combining various aspects of trade, industry, foreign investment, exchange rate, public finance and the financial sector to create a market-oriented environment. Many policy changes were brought in covering different aspects of import-export, FDI, Foreign Portfolio Investment etc. One important policy changes pertinent to India’s forex exchange system were brought in -- rupees was made convertible in current account. This paved to the path of foreign exchange payments/receipts to be converted at market-determined exchange rate. However, it is worthwhile to mention here that changes brought in by government of India to make the exchange rate market oriented have not happened in one big bang. This process has been gradual. The Indian forex market owes its origin to the important step that RBI took in 1978 to allow banks to undertake intra-day trading in foreign exchange. As a consequence, the stipulation of maintaining “square” or “near square” position was to be complied with only at the close of business each day. During the period 1975- 1992, the exchange rate of rupee was officially determined by the RBI in terms of a weighted basket of currencies of India’s major trading partners and there were significant restrictions on the current account transactions. The initiation of economic reforms in July 1991 saw significant two-step downward adjustment in the exchange rate of the rupee on July 1 and 3, 1991 with a view to placing it at an appropriate level in line with the inflation differential to maintain the competitiveness of exports. Subsequently, following the recommendations of the High-Level Committee on Balance of Payments (Chairman: Dr C. Rangarajan), the Liberalized Exchange Rate Management System (LERMS) involving dual exchange rate mechanism was instituted in March 1992 which was followed by the ultimate convergence of the dual rates effective from March 1, 1993 (christened modified LERMS). The unification of the exchange rate of the rupee marks the beginning of the era of market determined exchange rate regime of rupee, based on demand and supply in the forex market. It is also an important step in the progress towards current account convertibility, which was finally achieved in August 1994 by accepting Article VIII of the Articles of Agreement of the International Monetary Fund. The appointment of an Expert Group on Foreign Exchange (popularly known as Sodhani Committee) in November 1994 is a landmark in the design of foreign exchange market in India. The Group studied the market in great detail and came up with far reaching recommendations to develop, deepen and widen the forex market. In the process of development of forex 141 CU IDOL SELF LEARNING MATERIAL (SLM)
markets, banks have been accorded significant initiative and freedom to operate in the market. To quote a few important measures relating to market development and liberalization, banks were allowed freedom to fix their trading limits, permitted to borrow and invest funds in the overseas markets up to specified limits, accorded freedom to determine interest rates on FCNR deposits within ceilings and allowed to use derivative products for asset-liability management purposes. Similarly, corporates were given flexibility to book forward cover based on past turnover and allowed to use a variety of instruments like interest rates and currency swaps, caps/ collars and forward rate agreements in the international forex market. Rupee-foreign currency swap market for hedging longer term exposure has developed substantially in the last few years. 8.2.2 Market Profile The Indian forex market is predominantly a transaction based market with the existence of underlying forex exposure generally being an essential requirement for market users. Similarly, regulations in most cases require end-users to repatriate and surrender foreign exchange in the Indian forex market. All forex transactions of Government of India are routed through the market except for aid transactions. The forex market is made up of Authorized Dealers (generally banks), some intermediaries with limited authorization and end users viz., individuals, corporates, institutional investors and others. Market making banks (generally foreign banks and new private sector banks) account for a significant percentage of the overall turnover in the market. The average monthly turnover in the merchant segment of the forex market increased to US$ 40.5 billion in 2003-2004 from US$ 27.0 billion in 2002- 2003. In the inter-bank segment, the turnover has moved up from US$ 103 billion in 2002-2003 to US$ 134.2 billion in 2003- 2004. Consequently, the average monthly total turnover increased sharply to US$ 174.7 billion in 2003-2004 from US$ 130 billion in the previous year. The inter-bank to merchant turnover ratio hovered in the range of 2.9 – 3.9 during the year. 8.2.3 Trade and Financial Awareness There is large empirical literature suggesting that trade integration helps promote economic growth. In contrast, recent empirical research is unable to establish a clear link between financial integration and growth. There is therefore now a consensus among academicians and policy makers that trade liberalization should take precedence over financial liberalizations. The RBI approach makes a distinction among the different participants in order to assess, on an ongoing basis, the gains as well as the vulnerabilities of foreign currency exposures to the system. 142 CU IDOL SELF LEARNING MATERIAL (SLM)
In the capital account, apart from the Government’s, there are three balance sheets that we take into account whether for residents or for non-residents: the balance sheet of the households, the corporates and the financial intermediaries. Although in theory, everything may be integrated, in our phase of development, definitely these three are distinct in terms of their immediate reactions to market forces. In particular, this approach recognizes the need to put in place appropriate prudential regulation in regard to the financial intermediaries in so far as foreign currency transactions are concerned. 8.2.4 Disclosure and Transparency Initiatives RBI has been transparent in making available, in public domain, appropriate data relating to forex market and those resulting from RBI operations in the foreign exchange market. RBI disseminates the daily reference rate which is an indicative rate for market observers through its website. The movements in foreign exchange reserves of the RBI are published on a weekly basis in the Weekly Statistical Supplement (WSS). WSS also carries data on exchange rates of rupee against some major currencies. The monthly Bulletin of RBI gives data regarding purchases and sales of foreign currency undertaken by RBI against the rupee. The data regarding the Balance of Payments and the External Debt profile of the country is put out on a quarterly basis. RBI has already achieved full disclosure of information pertaining to international reserves and foreign currency liquidity position under the Special Data Dissemination Standards (SDDS) of IMF. With the concurrence of Government of India, RBI decided to compile and make public half- yearly reports on management of foreign exchange reserves for bringing about more transparency and also for enhancing the level of disclosure in this regard. The first such report with reference to September 30, 2003 was put in public domain through websites of both the Government of India and RBI in February 2004. The second report on foreign exchange reserves with reference to March 31, 2004 is now available at RBI website. 8.2.5 Institutional Development It has been well documented that the vast size of daily foreign exchange trading, combined with the global interdependencies of the forex market and payment systems involves risks stemming from settlement of forex trades on gross basis. Settlement of forex transactions spans different time zones and payment systems. As a result, counterparties assume various types of risks in the course of settlement. As suggested by the Sodhani Committee, RBI took the initiative to establish Clearing Corporation of India Limited (CCIL) in 2001 to mitigate risks in the Indian financial markets. 143 CU IDOL SELF LEARNING MATERIAL (SLM)
As India’s first centralized clearing and settlement system for the financial sector, CCIL’s role in facilitating settlement of both debt and forex transactions is perhaps unique. CCIL undertakes settlement of forex trades on a multilateral net basis through a process of novation and all trades accepted are guaranteed for settlement. On an average, CCIL daily settles over 3,500 deals covering an average gross volume of around US$3.5 billion, representing over 80 per cent of the market. CCIL has been able to offer netting advantage consistently. In addition to benefits of risk mitigation, CCIL’s intermediation also provides to its members other tangible benefits such as improved efficiency, lower operational cost and easier reconciliation of accounts with correspondents. CCIL has improved operational efficiency with a zero failure rate. We will be happy to share our experience with our Asian friends. Since it started its operations, CCIL has consistently endeavored to add value to the services, and has gradually brought the entire gamut of forex transactions under its purview. It has also, over time, added more and more functionalities enhancing the value of its product. Similarly, CCIL has also launched a Forex Trading Platform to facilitate US Dollar/Rupee deals by banks in India. This platform has been given to members free of cost. The platform offers both Order Matching and Negotiation modes for dealing. The USP of the platform is its offer of Straight-Through Processing capabilities as it is linked to CCIL’s settlement platform. RBI encourages the authorized dealers to take full advantage of this and intends monitoring the use of this platform to make it more user friendly and widely used. In India, the Foreign Exchange Dealers Association of India (FEDAI) as a self-regulatory organization formed by authorized dealers plays a constructive role in market development by initiating debates on important issues, organizing training programmes and providing technical expertise on various matters. We expect the FEDAI to enhance its catalytic role in market development in the years ahead. To further the participatory process in a more holistic manner by taking into account all segments of the financial markets, the ambit of the Technical Advisory Committee (TAC) on Money and Securities Markets set up by RBI in 1999 has been expanded in 2004 to include forex markets and the Committee has been renamed as TAC on Money, Securities and Forex Markets. 8.2.6 Tasks Ahead The Reserve Bank will continue to adopt an approach characterized by gradualism in respect of future liberalization of forex markets. In terms of sequencing, forex markets have to be aligned to external sector reforms and development of financial markets as part of overall reform. There are several aspects of reform in external sector and forex markets are one of them. Therefore, further liberalization in forex markets has to be harmonized with progress in other areas. 144 CU IDOL SELF LEARNING MATERIAL (SLM)
As you are aware, all major reforms in the market have been brought about after soliciting the opinions of market participants and thus the system of participatory process in market development is very much in place and will continue. In order to further the participatory process, I am happy to inform you that yesterday I had discussions with my colleague Dr. Rakesh Mohan and Governor Dr. Reddy. It has been decided that RBI will immediately set up a Committee to undertake a comprehensive review of the liberalization process set in motion in the last decade, study recent international experience and identify various options for future forex market development in India. The Committee will interact with market participants and experts for this purpose. The Committee will prepare a report within three months which will be placed before TAC. The report will then be placed in the public domain for inviting suggestions. On the basis of the suggestions received, a road map will be drawn up for further liberalization to reach global standards. No doubt we will be associating, as usual, the Forex Association to assist us in this endeavor. Let me conclude by thanking the Assembly for giving this opportunity. Our officers are also participating in the deliberations and we will get a feedback from them. Wish you all the best in your endeavors. 8.3 SUMMARY Increase in foreign capital, in turn, leads to an appreciation in the value of its domestic currency. Foreign investors will sell their bonds in the open market if the market predicts government debt within a certain country New thinking in terms of both the theory and practice of finance which have resulted in the development of many new financial instruments and derivative products. 8.4 KEYWORDS CHIPS – Clearing House Interbank Payment System CHAPS – Clearing House Automated Payment System Arbitrage – it is the simultaneous buying and selling of foreign currencies with intention of making profits from the differences between the exchange rate prevailing at the same time in different markets 8.5 LEARNING ACTIVITY 1. Learn about impact of COVID 19 on International Forex market ___________________________________________________________________________ ___________________________________________________________________________ 145 CU IDOL SELF LEARNING MATERIAL (SLM)
8.6 PRATICAL APPLICATIONS Despite rising sales revenues, BMW was conscious that its profits were often severely eroded by changes in exchange rates. The company’s own calculations in its annual reports suggest that the negative effect of exchange rates totaled €2.4bn between 2005 and 2009. BMW did not want to pass on its exchange rate costs to consumers through price increases. Its rival Porsche had done this at the end of the 1980s in the US and sales had plunged. The strategy BMW took a two-pronged approach to managing its foreign exchange exposure. One strategy was to use a “natural hedge” – meaning it would develop ways to spend money in the same currency as where sales were taking place, meaning revenues would also be in the local currency. However, not all exposure could be offset in this way, so BMW decided it would also use formal financial hedges. To achieve this, BMW set up regional treasury centers in the US, the UK and Singapore. How the strategy was implemented. The natural hedge strategy was implemented in two ways. The first involved establishing factories in the markets where it sold its products; the second involved making more purchases denominated in the currencies of its main markets. BMW now has production facilities for cars and components in 13 countries. In 2000, its overseas production volume accounted for 20 per cent of the total. By 2011, it had risen to 44 per cent. In the 1990s, BMW had become one of the first premium carmakers from overseas to set up a plant in the US – in Spartanburg, South Carolina. In 2008, BMW announced it was investing $750m to expand its Spartanburg plant. This would create 5,000 jobs in the US while cutting 8,100 jobs in Germany. This also had the effect of shortening the supply chain between Germany and the US market. The company boosted its purchasing in US dollars generally, especially in the North American Free Trade Agreement region. Its office in Mexico City made $615m of purchases of Mexican auto parts in 2009, expected to rise significantly in following years. A joint venture with Brilliance China Automotive was set up in Shenyang, China, where half the BMW cars for sale in the country are now manufactured. The carmaker also set up a local office to help its group purchasing department to select competitive suppliers in China. By the end of 2009, Rmb6bn worth of purchases were from local suppliers. Again, this had the effect of shortening supply chains and improving customer service. At the end of 2010, BMW announced it would invest 1.8bn rupees in its production plant in Chennai, India, and increase production capacity in India from 6,000 to 10,000 units. It also announced plans to increase production in Kaliningrad, Russia. Meanwhile, the overseas regional treasury centres were instructed to review the exchange rate exposure in their regions on a weekly basis and report it to a group treasurer, part of the group finance operation, in Munich. The group treasurer team then consolidates risk figures globally and recommends actions to mitigate foreign exchange risk. 146 CU IDOL SELF LEARNING MATERIAL (SLM)
Solution: By moving production to foreign markets the company not only reduces its foreign exchange exposure but also benefits from being close to its customers. In addition, sourcing parts overseas, and therefore closer to its foreign markets, also helps to diversify supply chain risks. 8.7 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Explain the recent developments in Forex market? 2. List out the factors influencing Forex market. 3. What are the factors adopted in the market 4. List out the Strategies adopted to develop forex markets 5. Define hedging. Long Questions 1. Briefly explain the Forex market structure and its development 2. Explain the Forex market participants and their approach towards the market 3. Explain the Strategies adopted by Indian forex markets and the factors influencing the market 4. Explain the tern Recession and Speculation in detain. 5. Explain the political stability and performance of Forex market. B. Multiple Choice Questions 1. A swap deal is executed by a. entering into another swap deal b. settling the difference int he rates c. actual delivery of currencies d. None of these 2. The market forces influencing the exchange rate are not fully operational under 147 a. floating exchange rate system b. speculative attack on the market c. fixed exchange rate system d. current regulations of IMF CU IDOL SELF LEARNING MATERIAL (SLM)
3. Indirect rate in foreign exchange means - a. the rate quoted with the units of home currency kept fixed b. the rate quoted with units of foreign currency kept fixed c. the rate quoted in terms of a third currency d. None of these 4. Mr. Raunak believes that there is a very strong bullish trend in USDINR. He also believes that there will be a decrease in volatility. So which option strategy is he most likely to use? a. Long call b. Long put c. Short call d. Short put 5. What is done when a client defaults in making the Mark to Market margin payments? a. The matter is reported to the clients bankers and amount is recovered from his banks b. The client is allowed to a maximum of 5 more trades so that he can make profits and pay the margins c. The amount of unpaid mark to market margin is recovered from his Initial Margin d. SEBI handles the matter as per its guidelines Answers 1 – c 2 – b 3 – c 4- a 5-c 8.8 REFERENCES OP Aggarwal, Trade and forex exchange, Himalaya Publications, 8th Edition Ranjit Singh, Forex Trading: RT Publications Shah Paresh, Forex Management, Wiley Ankit Gala and Jitendra Gala; Foreign Exchange and Forex Trading, Buzzing stock Publishing House Peters Jelle: Forex for Ambitious Beginners: Odyssean Publishing Sudhir Kochhar: Foreign Exchange Operations under FEMA: Bloomsbury Publishing (IN) 148 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT – 9: PRESENT STATUS OF INDIAN FOREX MARKETS Structure 9.0 Learning Objectives 9.1 Introduction 9.2 Present status of Indian forex markets 9.3 Forex market structure 9.4 Forex market participants 9.5 Forex market Policies 9.6 Forex market strategies 9.7 Recent developments in India 9.8 Summary 9.9 Keywords 9.10 Learning activity 9.11 Practical Applications 9.12 Unit End Questions 9.13 References 9.0 LEARNING OBJECTIVES After studying this unit, students will be able to: Explain the present status of Indian Forex Market. Identify the structure and participants of Forex market Analyse the various policies adopted by Indian forex markets. Identify the strategies adopted by Indian forex markets. 9.1 INTRODUCTION In the last couple of years, the Indian forex markets have noticed heightened activities and extreme volatilities on account of persisting weakness in the dollar. The burgeoning forex reserves crossing $116 bn mark, two digit GDP growth, growing current account surplus and 149 CU IDOL SELF LEARNING MATERIAL (SLM)
continuous appreciation of the Indian rupee against the dollar have justified `India Shining' to a certain extent. 9.2 PRESENT STATUS OF INDIAN FOREX MARKET In the recent past, periods of exchange rate stability have bred complacency. Importers were confident that the Reserve Bank of India (RBI) would intervene to halt any rupee decline whereas exporters were of the view that the Rupee has always been over rated and that there is no way that it shall appreciate from the present value. This traditional mindset has kept companies away from hedging their exposures. Due to the generic corporate reluctance, lack of information & technology and consideration of hedging as unwanted cost centers, companies involved in hedging have mostly gone the conservative way to hedge their exposures, i.e. by entering into forward contracts (FC) with banks, which have been the Authorized Dealers (AD) in foreign exchange Market in India. The limited use and general lack of interest in the available instruments can be explained by the fact that dependence on external sources of funding was limited and the external sector wasn’t really developed. Going forward, companies do take cognizance of the importance of currency risk management; however, one is not certain how many of the companies are working towards building capacity to deal with this changing scenario. However, many firms still prefer to keep their risk exposures un-hedged as they find the forward contracts as cost centres. The problem is accentuated by the fact that in the Indian context the market for derivatives in India other than forward contracts is very shallow. Nevertheless, new financial derivatives have been allowed in the market to provide for exposures arising out of increased business activity in the external sector. 9.3 FOREX MARKET STRUCTURE The Foreign Exchange Market is a market where the buyers and sellers are involved in sale and purchase of foreign currencies. In other words a market where the currencies of different countries are bought and sold is called foreign exchange market. 150 CU IDOL SELF LEARNING MATERIAL (SLM)
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