Forex n Risk Mgt

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A Comprehensive Project Report On “ Forex and Risk Management ” At VIZAG STEEL PLANT

Prepared by PARIKH DEEPAL A.

Guided by Mr. Alpesh Shah Mrs. Namrata Mehta

MBA IV Semester :

Ac ad emic Year

:

2008-'09

Roll No.

:

_ 3 3 ( o f 4 th sem.)

Seat No.

:

_____  

College

:

Shree H. N. Shuk la C ol le ge of Management Studies

S ub mitted to

:

Sau ra sh tra Un iversi ty

Declaration I

under signed

H .N .SHU KL A

D ee pa l

CO LL EGE

A.

Par ikh,

OF

the

stude nt

MANA GE ME NT

of

MB A,

STUDIES,

Rajkot(Saurashtra University), here by declare that the project work   pr es en te d he r e is my ow n w ork or k an d ha s be en c a rri rr i ed ou outt un unde de r th e supervision of Prof. Alpesh Shah and Prof. Namrata Mehta of our  College.

This Th is repo report rt has has no nott been been prev previo ious usly ly su subm bmit itte ted d to any any othe other  r  university for any other examination.

Place: R a j k o t

D ee pa l A. Pa r ik h

Date :

Signa tur e

Preface The trend towards liberalization of the economy and growing integration of glob global al fina financ ncia iall mark market etss is irre irreve vers rsib ible le.. Th Thee sp spee eed d of inno innova vati tion on has has accelerated the pace of reforms and the new technology technology demands almost instant responses. responses. The new developments, in the coming years of globalization in India will bring into sharp focus the role of exchange rates and interest rates in  business decision.

As India is becoming integrated part of the world, trade with world will increase. The foreign exchange and risk management will required to manage  professionally.  professionally.

Stee Steell comp compri rise sess on onee of the the mo most st impo import rtan antt inpu inputs ts in all all sect sector orss of  economy. Visakhapatnam Steel Plant is a multi-product steel-manufacturing unit. un it. The Resear Research ch invo involve lvess the study study of bo both th forei foreign gn exchan exchange ge and risk  risk  manage managemen ment. t. Ev Every ery organi organizat zation ion exchan exchange ge po polic licies ies and risk risk analys analysis is for  evalua evaluatio tion n of the the perfo performa rmance ncess of bu busin siness ess.. For For the achiev achieveme ement nt,, Forei Foreign gn exchange and risk management is the major and important tool of effective financial management.

Acknowledgement

“Learnin “Learning g and acquiring acquiring knowle knowledge dge has no leaps and bounds bounds.. It is one resource that never gets exhausted, the more you preach, the better it gets and the more it lives down down through through ages. ages. From the the day since man set his foot foot on earth, earth, lear learni ning ng proc proces esss had had bega began n and and is stil stilll evol evolvi ving ng maki making ng life life happ happie ierr and and memorable. One can only lead a person person to things he needs to know, know, but never can teach him how to learn. learn. Experience Experience through through rough rough and new paths, paths, failures failures and hardship makes a man perfect”.

I will remain indebted to Mr. Alpesh Shah and Mrs. Namrata Mehta (Faculty, HNS Rajkot), my project guide for his invaluable ideas and assistance, which enable me, negotiate every hurdle that I encountered during the project work.

I am also thankful to Mr. Navneet Thakrar Manager of SBI, Porbandar  without whose support I would not have been in a position to carry out the  project such such successfully. successfully.

Last but not the least; I would like to express my gratitude to my colleagues and friends for their moral support and valuable inputs for my project.

Deepal A. Parikh H.N.S.

INDEX Chapter No.

Particular

Page No.

Declaration

II

Preface

III

Acknowledgement

IV

1.

Industry Overview

7.

2.

Company Profile

13.

3.

6.



Background of VSP



Hallmark of VSP



Future Plans



SWOT Analysis

Research Methodology 

Relevance of the Study



Objectives of the Study



Research Design



Scope of the Study



Data Collection

Theoretical Aspects of the study 

Forex



Financial Arrangement of VSP



Significance of Risk 



Financial Risk & Integrated Risk Management System



Hedging Mechanism

13. 17. 20. 22. 24.

25. 25. 26. 27. 27.

28.

29. 44. 52.

56. 61.

7.



Currency Swaps

67.



Letter of Credit

74.

Analysis & Interpretation

78.

 Technical Analysis

86.

8.

Summary & Findings

100.

10.

Suggestion & Conclusion

103.

11.

Bibliography

107.

INDUSTRY OVERVIEW

- 7 -

Industry Overview The base of the economic stability of nation depends on the strong industrial it enjoys. The Indian economy is on a new growth path with buoyancy in capital markets, positive growth in GDP, strong Forex reserves and a remarkable growth in industrial sector. Industry output has grown by 8.2% in 2004-05 compared to 7.0% growth in 2003-04. Manufacturing industry has grown at 10% (till Apr 05) as against 8.8% growth in Apr 04. With brisk  demand for steel, textiles, non-ferrous metals, gem & jewellary. The future  prospects of Indian industrial sector as a whole looks promising as outlays on mega projects in steel, power & oil natural gas sectors are contemplated in unprecedented manner. India is going to be a base for expansion of capacity of  many industries by many multinationals and others with lower costs & higher  scope for increasing exports to neighboring countries. The following literature looks into the global & Indian steel sector  scenario in brief.

Global Scenario :

Global steel demand is on rise on the back of accelerated infrastructure activity in China, booming housing industry & recovering auto industry in U.S,  buoyant housing & white good industry in Europe. Reconstruction work in Iraq is expected to fuel further demand for steel over next 3 years. At present China is the world’s largest crude steel producer followed by Japan & U.S.A. while U.S.A is the largest importer of semi finished & finished steel products, Japan is the largest exporter of the same. However, the world at large is grappling with over capacity problem. The reasons for this difficult phase are owned to: - 8 -





Demand – Supply mismatch due to unfair priced trading regime. Large gap between installed capacity & effective capacity and effective capacity & actual production.



Anti-dumping measures taken against CIS, China, Brazil, India & a few other countries led to distortion in world trade.



Over capacity.

The global steel industry is facing the raw material shortage in wake of China’s massive infrastructure building exercise in view of 2008 Beijing Olympics. The prices may stabilized after the Olympics. A move has  been initiated globally to cut production of steel thereby to control the declining steel prices. This cut down of capacity is expected to restore supply demand balance to some extent. It is projected that China will emerge a net exporter for exports of Semi, long  products & HR wide coils. Imports by U.S may continue with the dollar  losing its shine against major currencies.Global steel industry is presently  poised to reasonable growth, which is reflected in renewed interest shown  by entrepreneurs for investments in the sector. The demand push in China, India CIS & also in U.S. Indian steel sector:

Operating performance is a main driver of competitiveness of any company. Based on this parameter Indian steel industry is much below global standards. Although significant improvement has been observed in material, energy and manpower productivity, it is not in a position to compete with steel majors like SCO, CS or NUCOR. India is placed in 8 th  position overall among the steel producing countries in the world.

- 9 -

The reasons for slow growth in India steel industry are:•

Poor productivity due to small size of plants & policy lapses and poor  investment in technology.



Less spending on R & D (less than 1% of revenues) & use of obsolete technology.



Outdated mining policies.



High transaction costs (nearly 10% of foreign trade).



Costly freight charges.



Cost of capital is 2 times the world average interest rate.



Taxes and levies constitute 30% of final value of steel.



Significant government intervention.

In line with global trend, the Indian steel industry has been passing through tough conditions. The prices have declined due to over capacity, cheap imports, declining global steel prices and also due to anti dumping duty imposed by USA on Indian exports. However, the present condition is better compared to last decade, which saw steel prices at rock bottom levels. There is a gradual improvement in steel prices owing to1. Trade cases & import restrictions by many steel-producing countries. 2. Voluntary production cuts after sharp tall in prices. 3. Continuing strong demand in USA, China. 4. Recovery in Asian Economics.

The consumption of finished carbon steel increased from 14.84 MT in 1991-92 to 33.37 MT in 2005-06. China has been an important export destination for  Indian steel.

- 10 -

In 2005-06 the production of finished carbon steel & pig iron are as follows.

2005-2006 Category

(million tones)

Pig Iron

3.171

Finished Carbon Steel

38.385

40 30

Pig Iron

20

Finished Carbon Steel

10 0 2005-2006(million tones)

The share of main producers (SAIL, RINL, TISCO) & secondary producers in total production of finished carbon steel was 40% & 60% respectively during the year 2005-06.

- 11 -

The total steel imports are estimated to be 2.050 MT while exports stands at 4.375 MT in 2005-06. Domestic demand is expected to steadily rise from the current level of 34 million tones of apparent to the projected level of 60 MT by 2011-12. This makes it necessary to have fresh capacity additions in steel. This in turn is to be supported by adequate sourcing of metallic and infrastructure growth including  port development to support the transportation needs of output to cater both domestic & global demands. The industry now looks ahead with anew resolve & determination. Reaping the  benefits of globalized markets calls for utmost vigilance from all stakeholders –   producers, consumers & state. The industry should capitalize the opportunities and mitigate the dangers of synchronized global trends.

- 12 -

COMPANY PROFILE

- 13 -

PROFILE OF VSP INTRODUCTION:

Steel occupies the foremost place among the materials in use today and  pervades all walks of life. All key discoveries of human genius, for  instance, Steam Engine, Railway, means of Communication and Connection, Automobile, Aero Plane and Computers are in one way or  other, fastened together with Steel and its sagacious and Multifaceted applications. Steel is versatile material with multitude of useful properties, making it indispensable for furthering and achieving continual growth of  economy

be

it

Construction,

manufacturing,

infrastructure

or 

consumables. The level of steel consumption has long been regarded as an index of industrialization and economic maturity attained by a country. Keeping in view of the importance of steel, the following integrated steel plants with foreign collaborations were set up in public sector in  post independence era

Background of Visakhapatnam Steel Plant :

To meet growing domestic needs of steel, Government of India decided to set up an Integrated Steel Plant at Visakhapatnam. An agreement was signed with erstwhile USSR in 1979 for co-operation in setting up 3.4 MT integrated steel plant at Visakhapatnam. The Company started its commercial production in 1990-91 and its financial results in Table

- 14 -

FY

Gross Sales

Operating Profit

Interest

Depreciation Net Profit

90-91 245

-88

192

197

-478

91-92 772

-101

437

449

-987

92-93 1185

-31

198

340

-568

93-94 1751

114

346

340

-573

94-95 2209

416

366

415

-364

95-96 3039

633

407

430

-204

96-97 3135

606

430

422

-246

97-98 3071

460

198

439

-177

98-99 2761

15

361

111

-457

99-00 2973

252

382

432

-562

00-01 3436

504

351

445

-291

01-02 4081

690

290

475

-75

02-03 5058

1162

187

455

521

03-04 6169

2053

49

457

1547

04-05

8181

3271

11

1006

2254

05-06 8482

2336

31

416

1890

06-07 9800

2950

40

520

2100

07-08 1200

2600

60

640

2450

- 15 -

The Company started its commercial production in 1990-91 and its financial results in Table given above It can be seen from the above table during the year 2002-03, the company turned around by earning a net profit of Rs. 521 Crores. In the same year, it bagged the PRIME MINISTER TROPHY for its excellent  performance in the Steel Industry. In September 2003, RINL became a DEBT FREE COMPANY. Technology:

VSP was equipped with state of the art technology of steel making, large scale computerization and automation was incorporated in the plant to achieve International Level of Efficiency and Productivity, the organizational manpower has been rationalized. Major Sources of Inputs:

- 16 -

Raw Material

Source

Iron Ore lumps and fines

Bailadilla, MP

BF Limestone

Jaggayyapeta, AP

BF Dolomite

Madharam, Andhra Pradesh

SMS Dolomite

Madharam, Andhra Pradesh

Manganese Ore

Chipurupalli, Andhra Pradesh

Boiler Coal

Talcher, Orissa

Coking Coal

Australia

Medium Coking coal (MCC)

Gidi/swang/rajarappa/kargali

HALLMARK OF VIZAG STEEL AS AN ORGANISATION

Today, VSP is moving forward with aura of confidence and with pride amongst its employees who are determined to give their best for the company to enable it to reach new heights in organizational excellence. At the same time, no single advantage accruing from a knowledge society if found wanting by the neighborhood community with the growth & development of a phenomenon called VIZAG STEEL existing so close to its proximity.

Futuristic enterprises, academic activity,

 planned & progressive residential localities but few of the plentiful ripple effects of this transformation and each one of us take immense pride to uphold the philosophy of mutual (i.e., individual and societal) progress. As a “NET POSITIVE COMPANY” in January, 2006 by wiping out all it’s Accumulated losses during 2005-06.

- 17 -

Statistical information:COMMERCIAL PERFORMANCE – (Rupees in Crores) Year

Sales Turnover

Domestic Sales

Exports

2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07

3436 4081 5059 6174 8181 8469 9126

3122 3710 4433 5406 7933 8026 8702

322 371 626 768 248 443 425

- 18 -

FINANCIAL PERFORMANCE (RUPEES IN CRORES) Year

Gross Margin

Cash Profit

Net profit

2000-01

504

153

(-) 291

2001-02

690

400

(-) 75

2002-03

1049

915

521

2003-04

2073

2024

1547

2004-05

3271

3260

2008

2005-06

2383

2355

1251

2006-07

3672

2600

1806

2007-08

3960

2970

2450

FUTURE PLANS:VISION

- 19 -



To be a continuously growing world-class company.



Harness our growth potential & sustain profitable growth



Deliver high quality and cost competitive products and be the first choice of customers



Create an inspiring work environment to unleash the creative energy of   people



Achieve excellence in enterprise management



Be a respected corporate citizen, ensure clean and green environment and develop vibrant communities around us

MISSION:-

To attain 16 million ton liquid steel capacity through technological up gradation, operational efficiency and expansion to produce steel at international standards of cost and quality, and to meet the aspirations of  stakeholders.

- 20 -

Objectives:

Expand plant capacity to 6.3 Mt by 2008-09, 8.5 Mt by 2010-11, 13.0 Mt by 2014-15 With the mission to expand further in subsequent phases as per the Corporate Plan.



Be amongst the top five lowest cost liquid steel producers in the world by 09-10



Achieve higher levels of customer satisfaction than competitors



Vibrant work culture in the organization



Be recognized as a excellent business organization by 2008-09



Be proactive in conserving environment, maintaining high levels of safety and addressing social concerns

CORE VALUES:

Commitment



Customer Satisfaction



Continuous improvement



Concern for Environment



Creativity & Innovation

- 21 -

SWOT ANALYSIS :

SWOT analysis of VSP depicts the strengths of VSP, weakness that are to be avoided, opportunities that should be banked, and threats that should be faced & yet survive in the business. Strengths & Weaknesses:

Strengths •

Weaknesses

Availability

of

investment and

funds

for  



redemption of 

materials mines resulting in high

 preference equity(Rs. 7686 Cr. As

cost of raw materials

on 31.03.08) •



Availability

of

infrastructure

land facilities

modernization

for 

facilities •

Image

as

“value

for

money

supplier” •

Superior

basic

steel

making

technology •

Strong committed workforce

- 22 -

Capital repairs, upgradation and

and

expansion unto 16 MT •

Lack of inhouse or captive raw

Lack

of

automation

due

higher

for

major 

levels

of  

 Opportunities & Threats :

Opportunities •

High

to

Threats moderate

rates

of 



economic growth projected and

materials rising input costs

strong demand forecast for steel •



Shift of value chain towards raw

Commissioning of Gangavaram

Massive

expansion

plans

of 

existing competitors

Port will enhance port based •

advantage for VSP •

Entry of international players Dependency on single supplier for  sourcing iron ore



Heavy

order

bookings

of  

equipment suppliers thus adverse impact on expansion plans – high costs and delays.

- 23 -

RESEARCH METHODOLOGY

- 24 -

Research Methodology Relevance of the Study

The level of steel consumptions has long been regarded as an index of  industrialization and economic maturity attained by country. Keeping in view the importance of steel, the integrated steel plants with foreign collaborations were set up in the public sector in the post-independence era. Efficient management of financial resources and deliberate analysis of  financial results are pre requisite for success of an enterprise. For the achievement of that, Foreign exchange and risk management are the major and important tool of effective financial management. Every organization exchange  policies and risk analysis for evaluation of the performances of business.

Objective of the Study

The complexity of experiencing foreign exchange exposure in steel industry and hedging of associated risks has been more challenging as never   before. The objectives of taking up the subject for the project work at VIZAG STEEL are as follows:



To understand the nature of foreign exchange transactions undertaken in VIZAG STEEL .



To ascertain the requirement of imported raw materials, spares, equipments etc for the steel plant and payments.



To ascertain the value of export, other earnings in foreign exchange and realization.



To assess the foreign exchange payments towards procurement of  capital equipments, technological know-how, services of foreign experts etc.

- 25 -



To analyze the risks involved in undertaking the foreign exchange transactions in current scenario.



To understand the risk philosophy, risk policy for foreign exchange transactions and perceptions about the existing risks at VIZAG STEEL.



To evaluate the risk management practices adopted at VIZAG STEEL to mitigate foreign exchange risks and their effectiveness.



To identify the deficiencies, study the impact and suggest measures to overcome the same in the current scenario.

Research Design

Research design is the blueprint of the research project. It includes the different things which are methods, sampling plan, data collection methods. It  provides the guidance as well as information for the study. Research design has been in “Descriptive nature.”

- 26 -

Scope of Research

In order to undertake the study it is essential to understand the operations of the company associated with the requirements of foreign exchange and the risk management efforts. It is also pertinent to find out such efforts in other  corporate in steel industry. The study involves collection of data from secondary sources relating to foreign exchange requirements on account of import of raw materials, spares,  payment of ocean freight, arrangement of suppliers/ buyers credit/ loans,  payments towards hiring of technological services from foreign experts etc.. On the other hand the forex realizations from exports have to be collected to understand the mode of collection of export proceeds, timing and utilization of foreign exchange, parking of funds, if any.

Data Collection Secondary data: •

The secondary data was collected from already published sources such as,  pamphlets of annual reports, Website.

The data collection includes: •



Collection of required data from website and annual report of  Visakhapatnam Steel Plant. Reference from textbooks and journals relating to financial management.

- 27 -

THEORY ASPECTS OF RESEARCH

- 28 -

FOREIGN EXCHANGE Exchange word was not aware in that age . With the changes in the needs, human being became lesser self sufficient in meeting the needs and started seeking other things in return for the available commodities. The Breton Woods Agreement was initiated in 1944 in an effort to keep cash from draining out. Thus the marketability and familiarity of a commodity determined its acceptance and use as means of exchange. Over a period of time, metals in the form of coins were introduced as medium of exchange. The modern era of foreign exchange first emerged in 1971 with the collapse of the Bretton Woods Agreement. These persons enjoyed the trust of  the people and were entrusted with the job of safe keeping of surplus money. Paper currency with sovereign authentication became the medium exchange and accepted all over the world. This was a major development and ultimately led to the spread of banking services. People were confident that they would receive certain value, on demand, against the paper currency or note they possess. With the movement of goods and services across the border of countries in the form of International Trade, the requirement of foreign exchange or  currencies of other countries became essential. The necessity was also felt due to the reasons like different monetary units of different countries, restrictions  between the countries for export/imports and the national payments, different legal practices etc. In India, foreign exchange has been given a statutory definition. Section 2 (b) of foreign exchange regulation ACT, 1973 states: Foreign Exchange means Foreign currency and includes-

- 29 -



All deposits, credits and balance payable in any foreign currency and any draft, traveler’s cheques, letter of credit and bills of exchange. Expressed or drawn in India currency but payable in any foreign currency.



Any instrument payable, at the option of draw or holder thereof or any other party thereto, either in Indian currency or in foreign currency or   partly in one and partly in the other.

Foreign Exchange in the Global Economy:-

The foreign exchange market has been an invisible hand that guides the sale of goods, services and raw materials on every corner of the globe. The forex market was created by necessity. Traders, bankers, investors, importers and exporters recognized the benefits of hedging risk, or speculating for profit. The fascination with this market comes from its sheer size, complexity and almost limitless reach of influence. Inter-bank currency contracts and options, unlike futures contracts, are not traded on exchanges and are not standardized. Banks and dealers act as  principles in these markets, negotiating each transaction on an individual basis. Forward "cash" or "spot" trading in currencies is substantially unregulated there are no limitations on daily price movements or speculative positions.

ABOUT FOREIGN EXCHANGE MARKET

There is no market place called the foreign exchange market. It is mechanism through which one country’s currency can be exchange i.e. bought or sold for  the currency of another country. The foreign exchange market does not have any geographic location.

- 30 -

Forex Market is stated that it is functioning throughout 24 hours a day. Foreign exchange market is described as an OTC (over the counter) market as there is no physical place where the participant meets to execute the deals, as we see in the case of stock exchange. The largest foreign exchange market is in London, followed by the New York, Tokyo, Zurich and Frankfurt. The markets are situated throughout the different time zone of the globe in such a way that one market is closing the other is beginning its operation.

RBI has granted to various firms and individuals, license to undertake moneychanging business at seas/airport and tourism place of tourist interest in India. In order to provide facilities to the public and foreigners visiting India, for  exchange of foreign currency into Indian currency and vice-versa. Certain authorized dealers in foreign exchange (banks) have also been permitted to open exchange bureaus.

Even among the banks RBI has categorized them as follows: Branch A – They are the branches that have nostro and vostro account. Branch B – The branch that can deal in all other transaction but do not maintain nostro and vostro a/c’s fall under this category. Branch C - such branches cannot do anything with forex business.

For Indian we can conclude that foreign exchange refers to foreign money, which includes notes, cheques, bills of exchange, bank balance and deposits in foreign currencies.

Market size and liquidity:-

- 31 -

The foreign exchange market is unique because of  

Its trading volumes,



The extreme liquidity of the market,



The large number of, and variety of, traders in the market,



Its geographical dispersion,



Its long trading hours: 24 hours a day (except on weekends),



The variety of factors that affect exchange rates.



The low margins of profit compared with other markets of fixed income (but profits can be high due to very large trading volumes)

Average daily turnover in traditional foreign exchange markets is estimated at $3.21 trillion. Daily averages in April for different years, in billions of US dollars, are presented on the chart below:

- 32 -

This $3.21 trillion in global foreign exchange market "traditional" turnover was  broken down as follows: 

$1,005 billion in spot transactions



$362 billion in outright forwards



$1,714 billion in forex swaps



$129 billion estimated gaps in reporting

Exchange-traded forex futures contracts were introduced in 1972 at the Chicago Mercantile Exchange. Forex futures volume has grown rapidly in recent years, and accounts for about 7% of the total foreign exchange market volume, according to The Wall Street Journal Europe Foreign exchange trading increased by 38% between April 2005 and April 2006 and has more than doubled since 2001. Average daily global turnover in traditional foreign exchange market transactions totaled $2.7 trillion in April 2006 according to IFSL estimates based on semi-annual London, New York, Tokyo and Singapore Foreign Exchange Committee data. This is largely due to the growing importance of foreign exchange as an asset class and an increase in fund management assets, particularly of hedge funds and pension funds. The biggest geographic trading centre is the UK, primarily London, increased its share of global turnover in traditional transactions from 31.3% in April 2004 to 32.4% in April 2006 The ten most active traders account for almost 73% of trading volume, according to The Wall Street Journal Europe, (2/9/06 p. 20). The bid/ask spread is the difference between the price at which a bank or market maker will sell ("ask", or "offer") and the price at which a market-maker will buy ("bid") from

- 33 -

a wholesale customer.

Foreign Exchange Markets – scope:-

The forex market dwarfs the combined operations of the New York, London, and Tokyo futures and stock exchanges. Daily turnover on the spot market is approximately US$1.5 trillion per day. Spot transactions and forward outright FX trading takes place in the inter-bank  market. 51% of the market is in spot FX transactions, followed by 32% in currency swap transactions. Forward outright FX transactions represent another  5% of this daily turnover. Options on inter-bank FX transactions making up another 8%. Therefore the inter-bank market accounts for 96% of the global foreign exchange market, with the remaining 4% being divided among all the global futures exchanges.

- 34 -

Exchange rate

Exchange rate can be defined as the rate at which one currency is converted into another currency. For example the Indian Rupees can be exchanged to obtain US dollar. Say one US dollar can be had by paying Rs 44. This exchange rate can be expressed in the form of either as Direct quote as USD 1 = INR 44, where the home currency is variable unit or  alternatively, expressed in  Indirect quote as INR 1 = USD 0.022727, where the home currency is taken as 1 unit. The principle adopted in exchanging the currency in Direct quote is  Buy Low & Sell High and similarly in the Indirect quote is  Buy High or Sell Low. There are two important theories behind determination of exchange rates. They are as follows: 

Purchasing power parity theory.



Balance of payments theory or Demand & Supply theory.

1. PURCHASING POWER PARITY (PPP) THEORY:

According to the purchasing power parity theory, after the First World War, the rate of exchange between two currencies in the long run will be determined by their respective purchasing power. It emphasizes that the rate of exchange between two currencies must and essentially depend upon the quotient of the internal purchasing power of these currencies.

- 35 -

In the long run the value is determined by the relative values of two currencies as indicated by their relative purchasing power over goods and services. In other words, the rate of exchange tends to rest at a point which expresses equality between the respective purchasing power of the two countries. This point is called the parity of purchasing power. The exchange rate between one country and another is in equilibrium when the domestic purchasing power at that rate of exchange is equivalent. For  example assume that X commodity in India costs Rs:44/ per Kg and the same in U.S.A costs USD 1, then the exchange rate under purchase  parity would be USD 1= INR 44. A change in the purchasing power of  currencies will be reflected in their exchange rates. The index number of   prices may be used to determine the purchasing power parity. If there is a change in the new equilibrium, the rate of exchange can be found out by the following formulae :

ER = Er ( Pd/Pf) Where

ER = Equilibrium exchange rate Er = Exchange rate in the reference period Pd = Domestic price index Pf = Foreign country’s price index.

2. BALANCE OF PAYMENTS THEORY:-

The Balance of Payments theory also known as the Demand and supply theory advocates that the foreign exchange rate, under free market conditions, is determined by demand and supply of currency in the foreign exchange market. The value of currency appreciates when the demand for it increases and depreciates when the demand falls, in relation to its supply in the foreign - 36 -

exchange market. The extent of the demand and supply of a country’s currency in foreign exchange market depends on the balance of payment position. The  balance of payments theory provides a fairly satisfactory explanation of the determination of rate of exchange. Determinants of Exchange rate:-

a) Balance of payments (Bop) : Balance of payment represents the demand for  and supply of foreign exchange. Exchange rate (ER) is influenced by the change in exports and imports of a country. If exports of a country exceed its imports, the demand for home currency increases due to greater flow of foreign exchange so that the ER moves in favor of home currency and it appreciates. On the other hand, if imports are more than exports, the BoP of a country shows deficit resulting in increase in demand for the foreign currency and the ER  moves against the home currency causing depreciation in the home currency.

 b) Interest rates : The movement of foreign exchange is also dependant on the arbitrage arising out of the interest rates between the domestic currency and other currencies. The difference in the interest rates lead to currency carrytrades. Currency carry-trades is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates - which can often be substantial, depending on the amount of leverage the investor chooses to use. c) Inflation: It is the changes in relative price levels of Two countries that cause changes in the exchange rate. In other words increase in price level reduces the  purchasing power of common man. For example if the whole sale prices in Britain rises more than the relative price rise in USA, the situation leads to rise in the prices of British goods in terms of pounds /dollars in USA. British goods - 37 -

will become dearer in the USA, On the other hand, the American goods become cheaper in Britain causing increase of American exports and

increase in

demand for US dollars. d) Money supply

: Volume of money supply also affect the movement of 

exchange rate . This includes the purchase and sale of currencies and negotiable instruments such as bank drafts, letters of credit,

Bills of exchange etc.. The

credit availability and fixation of bank rates also influence the exchange rate. If  the money supply increases, it will fuel inflation and the home currency  becomes cheaper vis-à-vis foreign currency.

- 38 -

e) National income: The national income also influences the exchange rate. Higher GDP reflects stronger economy and currency commands a strong  position in the international market. Growth in GDP shows increase in  production, consumption and export of commodities/services thereby increase in inflow of foreign currencies thereby movement of exchange rate in favor of home currency. f) Resources: The availability of natural resources in the country like, mines , minerals, natural gases, coastal lines etc helps in improving the national income and increased participation in the international trade. It is important to make best use of the available resources in harnessing country’s growth and improve per capita income. g) Movement of capital: Short term or long term capital movements of capital in the form of FII/FDI inflows or outflows also influence the exchange rate. Foreign Capital-in Flows tend to appreciate the value of the home currency. The exchange rate will move in favor of the capital-importing country and against the capital-exporting country. h) Political factors: Political conditions in the country have a significant influence on the exchange rate. Political stability, strong and efficient governance create confidence in the mind of citizens as well as foreigners to invest their funds in the country in the form of joint ventures, acquisitions, deposits, equity participation etc.. With the inflow of capital, the demand for domestic currency rises and the exchange rate moves in favor of the home currency.

- 39 -

i) Market forces: Efficient and effective operation of Stock exchanges, operation in foreign securities, debentures, stocks and shares etc. exert significant influence on the exchange rate. If the stock exchanges play conducive role in the sale of securities, debentures, shares etc to foreign investors, the demand for the domestic currency will rise and the exchange rate becomes favorable.  j) Speculation: The growth of speculative activities also influence the exchange rate. Speculation causes short- term movement of funds causing volatility in the movement of exchange rates. Uncertainty in the global financial market encourages speculation in foreign exchange. If the speculators expect a fall in the value of currency in the near future, they will sell to acquire appreciating currency to exchange later in the financial market. k) Structural changes: It is another important factor which influences the exchange rate of the currency. These changes bring a shift in the consumer demand for commodities. They include technological changes, innovations, taste, preferences etc. which affect the demand for existing  products and requirement of new products.

- 40 -

EXCHANGE RATE SYSTEMS

Broadly there are two important exchange rate systems, namely the Fixed exchange rate system and Flexible exchange rate system. They are  brought out below: FIXED EXCHANGE RATE

Countries following the Fixed exchange rate (also known as stable rate or   pegged exchange rate) system agree to keep their currencies at a fixed ratio or pegged rate to a major currency and change their value when the economic situation forces them to do so. For example, Chinese Yuan is  pegged to US dollar. Under the gold standard, the values of currencies were fixed in terms of ounce of gold. With the collapse of the Brettonwoods System in August 1971, some of the members adopted floating currency method while others still embraced the fixed exchange rate system.

FLOATING/FLEXIBLE EXCHANGE RATE

Under the floating exchange rate system, exchange rates are freely determined in an open market environment based on the supply and demand for  the currencies and there is no intervention from regulatory authority to control the exchange rate. Whereas under flexible exchange rate system, the exchange rate is fixed but subject to frequents adjustments depending upon the market conditions by intervention of regulatory authority. Balance of payment is an important factor in determining the exchange rate under this system. This situation makes foreign goods cheaper in terms of the domestic currency and domestic goods become more expensive in terms of the foreign currency. It

- 41 -

encourages imports and discourages exports, resulting in the restoration of the  balance of payments equilibrium. On the other hand, a deficit in the balance of payments will give rise to an excess supply of the country’s currency and the exchange rate will tend to fall. If there is deficit in balance of payments, the exchange rate falls and this makes domestic goods cheaper in terms of the foreign currency and foreign goods more expensive in terms of the domestic currency. This encourages exports, and discourages imports and thus establishes the balance of payments equilibrium.

EXTERNAL VALUE OF RUPEE

In the year 1971, USA suspended the convertibility of the US dollar into gold leading to the collapse of fixed parity system under the Bretton woods agreement. In view of the uncertainties in the international situation, Indian Rupee was pegged at 1Re = USD 0.133333. To correct the situation Govt. of  India de-linked Rupee from Pound sterling on 25 Th September 1975 and linked it to an undisclosed basket of currency but pound sterling was retained as the intervention currency in terms of which the external value of Rupee was fixed. In the year 1991 Rupee was further devalued by 22pct and dual exchange rate was introduced. With effect from March 1992, US dollar was adopted as the intervention currency in place of sterling and Rupee was partially floated. The external value of the Rupee was made fully independent on market forces from March 1993 and official rate was abolished.

CONVERTIBILITY OF RUPEE

Convertibility of Rupee refers to its conversion into any foreign currency as desired by its holder. The currency is considered as fully convertible if the holder can convert it into any other currency at rates - 42 -

determined by the forces of demand and supply without any intervention from the government. The convertibility involves two steps like determination of rate  by market forces and the absence of restrictions on the repatriation of the currency. Rates as of 2008-06-27 19:09:36 UTC (GMT). Base currency is INR.

Currency Unit =======================

INR per Unit =============

Units per INR  =============

USD United States Dollars

42.7800000000

0.0233754091

EUR Euro

67.4783476888

0.0148195686

AUD Australia Dollars

41.0575439811

0.0243560599

JPY Japan Yen

0.4029680400

2.4815863810

INR India Rupees

1.0000000000

1.0000000000

 NZD New Zealand Dollars

32.5256614444

0.0307449551

CHF Switzerland Francs

41.9975769690

0.0238108975

ZAR South Africa Rand

5.4229133525

0.1844027251

AFN Afghanistan Afghanis

0.9281686828

1.0773903693

ISK Iceland Kronur

0.5317027942

1.8807499433

12.7229200712

0.0785983088

KES Kenya Shillings

0.6632558140

1.5077138850

 NZD New Zealand Dollars

32.5256614444

0.0307449551

 NGN Nigeria Nairas

0.3633429591

2.7522206639

 NOK Norway Kroner

8.4497234551

0.1183470684

31.3935569102

0.0318536699

0.0411166674

24.3210372698

SDG Sudan Pounds

20.8109357138

0.0480516597

CHF Switzerland Francs

41.9975769690

0.0238108975

ILS Israel New Shekels

SGD Singapore Dollars KRW South Korea Won

- 43 -

GBP United Kingdom Pounds

85.2659900992

Currency remittances are broadly classified into two categories, I) Current account ii) Capital account

- 44 -

0.0117280055

Financial Arrangements Of VSP The capital structure of VSP at the time of completion of the plant was represented by Share Capital of Rs. 6170.57 crores and external debt (loan funds) of Rs. 3608.86 crores. With this capital composition, the Debt to Equity was 0.58 and as of now there is no external debt except cash credit which is  being utilized at the minimum possible levels for the purpose of working capital requirements. VSP had become debt free company during 2002-03 FY by  paying out entire debt from the internal generations. As on date, the Equity is Rs. 7827.32 crores and the cash credit is Rs. 88.15 crores as per the balance sheet of 2005-06 FY. The increase in the Equity is due to conversion of Govt. loan and its accrued interest into preference share capital. VSP has got financial arrangements for Working Capital with various Banks under Multiple Banking Arrangement (MBA). This arrangement comprises Fund Based and Non-Fund based Working Capital. Fund Based Working Capital includes Cash Credit (CC), Working Capital Demand Loan (WCDL) and Export Packing Credit (EPC) and the Non-Fund based Working Capital includes Letter of Credit (LC) and Bank Guarantee (BG). VSP is  presently managing with total working capital limits up to Rs. 1801.65 crores as on 31.03.2006 out of which the fund based limit is Rs. 570.65 crores and nonfund based limit is Rs. 1231 crores. The Working Capital limits for each category of basis are as below.

- 45 -

Working Capital limits in 2006-07 Fund based

Rs in Crs

Cash Credit

131.84

Working Capital Demand Loan

263.14

Export Packing Credit

175.67

Sub-Total:

570.65

Non-Fund based

Letter of Credit

1176.00

Bank Guarantee

55.00

Sub-Total:

1231.00

TOTAL

1801.65

EXCHANGE CONTROL

Exchange control refers to the control by the government or centralized agency of transactions involving foreign exchange. It is one of the important mechanisms of achieving certain national objectives like improvements in the  balance of payments position, promotion of exports, regulation of essential imports, conservation of foreign exchange, control of outflow of capital and maintenance of the external value of the currency etc. Exchange control in India was introduced in India in 1939 to conserve the foreign exchange and utilize them for essential purposes. In order to continue with the control of foreign exchange, Foreign Exchange Regulation Act( FERA) 1947 was enacted. The act was reviewed in 1973 and 1993. Foreign Exchange Management Act( FEMA) 1999 was enacted. The main objective of FEMA is - 46 -

focused on facilitating external trade and payments and for promoting the orderly development and maintenance of foreign exchange markets in India. The foreign exchange resources and transactions of the nation are monitored by the exchange control authority. Central government may from time to time give Reserve bank such general or specific directions as it thinks fit and Reserve bank shall comply with such directives. Though the exchange control regulatory measures are administered by Reserve bank, the foreign exchange transactions are routed through the persons/agencies authorized by Reserve bank such as authorized dealers, money changers, offshore banking unit or any other person .

Objectives of exchange control

The major objectives of exchange control are outlined below : -

Monitoring the transactions distinctly under current and capital account through the authorized dealers.

-

Conservation of foreign exchange to maintain the external value of Rupee and utilization to meet import requirements.

-

Improvement of Balance of payments

-

Maintain exchange rate stability and control speculation

- 47 -

METHODS OF EXCHANGE CONTROL

The various methods of exchange control may be broadly classified into 1) unilateral method and 2) bilateral method.

UNILATERAL METHOD:

Unilateral

measures refer to those methods which may be adopted by a

country unilaterally. i.e without any reference to or understanding with other  countries. The unilateral measures are outlined below :



REGULATION OF BANK RATE: A Change in the bank rate is usually followed by changes in all other rates of interest and affect the flow of  foreign capital.



REGULATION OF FOREIGN TRADE: The rate of exchange may be controlled by regulating the foreign trade of the country. Encouraging the exports and discouraging the imports.



EXCHANGE RATE PEGGING : Exchange rate pegging refers to the  policy of the government of fixing the exchange rate to specific currency arbitrarily either below or above the normal market rate.

BILATERAL METHOD: 

PRIVATE COMPENSATION AGREEMENT : Under this method, a firm in one country is required to equalize its exports to the other country. So that there will be neither a surplus nor a deficit.

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CLEARING AGREEMENT: Under the clearing agreement importers make payments in domestic currency for clearing the goods. The need for  foreign exchange does not arise except for getting the net balance  between the two countries.



STAND STILL AGREEMENT: The stand still agreement seeks to  provide the debtor country sometime to adjust their position by  preventing the movement of capital out of the country through a moratorium on the outstanding short term foreign debts.

Foreign exchange regulation and control

The most important concept in the foreign exchange system is the regulation and control of foreign exchange. Proper management of the foreign exchange reflects the country’s economic system and strength. As defined in FEMA , “ Foreign Exchange” includes deposits, credits, drafts, traveller’s cheques, letters of credit, bills of exchange payable in foreign currency. Under “ FEMA” foreign exchange transactions have been divided into two broad categories current account transactions and capital account transactions.



CAPITAL ACCOUNT TRANSACTIONS: Transactions that alter the assets and liabilities of a person resident in India (or) a person resident outside India have been classified as capital account transactions.



CURRENT ACCOUNT TRANSACTIONS: All transactions other than

capital account transactions that do not alter the assets and liabilities of a person & including dues against foreign trade, short term

banking and credit

facilities, interest on loans / investments, remittance for living expense of  relatives living abroad.

- 49 -

Reserve bank has notified comprehensive simple and transparent regulations under FEMA, 1999 governing various capital account transactions. The new regulations clearly indicate the types of permissible capital account transactions and Simplified procedures while granting more powers to authorized dealers i.e. banks. Except as provided by the Act, no person shall in foreign exchange (or) foreign securities, make remittance abroad, receive  payments from abroad, acquire (or) posses any foreign exchange foreign security (or) foreign immovable property. Any Indian resident may hold, own, transfer (or) invest in foreign currency, foreign security, (or) foreign property abroad if these were acquired when he was resident abroad (or) inherited these from a resident abroad.

FOREIGN EXCHANGE AND INTEREST RATE - RISKS

The exchange risk is defined as the net potential gains or losses which can arise from exchange rate changes to the  foreign exchange exposure of an enterprise. The foreign exchange exposure covers all the transactions, assets and liabilities of an enterprise which are denominated in currencies other than the reporting currency of the enterprise. Thus exposure relates to the total value of  assets, liabilities or cash flows of an enterprise denominated in foreign currency and exchange risk relates to the excess or shortfall in that exposure due to exchange rate fluctuations. Thus exposure relates to absolute value and the risk  relates to the changes in the value.

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The foreign exchange risk can be broadly categorized as follows :  Conversion or transaction risk :

The gain or loss arising out of 

converting foreign currency into domestic currency is known as conversion risk. It arises on account of exchange rate fluctuations when the foreign currency denominated transaction is settled and converted into the domestic currency.

 Accounting or translation risk :

The risk arising out of translating the

assets or liabilities of the enterprise denominated in the foreign currency in to domestic currency to show in the books without actual conversion with reference to the earlier reported rate.

 Economic or Sovereign risk :

It arises out of the change in the many

attributes like interest rates, inflation, political scenario, exchange control, regulatory measures. Etc of other countries but affects the exchange rate  between two currencies. These risks are less clearly perceived but have wide ramifications with far reaching effects.

 Interest rate - risks:

Apart from the above a corporate is also exposed

to risk on account of fluctuation in the interest rates in the market. It refers to the changes in the cash flows or future value of a firm on account of changes in the interest rates. Interest is charged on either fixed rate or floating rate basis. Whereas in case of floating rate, the interest is linked to some bench marked rates like LIBOR or MIBOR or SIBOR  etc.. In fact in case of LIBOR, the interest rates are offered for different tenors in different currencies.

- 51 -

In case of Fixed interest rate, the risk arises out of change in the interest rates in the form of opportunity cost. For example if the interest rate goes down after taking loan on fixed rate basis then the differential rate can be considered as loss of opportunity, However it is beneficial in case the interest rate rises. In case of Floating interest rate, the risk arises out of the fluctuation in the  benchmark interest rates. The loss arises in terms of additional outflow on account of rise in the interest rate. Any change in the interest rates also creates capital risk in the form of change in the price of underlying investment.

- 52 -

SIGNIFICANCE OF RISK MANAGEMENT Risk is the likelihood, or probability, that a given adverse event will occur and Risk management deals with the assessing the magnitude of impact of  such event on operations, financial reporting, and possibly strategy to mitigate or reducing the impact if the event does occur. Some risks are discrete and others are continuous with a range of possible results associated with such event with a likelihood of occurrence. Measures for likelihood are also discrete or  continuous. Measures of potential impact may be in terms of possible disruption of operations, monetary loss or impairment of strategic objectives. Since risks are inevitable, the desire to shadow the risks by maneuverable strategies to manage them has become natural. Today’s business faces many risks which are either internally driven or  externally driven in nature. All these risks can be broadly categorized into Four  types with Two dimensions, as follows:

WHO IS INVOLVED IN RISK MANAGEMENT?

Customer  

End-user 



Project Team



Management



Product Management



Related Projects



Subcontractors and Suppliers

Steps in the risk management process - 53 -



Identification of risk in a selected domain of interest



Planning the remainder of the process.



Mapping out the following: 1. the social scope of risk management 2. the identity and objectives of stakeholders 3.the basis upon which risks will be evaluated, constraints.



Defining a framework for the activity and an agenda for identification.



Developing an analysis of risks involved in the process.



Mitigation

of

risks

using

available

technological,

human

and

organizational resources.

Risk identification :

Comprehensive risk identification using a well-structured systematic  process is critical. Risk Champion should identify risks at the Business Function. Risks can be identified in a number of ways, like conducting Workshops, Brainstorming, Interviews , Press and media searches, Seminars, Discussion with peers etc. Effectiveness of risk identification tools is measured in terms of weighted average score in the scale with a range of 1 to 7 i.e. low to high. Weighted Average score with 1 shows low effectiveness and 7 shows high effectiveness.

The risk identification tools are as follows

- 54 -



round table debates on key risks



interactive workshop



strategic risk reviews



specific studies/surveys



structured interviews



management reports



checklists / questionnaires



Risk Measurement Matrix

The identified risks are put in a matrix form by observing the following few steps :- Risk are segregated into separate risk category - Risk owner is appointed for each risk category - A measurement scale is established to rate the risks as being high, medium, or low impact / probability - The measurement scale may be quantified in rupee terms of the loss, Where quantification is not possible, the occurrence of a particular E vent may be assessed.

- Measurement scale is used to assess the criticality of the risk. - Accordingly, the risk information should be escalated to the required Level. Further the impact of the risks is assessed in terms of the area of impact and the likelihood criteria: Likelihood criteria - in terms of probability of occurrence on a 5 point scale from very high, high, moderate, low and very low.

- 55 -

Risk Assessment:

Risk is typically assessed along two dimensions. Risk assessment across an enterprise requires a combination of qualitative and quantitative methodologies. Quantitative assessment is possible when sufficient data are available. Qualitative assessment methodologies may be used where  potential likelihood and impact are low or where numerical data and expertise for quantitative assessments are not available. Qualitative assessments may also be used for high-impact events that require substantive expertise for assessment. Risk Evaluation:

It is the process used to determine the Risk Management priorities by comparing the level of perceived risks against pre-determined standards/ target risk levels or other criteria and to generate a prioritized list of risks for further monitoring and mitigation. There may be a range of possible outcomes associated with an event.  Risk evaluation helps in assessing the Consequences/ Impact of the outcome of an event expressed qualitatively or quantitatively, being a loss, injury, disadvantage or gain. The output of  a risk evaluation is a prioritized list of risks for further action .The Risks ratings are the combined scores of likelihood and impact of the outcome of an event. Risks are prioritized in three categories: 

High



Medium ( Yellow zone or cautionary )



Low

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( Red zone or unacceptable )

( Green zone or acceptable )

Financial Risks and Integrated Risk Management System Financial risks

Now a day’s businesses face many risks while executing the transactions or holding the exposure in asset, liability or commodity including currencies. The internal driven financial risks like cash management, Debtors collection, credit availment, investment of Surplus funds etc are more focused on the Organization’s external driven financial

managerial acumen and the

risks are more market oriented, which is

influenced by the environmental forces such as credit policies, liquidity growth, interest rates, taxation laws, accounting standards, exchange rate fluctuations, commodity risks etc.. With the liberalization of economy by moving away from the erstwhile enforcement of draconian laws to user friendly regulatory measures and globalization of trade/services by lifting the international trade barriers, reduction of taxes & duties on imports, taxation incentives, creation of  SEZs, entering into FTAs and adopting uniform currencies across countries lead to greater convergence of national and international trade. This changing scenario not only benefits the consumers but also encourages to change the socio economic needs of the people. Different currencies, trade practices, economic elements put the firms into greater  financial risks unless the firm is suitably geared up to meet such challenges by looking at the opportunities out of such risks.

- 57 -

Forex Risks

The foreign exchange ( Forex) risks can be defined as the risks arising out of the transactions involving currencies of different countries. Risk is the  potential for change in the price or value an asset or commodity. It is not correct to interpret risk as a potential loss. Depending upon the potential in the risk, the return can move upward or downward. Risk and Return in a decision making process move together in same direction. It largely depends upon the risk appetite of the organization to accept the risk  exposure or hedge it.

Risk identification and measurement :

It is an important step in the

mechanism of risk management. Wrong identification will lead to basis risk i.e. risk assumptions. The risks associated with the international trade arise out of the exposures on account of transaction or conversion, Accounting or translation or Operating or economic fronts. Broadly the risks on these transactions involving commodities, assets or liabilities can  be classified into few categories as follows :

a) Conversion risk : Risk arising out of converting one currency into another  with or without

any underlying transaction.

i) Exchange rate: The rate at which the currency is converted in to other  currency. ii) Accounting: The rate at which the currency exposure is translated in the books of accounts.

- 58 -

 b) Economic risk: It arises out of the change in the interest rates and the inflation prevailing in the Two countries. c) Sovereign risk: It arises out of the change in the political scenario, exchange control, regulatory measures etc of the Two countries. d) Liquidity risk: This implies the market depth of the currency.

The exposure must be analyzed to arrive at the various components of  risk associated with it. The corporate is exposed to risks both on account of fluctuations in the exchange rate and interest rate as well for the repayment to be made in future. Even a simple import /export transaction can affect the bottom line of the organization unless a prudent risk  strategy is adopted. The risk measurement involves the assessment of potential downside the corporate could face if the risk remains un-hedged. The corporate has to assess about the extra fund required in case the domestic currency  becomes weaker or the interest rate move higher.

Risk control and monitoring:

Analysis of Sensitivity to various risks that corporate faces assumes considerable significance. Corporate has to analyze the decision of hedging the risk vis-à-vis keeping the exposure open and the resultant impact. The hedging decision will depend upon the risk appetite and the cost of hedging. If the expectation shows a hit on the bottom line due to fluctuations then corporate would tend to hedge with smaller cost rather than facing it. The risk appetite of  corporate hinges upon the sensitivity to risk.

After analyzing the risk 

component, corporate can actually go about setting the risk  hedging guidelines, deciding the limits and setting prudent

- 59 -

risk norms. Based on the exposure undertaken and the sensitivity to the risks presented by the exposure, corporate can decide on when to hedge and how much of the exposure to hedge. Corporate can assign risk weights to various exposures and then look to arrive at an over all risk  weighted figure. Corporate can set up various models to track the risk amount at any point of time.

Integrated Risk Management System (IRMS)

At a world class level, the Four dimensions of effective Integrated Risk  Management System are:

1.  Risk culture -the degree to which management recognizes the need for  management competency and establishes standards and protocols for risk  management processes. This culture encompasses an organization’s appetite and tolerance for risk in its daily operating activities.

2.  Risk management structure -the form used to assign responsibility for risk  management and to create a common process for assessing and communicating risk issues from detailed process levels to the highest levels of decision-making in an organization.

3.  Resources - management’s commitment to building a risk management competency risk management leaders and process facilitators, development of  learning and education programs for employees and establishment of effective risk management monitoring functions.

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4. Tools and techniques -the policies, processes, risk language and technology  based tools for managing risk.

The risk management practices revolves in a cyclical order from the identification of risks till review of hedging mechanism adopted to mitigate or  reducing the impact of the risks and to adopt better methods by learning from the experiences in the past. The cycle starts with identification of risks, quantification of risks, adoption of strategy, hedging mechanism (if any) and review. The strategies depend largely upon the risk environment and the risk  appetite of the organization.

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HEDGING MECHANISM

EXTERNAL HEDGING : Forward contract hedge

Forward contract has been most widely used form of hedging exchange rate risk. In a Forward contract, the acquisition or disposal of foreign exchange is done at a pre determined exchange rate for settlement on a future date. Thus an exporter who is expecting to receive the foreign exchange after 6 months can sell this amount to bank under a forward contract so that the receivable can be realized by the exporter at the forward rate irrespective of the prevailing rate on the date of realization. Also there is an element of opportunity loss or gain by entering into forward contract based on the movement of actual spot rate on the date of settlement vis-à-vis the forward rate. However at the time of hedging or  entering into forward contract it is not possible to predict about the spot rate on the date of settlement in future. Money market hedge

Under this method the risk is covered by borrowing in foreign currency converting the same into home currency and investing in the money market to neutralize the position. Futures

Futures are standardized contracts covering selective currencies in specific lots and with specific periods. It is not flexible in nature as the size of the futures may not match with the value of transaction and there by a part of the transaction may remain uncovered or there may be excess in the coverage without underlying risk.

- 62 -

Currency options hedge

Exposure to movements in foreign exchange rates and currency market volatility can be an advantage, particularly to currency speculators. While some regard any forex risk with alarm and hedge it as soon as it occurs, some hedge it actively. Others never use the forward forex market and regard all windfall  profits or losses as "acts of God".

All corporate treasurers, hedging their forex exposures with forward contracts, are aware that forward contracts are the best hedging instruments for  safeguarding against adverse rate movements. This flexibility of currency options, however, carries a price tag with it in the form of option premium, which is usually payable upfront.

An option is a unique financial instrument or contract that confers upon the holder or the buyer thereof, the right  but not an obligation to buy or sell an underlying asset, at a specified price, on or up to a specified date. In short, the option buyer can simply let the right lapse by not exercising it. On the other  hand, if the option buyer chooses to exercise the right, the seller of the option has an obligation to perform the contract according to the terms agreed. Options on spot currencies are commonly available in the inter bank  over-the-counter markets while those on currency futures are traded on exchanges like the Chicago Mercantile Exchange (CME) and the Singapore International Monetary Exchange (SIMEX).

- 63 -

Terminology Call Option

A call option gives the option buyer the right to buy one currency X against another Y at a stated price on or before a stated date. Put Option

A put option gives the option buyer the right to sell one currency X against another currency Y at a stated price on or before a stated date. In foreign exchange transactions one currency is bought by selling another  currency. Thus if we consider the EUR/USD currency pair, a call option on the euro is no different from a put option on the dollar. Similarly, a put option on the euro is nothing but a call option on the dollar. Strike Price

This is the price specified in the option contract at which the option buyer can  buy or sell currency X against currency Y or for instance the euro against the dollar. Maturity Date

Date on which the option expires. American Option

A call or put option that can be exercised by the buyer on any business day up to and including the maturity date. European Option

A call or put option that can be exercised only on the maturity date. Volatility

- 64 -

The greater the chances of the underlying currency moving higher or lower over  the maturity of the option, the higher will be the premium. The statistical measure normally used to gauge the volatility of markets is the standard deviation, more correctly the standard deviation of daily percentage changes in the underlying price. Volatility describes the size of likely price variations around the trend rather than the trend itself. The figure is usually annualized to give a constant measure. For instance, annualized volatility of 20% means that the currency has a 68% chance of being up or down within a 20% band within one year. It is possible to convert this figure into a daily volatility measure by dividing the annualized volatility by the square root of the number of trading days in a year (sq. root of 250 = 15.8). For instance, with spot euro at 0.87 and volatility at 13%, there is a 68% probability that the spot rate will range between 0.8628 and 0.8772 in a one-day period. Volatility is a key variable in option pricing. For at-the-money options, the relationship is almost linear.

Interest rate differentials

The effect of interest rates on option premiums is the least obvious, and yet,  particularly with currency options, it is one of the most important components of the premium. For stock or commodity options, higher the interest rate, higher  is the call option premium. This is so because higher the interest rate, greater is the opportunity cost of funds, which have to be deployed to buy the concerned stocks or commodities. In currency options, the situation is complicated by the fact that there are two interest rates involved, the domestic interest rate and the foreign interest rate . In this case, since the euro is priced in terms of the dollar, the domestic interest rate is that for the dollar and the foreign interest rate is that for the euro. The premium of an euro call option will increase if the dollar 

- 65 -

interest rate rises or the euro interest rate falls because in either case the cost of  holding euros increases.

HEDGING WITH CURRENCY OPTIONS

The objective of including currency options in hedging arsenal has obviously to be to get the best protection available at the least possible cost. This is easier said than done. However, a corporate with foreign currency  payables say in euro could use the following decision tree as a guide:

- 66 -

Currency hedging decision tree

View of currency

View of risk

Action

Very bullish

Risk averse

Buy currency forward

Very bullish

Risk tolerant

Buy currency forward

Bullish

Risk averse

Buy currency forward

Bullish

Risk tolerant

Buy atm call

Flat market

Buy ootm call

Flat market

Risk tolerant

Do nothing *

 No view

Risk averse

Buy atm call

 No view

Risk tolerant

Do nothing *

Bearish

Risk averse

Buy ootm call

Risk averse

Risk tolerant

Do nothing *

Risk averse

Buy far ootm call

Risk tolerant

Do nothing *

Very bearish

- 67 -

Currency swaps Definition:

A currency swap is a contract which commits two counter parties to an exchange, over an agreed period, two streams of payments in different currencies, each calculated using a different interest rate, and an exchange, at the end of the period, of the corresponding principal amounts, at an exchange rate agreed at the start of the contract. Example: Bank UK commits to pay Bank US, over a period of 2 years, a stream of interest on USD 14 million, the interest rate is agreed when the swap is negotiated; in exchange, Bank US commits to pay Bank UK, over the same  period, a counter stream of sterling interest on GBP 10 million; this interest rate is also agreed when the swap is negotiated. Bank UK and Bank US also commit to exchange, at the end of the two year period, the principals of USD 14 million and GBP 10 million on which interest payments are being made; the exchange rate of 1.4000 is agreed at the start of the swap.

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We can now see from the above that currency swaps differ from interest rate swaps in that currency swaps involve:







An exchange of payments in two currencies.  Not only exchange of interest, but also an exchange of principal amounts. Unlike interest rate swaps, currency swaps are not off balance sheet instruments since they involve exchange of principal at the end of the  period.



The idea of entering into the currency swap is that, Bank US is probably expecting an amount of GBP 10 million at the end of the period, while Bank UK is expecting an amount of USD 14 million, which they agreed to exchange at the end of the period at a mutually agreed exchange rate.



The interest payments at various intervals are calculated either at a fixed interest rate or a floating rate index as agreed between the parties.



Currency swaps can also use two fixed interest rates for the two different currencies – different from the interest rate swaps.



The agreed exchange rate need not be related to the market.



The principal amounts can be exchanged even at the start of the swap

- 69 -

- 70 -

If in the above-mentioned swap, the two banks agree to exchange the principal at the beginning.



Bank UK will sell GBP to Bank US in exchange for US Dollars.



This would be at an exchange rate, most likely the spot rate.



These banks would borrow the respective currencies, which they have sold.



But at maturity, this exchange of principal would be reversed at the original exchange rate. (This kind of swap is called a par swap).

Types of Currency Swaps Cross-currency coupon swaps

These are fixed-against-floating swaps.

- 71 -

Cross-currency basis swap

These swaps involve payments attached to a floating rate index for both the currencies. In other words, floating-against-floating cross-currency basis swaps.

Risk Management with currency swaps:

Example

:

Principal exchanged at Maturity

A UK Co. With mainly sterling revenues, has borrowed fixed-interest dollars in order to purchase machinery from the U.S. It now expects the GBP to depreciate against the USD and is worried about increase in its cost of  repayment.

- 72 -

It could now hedge its exposure to a dollar appreciation by using a GBP/USD currency swap. It would fix the rate at which the company, at maturity, could exchange its accumulated sterling revenues for the dollars needed to repay the  borrowing. Fixing the exchange rate hedges the currency risk in borrowing dollars and repaying through sterling. Assuming, the Company expects not only the dollar to appreciate, but also the GBP interest rates to fall. It could take advantage of this situation, by swapping from fixed-interest dollars into floating interest sterling.

Stages I.

At the start of the swap, the GBP/USD rate is agreed at which the  principal amounts will be exchanged at maturity (probably, the prevailing GBP/USD spot rate)

II. III.

At the same time, interest rates for use in the swap are also agreed Over the life of the swap, the UK Company will pay a stream of sterling floating interest through the swap and will receive a counter stream of  dollar fixed interest in exchange. The dollar interest received through the swap will be used to service the dollar borrowing; the sterling interest  paid through the swap will be funded from earnings.

- 73 -

IV.

At maturity, the company will pay a sterling principal amount through the swap and receive a dollar principal amount in exchange. The exchange is made at the GBP/USD rate agreed at the start of the swap. The company will fund its payment of principal through the swap from accumulated sterling earnings from its business.

- 74 -

Letter of Credit When the export draws a bill of exchange on the importer he faces the risk of repudiation of the contract by the importer. The superior method of  settlement of debt was devised which could assure the exporter that if he exports the goods as per the contract entitled into with the importer and  produces evidence to that effect, he would receive payment without default. Letter of Credit is an undertaking by the importers bank that if the exporter exports the goods and produces documents as stipulated in the letter, the bank would make payment to the exporter. Thus the obligation of the importer under the contract is supplemented by a superior obligation of a bank  to make payment. The exporter now looks into the bank which opened the Letter of Credit for payment instead of relying on the importer.

Mechanism of the Letter of Credit

Article 2 of the uniform customs and practices for documentary credits (UCP) defines a Letter of Credit as to mean “any arrangement, however named or  described, whereby a bank (the issuing bank), acting at the request and on the instructions of a customer (the applicant) or an own behalf. 1. Is to make a payment or to the order of a third party (the  beneficiary) or is to accept and pay bills of exchange drawn by the  beneficiary or  2. Authorises another bank to effect such payment, or to accept and  pay such bills of exchange, or 

- 75 -

3. Authorises another bank to negotiate, against the stipulated documents, provided that the terms and conditions of the credit are complied with.” A clear understanding of above definition will be facilitated if one understands how a Letter of Credit operates. A summary of a stages in the operation of a Letter of Credit is given below.

Operation of a Letter of Credit

- 76 -

Exporter London

Importer Mumbai Ships Goods to

(Beneficiary)

(5)

Presents Documents and obtains payment from (6) Midland

(Applicant) Recovers amount from (8)

Bank 

London (Negotiation Bank)

Bank

of

India

Mumbai (Issuing Bank) Obtains Reimbursement from (7)

Utilization of Letter of Credit

1. The transaction originates when the exporter in London and the importer  in Mumbai enters into the contract of sale. The contract covers all - 77 -

important particulars such as the descriptions, value and quantity of  goods, the due date for shipment, method of payment etc. One of the stipulations is that a letter of credit should be opened in favour of the exporter. 2. The importer applies to his bank (Bank of India) requesting and authorizing the bank to open a letter of credit in favour of the exporter  and pay bills drawn by the exporter under the letter of credit. The application would stipulate the conditions, especially with regard to the documents to be submitted by the exporter along with the bill. 3. Though the letter of credit is addressed to the exporter, it would normally  be sent to the correspondent bank of Bank of India in London (Midland Bank) with a request to forward it to the beneficiary. When it is sent to the Midland bank which, in the capacity of corresponding bank is in the  position of the signature of the officials of Bank of India, the signature on the credit are verified before it is forwarded to the exporter. 4. Within the stipulated date of shipment, the exporter ships the goods to a  port in the importer’s country (Mumbai) and obtains bill of lading from the shipping company. 5. The exporter’s bank verifies the documents to make sure that they satisfy the conditions stipulated in the letter of credit and pay the amount to the exporter. Then the documents forwarded to Bank of India for payment. 6. On receipt of the documents after verifying that they satisfy the requirements of the letter of credit, Bank of India makes payment to Midland Bank. The amount of the bill would be recovered by the bank  from the importer and the documents would be delivered to him.

- 78 -

By this time, it would have been understood that “in credit operations all parties concerned deal in the documents, and not in goods, services and/or other   performance to which the documents may relate.” (Article 4). Thus, though the seller under the letter of credit is assured of payment, the buyer has no guarantee that required the goods have been exported to overcome this difficulty the credit may specify some other documents to accompany the bill.

- 79 -

- 80 -

ANALYSIS & INTERPRETATION OF THE STUDY

Over view of FOREX transactions at VIZAG STEEL

A) OCEAN FREIGHT PAYMENTS

Depending upon the flag of the vessel the ocean freight payments are made in US dollar or INR. Payments to Indian flag vessel owners are made in INR and all other payments are made in USD. Generally the dispatch/demurrage at the load port do not carry any impact due to the fact that the compensation is dove tailed to the similar terms in the supply agreement. About 70 to 80 vessels are handled in a year.

B) IMPORT OF SPARES AND PAYMENTS FOR TECHNICAL SERVICES

Since the plant has adopted modern steel technologies for operations, the technical know how and major operational breakdowns are attended by the foreign technical experts from time to time either as per schedule or in the time of exigencies. In fact with the globalization and liberalization in international trade, The payments to these foreign experts are made either as per man days or  as part of the design, drawing, supply, execution on turnkey basis. In many cases the drawings have been utilized for indigenous production through local agencies to avoid foreign exchange outflow.

 Mode of payments: Against Letter of Credit ( L/C) both on

Sight and usance basis or direct payments covering each transaction as per the terms of AT or purchase order. - 81 -

 Transaction in Currency : Euro, USD, JPY, CHF,GBP

C) IMPORT OF EQUIPMENTS FOR EXPANSION:

The purpose global tenders have been invited and the suppliers are being short listed. The supplies comprise of a major element of payments in foreign exchange. The details of foreign exchange outgo has not been exactly assessed as yet.

D) EXPORT OF PIG IRON AND STEEL PRODUCTS:

The products are mainly exported to overeas markets in south east Asian countries such as Philippines, Indonesia, Malaysia, Thailand and neighboring countries such as Nepal, Bangladesh, Sri lanka and other countries i.e. USA, UAE, Myanmar and many other Asian/African countries. The contracts are entered into with the buyers and are denominated in US dollars only. Most of the shipments are made against Letter of credit issued by foreign banks on behalf of the customers. In few cases, customers prefer to make advance payments covering the value of shipment. 

Mode of realization: Against Letter of Credit ( L/C) both on Sight basis issued by 1 st class international banks on behalf of  customers covering each shipment/agreement.

 Transaction in Currency : USD

Availing Suppliers/Buyers/short term credit

VIZAG STEEL has been offering suppliers/buyers credit in foreign currencies for quite long time. Earlier the objective was to augment working - 82 -

capital to minimize the cost due to high interest rates in the domestic market. In fact the suppliers/ buyers credits, which were accepted at 50 bps points over 6 months LIBOR have been turned down by the company to avail own source of  financing to cover the raw material shipments. For this purpose company invite  bids

from all probable sources ( banks only and no intermediaries ) for 

financing.

One basis point reduction in financing saves company in modest terms of  about Rs 2200 per million USD in credit over the tenor of about 180 days. Thus availing credit for each shipment size of about 5-6 million and total requirement of USD 350- 400 million enriches company to a great extent. The major  financing banks are as follows : 

State Bank of India – Singapore, Manama, Bahrain, New York 



Bank of Baroda – New York, Deira



Bank of India – London

By availing credit at LIBOR linked rates which is cheaper than the domestic interest rates, company has earned on interest arbitrage by holding the corresponding amount in the domestic market at higher rates within the  permissible guidelines of Department of Public enterprises ( DPE) for investing surplus funds.

IMPORTS DATA (in lakhs)

COUNTRY

AMOUNT IN AMOUNT

INR 2004-05 GERMANY 2546.712 - 83 -

INR 2005-06 3370.36

IN AMOUNT IN AMOUNT IN INR 2006-07 5548.8

INR 2007-08 3090.6

JAPAN U.S.A AUSTRIA ITALY ENGLAND TOTAL

159.165 95.5017 222.8373 31.833 127.335 3183.384

210.64 126.38 294.9 42.129 168.518 4212.927

346.8 208.08 485.58 69.36 277 6935.62

217.531 180.518 304.544 48.506 280.52 4122.219

EXPORTS DATA OF FINANCIAL YEARS 2004-05 TO 2007-08

DESTINATION AMT

IN AMT IN INR 

INR  04-05 AFRICA 0 BANGLADESH 175188943. INDONESIA - 84 -

6 16720357.5

AMT

IN AMT

IN

05-06

INR 06-07

INR 07-08

0

18283779

0

929138409 0

641881339 0

0 833287800

JAPAN

8 0

109866906 0 257864850 357585030

8 0 0

1383202072 0 418618412

KOREA MALAYSIA MYANMAR

0 1101431300 79471600.6

158716325

0

20997291

 NEPAL

9 90750833.3

SINGAPORE SRI LANKA

4 0 204053719.

334053227 276003834

132431041 0

468563285 0

SUDAN TAIWAN

7 1135075.91 99146808.2

1063798170 708175

449378888 0

779835261 0

THAILAND UAE

8 3652722480 180015406.

0 0

331451040 960324303

0 1516791554

172141621

99639298

0

USA

8 178986940.

349339059

517012511 424907126

0

Grand Total

4 2492173466

3899348700

7

5421295675

EXPORTS DATA OF FINANCIAL YEARS FROM 2004-08

- 85 -

- 86 -

Overall Imports and Exports Data FINANCIAL YEARS Imports Total(in lakhs) AMOUNT IN INR   3183.383

Exports Total 24921.73466

2004-05 AMOUNT

IN

INR   4212.927

38993.487

2005-06 AMOUNT

IN

INR   6935.62

42490.71267

2006-07 AMOUNT

IN

INR  

4122.219

2007-08

Graph of Imports and Exports in INR 

- 87 -

54212.95675

TECHNICAL ANALYSIS

Correlation Coefficient:

In  probability theory and statistics, correlation, (often measured as a correlation coefficient), indicates the strength and direction of a linear 

relationship between two random variables. In general statistical usage, correlation or co-relation refers to the departure of two variables from

independence. In this broad sense there are several coefficients, measuring the degree of correlation, adapted to the nature of data. A number of different coefficients are used for different situations. The best known is the Pearson product-moment correlation coefficient, which is obtained  by dividing the covariance of the two variables by the product of their  standard deviations. a) The following is the correlation matrix formed by the exports data in INR  for financial years from 2004-05 to 2007-08: Correlation Coefficients of the exports in INR, using the observations 2004-05 to 2007-08 5% critical value (two-tailed) = 0.9500 for n = 4 AFRICA

BANGLA

INDONESIA JAPAN

KOREA

1.0000

0.3215

-0.3422

0.4392

-0.3333

AFRICA

1.0000

-0.6964

-0.4081

0.7714

BANGLA.

1.0000

0.6937

-0.3422

INDONESIA

1.0000

-0.5699

JAPAN

1.0000

KOREA

MALAY

- 88 -

MYANMA

NEPAL

SINGAP

SRILANK  

SIA

R

-0.6803

-0.6078

-0.4675

-0.3333

-0.3099

AFRICA

-0.5012

0.5315

-0.1617

-0.7714

0.4631

BANGLA.

-0.0556

-0.4108

0.7921

-0.3422

0.2625

INDONESIA

-0.5850

-0.8515

0.4080

-0.5699

0.0281

JAPAN

-0.1621

0.8810

0.2925

1.0000

0.7789

KOREA

1.0000

0.3203

-0.2702

-0.1621

-0.4633

MALAYSIA

1.0000

0.0955

0.8810

0.4941

MYANMAR  

1.0000

0.2925

0.7937

NEPAL

1.0000

0.7789

SINGAPO.

1.0000

SRILANKA

- 89 -

ORE

SUDAN

TAIWAN

THAILAND

UAE

USA

-0.5489

0.9543

-0.2467

-0.1062

0.7669

AFRICA

0.0730

0.2111

-0.7190

0.5455

0.8154

BANGLA.

-0.5360

-0.4627

0.0117

-0.8965

-0.7940

INDONESIA

-0.9381

0.2849

-0.1932

0.9393

-0.1665

JAPAN

0.2945

-0.4590

-0.6608

0.4724

0.2640

KOREA

0.8259

-0.4306

0.8346

0.4142

-0.5498

MALAYSIA

0.6967

-0.6006

-0.2277

0.6935

0.0409

MYANMAR  

-0.4481

-0.6935

-0.4908

-0.6503

-0.5653

NEPAL

0.2945

-0.4590

-0.6608

0.4724

0.2640

SINGAPO.

-0.2622

-0.5646

-0.8407

-0.1847

-0.0482

SRILANKA

1.0000

-0.3270

0.5088

0.8412

-0.0834

SUDAN

1.0000

0.0284

0.0571

0.7346

TAIWAN

1.0000

0.1571

-0.4381

THAILAND

1.0000

0.4632

UAE

1.0000

USA

- 90 -

Inferences: i.

For the value in the matrix greater than >0.9 has high positive correlation with the corresponding countries, from the above data Africa and Taiwan has high positive correlation (since value is

0.9543). ii.

For the value < -0.9 has high negative correlation so here Sudan and Japan and Sudan and UAE (since the values are -0.9831 and -0.9393

respectively).

 b) The following is the correlation matrix formed by the imports data in INR  for financial years from 2004-05 to 2006-07:

Correlation Coefficients, using the observations 2004 - 2007 5% critical value (two-tailed) = 0.9500 for n = 4 GERMANY JAPAN USA

AUSTRIA ITALY ENGLAD

1.0000

- 91 -

0.9892

0.793 5

0.9892

0.9541

0.6231

GERMAN

1.0000

0.874 1

1.0000

0.9877

0.7310

JAPAN

1.000 0

0.8741

0.9393

0.9704

USA

1.0000

0.9877

0.7310

AUSTRIA

1.0000

0.8288

ITALY

1.0000

ENGLAN

Inferences: i.

For the value in the matrix greater than >0.9 has high positive correlation with the corresponding countries, from the above data Japan and Germany, Austria and Germany, Austria and Japan, Italy and Germany, Italy and Japan, Italy and USA, England and USA and Italy and Austria and has high positive correlation.

ii.

As Austria and Japan has value 1.0, this shows both the countries move in the same way. In other words, the price incurs for the import of raw material from Austria is same as Japan. If the amount of Japan imports increases by a percentage for the next year, the same  percentage of amount is imported from Austria.

- 92 -

Summary Statistics:

Some of the statistical definitions are given below: Standard Deviation

In  probability and statistics, the standard deviation is a measure of the dispersion of a set of values. It can apply to a  probability distribution, a random variable, a population or a multiset. The standard deviation is usually denoted with the letter σ (lower case sigma). It is defined as the root-mean-square (RMS) deviation of the values from their  mean, or as the square root of the variance. The standard deviation remains the most common measure of statistical dispersion, measuring how widely spread the values in a data set are. If many data points are close to the mean, then the standard deviation is small; if many data points are far from the mean, then the standard deviation is large. If all data values are equal, then the standard deviation is zero. A useful property of  standard deviation is that, unlike variance, it is expressed in the same units as the data. In finance, standard deviation is a representation of the risk associated with a given security (stocks, bonds, property, etc.), or the risk of a portfolio of  securities. Risk is an important factor in determining how to efficiently manage a portfolio of investments because it determines the variation in returns on the asset and/or portfolio and gives investors a mathematical basis for investment decisions. The overall concept of risk is that as it increases, the expected return on the asset will increase as a result of the risk premium earned – in other  words, investors should expect a higher return on an investment when said investment carries a higher level of risk. Calculating the average return (or arithmetic mean) of a security over a given number of periods will generate an expected return on the asset. For each - 93 -

 period, subtracting the expected return from the actual return results in the variance. Square the variance in each period to find the effect of the result on the overall risk of the asset. The larger the variance in a period, the greater risk  the security carries. Taking the average of the squared variances results in the measurement of overall units of risk associated with the asset. Finding the square root of this variance will result in the standard deviation of the investment tool in question. Coefficient of Variance:

In probability theory and statistics, the coefficient of variation (CV) is a normalized measure of  dispersion of a  probability distribution. It is defined as the ratio of the standard deviation to the mean :

This is only defined for  non-zero mean, and is most useful for variables that are always positive. It is often reported as a percentage (%) by multiplying the above calculation by 100. The absolute value of the coefficient of variation expressed as a percentage is often referred to as the relative standard deviation (RSD or %RSD). The coefficient of variation can be useful for data measured on a ratio scale, but is not useful for data on an interval scale.

Standardized moments are similar ratios, scale invariant.

Comparison to standard deviation:

- 94 -

, which are also dimensionless and

Advantages The coefficient of variation is useful because the standard deviation of data must always be understood in the context of the mean of the data. The coefficient of variation is a dimensionless number . So when comparing between data sets with different units or wildly different means, one should use the coefficient of variation for comparison instead of the standard deviation. Disadvantages •

When the mean value is near zero, the coefficient of variation is sensitive to small changes in the mean, limiting its usefulness.



Unlike the standard deviation, it cannot be used to construct confidence intervals for the mean.

Skewness:

In probability theory and statistics, skewness is a measure of the asymmetry of  the probability distribution of a real-valued random variable. Consider the distribution in the figure. The bars on the right side of the distribution taper differently than the bars on the left side. These tapering sides are called tails (or snakes), and they provide a visual means for determining which of the two kinds of skewness a distribution has:

- 95 -

1. cognegative skew: The left tail is longer; the mass of the distribution is concentrated on the right of the figure. The distribution is said to be left skewed .

2. positive skew: The right tail is longer; the mass of the distribution is concentrated on the left of the figure. The distribution is said to be right skewed .

- 96 -

Summary Statistics, using the observations of Exports in INR for Financial Years 2004-05 to 2007-08

Variable

Mean

Median

Min

Max

AFRICA

45.709

0.0000

0.0000

182.84

BANGLADESH 4.3801e+07

7855.1

0.0000

1.7519e+08

INDONESIA

4.1822E+06

4166.4

0.00000

1.6720E+07

JAPAN

6204.7

5493.3

0.0000

13832

KOREA

644.66

0.0000

0.0000

2578.6

MALAYSIA

4694.1

3881.0

0.0000

11014

MYANMAR

647.96

502.34

0.0000

1587.2

 NEPAL

2564.5

2332.4

907.51

4685.6

SINGAPORE

690.01

0.0000

0.0000

2760.0

SRI LANKA

6242.7

6146.1

2040.5

10638

SUDAN

4.6081

3.5409

0.0000

11.351

TAIWAN

1076.5

495.73

0.0000

3314.5

THAILAND

15325

12386

0.0000

36527

UAE

1129.5

1358.9

0.0000

1800.2

USA

2613.3

2641.6

0.0000

5170.1

VARIABLE

S.D.

C.V.

SKEWNESS EXCSKURT

AFRICA

91.419

2.0000

1.1547

-0.66667

BANGLADESH 8.7592E+07

1.9998

1.1547

-0.66667

INDONESIA

8.3588E+06

1.9987

1.1547

-0.66667

JAPAN

7258.1

1.1698

0.075850

-1.8995

KOREA

1289.3

2.0000

1.1547

-0.66667

- 97 -

MALAYSIA

4600.3

0.98002

0.58316

-0.93311

MYANMAR

710.71

1.0968

0.50988

-1.2726

 NEPAL

1768.7

0.68970

0.24722

-1.6145

SINGAPORE

1380.0

2.0000

1.1547

-0.66667

SRI LANKA

3761.9

0.60261

0.065991

-1.4461

SUDAN

5.5992

1.2151

0.27622

-1.6406

TAIWAN

1563.5

1.4524

0.87754

-0.93440

THAILAND

15461

1.0089

0.59833

-0.99094

UAE

835.39

0.73962

-0.61680

-1.2178

USA

2222.6

0.85046

-0.035441

-1.3528

*S.D. is Standard Deviation and C.V. is Coefficient of Variance Summary Statistics, using the observations of Imports in INR for Financial Years 2004-05 to 2007-08

VARIABLE

MEAN

MEDIAN

MIN

MAX

GERMANY

3639.1

3230.5

2546.7

5548.8

JAPAN

233.53

214.09

159.16

346.8

USA

152.62

153.45

95.502

208.08

AUSTRIA

326.97

299.72

222.84

485.58

ITALY

47.957

45.317

31.833

69.360

ENGLAND

213.34

222.76

127.33

280.52

VARIABLE

S.D.

C.V.

SKEWNESS

EXCSKURT

GERMANY

1318.2

0.36224

0.92012

-0.81896

JAPAN

79.875

0.34203

0.77469

-0.86521

- 98 -

USA

51.007

0.33421

-0.035143

-1.6090

AUSTRIA

111.85

0.34209

0.77491

-0.86513

ITALY

15.836

0.33021

0.52479

-1.0312

ENGLAND

77.399

0.36279

-0.13715

-1.8167

- 99 -

Overall Summary Statistics, using the observations of Total Imports and Exports in INR for Financial Years 2004-05 to 2007-08: VARIABLE

MEAN

MEDIAN

MIN

MAX

Imports total

4613.5

4167.6

3183.4

6935.6

Exports total

40155

40742

24922

54213

VARIABLE

S.D.

C.V.

SKEW

EXCSKURT

Imports total

1616.5

0.35038

0.85769

-0.82982

Exports total

12062

0.30039

-0.16343

-1.0488

Inferences: •

Based on the value of C.V.(Coefficient of Variance) of Imports and Exports in INR as C.V. < 1, the distribution has low variance so it has low risk or volatility.



As C.V. of Imports > C.V. of exports, volatility of Imports currency is more than that of Exports currency.

- 100 -

Imports and Exports in INR 

- 101 -

SUMMARY AND FINDINGS

- 102 -

SUMMARY AND FINDINGS

i.

Thee level Th level of imp impor orts ts of of the the compa company ny is is much much more more as com compa pare red d to the the exports of the company. A broad picture of the the forex inflow and outflow for the four years period 2004 to 2008 is placed at Table. The forex earnings as percentage of Forex outflow had reached a high of  78.63% during 2003-04. However now the forex earnings has come down to a level of 20%of the total forex requirement due to increase in the  prices of raw raw materials and and considerable considerable reduction in exports. exports.

ii. ii.

Expo Ex port rt of stee steell prod produc ucts ts duri during ng the the peri period od 2004 2004-0 -05 5 to 2007 2007-0 -08 8 was was anal analyz yzed ed.. Th Thee majo majorr expo export rt dest destin inat atio ions ns are are Th Thai aila land nd,, Mala Malays ysia ia,, Bangladesh, Sri Lanka, USA, Japan. Even though the efforts are made to increase the no of overseas destinations.

iii. iii.

Sinc Sincee the the su supp ppli lier erss of spar spares es and othe otherr access accessor orie iess are are sele select cted ed again against st tender/ original equipment manufacturers(OEMs) manufacturers(OEMs) etc the suppliers expect  payment in the currency to their convenience. convenience.

iv.

Most Mo stly ly the the compan company y has avai availed led cred credits its from from the the branc branches hes of of Indian Indian PSU PSU  banks like SBI, BOB, BOI, EXIM Bank to avail the cheaper source of  credit and by avoiding the withholding tax on the interest payments.

- 103 -

In orde orderr to meet meet the the chal challe leng nges es in Fore Forex x tran transa sact ctio ions ns,, Mana Manage geme ment nt at VIZAG STEEL has taken a very positive step, to constitute a separate group to study and deal with the complicated matter of dealing with the FOREX exposures. •

Alth Althou ough gh deta detail ilss abou aboutt the the FORE FOREX X tran transa sact ctio ions ns are are avai availa labl blee in a transparent manner for the transactions in different sections there is no consolidation of the same.



There is lack of consultation consultation to deal with the complications complications in case of any adverse movement in exchange rates or change in market view.



The infrastructure facility in the form of front office/ dealing room, back  offic office, e, approp appropria riate te commu communic nicati ation on facili facilitie tiess are no non n existe existent nt in the the company.



The risk appetite of management is not measured and a proper risk  management policy is not in place to deal with the FOREX transactions.



Thee mo Th move veme ment nt of fore foreig ign n curr curren enci cies es in the the form form of ocea ocean n frei freigh ghtt  payments/ demurrage payments or receipts on account dispatch, other  earnings are not planned and made at the prevailing market rates.



In spite of complications in dealing with the foreign exchange and risks involved in the exposure, management has not reckoned the specialized efforts needed to hedge it.



As of now the company faces risks on account of open position, maturity mismatch between exports and imports etc.



Short term credit is being availed from the foreign branches of SBI, BOB, Canara bank etc

- 104 -

SUGGESTION AND CONCLUSION

- 105 -

SUGGESTIONS AND CONCLUSION Keeping in mind the existing system , the volume & value of transactions, requirements in the expansion in the offing, developments in the Forex market, availability of the hedging products etc, the following measures are suggested to improve performance and effectiveness in the risk management practices in the company.

 DEVELOPMENT OF AN EFFECTIVE RISK POLICY

It is essential to evolve a comprehensive risk policy to manage Development of  a clear, concise and appropriate risk policy with parameters to deals with various risks associated with dealing in foreign exchange need to be formulated covering following broad parameters: o

The objective of risk management has to be in consistent with the Mission and vision of the company.

o

The focus of the risk management should be clearly spelled out to operate as a profit centre or as a cost centre in order to minimize/ protect the currency exposure.

o

Recognition of attributes to the risks and risk appetite of the company must be made explicit.

o

As policy is only a guideline for decision making, it should be flexible in nature to adapt to changing environment.

o

It should be futuristic to accommodate variety of transactions which is comprehensible at that point of time.

o

An important aspect is that policy should lay emphasis on complying with the extant foreign exchange laws of land, accounting standards for  reporting etc.

- 106 -

 SENSITIVITY TO RISKS

Analysis of sensitivity to the various risks is essential to understand the impact of changes to the bottom line in order to decide about hedging the risk in line with risk appetite of the company. The risk appetite in turn will largely depend upon the sensitivity of the risk. If the foreign exposure a remain un-hedged then company is exposed to the risks and the bottom line may suffer due to down side risks in dealing with foreign exchange.

 RISK CONTROL GUIDE LINE

VIZAG STEEL has to evolve a multi tier exposure monitoring system to fix the upper limit and review the same from time to time. Suitable frame works for reporting and evaluating quality of all decisions have to be made by various functional groups.

- 107 -



INTEGRATED FOREX OPERATIONS

o

The

infrastructure

facilities

like

telephone,

hotmail,

internet,

Reuter/Bloomberg/Telerate screen etc may be provided to facilitate transactions. o

Tie up with banks/ reputed consultants to extend advisory services/ operational guidelines for effective dealings.

o

The skilled manpower may be specifically trained to acquire adequate knowledge and expertise in handling these complicated transactions in dynamic atmosphere.

o

Personnel dealing with foreign exchanges from different departments like Materials Management, Marketing and projects may be trained to acquire working level knowledge.

o

Appropriate power, responsibilities and guidelines may be provided to deal with the forex transactions without putting the interest of the company.

o

To ensure hedging in a planned manner within the parameters laid down in the policy document.

o

Forex cell will be responsible for control and direction of the Currency Risk Management and ensure that the Risk Management practices and controls are in line with the policy set.

- 108 -

BIBLIOGRAPHY

- 109 -

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