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ACKNOWLEDEMENT
We, the students of S.K.Patel Institute of Management & Computer Studies are extremely thankful to our institute for giving us an opportunity to undertake this Grand Project. We are very much thankful to Mr.VARUN PANJABI (Branch manager) and Mr.SUNIL KHIYANI (Forex Analyst) For providing us the permission to undergo a grand project under their supervision and patiently responding to our various queries and for his valuable guidance. We are also thankful to our Director Prof. S.C.Chinnam Reddy & Prof. Sonu Gupta (project guide) and Prof. S.G.Das (co-ordinator) for providing us the helpful support for completing the report in a for given schedule. Thanks for their benevolent support and kind attention. Their valuable guidance at each and every stage of the project always gave a Phillip to our enthusiasm. Last but not the least we express our gratitude to all people who are directly or indirectly involved in the preparation of this report.

Mohammed Ali Ansari. Sudhir Purohit. Dimple Patel.

EXECUTIVE SUMMARY

The

rapid

industrialization, facilities, the

advancement availability

in of

technology rapid means

and of

communication

transportation has all contributed towards the globalization of business across the frontiers of countries. There have been new innovations in the products developments. The government of India has also opened Indian economy. Various fiscal, trade and industrial policy decisions have been taken and new avenues provided to foreign investors like FII’s and NRI’s etc. for investment especially infra-structural sectors like power, and telecommunications etc. This projects attempts to study the intricacies of the Foreign Exchange Market and to measure awareness level among the importers and exporters. The main purpose of this study is to give a better idea and the comprehensive details of foreign exchange risk management and to understand the services of a foreign exchange advisory firm. The project starts with the various concept and system used in the foreign exchange market in the world. It also highlights about the exchange rate system used in various countries till date. The second part of the study include the various function of the Mecklai Financial & Commercial Services Ltd. regarding risk management services provided by them to their clients and analysis of survey. The project then highlights the various hedging tools used by various banks and individuals to hedge their risk. The major hedging tools included are forward, options, swaps and futures.

Lastly the project highlights the risk management with particular emphasis of the risk managed by various banks and the tool used by it. The scope of our project has been limited by the fact that the major aspect of the risk management are handled at the head office situated in Mumbai. Most of the task of forecasting and analysis has been done from their head office and daily reports are sent to various branches.

Acknowledgement Executive summary

Sr.No. 1.

Particulars Introduction 1.1 1.2 1.3 1.4 1.5 Foreign Exchange Overview. About Foreign Exchange Market. Foreign Exchange in India. Fluctuation of Indian Rupee Participants in foreign exchange

Page no.

2.

Research Methodology 2.1 2.2 2.3 2.4 2.5 2.6 3. Main objective Sub objectives Sample size Data collection Data analysis Limitations of the Study.

Company Profile. 3.1 3.2 3.3 3.4 3.5 Introduction. Mission of the Company. Values for Company. Services rendered by Mecklai. Technical & Fundamental analysis

4.

Exchange Rate System. 4.1 4.2 4.3 4.4 Gold Standard Bretton Wood System. Floating Rate Systerm. Purchasing Power Parity.

5.

Fundamentals in Foreign Exchange. 5.1 5.2 Methods of Quotating Rates. Factors Affecting Rate of Exchange.

6.

Hedging Tools

6.1 6.2 6.3 6.4 7.

Forward Options Swaps Futures

Risk Management 7.1 7.2 7.3 7.4 7.5 From Exporter’s Point of View From Importer’s Point of View Risk management process Types of risk in foreign exchange Types of exposure in forex

8.

Research and finding 8.1 8.2 8.3 8.4 8.5 8.6 Details of org.survryed Survey analysis Summary of analysis Facts from the survey Findings Conclusion

9. 10. 11

Recommendation Annexure Questionnaire Bibliography

INTRODUCTIO N

FOREIGN EXCHANGE MARKET OVERVIEW
In today’s world no economy is self sufficient, so there is need for exchange of goods and services amongst the different countries. So in this global village, unlike in the primitive age the exchange of goods and services is no longer carried out on barter basis. Every sovereign country in the world has a currency that is legal tender in its territory and this currency does not act as money outside its boundaries. So whenever a country buys or sells goods and services from or to another country, the residents of two countries have to exchange currencies. So we can imagine that if all countries have the same currency then there is no need for foreign exchange.

NEED FOR FOREIGN EXCHANGE
Let us consider a case where Indian company exports cotton fabrics to USA and invoices the goods in US dollar. The American importer will pay the amount in US dollar, as the same is his home currency. However the Indian exporter requires rupees means his home currency for procuring raw materials and for payment to the labor charges etc. Thus he would need exchanging US dollar for rupee. If the Indian exporters invoice their goods in rupees, then importer in USA will get his dollar converted in rupee and pay the exporter. From the above example we can infer that in case goods are bought or sold outside the country, exchange of currency is necessary. Sometimes it also happens that the transactions between two countries will be settled in the currency of third country. In that case both the

countries that are transacting will require converting their respective currencies in the currency of third country. For that also the foreign exchange is required.

ABOUT FOREIGN EXCHANGE MARKET
Particularly for foreign exchange market there is no market place called the foreign exchange market. It is mechanism through which one country’s currency can be exchange i.e. bought or sold for The currency of another country. The foreign exchange market does not have any geographic location. Foreign exchange market is described as an OTC (over the counter) market as there is no physical place where the participant meets to execute the deals, as we see in the case of stock exchange. The largest foreign exchange market is in London, followed by the New York, Tokyo, Zurich and Frankfurt. The markets are situated throughout the different time zone of the globe in such a way that one market is closing the other is beginning its operation. Therefore it is stated that foreign exchange market is functioning throughout 24 hours a day. In most market US dollar is the vehicle currency, viz., the currency sued to dominate international transaction. In India, foreign exchange has been given a statutory definition. Section 2 (b) of foreign exchange regulation ACT,1973 states: Foreign exchange means foreign currency and includes : • All deposits, credits and balance payable in any foreign currency and any draft, traveler’s cheques, letter of credit and bills of

exchange. Expressed or drawn in India currency but payable in any foreign currency. • Any instrument payable, at the option of drawee or holder thereof or any other party thereto, either in Indian currency or in foreign currency or partly in one and partly in the other.

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

Following are the major bifurcations:  Full fledge moneychangers – they are the firms and individuals who have been authorized to take both, purchase and sale transaction with the public.  Restricted moneychanger – they are shops, emporia and hotels etc. that have been authorized only to purchase foreign currency towards cost of goods supplied or services rendered by them or for conversion into rupees.  Authorized dealers – they are one who can undertake all types of foreign exchange transaction. Banks are only the authorized

dealers. The only exceptions are Thomas cook, western union, UAE exchange which though, and not a bank is an AD. Even among the banks RBI has categorized them as follows:  Branch A – They are the branches that have nostro and vostro account.  Branch B – The branch that can deal in all other transaction but do not maintain nostro and vostro a/c’s fall under this category.  Branch C business. such branches cannot do anything with forex

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.

Fluctuation of Indian Rupee
Calendar year (Jan – Dec)
DATE 1994 (Jan - Dec) 1995 (Jan - Dec) 1996 (Jan - Dec) 1997 (Jan - Dec) 1998 (Jan - Dec) 1999 (Jan - Dec) 2000 (Jan - Dec) 2001 (Jan - Dec) 2002 (Jan - Dec) 2003 (Jan - Dec) 2004 (Jan - Dec) USD/INR 0.03% JPY/INR 11.93% CHF/INR 13.13%

year – on – year
EUR/INR NA GBP/INR 5.48% 46.37 48.91 NA 10.74% 49.05 54.32 NA 11.04% 54.56 60.59 NA 5.90% 61.46 65.09 NA 9.39% 64.63 70.70 -12.37% 0.10%

31.37 31.38 28.08 31.43 21.12 23.90 11.95% 8.56% 27.15%

31.37 35.12 31.46 34.16 23.94 30.44 1.90% -9.17% -15.05%

35.18 35.85 34.04 30.92 30.49 25.90 9.51% -2.28% 1.16%

35.87 39.28 30.94 30.23 26.75 27.06 8.39% 23.48% 14.71%

39.23 42.52 30.05 37.10 26.84 30.79 2.42% 13.27% -11.87%

42.48 43.51 37.53 42.51 30.98 27.30 50.09 43.89 70.20 70.27 7.43% -4.64% 3.51% -1.97% -1.22%

43.49 46.72 42.68 40.70 27.57 28.54 44.25 43.37 70.47 69.61 3.39% -9.93% -0.45% -2.91% 0.42%

46.66 48.24 40.79 36.74 28.97 28.84 43.94 42.66 69.65 69.94 -0.60% 10.54% 19.02% 16.95% 9.68%

48.28 47.99 36.62 40.48 29.08 34.61 43.01 50.3 70.14 76.93 -5.10% 5.47% 5.70% 13.73% 4.87%

48.02 45.57 40.42 42.64 34.75 36.73 50.38 57.30 77.37 81.13 -4.32% -0.04% 4.57% 3.41% 2.86% 45.61 43.64 42.55 42.53 36.81 38.50 57.43 59.39 81.68 84.02

PARTICIPANTS IN FOREIGN EXCHANGE MARKET
The main players in foreign exchange market are as follows: 1. CUSTOMERS The customers who are engaged in foreign trade participate in foreign exchange market by availing of the services of banks. Exporters require converting the dollars in to rupee and imporeters require converting rupee in to the dollars, as they have to pay in dollars for the goods/services they have imported. 2. COMMERCIAL BANKS They are most active players in the forex market. Commercial bank dealing with international transaction offer services for conversion of one currency in to another. They have wide network of branches. Typically banks buy foreign exchange from exporters and sells foreign exchange to the importers of goods. As every time the foreign exchange bought or oversold position. The balance amount is sold or bought from the market. 3. CENTRAL BANK

In all countries Central bank have been charged with the responsibility of maintaining the external value of the domestic currency. Generally this is achieved by the intervention of the bank.

4. EXCHANGE BROKERS Forex brokers play very important role in the foreign exchange market. However the extent to which services of foreign brokers are utilized depends on the tradition and practice prevailing at a particular forex market center. In India as per FEDAI guideline the Ads are free to deal directly among themselves without going through brokers. The brokers are not among to allowed to deal in their own account allover the world and also in India. 5. OVERSEAS FOREX MARKET Today the daily global turnover is estimated to be more than US $ 1.5 trillion a day. The international trade however constitutes hardly 5 to 7 % of this total turnover. The rest of trading in world forex market is constituted of financial transaction and speculation. As we know that the forex market is 24-hour market, the day begins with Tokyo and thereafter Singapore opens, thereafter India, followed by Bahrain, Frankfurt, paris, London, new york, Sydney, and back to Tokyo. 6. SPECULATORS The speculators are the major players in the forex market. Bank dealing are the major pseculators in the forex market with a view to make profit on account of favorable movement in exchange rate, take position i.e. if they feel that rate of

particular currento go up in short term. They buy that currency and sell it as soon as they are able to make quick profit.  Corporation’s particularly multinational corporation and transnational corporation having business operation beyond their national frontiers and on account of their cash flows being large and in multi currencies get in to foreign exchange exposures. With a view to make advantage of exchange rate movement in their favor they either delay covering exposures or do not cover until cash flow materialize.  Individual like share dealing also undertake the activity of buying and selling of foreign exchange for booking short term profits. They also buy foreign currency stocks, bonds and other assets without covering the foreign exchange exposure risk. This also result in speculations.

Research Methodology

OBJECTIVES
 This project attempts to study the intricacies of the foreign exchange market.  To get a better idea and the comprehensive details of foreign exchange risk management and to study the organization on ‘how they manage the foreign exchange risk.  To know about the various concepts and technicalities in foreign exchange.  To know the various functions of MECKLAI regarding their advisory services.  To measure the awareness level for managing foreign exchange.  To get the knowledge about the hedging tools used in foreign exchange.

SAMPLE SIZE
As this is the research for finding the awareness of exporters and importers about forex risk and risk management. It is done by conducting a survey which explores the awareness of organization into import-export business. The data collection was basically of

primary nature. Sample size for doing survey was 30 organizations which are either in business of export & import or both.

DATA COLLECTION
Data collection technique for this research report is primary As well as secondary data collection. The data is being collected by making the Importer and Exporters of Ahmedabad city to fill up the questionnaire. While the secondary data was collected from books, newspapers, other publications and internet.

DATA ANALYSIS
Primary data has been analyzed by the percentage method which is comprehensively studied for having an integrated evaluation. Secondary data are analyzed by brainstorming.

LIMITATIONS OF THE STUDY
 Time constraint.  Resource constraint.  Bias on the part of interviewers.

ABOUT THE COMPANY
Mecklai Financial is a professional risk management consulting company, which uniquely blends the skills of the best market practitioners with in-depth understanding of business processes and risk. And on that basis it provides customized solutions and thereby caters the need of their clients.

MISSION OF THE COMPANY To use their breadth of knowledge to enable clients to. a. Ensure that their bottom line does not suffer from unpleasant surprises, b. Extract optimal - i.e., risk-adjusted - value out of financial markets, and
c.

Enhance management information to enable better performance attribution, more accurate regulatory reporting, and, ultimately, more effective strategic decision-making.

They have over 50 advisors and consultants, working out of 6 offices across India, who work as a cohesive team, expressing the values that define Mecklai and which, in sum, differentiate them companies. VALUES TO THE COMPANY a) Non-stop learning Learning about markets from other

Learning about risk, Learning about life - continuous non-stop learning b) Unalloyed Integrity When someone from Mecklai says something, they mean it - if it involves a commitment it will be met; if it involves a deliverable, it will be delivered before time; if it involves a market view, it will be the genuine article, an honest, considered opinion on the market.

c) Customer Service with a special touch of joy – To truly live, and work, by the dictum "business is pleasure, work is play!" Mecklai Financial & Commercial Services has signed a "nonexclusive introducing broker agreement with ED & F Man International Limited to provide Indian corporate clients access to international futures exchanges to hedge commodity price risk. The agreement covers a spectrum of commodities: soybean oil and meal, palm oil, coffee, sugar, cotton, paper pulp and fertilizers. The pact does not cover hedging on the London Metal Exchange. As a result of the recommendations of the R V Gupta Committee, Indian corporations are now permitted to access international exchanges to hedge their commodity price risk using certain specified instruments and with certain operational constraints.

Man International is one of the leading commodity brokers in the world and part of the British ED&F Man Group Plc. "We believe that the combination of Man's market access and execution skills and Mecklai's customer network and risk management skills will bring an added dimension of balance and strength to Indian commodity players," a statement from Mecklai said. Mecklai is the leading risk management company in India, having pioneered the concept of analytical decision making in the domestic foreign exchange market nearly 30 years ago. Mecklai currently advises nearly 1,000 Indian corporate customers on how to manage risk arising out of their exposure to forex, interest rate and commodity markets. Mecklai Commodities was set up last year as a division of Mecklai Financial to focus on the growing needs of the commodity sector. In addition to providing training programmes to corporations and financial institutions on commodity price risk, Mecklai Commodities has also consulted with various domestic commodity exchanges as well as the Forward Markets Commission on structural issues confronting the domestic commodity trade. More information is available from K N Dey The agreement is expected to make Mecklai Financial an agent for ED&F Man and a broker for soft commodities.

SERVICES OF THE COMPANY

They have relationships with over 1,000 corporate, ranging from small mom and pop exporters to some of the largest and wellmanaged companies in India. Their services include INFORMATION SERVICE We provide a comprehensive forex information service, which includes a) The fortnightly Mecklai Market Report, one of the most sought after newsletters in the country; b) Four daily information feeds (by fax or email) providing detailed information about the markets, including the Mecklai Daily Rate Sheet, which is now a benchmark in the Indian forex market; c) Subscriber access to our web-site, www.mecklai.com, which provides a wide range of information and analysis, training materials and value-added services I. Price ticker: Which is updated every two minutes with spot and forward INR/USD rates, as well as cross rates of major international currencies; we get these rates from Mecklai & Mecklai, one of our sister companies, which is a leading inter-dealer broker in the domestic forex market. Globally, broker rates are considered even more accurate than vendor (e.g., Reuters') rates, since they are based on actual deals done.

(i)

Forward rate calculator:

Which enables you to calculate the most current price for, say, January 12 dollar exports or August 19 Euro imports. This is particularly useful in negotiating finer prices with your bankers (ii) FRA calculator:

Which enables you to get a "feel" of the forward market for interest rates. With more and more companies using LIBOR based financing, whether for short-term working capital or for term loans, this is an essential tool for assessing the cost of borrowings, particularly when you need to hedge (iii) Option premium calculator:

Which provides our own modified Black-Scholes pricing for options in a wide range of currencies, including USD/INR. Again, this is very useful in negotiations with bankers. d) Access to our e-mail help desk; and e) Intra-day SMS updates RISK MANAGEMENT ADVISORY SERVICES Markets are continuously changing, particularly in emerging economies like India. Companies' businesses are always in flux, more so as technology drives margins to the ground and brings newer challenges virtually every week. Change creates risk and to be truly effective, risk management has to itself be a live function - in other words, risk management is always a work in progress. Recognizing this, their risk management advisory service is designed to provide long term value to clients by assisting them to most effectively

run the "front office" of their treasury, covering forex, interest rate and derivative markets. Their services involve helping companies understand the need for benchmarking, separating hedging from trading, taking risk-balanced decisions in the market, and, increasingly, building internal skills for all of the above.

CORPORATE SERVICES
Few companies in India (and, indeed, globally) have well structured market risk management processes, as a result of which, risk management is often subject to intervention from the highest reaches of the company, which, in turn, most often leads to sub-optimal performance. Their effort is to assist companies to understand the lacunae in their processes and assist them to build sustainable risk management frameworks, so that market decision-making is treated as most other corporate functions - viz., executed by experts and overseen by senior management. To this end, they provide an array of middle and back office services to clients, including 1) RISK AND TREASURY AUDIT For large companies with reasonable well run treasuries, this can be a very valuable exercise, since it enables management to take a fresh look at the function to bring it up to current best practices; it also enables more ready compliance with certain regulatory requirements such as Clause 49 of the listing agreement. 2) RISK MANAGEMENT POLICIES

Most companies do not have articulated risk management policies, and, even those that do, seldom have it linked in to their business plans; we have developed a easy-to-understand yet structurally sound set of processes, which are designed to (i) Provide management with a high degree of certainty of the rupee value of their forex flows - i.e., eliminate the likelihood of negative surprises, and (ii) Enable treasury to try and capture some opportunity in markets, once above is taken care of They have designed policies for companies in a wide array of industries from IT to textiles to heavy manufacturing to commodity manufacturing to commodity trading; the underlying approach to risk stays the same, although the overall framework does need to take into account the microstructure of the particular business. 3) PERFORMANCE ATTRIBUTION SERVICES It is important to be able to quantify the gains (or losses) that accrue to a company because of market movements; for instance, from the late 1990s, IT companies had huge margins, some part of which was certainly attributable to the weakening rupee - what was (and is) needed is a methodology to quantify what part of the margin was a result of this; using our approach to risk management - (b), above - we are able to create a benchmark hedging process, which gives a quantitative picture of how much value the market has added to (or subtracted from) a company's portfolio over any given time period; this information can be invaluable in strategic planning; we offer this as a quarterly subscription service.

4) ACCOUNTING VALUATION SERVICES With accounting standards becoming more and more stringent (and with regulators requiring senior management sign-off on financial statements), companies need to have independent verification of the values of the derivatives they carry on their books; this is all the more important given the fact that over the past few years a large number of Indian companies have bought derivatives, in many cases with very little understanding of the risks; in most cases, companies do not value these derivatives, contenting themselves with disclosing the nominal value in the Notes to Accounts; some companies do maintain valuations for management accounts, but in most cases these valuations are obtained from vendor banks (leading to a seller's bias) or (in very few cases) from the company's treasury itself (leading to a buyer's bias); we provide certified valuations for derivatives - both financial and those embedded into business contracts - for company balance sheets.

5) ECB ADVISORY With more and more companies accessing international capital markets, we offer an advisory service to enable managements to (a) assess the true - i.e., risk-adjusted - benefit of borrowing overseas, and (b) minimize fees on the borrowing program, while ensuring success of the operation.

SOFTWARE SOLUTIONS

As an extension of their corporate services - in particular, risk management policy development – they have created a software cell, which develops solutions to enable companies to implement the policy prescriptions we recommend. The solution is continually evolving, both in the spread of functionalities it provides and in its technological level. It uses some standard analytics - viz., Black Scholes for option pricing and incorporate our proprietary volatility and Value at Risk (VaR) models. The solution can be customized to meet company-specific requirements, and can be quite readily integrated into most ERPs by way of a data transfer bridge. The current version (3.0) is described below. Mecklai Risk Manager (MRM) is a forex risk management software that creates a middle management to a) Set the risk limit for the cash flow of its at-risk forex portfolio (for both current account transactions and translation) at the start of the financial year and at pre-set subsequent risk identification dates (say, the 1st of each month); the software uses at-the-money option pricing to define the risk existing in the company's portfolio and sets the target value by deducting/adding the option premium to the notional value (mark to market) of the portfolio depending on whether the portfolio is long/short foreign currency; this process, which is objective and replicable, enables the company to separate the market from its business - the risk limit, which is to be protected by treasury, serves as the transfer price(s) to the business divisions; the process links the forex risk management activity directly to the business plan, with any adverse variations from the target value requiring accountability from the treasury. office function that enables company

b) Control the risk management process through a series of alerts, which are activated when market movements threaten the risk limit, any regulatory constraints are being breached, etc. c) Track the performance of the treasury and attribute performance differentially between the treasury and the market, using a batch run benchmark hedging process. These key functions are supported by the Back Office and Front Office modules, which enable the following processes: Back Office: (i) create and maintain the company's risk profile, including keeping track of variances (i.e., changes from business forecasts) created by any business divisions (ii) maintain daily track of the regulatory limit, set up by the middle office at the start of operations and modified by fresh exposures and transactions (iii) reconcile all transactions undertaken by the Front Office with confirmations from bank counterparties.

Front Office:

(i)

enter

all

transactions

-

viz.,

forward

covers,

options,

cancellations of forward covers and/or options, drawing down and settlement of PCFC, , management of EEFC balances, realizations (including whether set off against forward or option, realized at spot or used to settle PCFC), payments (including whether paid through a forward contract or option (ii) or from EEFC or at spot); Deal Slips for all transactions are automatically generated and emailed to the Back Office for confirmation and reconciliation. (ii) maintain daily track of the mark to market (MTM), at-risk value (MTM modified by the value at risk), and risk available (difference between the at-risk value and the target value set by management); the calculations are run automatically by the software based on a market data feed that (for the current version) we provide daily.

(iii) if the risk available turns negative, the Front Office HAS to hedge the software provides a module to assist this process.

(iv) if the risk available is positive, the Front Office may or may not hedge or take positions - the software provides a module to assist this process MRM was designed to enable Mecklai's approach to risk management that envisages a particular framework for risk management. However, the software, which is a client server application, built in dotnet technology is sufficiently flexible and modular so that it can be customized to meet the process and policy requirements of different businesses. The use of the MRM software is subject to the availability of

third party software and/or the availability of certain minimum requirements regarding hardware as specified below: Hardware Intel RAM P4 512 comparable MB or or higher; higher;

Hard Disk - 1 GB Software Operating System - Windows 2000, Windows XP Application - Microsoft Office 2000 or higher Mecklai Risk Manager Software

Technical analysis
Technical analysis is concerned with what has actually happened in the (forex) market, rather than what should happen. A technical analyst will study the price and volume movements and from that data create charts (derived from the actions of the market players) to use as his primary tool. The technical analyst is not much concerned with any of the “bigger picture” factors affecting the market, as is the fundamental analyst, but concentrates on the activity of that instrument’s market. Technical analysis is based on three underlying principles: 1. Market action discounts everything This means that the actual price is a reflection of everything that is known to the market that could affect it, for example, supply and demand, political factors and market sentiment. The pure technical analyst is only concerned with price movements, not with the reasons for any changes. 2. Prices move in trends Technical analysis is used to identify patterns of market behaviour which have long been recognised as significant. For many given patterns there is a high probability that they will produce the expected results. Also there are recognised patterns which repeat themselves on a consistent basis. 3. History repeats itself Chart patterns have been recognised and categorised for over 100 years and the manner in which many patterns are repeated leads to the conclusion that human psychology changes little with time.

Fundamental analysis
The fundamental analyst identifies and measures factors that determine the intrinsic value of a financial instrument, such as the general economic and political environment, and including any that affect supply and demand for the underlying product or service. If there is a decrease in supply but the level of demand remains the same, then there will be an increase in market prices. An increase in supply produces the opposite effect.

For example, an analyst for a given currency studies the supply and demand for the country’s currency, products or services (Merchandise Trade); its management quality and government policies; its historic and forecasted performance; its future plans and the most important for the shorter term, all the economic indicators.

From this data, the analyst constructs a model to determine the current and forecasted value of a currency against an other. The basic idea is that unmatched increases in supply tend to depress the currency value, while unmatched increases in demand tend to increase the currency value. Once the analyst estimates intrinsic value, he compares it to the current exchange rate and decides whether the currency ought to rise or fall.

One difficulty with fundamental analysis is accurately measuring the relationships among the variables. Necessarily, the analyst must make estimates based on experience. In addition, the forex markets tend to anticipate events and discount them in the currency value in advance. Finally, serving as both a disadvantage and even as an

advantage (depending upon the timing), the markets often take time to recognise that exchange rates are out of line with value.

EXCHANGE RATE SYSTEM

INTRODUCTION

Countries of the world have been exchanging goods and services amongst themselves. This has been going on from time immemorial. The world has come a long way from the days of barter trade. With the invention of money the figures and problems of barter trade have disappeared. The barter trade has given way ton exchanged of goods and services for currencies instead of goods and services. The rupee was historically linked with pound sterling. India was a founder member of the IMF. During the existence of the fixed exchange rate system, the intervention currency of the Reserve Bank of India (RBI) was the British pound, the RBI ensured maintenance of the exchange rate by selling and buying pound against rupees at fixed rates. The inter bank rate therefore ruled the RBI band. During the fixed exchange rate era, there was only one major change in the parity of the rupeedevaluation in June 1966. Different countries have adopted different exchange rate system at different time. The following are some of the exchange rate system followed by various countries.

THE GOLD STANDARD
Many countries have adopted gold standard as their monetary system during the last two decades of the 19th century. This system was in vogue till the outbreak of world war 1. under this system the parties of currencies were fixed in term of gold. There were two main types of gold standard: 1) gold specie standard Gold was recognized as means of international settlement for receipts and payments amongst countries. Gold coins were an accepted mode of payment and medium of exchange in domestic market also. A country

was stated to be on gold standard if the following condition were satisfied:  Monetary authority, generally the central bank of the country, guaranteed to buy and sell gold in unrestricted amounts at the fixed price.  Melting gold including gold coins, and putting it to different uses was freely allowed.  Import and export of gold was freely allowed.  The total money supply in the country was determined by the quantum of gold available for monetary purpose. 2) Gold Bullion Standard Under this system, the money in circulation was either partly of entirely paper and gold served as reserve asset for the money supply.. However, paper money could be exchanged for gold at any time. The exchange rate varied depending upon the gold content of currencies. This was also known as “ Mint Parity Theory “ of exchange rates. The gold bullion standard prevailed from about 1870 until 1914, and intermittently thereafter until 1944. World War I brought an end to the gold standard.

BRETTON WOODS SYSTEM
During the world wars, economies of almost all the countries suffered. In ordere to correct the balance of payments disequilibrium, many countries devalued their currencies. Consequently, the international trade suffered a deathblow. In 1944, following World War II, the United

States and most of its allies ratified the Bretton Woods Agreement, which set up an adjustable parity exchange-rate system under which exchange rates were fixed (Pegged) within narrow intervention limits (pegs) by the United States and foreign central banks buying and selling foreign currencies. This agreement, fostered by a new spirit of international cooperation, was in response to financial chaos that had reigned before and during the war. In addition to setting up fixed exchange parities (par values) of currencies in relationship to gold, the agreement established the International Monetary Fund (IMF) to act as the “custodian” of the system. Under this system there were uncontrollable capital flows, which lead to major countries suspending their obligation to intervene in the market and the Bretton Wood System, with its fixed parities, was effectively buried. Thus, the world economy has been living through an era of floating exchange rates since the early 1970.

FLOATING RATE SYSTEM
In a truly floating exchange rate regime, the relative prices of currencies are decided entirely by the market forces of demand and supply. There is no attempt by the authorities to influence exchange rate. Where government interferes’ directly or through various monetary and fiscal measures in determining the exchange rate, it is known as managed of dirty float.

PURCHASING POWER PARITY (PPP)

Professor Gustav Cassel, a Swedish economist, introduced this system. The theory, to put in simple terms states that currencies are valued for what they can buy and the currencies have no intrinsic value attached to it. Therefore, under this theory the exchange rate was to be determined and the sole criterion being the purchasing power of the countries. As per this theory if there were no trade controls, then the balance of payments equilibrium would always be maintained. Thus if 150 INR buy a fountain pen and the samen fountain pen can be bought for USD 2, it can be inferred that since 2 USD or 150 INR can buy the same fountain pen, therefore USD 2 = INR 150. For example India has a higher rate of inflation as compaed to country US then goods produced in India would become costlier as compared to goods produced in US. This would induce imports in India and also the goods produced in India being costlier would lose in international competition to goods produced in US. This decrease in exports of India as compared to exports from US would lead to demand for the currency of US and excess supply of currency of India. This in turn, cause currency of India to depreciate in comparison of currency of Us that is having relatively more exports.

FUNDAMENTALS EXCHANGE RATE

IN

METODS OF QOUTING RATE

Exchange rate is a rate at which one currency can be exchange in to another currency, say USD = Rs.48. This rate is the rate of conversion of US dollar in to Indian rupee and vice versa.

EXCHANGE QUOTATION

______________________

DIRECT

INDIRECT

VARIABLE UNIT

VARIABLE UNIT

HOME CURRENCY

FOREIGN CURRENCY

There are two methods of quoting exchange rates. 1) Direct methods Foreign currency is kept constant and home currency is kept variable. In direct quotation, the principle adopted by bank is to buy at a lower price and sell at higher price.

2) In direct method: Home currency is kept constant and foreign currency is kept variable. Here the strategy used by bank is to buy high and sell low. In India with effect from august 2, 1993 all the exchange rates are quoted in direct method. It is customary in foreign exchange market to always quote two rates means one for buying and another rate for selling. This helps in

eliminating the risk of being given bad rates i.e. if a party comes to know what the other party intends to do i.e. buy or sell, the former can take the letter for a ride. There are two parties in an exchange deal of currencies. To initiate the deal one party asks for quote from another party and other party quotes a rate. The party asking for a quote is known as’ asking party and the party giving a quotes is known as quoting party. The advantage of two–way quote is as under i. ii. The market continuously makes available price for buyers or sellers Two way price limits the profit margin of the quoting bank and comparison of one quote with another quote can be done instantaneously. iii. As it is not necessary any player in the market to indicate whether he intends to buy or sale foreign currency, this ensures that the quoting bank cannot take advantage by manipulating the prices. iv. v. ` In two way quotes the first rate is the rate for buying and another for selling. We should understand here that, in India the banks, which are authorized dealer always, quote rates. So the rates quoted- buying and selling is for banks point of view only. It means that if exporters want to sell the dollars then the bank will buy the dollars from him so while calculation the first rate will be used which is It automatically insures that alignment of rates with market rates. Two way quotes lend depth and liquidity to the market, which is so very essential for efficient market.

Buying rate, as the bank is buying the dollars from exporter. The same case will happen inversely with importer as he will buy dollars from the bank and bank will sell dollars to importer.

FACTOR AFFECTINGN EXCHANGE RATES
In free market, it is the demand and supply of the currency which should determine the exchange rates but demand and supply is the dependent on many factors, which are ultimately the cause of the exchange rate fluctuation, some times wild. The volatility of exchange rates cannot be traced to the single reason and consequently, it becomes difficult to precisely define the factors that affect exchange rates. However, the more important among them are as follows: • STRENGTH OF ECONOMY

Economic factors affecting exchange rates include hedging activities, interest rates, inflationary pressures, trade imbalance, and euro market activities. Irving fisher, an American economist, developed a theory relating exchange rates to interest rates. This proposition, known as the fisher effect, states that interest rate differentials tend to reflect exchange rate expectation. On the other hand, the purchasing- power parity theory relates exchange rates to inflationary pressures. In its absolute version, this theory states that the equilibrium exchange rate equals the ratio of

domestic to foreign prices. The relative version of the theory relates changes in the exchange rate to changes in price ratios. • POLITICAL FACTOR

The political factor influencing exchange rates include the established monetary policy along with government action on items such as the money supply, inflation, taxes, and deficit financing. Active government intervention or manipulation, such as central bank activity in the foreign currency market, also have an impact. Other political factors influencing exchange rates include the political stability of a country and its relative economic exposure (the perceived need for certain levels and types of imports). Finally, there is also the influence of the international monetary fund.



EXPACTATION OF THE FOREIGN EXCHANGE MARKET

Psychological factors also influence exchange rates. These factors include market anticipation, speculative pressures, and future expectations. A few financial experts are of the opinion that in today’s environment, the only ‘trustworthy’ method of predicting exchange rates by gut feel. Bob Eveling, vice president of financial markets at SG, is corporate finance’s top foreign exchange forecaster for 1999. eveling’s gut feeling has, defined convention, and his method proved uncannily accurate in foreign exchange forecasting in 1998.SG ended the corporate finance

forecasting year with a 2.66% error overall, the most accurate among 19 banks. The secret to eveling’s intuition on any currency is keeping abreast of world events. Any event,from a declaration of war to a fainting political leader, can take its toll on a currency’s value. Today, instead of formal modals, most forecasters rely on an amalgam that is part economic fundamentals, part model and part judgment.  Fiscal policy  Interest rates  Monetary policy  Balance of payment  Exchange control  Central bank intervention  Speculation  Technical factors

Hedging tools

Introduction
Consider a hypothetical situation in which ABC trading co. has to import a raw material for manufacturing goods. But this raw material is required only after three months. However, in three months the price of raw material may go up or go down due to foreign exchange fluctuations and at this point of time it can not be predicted whether the price would go up or come down. Thus he is exposed to risks with fluctuations in forex rate. If he buys the goods in advance then he will incur heavy interest and storage charges. However, the availability of derivatives solves the problem of importer. He can buy currency derivatives. Now any loss due to rise in raw material price would be offset by profits on the futures contract and viceversa. Hence, the derivatives are the hedging tools that are available to companies to cover the foreign exchange exposure faced by them.

Definition of Derivatives
Derivatives are financial contracts of predetermined fixed duration, whose values are derived from the value of an underlying primary financial instrument, commodity or index, such as : interest rate, exchange rates, commodities, and equities. Derivatives are risk shifting instruments. Initially, they were used to reduce exposure to changes in foreign exchange rates, interest rates, or stock indexes or commonly known as risk hedging. Hedging is the most important aspect of derivatives and also its basic economic purpose. There has to be counter party to hedgers and they are speculators. Derivatives have come into existence because of the prevalence of risk in every business. This risk could be physical, operating, investment and credit risk. Derivatives provide a means of managing such a risk. The need to manage external risk is thus one pillar of the derivative market. Parties wishing to manage their risk are called hedgers.

The common derivative products are forwards, options, swaps and futures.

1. Forward Contracts

Forward exchange contract is a firm and binding contract, entered into by the bank and its customers, for purchase of specified amount of foreign currency at an agreed rate of exchange for delivery and payment at a future date or period agreed upon at the time of entering into forward deal. The bank on its part will cover itself either in the interbank market or by matching a contract to sell with a contract to buy. The contract between customer and bank is essentially written agreement and bank generally stand to make a loss if the customer defaults in fulfilling his commitment to sell foreign currency. A foreign exchange forward contract is a contract under which the bank agrees to sell or buy a fixed amount of currency to or from the company on an agreed future date in exchange for a fixed amount of another currency. No money is exchanged until the future date. A company will usually enter into forward contract when it knows there will be a need to buy or sell for an currency on a certain date in the future. It may believe that today’s forward rate will prove to be more favourable than the spot rate prevailing on that future date. Alternatively, the company may just want to eliminate the uncertainity associated with foreign exchange rate movements. The forward contract commits both parties to carrying out the exchange of currencies at the agreed rate, irrespective of whatever happens to the exchange rate. The rate quoted for a forward contract is not an estimate of what the exchange rate will be on the agreed future date. It reflects the interest

rate differential between the two currencies involved. The forward rate may be higher or lower than the market exchange rate on the day the contract is entered into.

Forward rate has two components.  Spot rate  Forward points Forward points, also called as forward differentials, reflects the interest differential between the pair of currencies provided capital flow are freely allowed. This is not true in case of US $ / rupee rate as there is exchange control regulations prohibiting free movement of capital from / into India. In case of US $ / rupee it is pure demand and supply which determines forward differential. Forward rates are quoted by indicating spot rate and premium / discount. In direct rate, Forward rate = spot rate + premium / - discount.

Example:

The inter bank rate for 31st March is 44.60 Premium for forwards are as follows. Month April May June Paise 40/42 65/67 87/88

 If a one month forward is taken then the forward rate would be 44.60 + .42 = 49.12 If a two months forward is taken then the forward rate would be 44.60. + .67 = 49.37. If a three month forward is taken then the forward rate would be 44.60 + .88 = 49.58.

Example:
Let’s take the same example for a broken date Forward Contract Spot rate = 48.70 for 31st March. Premium for forwards are as follows

30th April 31st May 30th June

48.70 + 0.42 48.70 + 0.67 48.87 + 0.88

For 17th May the premium would be (0.67 – 0.42) * 17/31 = 0.137 Therefore the premium up to 17th May would be 48.70 + 0.807 = 49.507. Premium when a currency is costlier in future (forward) as compared to spot, the currency is said to be at premium vis-à-vis another currency. Discount when a currency is cheaper in future (forward) as compared to spot, the currency is said to be at discount vis-à-vis another currency.

Example:
A company needs DEM 235000 in six months’ time. Market parameters : Spot rate IEP/DEM – 2.3500 Six months Forward Rate IEP/DEM –2.3300 Solutions available:  The company can do nothing and hope that the rate in six months time will be more favorable than the current six months

rate. This would be a successful strategy if in six months time the rate is higher than 2.33. However, if in six months time the rate is lower than 2.33, the company will have to loose money.

 It can avoid the risk of rates being lower in the future by entering into a forward contract now to buy DEM 235000 for delivery in six months time at an IEP/DEM rate of 2.33.  It can decide on some combinations of the above.

Various options available in forward contracts:
A forward contract once booked can be cancelled, rolled over, extended and even early delivery can be made.

Roll over forward contracts
Rollover forward contracts are one where forward exchange contract is initially booked for the total amount of loan etc. to be re-paid. As and when installment falls due, the same is paid by the customer at the exchange rate fixed in forward exchange contract. The balance amount of the contract rolled over till the date for the next installment. The process of extension continues till the loan amount has been re-paid. But the extension is available subject to the cost being paid by the customer. Thus, under the mechanism of roll over contracts, the exchange rate protection is provided for the entire period of the contract and the customer has to bear the roll over charges. The cost of extension (rollover) is dependent upon the forward differentials

prevailing on the date of extension. Thus, the customer effectively protects himself against the adverse spot exchange rates but he takes a risk on the forward differentials. (i.e. premium/discount). Although spot exchange rates and forward differentials are prone to fluctuations, yet the spot exchange rates being more volatile the customer gets the protection against the adverse movements of the exchange rates. A corporate can book with the Authorised Dealer a forward cover on rollover basis as necessitated by the maturity dates of the underlying transactions, market conditions and the need to reduce the cost to the customer.

Example:
An importer has entered into a 3 months forward contract in the month of February.

Spot Rate = 48.65 Forward premium for 3 months (May) = 0.75 Therefore rate for the contract = 48.65 + 0.75 = 49.45

Suppose, in the month of May the importer realizes that he will not be able to make the payment in May, and he can make payment only in July. Now as per the guidelines of RBI and FEDAI he can cancel the contract, but he cannot re-book the contract. So for this the importer will go for a roll-over forward for May over July. The premium for May is 0.75 (sell) and the premium for July is 0.95 (buy). Therefore the additional cost i.e. (0.95 – 0.75) = 0.25 will have to be paid to the bank. The bank then fixes a notional rate. Let’s say it is 48.66. Therefore in May he will sell 48.66 + 0.75 = 49.41 And in July he will buy 48.66 + 119.75 = 49.85 Therefore the additional cost (49.85 – 49.41) = 0.4475 will have to be paid to the Bank by the importer.

Cancellation of Forward Contract
A corporate can freely cancel a forward contract booked if desired by it. It can again cover the exposure with the same or other Authorised Dealer. However contracts relating to non-trade transaction\imports with one leg in Indian rupees once cancelled could not be rebooked till now. This regulation was imposed to stem bolatility in the foreign exchange market, which was driving down the rupee.

Thus the whole objective behind this was to stall speculation in the currency. But now the RBI has lifted the 4-year-old ban on companies re-booking the forward transactions for imports and non-traded transactions. It has been decided to extend the freedom of re-booking the import forward contract up to 100% of un-hedged exposures Falling due within one year, subject to a cap of $ 100 Mio in a financial year per corporate. The removal of this ban would give freedom to corporate Treasurers who sould be in apposition to reduce their foreign exchange risks by canceling their existing forweard transactions and re-booking them at better rates. Thus this in not liberalization, but it is restoration of the status quo ante. Also the Details of cancelled forward contracts are no more required to be reported to the RBI. The following are the guidelines that have to be followee in case of cancellation of a forward contract. 1.) In case of cancellation of a contract by the client (the request

should be made on or before the maturity date) the Authorised Dealer shall recover/pay the, as the case may be, the difference between the contracted rate and the rate at which the cancellation is effected. The recovery/payment of exchange difference on canceling the contract may be up front or back – ended in the discretion of banks. 2.) Rate at which the cancellation is to be effected :

 Purchase

contracts

shall

be

cancelled

at

the

contracting

Authorised Dealers spot T.T. selling rate current on the date of cancellation.  Sale contract shall be cancelled at the contracting Authorised Dealers spot T.T. selling rate current on the date of cancellation.  Where the contract is cancelled before maturity, the appropriate forward T.T. rate shall be applied.

3.)

Exchange difference not exceeding Rs. 100 is being ignored by the

contracting Bank. 4.) In the absence of any instructions from the client, the contracts,

which have matured, shall be automatically cancelled on 15th day falls on a Saturday or holiday, the contract shall be cancelled on the next succeeding working day.

In case of cancellation of the contract
1.) 2.) Swap, cost if any shall be paid by the client under advice to him. When the contract is cancelled after the due date, the client is not

entitled to the exchange difference, if any in his favor, since the contract is cancelled on account of his default. He shall however, be liable to pay the exchange difference, against him.

Early Delivery Suppose an Exporter receives an Export order worth USD 500000 on 30/06/2000 and expects shipment of goods to take place on 30/09/2000. On 30/06/200 he sells USD 500000 value 30/09/2000 to cover his FX exposure. Due to certain developments, internal or external, the exporter now is in a position to ship the goods on 30/08/2000. He agrees this change with his foreign importer and documents it. The problem arises with the Bank as the exporter has already obtained cover for 30/09/2000. He now has to amend the contract with the bank, whereby he would give early delivery of USD 500000 to the bank for value 30/08/2000. i.e. the new date of shipment. However, when he sold USD value 30/09/2000, the bank did the same in the market, to cover its own risk. But because of early delivery by the customer, the bank is left with a “ long mismatch of funds 30/08/2000 against 30/09/2000, i.e. + USD 500000 value 30/08/2000 (customer deal amended) against the deal the bank did in the inter bank market to cover its original risk USD value 30/09/2000 to cover this mismatch the bank would make use of an FX swap.

The swap will be 1.) Sell USD 500000 value 30/08/2000.

2.)

Buy USD 500000 value 30/09/2000

The opposite would be true in case of an importer receiving documents earlier than the original due date. If originally the importer had bought USD value 30/09/2000 on opening of the L/C and now expects receipt of documents on 30/08/2000, the importer would need to take early delivery of USD from the bank. The Bank is left with a “ short mismatch “ of funds 30/08/2000 against 30/09/2000. i.e. USD 500000 value (customer deal amended) against the deal the bank did in the inter bank market to cover its original risk + USD 500000 To cover this mismatch the vank would make use of an FX swap, which will be ; 1. Buy USD value 30/08/2000. 2. Sell USD value 30/09/2000. The swap necessitated because of early delivery may have a swap cost or a swap difference that will have to be charged / paid by the customer. The decision of early delivery should be taken as soon as it becomes known, failing which an FX risk is created. This means that the resultant swap can be spot versus forward (where early delivery cover is left till the very end) or forward versus forward. There is every likelihood that the origial cover ratre will be quite different from the maket rates when early delivery is requested. The difference in rates will create a cash outlay for the bank. The interest cost or gain on the cost outlay will be charged / paid to the customer. Substitution of Orders

The substitution of forward contracts is allowed. In case shipment under a particular import or export order in respect of which forward cover has been booked does not take place. The corporate can be permitted to substitute another order under the same forward contract, provided that the proof of the genuineness of the transaction is given.

Advantages of using forward contracts:  They are useful for budgeting, as the rate at which the company will buy or sell is fixed in advance.  There is no up-front premium to pay whn using forward contracts.  The contract can be drawn up so that the exchange takes place on any agreed working day.

Disadvantages of forward contracts:  They are legally binding agreements that must be honoured regardless of the exchange rate prevailing on the actual forward contract date.  They may not be suitable where there is uncertainty about future cash flows. For example, if a company tenders for a contract and the tender is unsuccessful, all obligations under the Forward Contract must still be honoured.

2. OPTIONS

An option is a Contractual agreement that gives the option buyer the right, but not the obligation, to purchase (in the case of a call option) or to sell (in the case of put option) a specified instrument at a specified price at any time of the option buyer’s choosing by or before a fixed date in the future. Upon exercise of the right by the option holder, and option seller is obliged to deliver the specified instrument at a specified price.  The option is sold by the seller (writer)  To the buyer (holder)  In return for a payment (premium)  Option lasts for a certain period of time – the right expires at its maturity

Options are of two kinds 1.) Put Options 2.) Call Options

 PUT OPTIONS The buyer (holder) has the right, but not an obligation, to sell the underlying asset to the seller (writer) of the option.  CALL OPTIONS

The buyer (holder) has the right, but not the obligation to buy the underlying asset from the seller (writer) of the option.  STRIKE PRICE Strike price is the price at which calls & puts are to be exercised (or walked away from) AMERICAN & EUROPEAN OPTIONS  American Options The buyer has the right (but no obligation) to exercise the option at any time between purchase of the option and its maturity.  European Options The buyer has the right (but no obligations) to exercise the option at maturity only. UNDERLYING ASSETS :  Physical commodities, agriculture products like wheat, plus metal, oil.  Currencies.  Stock (Equities)

INTRINSIC VALUE:

It is the value or the amount by which the contract is in the option. When the strike price is better than the spot price from the buyers’ perspective.

Example: If the strike price is USD 5 and the spot price is USD 4 then the buyer of put option has intrinsic value. By the exercising the option, the buyer of the option, can sell the underlying asset at USD 5 whereas in the spot market the same can be sold for USD 4. The buyer’s intrinsic value is USD 1 for every unit for which he has a right to sell under the option contract.

IN, OUT, AT THE MONEY: In-the-money: An option whose strike price is more favorable than the current market exchange rate is said to be in the money option. Immediate exercise of such option results in an exchange profit. Example: If the US $ call price is (put) £1 = (call) US $ 1.5000 and the market price is £1 = US $ 1.4000, the exercise of the option by purchaser of US

$ call will result in profit of US $ 0.1000 per pound. Such types of option contract is offered at a higher price or premium. Out-of-the-money: If the strike price of the option contract is less favorable than the current market exchange rate, the option contract is said to be out-of-themoney to its market price.

At-the-money: If the market exchange rate and strike prices are identical then the option is called to be at-the-money option. In the above example, if the market price is £1 = US $ 1.5000, the option contract is said to be at the money to its market place. Summary Prices Spot>Strike Spot=Strike Spot<Strike Naked Options: A naked option is where the option position stands alone, it is not used in the conjunction with cash marked position in the underlying asset, or another potion position. Calls in-the-money at-the-money out-of-the-money out-of-the-money at-the-money in-the-money Puts

Pay-off for a naked long call: A long call, i.e. the purchaser of a call (option), is an option to buy the underlying asset at the strike price. This is a strategy to take advantage of any increase in the price of the underlying asset. Example: Current spot price of the underlying asset : 100 Strike price : 100 Premium paid by the buyer of the call : 5 (Scenario-1) If the spot price at maturity is below the strike price, the option will not be exercised (since buying in the spot is more advantageous). Buyer will lose the premium paid.

(Scenario-2) If the spot price is equal to strike price (on maturity), there is no reason to exercise the option. Buyer loses the premium paid. (Scenario-3) If the spot price is higher than the strike price at the time of maturity, the buyer stands to gain in exercising the option. The buyer can buy the

underlying asset at strike price and sell the same at current market price thereby make profit. However, it may be noted that if on maturity the spot price is less than the INR 43.52 (inclusive of the premium) the buyer will stand to loose. CURRENCY OPTIONS A currency option is a contract that gives the holder the right (but not the obligation) to buy or sell a fixed amount of a currency at a given rate on or before a certain date. The agreed exchange rate is known as the strike rate or exercise rate. An option is usually purchased for an up front payment known as a premium. The option then gives the company the flexibility to buy or sell at the rate agreed in the contract, or to buy or sell at market rates if they are more favorable, i.e. not to exercise the option.

How are Currency Options are different from Forward Contracts?  A Forward Contract is a legal commitment to buy or sell a fixed amount of a currency at a fixed rate on a given future date.  A Currency Option, on the other hand, offers protection against unfavorable changes in exchange raters without sacrificing the chance of benefiting from more favorable rates. Types of Options :  A Call Option is an option to buy a fixed amount of currency.

 A Put Option is an option to sell a fixed amount of currency.  Both types of options are available in two styles : 1. The American style option is an option that can be exercised at any time before its expiry date. 2. The European style option is an option that can only be exercised at the specific expiry date of the option.

Option premiums : By buying an option, a company acquires greater flexibility and at the same time receives protection against unfavorable changes in exchange rates. The protection is paid for in the form of a premium. Example: A company has a requirement to buy USD 1000000 in one months time. Market parameters: Current Spot Rate is 1,600 one month forward rate is 1.6000 Solutions available:

 Do nothing and buy at the rate on offer in one months time. The company will gain if the dollar weakens (say 1.6200) but will lose if it strengthens (say 1.5800).  Enter into a forward contract and buy at a rate of 1.6000 for exercise in one month’s time. In company wil gain if the dollar strengthens, but will lose if it weakens.  But a call option with a strike rate of 1.6000 for exercise in one month’s time. In this case the company can buy in one months time at whichever rate is more attractive. It is protected if the dollar strengthens and still has the chance to benefit if it weakens. How does the option work? The company buys the option to buy USD 1000000 at a rate of 1.6000 on a date one month in the future (European Style). In this example, let’s assume that the option premium quoted is 0.98 % of the USD amount (in this case USD 1000000). This cost amounts to USD 9800 or IEP 6125. Outcomes:  If, in one months time, the exchange rate is 1.5000, the cost of buying USD 1000000 is IEP 666,667. However, the company can exercise its Call Option and buy USD 1000000 at 1.6000. So, the company will only have to pay IEP 625000 to buy the USD 1000000 and saves IEP 41667 over the cost of buying dollars at the prevailing rate. Taking the cost of the potion premium into account, the overall net saving for the company is IEP 35542.

 On the other hand, if the exchange rate in one month time is 1.7000. The company can choose not to exercise the Call Option and can buy USD 1000000 at the prevailing rate of 1.7000. The company pays IEP 588235 for USD 1000000 and saves IEP 36765 over the cost of forward cover at 1.6000. The company has a net saving of IEP 30640 after taking the cost of the option premium into account. In a world of changing and unpredictable exchange rates, the payment of a premium can be justified by the flexibility that options provide.

MAKING THE MOST OF OPTIONS
Options are particularly flexible: The buyer can choose any strike rate and any end date. The management of an option position can be made even more flexible with the following techniques : Selling back an option The bank will at any time quote a price at which it is prepared to buy back an option it has sold. The valued of the option can be paid directly to the holder or can be incorporated in the rate on any new spot or forward deals done at the time. Extending or shortening an option The expiry date on an option can be changed, usually with payment of premium, either by the company to the bank (for an extension) or by the

bank to the company (for shortening). A payment of premium can be avoided by adjusting the strike rate when the expiry date is altered.

Changing other features of an option In principle, any feature of an option may be changed at any tiem (strike rate, option amount), with a resulting payment of premium in one direction or the other. Uses of Options  On account of market volatility, if one is not very sure of the rates, option contract is useful to limit losses and gives access to unlimited profit potential.  In calm markets, writing of options is a profitable business with relatively low risk.  Options contracts are ideal when tendering for a business contract where the outcome is uncertain.  Options are useful in carrying out ongoing transactions where exposures are uncertain in terms of timings amounts etc.  Option provides the best tool to hedge balance sheet translation exposure.  Options are useful for hedging foreign currency loan exposures.

OPTIONS- Indian Scene In the past, Indian market other than currency market has experienced derivative instruments in the form of futures, etc. The process of globalisation and integration of Indian Financial sector with the global economy has opened up vast potential of the world currency markets in the business, expecially the matured, highly liquid and competitive markets of currency options. The successful management of stability of rupee exchange rate against the US dollar dampened the sentiments of volatility of $/rupee rate. Stability of exchange rate stimulates growth of international trade in good/services, investment flows etc. The volatility and vulnerability of rupee against the currencies other than the US dollar is beyond management in terms of exchange rate stability of rupee. Considering this aspect and also the maturity of the world currency options market, the RBI introduced the cross currency options with effect from January 1994 in terms of its AD.

The main features are:  At present Indian residents can buy cross currency options only to hedge their foreign exchange exposures in non-US dollar currencies.  Corporate can buy but cannot write options.

Due to certain structural deficiencies of the Financial markets in India; the RBI has not permitted rupee-based currency options. Options are

allowed to be bought by clients only to cover their genuine exposures. Banks selling currency options have to hedge themselves immediately on back-to-back basis. The managing committee of FEDAI adopted, with certain modifications, “International Currency Options Master”(ICOM) agreement of British Bankers Association, London for cross currency options market in India. The cross currency options market is still in an infancy stage in India and the initial euphoria over cross currency subsided on account of the following factors.  The RBI introduced cross currency options in non US dollar currencies for covering genuine exposures of the corporate. Nearly 60 to 70% of the corporate exposures are denominated in the US dollar. As a result major of the corporate exposures did not require currency options as a hedging tool.  Reluctance of the corporates to part with the front-end fee as the price for purchase of an option contract.  The premium or price of the currency option contract is higher than the expectation of the corporates about the volatility of currency movements.  Rigidities attached to the cross currency option contract deals.  Absence of long term rupee yield curve, structural deficiencies of the financial market.  The most important problem is the absence of rupee based currency options. The above factors have certainly shunted the growth of cross currency options as a first derivative product on the Indian Foreign Exchange market.

Earlier Indian corporate clients had only two options to manage foreign exchange risk.

 To do nothing till the maturity of the transactions of  To book a forward contract and settle the transaction at contracted date of maturity of the contract. However, today corporate have additional tool at their disposal in the form of cross currency option for managing their currency exposures. Introduction of cross currency options is a certain raiser and its subsequent development application in the currency market will bring in onslaught of complex derivative products for both the corporates as well as the bankers. Example: Suppose French company expects to pay against it imports, USD 10,000,000 in six months time. They expect US $ to fall but do not want to take the chance of being wrong. Current market rates Spot USD/FRF 6 months USD/FRF 6.9150 6.9450

A 6 month “at the money” USD call/FRF put option contract costs 1 % The strike price would therefore be 6.9450

Option Premium is 10,000,000 * 1 % = FRF 691,500 The choices that the company has are :  Do nothing (aggressive).  Buy USD/sell FRF Forward (defensive) @ 6.9450  Hedge is means of the option (selective) USD Put/CHF call costs 1 % In six months time Case I: Spot USD/FRF = 7.0550  Choice 1 Where the company did nothing tthey buy USD from the market and pay USD 10,000,000 * 7.0550 = FRF 70,550,000.  Choice 2 Where the company bought forward they pay 10,000,000 * 6.9450 = FRF 69,450,000.  Choice 3 Where the company hedged the option they exercise the option to buy USD and pay FRF 69,450,000 plus Option Premium FRF 691,500. Case II: Spot USD/FRF = 6.9450

 Choice 1 Where the company did nothing they buy USD from the market and pay 10,000,000 * 6.9450 = FRF 69,450,000.  Choice 2 Where the company bought forward USD they pay 10,000,000 * 6.9450 = FRF 69,45,000.  Choice 3 Where the company hedge with option, whether the exercise the option or not they pay FRF 69,450,000 + the option premium = FRF 70,141,500. Case III: Spot USD/FRF = 6.8500  Choice 1 Where the company bought forward USD from the market and pay 10,000,000 * 6.8500 = FRF 68,500,000.  Choice 2 Where the company bought forward USD they pay 10,000,000 * 6.9450 = FRF 69,45,000.

 Choice 3

Where the company hedge with option, they don’t exercise the option but buy USD from the market and pay FRF 68,500,00 + the option premium = FRF 69,191,500. Choice Case 1 Case 2 Case 3 USD/FRF 6.8500 68,500,000 69,450,000 69,191,500 & 2 are Choice 1 is best

USD/FRF7.0550 USD/FRF 6.9450 1. Nothing 70,550,000 2. Forward 69,450,000 3. Option 70,141,500 Choice 2 is best 69,450,000 64,450,000 70,141,000 Choices 1 best

Thus the general rule for hedging exposures with options is that with hindsigtht one can deduce that there was always a better strategy. The question to be asked is what the risk is and does the option premium justify it ? Beside, always look at an option as an insurance policy, it never qualifies as a good investment but always provides protection against the unknown. 3. SWAPS WHY DID SWAPS EMERGE? In the late 1970’s, the first currency swap was engineered to circumvent the currency control imposed in the UK. A tax was levied on overseas investments to discourage capital outflows. Therefore, a British company could not transfer funds overseas in order to expand its foreign operations without paying sizeable penalty. Moreover, this British company had to take an additional currency risks arising from servicing a sterling debt with foreign currency cash flows. To overcome such a

predicament, back-to-back loans were used to exchange debts in different currencies. For example, a British company wanting to raise capital in the Frace would raise the capital in the UK and exchange its obligations with a French company, which was in a reciprocal position. Though this type of arrangement was providing relief from existing protections, one could imagine, the task of locating companies with matching needs was quite difficult in as much as the cost of such transactions was high. In addition, back-to-back loans required drafting multiple loan agreements to strate respective loan obligations with clarity. However this type of arrangement leads to development of more sophisticated swap market of today. WHAT ARE SWAPS? A contract between two parties, referred to as counter parties, to exchange two streams of payments for agreed period of time. The payments, commonly called legs or sides, are calculated based on the underlying notional using applicable rates. Swaps contracts also include other provisional specified by the counter parties. Swaps are not debt instrument to raise capital, but a tool used for financial management. Swaps are arranged in many different currencies and different periods of time. US $ swaps are most common followed by Japanese yen, sterling and Deutsche marks. The length of past swaps transacted has ranged from 2 to 25 years. PRESENT SCENARIO IN THE INDIAN MARKET  Genesis of the Interest Rate Swaps in India

Interest rates in India have been RBI determined for decades now. In the past five years, we have seen this situation changing. Gradually, India is moving towards a market determined interest rate regime. RBI is gradually freeing interest rates, and this has forced banks to manage risks on their own. Moreover, the Indian companies were used to the earlier easy go approach and surety in interest rates that they can borrow on. But now, corporate have a plethora of rates at which they can borrow. They have the option of loans linked to fixed or floating rates. Thus, Indian companies have to be se efficient with regards to management fo financial uncertainities, like s are elsewhere in the world. With all this deregulation and integration with global practices, there was a felt needs for Instruments to hedge against various risks. Derivatives for the money market were the next logical step in the process. This is exactly what RBI has done. The RBI Governor’s Statement on ‘Mid Term Review of Monetary and Credit Policy for 1998-99 announced on October 30, 1998, indicated that to further deepening the money market and to enable banks, primary dealers (PDs) and all India financial instituti9ons (FIs) to hedge interest risks, the RBI had decided to create an environment that would favor the introduction of Interest Rate Swaps. Accordingly, on July 7, 1999 RBI issued final guidelines to introduce IRS and Forward Rate Agreements (FRAs). The players are allowed to practice IRS/FRAs as product for their own balance sheet management and for market making purposes. The RBI has been criticized for being hasty in introducing such interest rate derivatives. It was said that our debt market is not mature enough to incorporate and deal with such products. Though the Indian debt market has not been properly developed, blaming the RBI move does

not seem to be proper because there products will have to be introduced sooner or later and the present time appears to be as good a time as any other. Moreover, this move may also help in quickening the development of a mature debt and money market. The legal framework: RBI Guidelines (summary) A brief summary of RBI guidelines regarding IRS issued on July 7, 1999 follows :  Interest rate swap refers to a financial contract between two parties exchanging a stream of interest payments for a notional principal amount on multiple occasions during a specified period.  Forward rate agreement (FRA) is being defined as the same on settlement date for a specified period from start date to maturity date. The players: Scheduled commercial banks excluding regional rural banks, primary dealers (PDs) and all India financial institutions have been allowed to undertake IRS as a product of their own asset liability management and market-making purposes. Types: Banks/PDs/FIs undertake different types of plain vanilla FRAs/IRS for interest rate risks arising on account of landings or borrowings made at fixed or variable interest rates. However, swaps having explicit/implicit option features like caps, floors or collars are not permitted.

Benchmark Rate: The players can use any domestic money or debt market rates as reference rate for entering into FRA/IRS, provided methodology of computing the rate is objective, transparent and mutually acceptable to counter parties. The reason stated for the same is that the benchmark rate is expected to evolve on its own in the market. Size of the notional principal amount : There will be no limit on the maximum or minimum size of the notional principal amount of FRA/IRS or the tenor of the IRS/FRAs. Regarding the exposure limits the banks; FIs and PDs have to arrive at the credit equivalent amount for the purpose of reckoning exposure to counter party. Exposure: The exposure should be within the sublimits and the participants concerned should fix this for the FRAs/IRS to corporate/FIs, banks/PDs. In case of the banks and the FIs, the credit exposure should be within the single/group borrower limits as prescribed by the RBI.  Facilitators The problem of locating potential counter parties was solved through dealers and brokers. A swap dealer takes on one side of the transaction as counter party. Dealers work for investment, commercial or merchant

banks. “By positioning the Swap”, dealers earn bid-ask spread for the service. In other words, the swap dealer earns the difference between the amount received from a party and the amount paid to the other party. In an ideal situation, the dealer would offset his risks by matching one step with another to streamline his payments. If the dealer were a counter party paying fixed rate payments and receiving floating rate payments, he would prefer to be a counter party receiving fixed payments and paying floating rate payments in another swap. A perfectly netted position as just described is not necessary. Dealers have the flexibility to cover their exposure by matching multiple parties and by using other tools such as fitires to cover an exposed position until the book is complete.

 Swap Market Participations Since swaps are privately negotiated products, there is no restriction on who can use the market : however, parties with low credit quality have difficulty entering the market. This is due to fact that they cannot be matched with counter parties who are willing to take on their risks. In the U.S. many parties require their counter parties to have minimum assets of $ 10 million. This requirement has become a standardized representation of “ eligible swap participants “. The following list includes a Sample of Swaps Market Participants : 1. Multinational Companies. Shell, IBM, Ronda, Unilever, Procter & Gamble, Pepsi Co.

2. Banks Banks participate in the swap market either as an intermediary for two or more parties or as counter party for their own financial management. 3. Sovereign and public sector institutions Japan, Republic of Italy, Electricity de France, Sallie Mae (U.S. Student Loan Marketing Association). 4. Super nationals World Bank, European Investment Bank, Asian Development Bank. 5. Money Managers Insurance companies, Pension funds.  Secondary Factors in the Development of the Swap Market As international barriers to financial markets began to disappear, swap dealers were able to switch between different indexes and different markets. By arbitraging capital and credit markets, they were able to borrow at the best index available and then swap to the desired index.

Heavy borrowing by the US government and government agencies in the ‘80s played a major role in the development of the swap market. Borrowing at the floating rates and swapping to the fixed rates met the

needs of the corporations and in effect added to the depth and the liquidity of the swap market. Taking a view on the future direction of the interest rates, swaps can be proved to very attractive instruments, and under a variety of yield curve conditions, they are among the cheapest to transact. Speculative trading of the swaps added enormously to the depth and liquidity of the market.  Foreign Exchange Swap Swaps are derivatives that involve a private agreement between two parties to exchange cash flows in the future according to a prearranged formula. The underlying instruments are liabilities or assets with interest expenses or incomes. Swaps can be broadly classified into two types – Interest Rate Swaps and Currency Swaps. The first recorded swaps were negotiated in 1981. Since then, the markets have grown very rapidly. A basic foreign exchange swap is the simultaneous purchase and sale of one currency for another, where the two contracts have different dates (different positions of same or different amount on different dates).  Cash Management Swap It is used to realize efficient cash management or to adjust the maturity dates of existing forward contracts. Handling Surplus and Deficit Cash Positions The international scope of business conducted by financial and nonfinancial organization will often require the management of cash flows in

more than one currency. From time to time, an entity will find itself with surplus cash balance in one currency and deficit balances in another currency.

 Swapping Forward Contracts Forward at Historical Rates. Corporations often face considerable uncertainty in timing and /of amount when forecasting currency cash flows. Forward contracts that were dealt to hedge such flows may mature on a date that does not match the actual cash flow. In such cases, the maturity of the original forward contract crates cash flows for which there is no immediate offset. Once again, the cash manager can borrow to fund the deficit, invest the surplus, or execute a cash management swap. Another method to deal with this type of situation is to swap contracts at historical rates. The new forward contract consists of the maturing forward rate adjusted by the current points and a working capital interest factor. Historical rate rollovers have the same basic economic as market rate saps. The also eliminate the need for any cash settlements on the original maturity date and avoid the accounting problems frequently associated with the FX gain/loss account. On small forward contractrs, the actual dollar amount of the net settlement ma be small, and cost of settling may be excessive given the amount involved. In other cases, an entity may not have the cash to settle on the swap but still want the swap done.

As a general comment, usage of historical rate swaps varies from market to market, but this type of swap is not a heavily traded transaction. One of the major reasons is its susceptibility to abuse. There are basically two types of swap transactions :  Interest Rate Swap  Currency Swap 1. INTEREST RATE SWAPS The most common type of interest rate swaps are “plain vanilla” IRS. Here, one party A, agrees to pay to the other party B, cash flows equal to interest at a predetermined fixed rate on a notional principal for a number ofyears. Simultaneously, A agrees to pay party B cash flows equal to interest at a floating rate on the same notional principal for the same period of time. The currencies of the two sets of interest cash flows are the same. Moreover, only the difference in the interest payments is paid/received; the principal is used only to calculate the interest amounts and is never exchanged. It is an arrangement whereby one party exchanges one set of interest payment for another e.g. fixed or floating. An exchange between two parties of interest obligations (payment of interest) in the same currency on an agreed amount of notional principal for an agreed period of time. Example :

Two counter parties are involved in a swap agreement, corporate A and corporate B and a dealer arranges the swap (taking a spread). Amount to be borrowed : USD 100 Mn. For 15 years. Following are the rates at which A and B can raise funds : Fixed Corporate A Corporate B Floating 5% 7% 6M LIBOR + 50bp 6M LIBOR + 100bp

It can be observed that Corporate A has advantage in borrowing in both fixed and floating market. (Fixed market 2 % and Floating market 50bp). However, by swapping interest rate obligation both A and B can borrow at lower rates. Corporate A borrows fixed @ 5 % Corporate B borrows floating @ 6 month LIBOR + 100bp. By entering into a swap agreement : A will become floating ratepayer; and B will become fixed rate player. Cash flow under the swap agreement;

Corporate A PAY 6 M LIBOR* 5%& 5% ----RECEIVE

Net cost: 6 M LIBOR (Pay 5 % cancels Receive 5 %) Corporate B PAY 5.5 %* 6 M LIBOR + 100bp & Net Cost : 6.5 % PAY/RECEIVE TO/FROM DEALER & PAY TO THE LENDER IN CASH MARKET NOTE: 1. Corporate have to borrow in cash market and meet their obligations. 2. It is assumed that the dealer takes a spread of 50bp.  Corporate A achieves floating rate at 6 M LIBOR better by 50bp than without swap.  Corporate B achieves fixed rate at 6.5 % better by 50bp than without swap. RECEIVE 6 M LIBOR * -----

 Dealer makes 50bp. Types of IRS We have discussed the plain vanilla swaps till now. These swaps can be subdivided into swaps made directly between two parties or with an exchange. Moreover, they can be classified on the basis of the floating reference rate used, which may be LIBOR, CP rate, T-Bill rate, etc. Apart from “plain vanilla” IRS discussed above, there are several other types of swaps.

Basis Swaps: Where both the legs are floating interest rates. Amortizing Swaps: Where the principal reduces in a predetermined way to correspond to the amortization schedule on a loan. Step-up Swaps: Where principal increases in a predetermined way Deferred/Forward Swaps: Where parties do not begin to exchange interest payments until some future date.

Combinations with currency Swaps: where fixed rate in one currency is exchanged with floating rate in another currency. Extendable Swaps: Where one party has the option to extend the life of the swap beyond the specified period. Put table Swaps: where one party has the option to terminate the swap early. Swaptions : which is options on swaps. Constant Maturity Swaps (CMSs): Where LIBOR is used as reference rate. Constant Maturity Treasury Swaps (CMTs): Where LIBOR is exchanged for a particular Treasury rate. Indexed principal Swaps: Where the principal reduces based on an index of interest rate levels. Differential Swaps:

Where a floating rate in domestic currency is exchanged for a floating rate in foreign currency, with both interest rates applied on same domestic principal. Back valued Swaps: Where past effective dates are used. Prepaid Swaps: where the fixed leg payer pays his obligations in advance, and only receives payments till maturity, zero coupon swaps are exactly opposite to prepaid swaps, where the whole payment is given at the maturity. Trends in Indian Markets Before coming to the actual trends in the market, let us look at the players. Most of the active participation is by foreign banks, followed by Indian banks, Corporates and finally, FI’s. The absence of nationalized banks from the Irs scene is noteworthy. Today, if a corporate wishes to enter an IRS deal, it will have to submit the following to its banker :  Certified copy of the firm’s Memorandum and Articles of Asssociation.  Board resolution authorizing derivative deals.  An ISDA Master Agreement.  Risk disclosure statement.  Certificate wing underlying loan exposure.

 A certificate stating that IRS is for hedging risks, not for speculation. Thus, we see that IRS today can be used by corporate only for an actual hedging exercise, and it has to have board permission. Moreover, the deal would be within the exposure limits of that firm for the bank with which it is dealing. These measures are to ensure that corporates do not undertake speculative activities, and start dealing only after they have proper risk management systems in place. On the first day of trading, more than 30 deals were recorded, worth over Rs. 600 crores in notional principal terms. Rs. 500 crores of this was accounted for by corporate deals. The rush was because the European and private banks wanted to be a part of the history, dealing on first day, rather than actual hedging. It has also been reported that some deals were circular between three players, with no real effect in any players’ position. No deal was stuck for more than a year’s tenor. Since the first day, there have been almost no deals, and the markets are cold. The reasons for this are many. At the short-term level, almost all the players expect the interest rates to go down in the next few months. This means that there are no conflicting views among players about interest rates, and so IRS deals are not very tempting. Again, there are very few floating rate loans around. These and other fundamental reasons have been discussed in the next secti9on. In spite of these, there are many underlying reasons for going for IRS. Today, the major financial intermediaries viz. Indian banks, foreign banks, financial institutions, and corporates have radically different sets of asset-liability structures. Thus for ALM alone, IRS are a good options. For example, the FI’s have much of their liabilities as bullet repayment

bonds, and the bulk of their assets by way of installment repayment loans. Thus, chances are that their liabilities portfolio is longer than their assets portfolio. Commercial banks, on the other hand, have bulk of their liability portfolio in relatively short-term maturities, and assets are at longer maturities with fixed interest rates. Thus, banks and FI’s alone can enter in a lot of mutually beneficial deals. Corporate would also like to hedge their interest rate risks, and convert their fixed rate loans to floating rates, now that the options are available. However, their needs would be medium term in nature (2 to 8 years), and as yet there are no takers for this long maturities.

The market is only about 2 months old now, and is yet to evolve. The likely problem in its evolution and the future is discussed in the following sections. FUTURE OUTLOOK FOR IRS IN INDIA As India shifts from RBI controlled to market driven interest rate regime, volatility in the interest rate is bound to increase. This implies greater use of risk hedging mechanism like IRS. As the obstacles discussed in Section 5 are tackled, we shall see the evolution of the money market derivative markets. The speed of this evolution depends on how quickly the fundamental problems are addressed and the market revives. The major concern, of course, will be the emergence of a floating rate loan market, as at least one leg of the IRS has necessarily to be a floating rate. This is the single major reason why thee are no only many IRS deals, but also even no possibilities of deals ill the current scenario for corporates.

Then, we have seen that the stage is set for the financial institutions, commercial banks and corporates to enter into swaps as soon as they have risk management systems in place and the market matures. In the short run however, there will not be much activity as the fundamentals are unlikely to change quickly. A major concern is the govt. borrowing, which distorts the interest rates and has a major impact on the market. In a mature market, no player should be so big that it can affect the interest rates in a large way, causing rates, which do not really reflect the sentiments of the markets. On the other hand, this same point causes volatility in the markets, which is another reason to hedge against risks, where IRS comes in. We wait to see how the markets evolve. Also likely in the medium term is the emergence of various types of swaps not currently allowed in India. Like IRS/FRA’s kicked off the derivative market in India, swaptions may well kick off the options market in India, though today, it looks as though equity options will come up earlier. As awareness increases, and it dawns on the players that swaps are excellent hedging instruments, the market can only improve. Finally, we come to speculation. This is likely to stay away from Indian markets, at least for the corporates till a long time to come. REI, or the govt. does not encourage speculation in any other markets by the corporates or individuals. This is likely to continue, as The current guidelines show. Moreover, for speculation, one needs volatility and diverse views, which are not present today. As these emerge, some players may be allowed to speculate, but the limits are likely to be strict and discouraging.

Overall, IRS is here to stay, and players will soon learn to use them effectively. Though in infancy now, the markets may evolve sooner than one may expect. 2. CURRENCY SWAPS Each entity has a different access and different long term needs in the international markets. Companies receive more favorable credit ratings in their country of domicile that in the country in which they need to raise capital. Investors are likely to demand a lower return from a domestic company, which they are more familiar with than from a foreign company. In some cases a company may be unable to raise capital in a certain currency. Currency swaps are also used to lower than risk of currency exposure or to change returns on investment into another, more favorable currency. Therefore, currency swaps are used to exchange assets or capital in one currency for another for the purpose of financial management. A currency swap transaction involves an exchange of a major currency against the U.S. dollar. In order to swap two other non-U.S. currencies, a dealer may need to arrange two separate swaps. Although, any currency can be used in swaps, many counter parties are unable to exchange of the principals takes place at the commencement and the termination of the swaps in addition to exchange of interest payments on agreed intervals. The exchange of principal and interest is necessary because counter parties may need to utilize the respective exchanged currencies. The uses of currency swaps are summarized below:

 Lowering funding cost  Entering restricted capital markets  Reducing currency risk  Supply-demand imbalances in the markets As for interest rate swaps, many variants of the plain vanilla currency swaps were created to meet some of the common financial management needs.  Amortizing currency swaps The notional principals of these swaps are scheduled to decrease over the life of the swaps. Therefore, principals are exchanged accordingly.  Accreting currency swaps The notional principals of these swaps increase periodically. Principals are exchanged as scheduled.  Floating-for-floating rate currency swaps As indicated by the name, this swap involves the exchange of a floating interest rate payment schedule in one currency against another floating interest rate payment schedule in another currency. Features:  Converts a stream of payments (fixed or floating) in one currency into a stream of another currency.

 Usually involves an exchange of principal at the end of the term at an exchange rate agreed at the outset of the deal. Flow Chart:

6 month GBP Libor BANK Fixed USD

CUSTOMER

6-MONTH GBP LIBOR TO LENDER

Borrow requires USD but has to borrow GBP lender

Following are risks associated with swaps :  Interest rate risk  Exchange rate risk

 Default risk  Sovereign risk  Mismatch risk (for dealers only) In 1987, a set of principal were arranged by the central banking authorities of the Group of Ten plus Luxembourg known as the Easle Supervisor’s Committee to standardize capital requirements across nations. According to this set of requirements, called the Easle Accord, dealers of swaps and other off – balance sheet instruments are imposed risk-adjusted capital requirements. CAPS & COLLARS  Caps are like insurance  Protect against rise in rates of interest  Benefits of falling rates available Interest Rate Cap is agreement between a corporate and a bank borrower with floating rate debt. Under the terms of the agreement, the bank undertakes to bear extra cost on account of interest rate going up beyond the agreed rate during the agreed period. For this undertaking, the borrower pays premium. This instrument caps the interest payment of the borrower as any rise above the cap will be borne by the bank which sells cap to the borrower. FLOORS It is a hedging product for investors for protection against falls in interest rates. Interest Rate floors, when it protects against fall in

interest rates, investors benefit from rising interest rates. Investor has to pay premium to the seller of Interest rate floor. This instrument defines the floor i.e. the minimum rate of interest the investor would earn in case the interest rate falls beyond the agreed limit.

COLLARS Where a corporate takes a view that the interest rate will remain in range, the corporate can combine cap and floor to achieve this objective. The corporate will buy Interest Rate Collar of between 7 % and 9 % if it believes that the interest rates would move between 7 % and 9 %. Corporate looses the benefit if rate falls below 7 %. However, as against this ‘loss’ the corporate pays fewer premiums and is protected against the upside risk. (Of interest rates rising). A Swap Deal There are 2 companies XYZ Co. and ABC Co. XYZ has borrowed capital from PQR at LIBOR + 0.5 (floating) and ABC has borrowed from DEF at 9.5 % (fixed). Both the partied want to cover their positions in a way that XYZ wants to convert its floating rate to fixed and ABC wants to convert its Fixed rate to floating rate. By doing this each of them wants to minimize the cost of capital. Here this is a 3 party deal, where bank behaves, as an intermediary. The role of the bank is to make a swap in a way that all the 3 parties earn equally.

XYZ Fixed Floating 11 %

ABC 9.5 % (more credit worthy) LIBOR

LIBOR + 0.05

XYZ borrows money from bank at 9.75 % and pays at LIBOR – 0.25 % ABC borrows from Bank at floating rate LIBOR – 0.25 % and pays at 9.5 %

Solution A Swap Deal

BANK

ABC XYZ

XYZ

Pays

Receives +Libor – 0.25% -9.75%

Pays = 10.75 +9.5% =

-Libor-0.75% ABC -0.25% -9.5%

-Libor+0.25%

Bank Receives Pays Receives Pays 9.75% -Libor +0.25% 9.5% +Libor-0.25%

Earnings

=

0.25%

Thus in the whole deal all the three parties earn 0.25%

EXAMPLES FROM INDIAN MARKET SBI-HUDCO Bank of India has entered into a long-term rupee- Japanese yen swap with Housing and Urban Development Corporation (HUDCO). According to a press release, HUDCO has swapped its foreign currency liability of Yen 2089 billions for equivalent rupee resources with SBI for a tenor of 10 years. Under the arrangement, HUDCO will deposit its yen with SBI on the day of transaction and SBI in return will pay the equivalelnt rupee resources to HUDCO. According to officials, the swap will be done at the prevailing exchange rate on the day of the transaction. According to officials, HUDCO will use the rupee resources for lending to their projects in India. The overseas branches of SBI in Japan to fund their own assts will use yen. As per the swap agreement, SBI would provide the long-term hedge to HUDCO for a period of 10 years to cover the exchange risk of the foreign liability. As a result of this, the swap will neutralize both the exchange rate risk and interest rate risk of HUDCO on yen loan by converting the yen flows into risk neutral fixed interest rate rupee flows for the company. At the end of 10 years, HUDCO will take back the yen by giving the rupee equivalent to SBI. Earlier SBI had stuck a rupee-dollar swap of sizable transaction with ICICI. At present, the bank is considering similar deals with companies,

which do not have international presence to manage the fo9reign currency risk effectively, said an official. The bank is actively involved in developing the derivative market in India by facilitating the use of hedging instruments such as currency swaps. This has been possible after the permission was granted by the RBI to enable the corporate to obtain suitable hedge for their exposures arising out of their foreign currency loans.

Nalco contains loss on yen loan via swap deal NATIONAL Aluminium Co (Nalco) has hedged its Yen 20-billion loan by swapping 50 percent of the principal into US dollars when the yen was at 144.15 against the dollar. Last week the yen tumbled to 147 to a dollar. The yen bullet loan is due for redemption on September 1998. By covering its exposure, Nalco has insulated itself against possible foreign exchange fluctuations. The benefits arising from sharp depreciation of the yen against the US dollar was partially nullified by the simultaneous depreciation of rupee. “ Depreciation of one yen to Rs.1.30 to neutralizes the effect on the loan,” said Mr. C. Venkatramana, finance director, Nalco.

In other words, there will be no impact on the bottom line of Nalco as far as the fluctuation is within this range mentioned above. Further, Nalco has parked about Yen 10 billion and $ 16 million in the exchange earners foreign currency (EEFC) account abroad. The EEFC corpus would more than mitigate the forex risk and its impact on the loan. 3. FUTURES In a futures contract there is an agreement to buy or sell a specified quantity of financial instrument in a designated Future month at a price agreed upon by the buyer and seller. A Future contract is evolved out of a forward contract and posses many of the same characteristics. In essence, they are like liquid forward contracts. Unlike forward contracts however, futures contracts trade on organized exchanges called futures markets. The characteristics of a future contract are  Standardization The future contracts are standardized in terms of quantity and quality and future delivery date.

 Margining

The other characteristics of a futures contract is the margining process. The margin differs from exchange to exchange and may change as the exchange’s perception of risk changes. This is known as the initial margin. In addition to this there is also daily variation margin and this process is known as marking to market.  Participants The majority of users are large corporations and financial institutions either as traders or hedgers.  Futures are exchange traded 1. In futures market there is availability of clearing house for settlement of transactions. CURRENCY FUTURES Currency futures markets were developed in response to the shift from fixed to flexible exchange rates in 1971. They became particularly popular after rates were allowed to float free in 1973, because of the resulting increased volatility in exchange rates. A currency future is the price of a particular currency for settlement in a specified future date. A currency future contract is an agreement to buy or sell, on the future exchange, a standard quantity of foreign currency at a future date at the agreed price. The counterpart to futures contracts is the future exchange, which ensures that all contracts will honored. This effectively eliminates the credit risk to a very large extent.

Currency futures are traded on futures exchanges and the most popular exchange are the ones where the contracts are fungible or transferable freely. The Singapore International Monetary Exchange (SIMEX) and the International Monetary Market, Chicago (IMM) are the most popular futures exchanges. There are smaller futures exchanges in London, Sydney, Tokyo, Frankfurt, Paris, Brussels, Zurich, Milan, New York and Philadelphia.

Pricing of Futures Contract Futures Price = Spot Price + Cost of Carrying (Interest) Cost of carrying is the sum of all costs incurred to carry till the maturity of the futures contract less any revenue, which may result in this period. In India there is no futures market available for the Indian Corporates to hedge their currency risks through futures. The advantages of Future Contract  Low Credit Risk : In case of futures the credit risk is low as the clearing house is the counter party to every futures.  Gearing : Only small margin money is required to hedge large amounts. The disadvantages of Future Contract

 Basic Risk : As futures contract are standardized they do not provide a perfect hedge.  Margining Process : The administration is difficult. It is observed that a futures contract is a type of forward contract, but there are several characteristics that distinguish from forward contracts.  Standardized Vs. Customized Contract : Forward contract is customized while the future is standardized.  Counter Party Risk : In case of futures contract, once the trade is agreed upon the exchange becomes the counter party. Thus reducing the risk to almost nil. In case of forward contract, parties take the credit risk to each other.  Liquidity : Futures contract are much more liquid and their price is much more transparent as compared to forwards.  Squaring Off: A forward contract can be reversed only with the same counter party with whom it was entered into. A futures contract can be reversed with any member of the exchange. CONTRIBUTION OF DERIVATIVES IN THE GROWTH OF FOREX MARKETS.

The tremendous growth of the financial derivatives market and reports of major losses associated with derivative products have resulted in a great deal of confusion about these complex instruments. Are derivatives a cancerous growth that is slowly but surely destroying global financial markets ? Are people who use derivative products irresponsible because they use financial derivatives as part of their overall risk management strategy ? Thos who oppose financial derivatives fear a financial disaster of tremendous proportions a disaster that could paralyze the world’s financial markets and force governments to intervene to restore stability and prevent massive economic collapse, all at taxpayers’ expense. Critics believe that derivatives create risks that are uncontrollable and not well understood. People have certain believes about derivatives which hampers the growth of the derivatives market. They are :  Derivatives are new, complex, high-tech financial products.  Derivatives are purely speculative, highly leveraged instruments.  The enormous size of the financial derivatives market dwarfs Bank Capital, Thereby Making Derivatives Trading an Unsafe and Unsound Banking Practice.  Only large multinational corporations and large banks have a purpose for using derivatives.  Financial derivatives are simply the latest risk management fad.  Derivatives take money out of productive processes and never put anything back  Only risk-seeking organizations should use derivatives

 The risks associated with financial derivatives are new and unknown  Derivatives ink market participants more tightly together, thereby increasing systematic risks. This is what some people believe, but it’s not the case. Actually the financial derivatives have changed the face of finance by creating new ways to understand, measure, and manage financial risks. Ultimately, derivatives offer organizations the opportunity to break financial risks into smaller components and then to buy and sell those components to best meet specific risk-management objectives. Moreover, under a market-oriented philosophy, derivatives allow for the free trading of individual risk components, thereby improving market efficiency. Using financial derivatives should be considered a part of any business’s risk-management strategy to ensure that value-enhancing investment opportunities can be pursued. Thus, financial derivatives should be considered for inclusion in any corporation’s risk-control arsenal. Derivatives allow for the efficient transfer of financial risks and can help to ensure that value-enhancing opportunities will not be ignored. Used properly, derivatives can reduce risks and increase returns. Derivatives also have a dark side. It is important that derivatives players fully understand the complexity of financial derivatives contracts and the accompanying risks. Users should be certain that the proper safeguards are built into trading practices and that appropriate incentives are in place so that corporate traders do not take unnecessary risks.

The

use

of

financial

derivatives

should

be

integrated

into

an

organization’s overall risk-management strategy and be in harmony with its broader corporate philosophy and objectives. There is no need to fear financial derivatives when they are used properly and with the firm’s corporate goals as guides.

RISK MANAGEMENT

WHAT IS THE NEED FOR ORWARD EXCHANGE CONTRACT?

The risk on account of exchange rate fluctuations, in international trade transactions increases if the time period needed for completion of transaction is longer. It is not uncommon in international trade, on account of logistics, the time frame cannot be foretold with clock precision. Exporters and importers alike, cannot be precise as to the time when the shipment will be made as sometimes space on the ship is not available, while at the other, there are delays on account of congestion of port etc. In international trade there is considerable time lag between entering into a sales/purchase contract, shipment of goods, and payment. In the meantime, if exchange rate moves against the party who has to exchange his home currency into foreign currency, he may end up in loss. Consequently, buyers and sellers want to protect them against exchange rate risk. One of the methods by which they can protect themselves is entering into a foreign exchange forward contract. RISK MANAGEMENT FROM EXPORTER’S POINT OF VIEW If on the 1st January 2000 exporter signs an export contract. He expects to get the dollar remittance during the June. Now let’s assume that on first January exchange rate between dollar and rupee is 48.7500 and due to the adverse fluctuation of exchange rate the actual rate in June is 48.500 so we can infer from the above that the export may loose 24 paise per dollar. As per instrument available in India exporter may enter a forward exchange contract with a bank. While entering the contract with bank, bank will give him a forward rate for June adding the premium to the spot rate of first January. Let suppose it is 48.8400 so exporter can earn 9 paise my exchange rate between dollar and rupee is 48.7500 and due to the adverse fluctuation of exchange rate the actual

rate in June is 8.5000 so we can infer from the above that the export may loose 24 paise per dollar. As per instrument available in India exporter may either a forward exchange contract with a bank. While entering the contract with bank, bank will give him a forward rate for June adding the premium to the spot rate of first January. Let suppose it is 48.8400 so exporter can earn 9 paise may cancel and rebook the contract as many as times they want.

IMPORTER’S POINT OF VIEW Let suppose on first January an importer signs a deal with foreign party. He expects to pay the bill in March on first January the exchange rate is 457500 and the importer expects that the dollar will depreciate in the month of March. So the importer will enter into the agreement with bank for the forward exchange contract. The bank will give him the forward rate. If the rate is lower than the today’s rate then the importer will enter into the contract with bank and the rate is high then he will not enter into the contract. In India importers cannot cancel the contract. They can cancel the contract at once and roll over for the future date. This way importers and exporters can minimize the risk due to the adverse foreign exchange rate movement.

RISK MANAGEMENT PROCESS
In a foreign exchange market, there exist price risk or market risk. Fluctuation in price of currencies due to several factors to which

business is exposed. Which can lead to unforeseen losses or windfall profit. The risk management process consists of the following elements I. Risk appreciation & identification Risk appreciation is the realization that a risk exists. It is accepted that exchange rates change and in a volatile way. Risk identification is however, not so simple .for example, a business which imports raw materials and sale finished goods in the domestic market. Certainly, it has currency exposures if the rupee falls, the cost of raw materials would go up and so will the price of finished goods which makes it difficult for the business to be competitive. Thus risk identification is required.

II. Risk measurement One of the broad measure in the risk measurement is the net open position (i.e. receipts minus payment ) in each currency. For

working out the net position, anticipated imports/exports. As indeed economic exposure can be taken into account. This is a speculative

exposure and should be limited according to the management attitude to risk,the vulnerability of the business to adverse movement, ets. III. Risk control Risk control is ensuring that only affordable risk are taken and ensuring that the risk management parameters laid down are followed. Actual reports needs to be compared with the prescribed limits.

Types of risk in foreign exchange 1. market risk or price risk the risk arising out of the movement in rates of foreign exchange currencies is the market risk or pricing risk. This risk arise out of the open currency position which is unchanged. Given the magnitude of exchange rate fluctuation the possibilities of substantial losses highly exists. 2. credit risk the credit risk arise when counter party, whether a customer or a bank, fails to meet his obligation and the resulting open position has to be covered at the ongoing rate. If the rate has moved against, a loss can result and vise versa. 3. Operations risk operations risk can arise because of failure of computer systems. A loss can also occure due to human error, fraud or lack of effective internal controls. Operative risk could also arise because most deals

are done over the telephone and there could also arise because most deals are done over the telephone and there could be misunderstanding over what was agreed in terms of rate. 4. liquidity risk the risk arises when for whatever reason market turn illiquid and positions cannot be liquidated except at a huge price concession. In volatile markets, the bid-offer spread tends to widen. Example ; usd ; inr market, in normal conditions, the inter bank bid-offer spread is 0.5 to 1 paise. But, when there is volatility or illiquidity due to demand-supply imbalance, the spread often widens to 5 paise or more. 5. settlement risk the risk is of the counter party failure during settlement, because of the time difference in the markets, in which cash flows in the currencies have to be paid and received. This risk has made many banks impose a settlement limit on counter parties for aggregate settlements on any value date.

TYPES OF EXPOSURES IN FOREIGN EXCHANGE MARKET There are 3 types of exposures existing in a foreign exchange market. 1. transaction exposure transaction exposures are the most common. Suppose that a company is exporting in euro and, while costing the transaction, materializes, i.e.the export is effected and the

euros sold for rupees, the exchange rate has moved to rs. 40 per euro. In this case, the profitability of the export transaction can be completely wiped out by the movement in the exchange rate. This is termed as the transaction exposure which arises whenever a business has forein currency denominated receipts or payments. 2. translation exposure translation exposure arise from the need to translate foreign currency assets or liabilities into the home currency for the purpose of finalizing the accounts for any given period. A typical example of a translation exposure is the treatment of foreign currency loans. Consider that a company has taken a medium term dollar loan to finance the import of capital goods worth $ 1mn. When the import materialized, the exchange rate was rs. 40 per dollar. The imported fixed asset was, therefore, capitalized in the books of company at rs. 400 lacs, for finalizing its accounts for the year in which asset was purchased. However, at the time of finalization of accounts, exchange rate has moved to rs, 45 per dollar, involving translation loss of rs. 50 lacs, in this case, under the income tax actg, the loss cannot be written off ; it has to be capitalized by increasing the book value of fixed asset purchased by drawing upon the loan. The book value of asset thus becomes rs. 450 lacs and consequently higher depreciation will have to be provided for thus reducing the net profit. If the foreign currency loan is used for working capital. In that case the entire transaction loss would have to be debited to profit and loss a/c in the year in which it occurs. The effect of transaction and translation exposure could be positive as well if the amount is favourable. The translation exposure of coursse becomes a transaction exposure at some stage the dollar

loan has to be repaid by u8ndertaking the transation of purchasing dollars against rupees.

3. ECONOMIC EXPOSURE both transaction and translation exposures are accounting concepts whereas economic exposure is different than an accounting concept. A company could have an economic exposure to the euro ; rupee rate even if it does not have any transaction or translation I euro currency ; this will be the case when its competitors are using European imports. If the euro weakens, the company loses its competitiveness against the competitors and vice versa. Generally, all businesses have economic exposures to exchange rates. Economic exposure to an exchange rate is the risk that a change in the rate affects the company’s competitive position in the market, or costs, and hence indirectly, its bottom line. Thus, economic exposures affects the profitability over a longer time span than transaction exposure.

DETAILS OF ORGANISATIONS SURVEYED (FROM THE QUISTIONAIRRE)

Number of organizations visited 30 ASSUMED SCALE OF BUSINESS FOR 1 2 PROJECT Small scale Medium scale

AMOUNT Up to Rs. 5 crore Between Rs. 5 crore to Rs. 20 crore Above Rs. 20 crore

3

Large scale

1

SCALE OF OPERATION Small Medium Large Not disclosed Total

NO. OF ORGANISATION 9 12 8 1 30

NO. OF ORGANISATION

3% 27% 30% Small Medium Large Not disclosed 40%

2 TYPES OF ORGANISATION Organization in exports Organization in imports Organization in exports & imports Total

NO. OF ORGANISSATION 17 6 7 30

NO. OF ORGANISSATION Organization in exports Organization in imports Organization in exports & imports

23%

57% 20%

3 EXPOSURE COVERAGE DETAILS NO. OF ORGANISATION Organization covering exposure 17 Organization not covering 13 exposure Total 30

NO. OF ORGANISATION

43% 57%

Organization covering exposure Organization not covering exposure

4 FOREX RISK AWARENESS NO. OF ORGANISATION Organization aware of forex risk 21 Organization unaware of forex 9 risk Total 30

NO. OF ORGANISATION

30%

Organization aware of forex risk Organization unaware of forex risk

70%

5 FOREX MARKET WATCH Organization keeping watch over forex

NO. OF ORGANISATION 16

Rates & its implication Organization not keeping watch over 14 forex Rates & its implication Total 30

NO. OF ORGANISATION

47%

53%

Organization keeping watch over forex Rates & its implication Organization not keeping watch over forex Rates & its implication

6 BANK TRANSACTION DETAILS Organizations transacting with only one

NO. OF ORGANISATIONS 23

Bank Organizations transacting with more than 7 One bank Total 30

NO. OF ORGANISATIONS Organizations transacting with only one bank Organizations transacting with more than one banks

23%

77%

7 CC LIMITS & TRANSACTIONS Organizations doing transaction with bank Where cc limits are there Organizations doing transactions at banks Other than where cc limits are there Not applicable ( as organization does not Have cc limits ) Total

NO. OF ORGANISATIONS 23 5 2 30

Organizations NO. OF ORGANISATIONS doing transaction with bankWhere cc limits are there 7% 17% Organizations doing transaction with bank otherthan Where cc limits are there Not applicable ( as organization does not Have cc limits AWARENESS ) NO.

76%

8 RBI GUIDELINES OF ORGANISATIONS Organizations awareness about RBI 15 Guidelines in managing forex risk Organization unaware about RBI Guidelines in managing forex risk Total 15 30

NO. OF ORGANISATIONS Organizations awareness about RBI Guidelines in managing forex risk Organization unaware about RBIGuidelines in managing forex risk

50%

50%

9 PERCENTAGE OF EX-IM OF TOTAL TURN OVER 20 % 40 % 50 % & ABOVE TOTAL

NO. OF ORGANISATIONS 5 3 22 30

NO. OF ORGANISATIONS

17% 10% 20% 40% 50 % & ABOVE 73%

1 0

SUBSCRIPATION OF ADVISORY SERVICES Organization availing advisory services

NO. OF ORGANISATIONS 8

Organization services Total

not

availing

advisory 22 30

NO. OF ORGANISATIONS

27%

Organization availing advisory services Organization not availing advisory services

73%

1 1

RATE COMPARISION DETAILS Organizations different Banks Organizations not comparing rates of Different banks Total comparing rates

NO. OF ORGANISATIONS of 13

17 30

NO. OF ORGANISATIONS

43% 57%

Organizations comparing rates of different banks Organizations not comparing rates of different

ANALYSIS OF EXPORT-IMPORT ORGANISATIONS AWARNESS ABOUT FOREX RISK & MANAGEMENT PART-I ANALYSIS OF ORGANISATION NO COVERING HTEIR EXPOSURE

(COMPARING IT WITH THE TYPE OF BUSINESS & SCALE OF OPERATIONS) Out of total number of organizations surveyed, 40% plus are having open position. Out of there 40 % plus, more than 80% of organizations are into small& medium scale business. All these 40% plus organizations are into exports business. 60% of them having more than 50% of their total turnover in exports. All the organizations largely are into the exports business, a couple of them being into exports as well as imports. In spite of all organizations being into exports, (as currently rupee is appreciating since last almost one year, it is feasible for exporters to cover themselves which was not the case in the past as rupee has always depreciated), neither in the past nor at present have organizations covered themselves.

A verbal communication with the organization suggests to mention that largely due to ignorance and at times neglecting this aspect of the business, has resulted into this fact, the prime reason being they feel this amount lost due to keeping their position open forms a very small amount compared to the volume of business they are into. PART-II ANALYSIS OF ORGANISATION NOT AWARE ABOUT RISKS IN FOREX MARKET. 30% of total organizations surveyed are not aware about various risks in forex market Out of these 30%, almost 90% of the organizations are into small & medium scale business. Out of 70% organizations claiming to be aware of forex risks, only 10% are really aware about risks other than price risk (Namely : Jindal, Hitachi & Metrochem)

The above fact of most organizations aware only about price risk is known by verbal conversation & discussion with the organization. Generally, all the organizations are aware about the price risk (i.e. volatility in rates of foreign currencies) in forex market. Still there is lack of awareness amongst organizations particularly of operations risk & the implications of liquidity risk that exists in the market which makes the bid price and offer price much costlier. It is found that organizations are least interested in knowing forex related risks and deals with the issue very lightly as they are only concerned with the bottom line ( i.e. whether thery are making or losing money out of foreign exchange transactions). However, the realization of significance of understanding

the risks association with the bottom line of forex transaction is still lacking. PART-III ANALYSIS OF ORGANISATIONS NOT KEEPING WATCH OVER MOVEMENTS IN VARIOUS INTERNATIONAL CURRENCIES, REASON OF FLUCTUATUIONS & ITS IMPLICATION ON FOREX BUSINESS. Almost 50% organizations (14 organisations) neglect keeping watch over forex market movements, its reasons & implications. The prime reasons of inserting this question in the survey are :  It helps organizations to decide whether they should cover themselves or leave the exposure open.  Engage in cross currency trading by knowing which currencies should be pursued for on the basis of their rates & movements.  Deciding whether to go for foreign currency borrowing or continue borrowing in domestic currency. Almost 50% (14 organisations) of the total organization neglect keeping a watch ovber movements in various foreign currencies, factors leading towards movements in rates and its implications on the foreign exchange business. This is an additional evident support that a large number of organizations are really neglecting the foreign exchange loss that may occur of foreign exchange profit that can be made by really remaining active in the market and securing themselves.

All the above aspects surely results into substantial loss making or saving the losses and making huge profits by entering into such transactions. However, largely cross CN trading & foreign currency borrowing is fraud to be operated and implemented by organizations having large scale operations. But still, even in case of small and medium scale organizations entering into forward contract necessarily requires the market knowledge to take the decision of whether or not to cover the exposure. As the figures indicate that more than 40% of organizations are keeping their exposures open and almost 50% of organizations are neglecting to have knowledge & understanding of forex market, this supports the fact & reason why organizations are not opting to cover their exposure. Only if there is sufficient market knowledge and understanding, the organization can decide whether or not to cover their exposure. Thus, from organizations viewpoint, which are not covering their exposure, for them, it is a matter of sheer luck whether they will incur loss or make profit from their transactions.

PART-IV ANALYSIS OF ORGANISATIONS TRANSACTING WITH ONLY ONE BANK & ITS RELEVANCE WITH CASH CREDIT LIMITS 70% of total organizations surveyed transacts with only one bank and at the same bank where they have their Cash Credit (CC) limits. 70% of the organizations (21 organisations) transact with only one bank out of which (expect two which are nt having cc limits with bank) all the

organizations are carrying out their foreign exchange transactions with the same bank where they have their CC limits. This point makes it crystal clear that in few cases organizations don’t have any options to transact elsewhere due to moral or legal binding with the bank and in other cases organizations don’t want to transact with other banks as they are highly interested in maintaining support with the same banks. At times, in spite of the fact that they are being either cheated or loosing because of difference in rates, still organizations prefer to transact with the same bank where they are always dealing and loose money in the process. In all the cases where in organizations are transacting with one bank and the same bank where CC limits are there, it is found that it is the rigidity of mindset out of which organizations don’t want to come out. Although, practically, at times, it becomes difficult to move suddenly to other banks and start doing transactions and at times the organizations have to do business with the same bank where they have their CC limits but still all the time transacting with the same bank even after knowing that organization is loosing money sounds irrational. Organisations can always have the option open to them and transact with different banks as and when required. Surely, a pint needs to be mentioned here is that due to lack of awareness, existence of ignorance amongst organizations or banks, deliberate deals from organizations part and few other such reasons, whatever it is, the fact is that banks are having a wide scope of making money from this foreign exchange business and which most of them are and from organizations viewpoint many of them are loosing marginally or substantially by transacting with the same bank.

PART-V ANALYSIS OF ORGANISATIONS NOT COMPARING RATES OF DIFFERENT BANKS Out of 70% organizations transacting with the same bank where they have their CC limits, 2/3rd of them do not compare rates of different banks and 1/3rd organizations do compare rates. Out of the total organizations (21 organisations) transacting with same bank where they have their CC limits, 2/3rd of organizations (14 organisations) do not comparethe rates offered by different banks. The remaining 1/3rd of organizations that are comparing rates of different banks and still transacting with the same bank suggests that :  They know that either they are being cheated or they are loosing because of in competitive rates offered by their bank and still they are ready to loose money. This figure of 1/3rd organizations aware about rate variance of different banks supports the analysis of previous topic, which mentions that organizations at times, knowingly are ready to loose money.

 Of the 2/3rd organizations not comparing rates of different banks, majority of them still believe that there is no difference between different bank rates and in few cases if at all the difference is there it is very marginal. One thing that organizations at times don’t count is that may be the rate difference between banks may be marginal but their volume of transaction is substantial which may eventually turn out to be a large amount.

SUMMARY OF ANALYSIS

As is mentioned in the initial part of the report in ‘Idea Generation of Research” about the level of awareness & comfort ability of knowing the risk involved in foreign exchange & risk management sufficient enough amongst concern. This issue was raised during the in house training at the “ Mecklai Financial and Commercial Services Ltd. “ after having conversations with several clients which prompted this query and after its discussion with the organizations consultant and Vice President. organizations to carry out transactions without losing unnecessary and avoidable losses due to ignorance was a question of

Now, after the completion of the survey and its analysis based on fact found figures, it is convincing that the question of concern & the issue is relevant and valid. A comprehensive analysis on several aspects which has evident support in the form of ‘Schedule’ and conversation & discussions with organizations employer/employees, it is a mater of fact that still there is a lack of awareness amongst organizations especially small scale & medium scale about managing their foreign exchange risk. A lack of market knowledge & ignorance of its implications on their foreign exchange business, becomes difficult for organizations whether or not to hedge their exposure and if at all they enter into hedging (in the form of forward contracts in India) at which point of time to enter becomes a question of concern. Also the fact remains as can be interpreted from the survey report, that still organizations are rigid and conservative to deal with only one bank and not to have options which can certainly save money and also increase dealing options for themselves. To sum up the analysis there is a long way to go increasing the awareness among organizations as well as banks in managing foreign exchange risk.

FACTS FROM THE SURVEY

1. 40% of the organizations keep their exposure uncovered out of which more than 80% of them are into small and medium scale business. 2. 70% of the organizations claim to be aware about foreign exchange risk. Only 10% of these organizations are aware about risk other than price risk. 3. More than 40% of the organizations have their exposure open. Almost 50% of the organizations are not having market knowledge of rate movements in various international currencies, reason of fluctuation and its implications on foreign exchange business. Lack of market knowledge restricts taking the judicial decision of whether or not to cover the exposure. 4. 70% of the organizations surveyed carry out their foreign exchange transactions with only one bank and all of them have their CC limits at the same bank.

5. Out of 70% organizations transacting with the same bank where they have their CC limits only 1/3rd of the organizations compare rates of different banks whereas 2/3rd organizations do not compare rates of different banks.

FINDINGS 1. Major organizations are conservative in dealing with one bank, wherein partially few of them are aware that they are being cheated or their banks offer in competitive rates and partially few of them are not aware at all. 2. One of the banks with which couple of organizations included in the survey are dealing, makes it compulsory for the customers to carry out their foreign exchange transactions with them as they have their CC limits. 3. Several organizations have committed that the foreign exchange aspect of business is a neglected area by them, different reasons being lack of awareness and knowledge, at times in spite of awareness shortage of time, absence of professional employees as organizations with small operations cannot afford to hire them, willingness to loses the money as they believe it forms a small amount of business and few other reasons. However, whatsoever

the reasons may be butr the fact remains that organizations are losing money and banks are making money. 4. It is found from organizations that at times the banks with whom they deal are also confused and have to consult their head offices due to unawareness existing at the branch level. 5. It is largely found by conversating with organizations that while dealing with only one bank even if they know that there is a rate difference as compared to other banks and try t negotiate with their bank, they are being to reduce the rates and the banks hold on to their stand. This locks the option of organizations to deal with other banks as they don’t have their account over there and lose money in spite of their awareness.

RECOMMENDATIONS

1. Raise the level of awareness amongst organizations by convincing them that it is their privilege to have options in dealing with different banks and negotiating in terms of rates. 2. Insist them to have market knowledge to protect their own interest and stop making unnecessary losses. 3. Explaining & convincing the significance of professional

consultants of advisors by making them understand that foreign exchange business is not only a matter of luck & explaining the implications of lack of market knowledge. 4.

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